UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q/A
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the Quarter Ended September 30, 2003.
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 from _______ to __________
Commission file number 001-13790
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HCC Insurance Holdings, Inc.
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(Exact name of registrant as specified in its charter)
Delaware 76-0336636
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(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
13403 Northwest Freeway, Houston, Texas 77040-6094
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(Address of principal executive offices) (Zip Code)
(713) 690-7300
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(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 [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12B-2 of the Act).
Yes [X] No [ ]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock as of the latest practicable date.
On October 31, 2003, there were 63.8 million shares of common stock, $1.00 par
value issued and outstanding.
Explanatory Note
This amendment includes changes from the previous report to reflect the impact
of a restatement due to the accounting for certain fee and commission income as
described herein. Revenue and net income for the nine months ended September 30,
2003 were reduced by $17.2 million and $10.2 million, respectively, as a result
of the restatement.
1
HCC INSURANCE HOLDINGS, INC.
INDEX
PAGE NO.
--------
Part I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets
September 30, 2003 and December 31, 2002 .................................................. 3
Condensed Consolidated Statements of Earnings
For the nine months and three months ended September 30, 2003 and 2002 .................... 4
Condensed Consolidated Statements of Changes in Shareholders' Equity
For the nine months ended September 30, 2003............................................... 5
Condensed Consolidated Statements of Cash Flows
For the nine months and three months ended September 30, 2003 and 2002 .................... 6
Notes to Condensed Consolidated Financial Statements............................................ 7
Item 2. Management's Discussion and Analysis........................................................... 22
Item 3. Quantitative and Qualitative Disclosures About Market Risk..................................... 32
Item 4. Controls and Procedures........................................................................ 32
Part II. OTHER INFORMATION
Item 1. Legal Proceedings.............................................................................. 33
Item 6. Exhibits and Reports on Form 8-K............................................................... 33
Signatures....................................................................................................... 34
This report on Form 10-Q/A contains certain "forward-looking statements" within
the meaning of Section 27A of the Securities Act of 1933, and Section 21E of the
Securities Exchange Act of 1934, which are intended to be covered by the safe
harbors created by those laws. We have based these forward-looking statements on
our current expectations and projections about future events. These
forward-looking statements include information about possible or assumed future
results of our operations. All statements, other than statements of historical
facts, included or incorporated by reference in this report that address
activities, events or developments that we expect or anticipate may occur in the
future, including such things as future capital expenditures, business strategy,
competitive strengths, goals, growth of our business and operations, plans and
references to future successes may be considered forward-looking statements.
Also, when we use words such as "anticipate," "believe," "estimate," "expect,"
"intend," "plan," "probably" or similar expressions, we are making
forward-looking statements. Many risks and uncertainties may impact the matters
addressed in these forward-looking statements.
Many possible events or factors could affect our future financial results and
performance. These could cause our results or performance to differ materially
from those we express in our forward-looking statements. Although we believe
that the assumptions underlying our forward-looking statements are reasonable,
any of these assumptions, and therefore also the forward-looking statements
based on these assumptions, could themselves prove to be inaccurate. In light of
the significant uncertainties inherent in the forward-looking statements which
are included in this report, our inclusion of this information is not a
representation by us or any other person that our objectives and plans will be
achieved.
Our forward-looking statements speak only as of the date made and we will not
update these forward-looking statements unless the securities laws require us to
do so. In light of these risks, uncertainties and assumptions, any
forward-looking events discussed in this report may not occur.
2
HCC Insurance Holdings, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
(unaudited, in thousands, except per share data)
September 30, 2003 December 31, 2002
------------------ -----------------
(restated)
ASSETS
Investments:
Fixed income securities, at market
(cost: 2003 - $1,034,445; 2002 - $807,772) $ 1,069,660 $ 841,548
Marketable equity securities, at market
(cost: 2003 - $15,118; 2002 - $15,815) 15,023 15,609
Short-term investments, at cost, which approximates market 430,379 307,215
Other investments, at estimated fair value
(cost: 2003 - $2,181; 2002 - $3,264) 2,181 3,264
------------- -----------
Total investments 1,517,243 1,167,636
Cash 25,004 40,306
Restricted cash 211,530 189,396
Premium, claims and other receivables 954,599 753,527
Reinsurance recoverables 906,642 798,934
Ceded unearned premium 255,401 164,224
Ceded life and annuity benefits 77,901 78,951
Deferred policy acquisition costs 100,393 68,846
Goodwill 344,497 335,288
Other assets 217,879 107,043
------------- -----------
TOTAL ASSETS $ 4,611,089 $ 3,704,151
============= ===========
LIABILITIES
Loss and loss adjustment expense payable $ 1,406,843 $ 1,155,290
Life and annuity policy benefits 77,901 78,951
Reinsurance balances payable 251,975 166,659
Unearned premium 558,701 331,050
Deferred ceding commissions 75,815 49,963
Premium and claims payable 841,869 730,801
Notes payable 310,505 230,027
Accounts payable and accrued liabilities 91,185 78,503
------------- -----------
Total liabilities 3,614,794 2,821,244
SHAREHOLDERS' EQUITY
Common stock, $1.00 par value; 250.0 million shares authorized;
(shares issued and outstanding: 2003 - 63,805; 2002 - 62,358) 63,805 62,358
Additional paid-in capital 444,012 416,406
Retained earnings 463,491 383,378
Accumulated other comprehensive income 24,987 20,765
------------- -----------
Total shareholders' equity 996,295 882,907
------------- -----------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 4,611,089 $ 3,704,151
============= ===========
See Notes to Condensed Consolidated Financial Statements.
3
HCC Insurance Holdings, Inc. and Subsidiaries
Condensed Consolidated Statements of Earnings
(unaudited, in thousands, except per share data)
For the nine months ended For the three months ended
September 30, September 30,
2003 2002 2003 2002
---- ---- ---- ----
(restated) (restated)
REVENUE
Net earned premium $ 535,354 $ 362,399 $ 189,440 $ 136,294
Fee and commission income 119,845 103,592 45,619 33,828
Net investment income 34,868 27,781 11,997 9,797
Net realized investment gain (loss) 352 1,159 168 (10)
Other operating income 8,249 3,271 3,133 1,131
----------- ---------- ----------- -----------
Total revenue 698,668 498,202 250,357 181,040
EXPENSE
Loss and loss adjustment expense 339,065 221,246 118,953 85,163
Operating expense:
Policy acquisition costs, net 102,915 70,370 37,046 28,082
Compensation expense 64,483 49,568 21,622 16,053
Other operating expense 41,237 34,765 14,041 11,960
----------- ---------- ----------- -----------
Total operating expense 208,635 154,703 72,709 56,095
Interest expense 5,497 6,892 1,901 2,051
----------- ---------- ----------- -----------
Total expense 553,197 382,841 193,563 143,309
----------- ---------- ----------- -----------
Earnings before income tax provision 145,471 115,361 56,794 37,731
Income tax provision 52,370 41,028 20,428 13,462
----------- ---------- ----------- -----------
Net earnings $ 93,101 $ 74,333 $ 36,366 $ 24,269
=========== ========== =========== ===========
BASIC EARNINGS PER SHARE DATA:
Earnings per share $ 1.48 $ 1.20 $ 0.57 $ 0.39
=========== ========== =========== ===========
Weighted average shares outstanding 63,078 62,170 63,717 62,335
=========== ========== =========== ===========
DILUTED EARNINGS PER SHARE DATA:
Earnings per share $ 1.45 $ 1.18 $ 0.56 $ 0.39
=========== ========== =========== ===========
Weighted average shares outstanding 64,106 62,841 64,885 62,871
=========== ========== =========== ===========
Cash dividends declared, per share $ 0.205 $ 0.19 $ 0.075 $ 0.065
=========== ========== =========== ===========
See Notes to Condensed Consolidated Financial Statements.
4
HCC Insurance Holdings, Inc. and Subsidiaries
Condensed Consolidated Statements of Changes in Shareholders' Equity
For the nine months ended September 30, 2003 (restated)
(unaudited, in thousands, except per share data)
Accumulated
Additional other Total
Common paid-in Retained comprehensive shareholders'
stock capital earnings income equity
----- ------- -------- ------ ------
BALANCE AS OF DECEMBER 31, 2002 $ 62,358 $ 416,406 $ 383,378 $ 20,765 $ 882,907
Net earnings -- -- 93,101 -- 93,101
Other comprehensive income -- -- -- 4,222 4,222
-----------
Comprehensive income 97,323
1,081 shares of common stock issued for
exercise of options, including tax benefit of
$3,305 1,081 19,700 -- -- 20,781
Issuance of 52 shares of
contractually issuable common stock 52 (52) -- -- --
Issuance of 314 shares for acquisition
of subsidiaries 314 7,958 -- -- 8,272
Cash dividends declared, $0.205 per share -- -- (12,988) -- (12,988)
--------- ----------- ---------- ---------- -----------
BALANCE AS OF SEPTEMBER 30, 2003 $ 63,805 $ 444,012 $ 463,491 $ 24,987 $ 996,295
========= =========== ========== ========== ===========
See Notes to Condensed Consolidated Financial Statements.
5
HCC Insurance Holdings, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(unaudited, in thousands, except per share data)
For the nine months ended For the three months ended
September 30, September 30,
2003 2002 2003 2002
---- ---- ---- ----
(restated) (restated)
Cash flows from operating activities:
Net earnings $ 93,101 $ 74,333 $ 36,366 $ 24,269
Adjustments to reconcile net earnings to
net cash provided by operating activities:
Change in premium, claims and other
receivables (177,880) (52,440) (7,934) (14,989)
Change in reinsurance recoverables (107,708) 52,969 (43,624) 22,933
Change in ceded unearned premium (91,177) (63,893) (25,364) (24,583)
Change in loss and loss adjustment
expense payable 251,553 (46,305) 101,720 (11,141)
Change in reinsurance balances payable 85,316 58,412 21,051 19,953
Change in unearned premium 227,651 100,800 60,931 32,421
Change in premium and claims payable,
net of restricted cash 60,968 (16,865) 2,123 24,513
Depreciation and amortization expense 8,485 7,933 2,921 2,555
Other, net (24,419) 7,884 (21,572) 215
---------- ---------- ---------- ----------
Cash provided by operating activities 325,890 122,828 126,618 76,146
Cash flows from investing activities:
Sales of fixed income securities 131,884 197,466 8,703 43,302
Maturity or call of fixed income securities 112,248 32,951 43,162 13,260
Sales of equity securities 1,165 3,417 -- --
Other proceeds 16,846 -- -- --
Change in short-term investments (114,801) 55,867 (25,238) 14,365
Cost of securities acquired (520,491) (412,521) (112,616) (125,421)
Payments for purchase of subsidiaries,
net of cash received (16,680) -- (12,601) --
Purchases of property and equipment (20,260) (3,948) (17,125) (1,110)
---------- ---------- ---------- ----------
Cash used by investing activities (410,089) (126,768) (115,715) (55,604)
Cash flows from financing activities:
Issuance of notes payable, net of costs 134,845 40,000 -- --
Sale of common stock 17,476 10,038 5,507 777
Payments on notes payable (68,723) (15,409) (1,101) (2,140)
Dividends paid and other, net (14,701) (12,831) (6,564) (3,887)
---------- ---------- ---------- ----------
Cash provided (used) by financing activities 68,897 21,798 (2,158) (5,250)
---------- ---------- ---------- ----------
Net change in cash (15,302) 17,858 8,745 15,292
Cash at beginning of period 40,306 16,891 16,259 19,457
---------- ---------- ---------- ----------
CASH AT END OF PERIOD $ 25,004 $ 34,749 $ 25,004 $ 34,749
========== ========== ========== ==========
See Notes to Condensed Consolidated Financial Statements
6
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 ("we," "us" and "our")
provide specialized property and casualty and accident and health insurance
coverages, underwriting agency and intermediary services to commercial
customers and individuals. Our lines of business include group life,
accident and health; aviation; our London market account (which includes
energy, marine, property and some accident and health); diversified
financial products (which includes directors and officers liability, errors
and omissions, employment practices liability and surety); and other
specialty lines of insurance. We operate primarily in the United States,
the United Kingdom, Bermuda and Spain, although some of our operations have
a broader international scope. We market our products both directly to
customers and through a network of independent and affiliated agents and
brokers.
Basis of Presentation
The unaudited condensed consolidated financial statements have been
prepared in conformity with accounting principles generally accepted in the
United States of America and include all adjustments which are, in our
opinion, necessary for a fair presentation of the results of the interim
periods. All adjustments made to the interim periods are of a normal
recurring nature. The condensed consolidated financial statements include
the accounts of HCC Insurance Holdings, Inc. and those of our wholly-owned
subsidiaries. All significant intercompany balances and transactions have
been eliminated. The condensed consolidated financial statements for
periods reported should be read in conjunction with the annual audited
consolidated financial statements and related notes. The condensed
consolidated balance sheet as of December 31, 2002, was derived from
audited financial statements, but does not include all disclosures required
by accounting principles generally accepted in the United States of
America.
This Form 10-Q/A has amended our previously filed Form 10-Q to reflect a
restatement to change the basis upon which the fee and commission income of
our underwriting agency and intermediary subsidiaries are accounted. This
restatement relates only to business underwritten by our underwriting
agencies or placed by our intermediaries that passes through one of our
affiliated insurance companies to an unrelated reinsurance company. This
income had previously been recognized at the later of the effective date of
a policy, the date when the premium could be reasonably established or the
date when substantially all the services relating to the insurance
placement had been rendered to the client. This income is now recognized
pro rata over the term of the underlying policy. The cumulative effect of
the restatement related to prior years, $3.9 million, which is recorded in
the first quarter of 2003, is not material to prior years or 2003. The
effect of the change only became material in 2003 as a result of recent
acquisitions. The change is a timing difference which generally reverses
over a twelve month period. The restatement does not impact the overall
amount of fees and commissions ultimately earned or previously collected in
cash. Additionally, it does not change the net earnings of our reporting
segments but, rather, results solely from changes to the consolidating
entries made in the preparation of our condensed consolidated financial
statements. Likewise, it does not change cash flow from operations.
7
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(1) GENERAL INFORMATION, CONTINUED
The effect of the restatement on revenue was a reduction of $17.2 million
for the first nine months of 2003 ($3.4 million for the three months ended
September 30, 2003). This amount includes $6.5 million associated with the
cumulative effect of the restatement related to prior years. The tables
below show the effect on net earnings and earnings per share.
Earnings per share
Amount Basic Diluted
------ ----- -------
For the nine months ended September 30, 2003:
Net earnings, as previously reported $ 103,288 $ 1.64 $ 1.61
Effect of adjustment on operations for the period (6,297) (0.10) (0.10)
Cumulative adjustment (3,890) (0.06) (0.06)
----------- --------- ---------
Net earnings, as reported herein $ 93,101 $ 1.48 $ 1.45
=========== ========= =========
For the three months ended September 30, 2003:
Net earnings, as previously reported $ 38,351 $ 0.60 $ 0.59
Effect of adjustment on operations for the period (1,985) (0.03) (0.03)
----------- --------- ---------
Net earnings, as reported herein $ 36,366 $ 0.57 $ 0.56
=========== ========= =========
During the fourth quarter of 2002, we completed three acquisitions. The
results of operations of these entities are included in our condensed
consolidated financial statements beginning on the effective date of each
transaction. Thus, our condensed consolidated statements of earnings and
cash flows for the nine and three months ended September 30, 2002 do not
contain any activity generated by these three entities. We are still in the
process of completing the purchase price allocation for one of these
acquisitions as we are still gathering some of the information needed to
make the required calculations. Any subsequent net adjustment will result
in a change to recorded goodwill.
During the first quarter of 2003, we adopted prospectively Financial
Accounting Standards Board Interpretation ("FIN") No. 46 entitled
"Consolidation of Variable Interest Entities". We now consolidate an
investment in a partnership that owns an office building leased to
unaffiliated third parties, whereas previously we used the equity method of
accounting to account for this investment. The partnership is not material
to our financial position, results of operations or cash flows.
Fee and Commission Income
Our fee and commission income in our condensed consolidated statements of
earnings includes fee income from our underwriting agencies and commission
income from our intermediaries earned by underwriting on behalf of and/or
placing business with unaffiliated (re)insurers and proceeds from ceded
reinsurance (ceding commissions in excess of policy acquisition costs).
8
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(1) GENERAL INFORMATION, CONTINUED
Income Tax
For the nine months and three months ended September 30, 2003 and 2002, the
income tax provision has been calculated based on an estimated effective
tax rate for each of the fiscal years. The difference between our effective
tax rate and the Federal statutory rate is primarily the result of state
income taxes and tax exempt municipal bond interest.
Stock Options
We account for stock options granted to employees using the intrinsic value
method of APB Opinion No. 25 entitled "Accounting for Stock Issued to
Employees". All options have been granted at fixed exercise prices at the
market price of our common stock at the grant date. Because of that, no
stock-based employee compensation cost is reflected in our reported net
earnings. Options vest over a period of up to seven years and expire four
to ten years after grant date. The following table illustrates the effects
on net earnings and earnings per share if we had used the fair value method
of SFAS No. 123 entitled "Accounting for Stock-Based Compensation".
For the nine months ended For the three months ended
September 30, September 30,
2003 2002 2003 2002
---- ---- ---- ----
Reported net earnings $ 93,101 $ 74,333 $ 36,366 $ 24,269
Stock-based compensation using
fair value method, net of income tax (5,525) (3,882) (1,654) (1,599)
---------- ----------- ----------- ----------
Pro forma net earnings $ 87,576 $ 70,451 $ 34,712 $ 22,670
========== =========== =========== ==========
Reported basic earnings per share $ 1.48 $ 1.20 $ 0.57 $ 0.39
Fair value stock-based compensation (0.09) (0.07) (0.02) (0.03)
---------- ----------- ----------- ----------
Pro forma basic earnings per share $ 1.39 $ 1.13 $ 0.55 $ 0.36
========== =========== =========== ==========
Reported diluted earnings per share $ 1.45 $ 1.18 $ 0.56 $ 0.39
Fair value stock-based compensation (0.08) (0.06) (0.02) (0.03)
---------- ----------- ----------- ----------
Pro forma diluted earnings per share $ 1.37 $ 1.12 $ 0.54 $ 0.36
========== =========== =========== ==========
Reclassifications
Certain amounts in our 2002 condensed consolidated financial statements
have been reclassified to conform to the 2003 presentation. Among these
reclassifications, proceeds from ceded reinsurance (ceding commissions in
excess of acquisition costs) have been classified as fee and commission
income rather than a reduction of operating expenses. Also, compensation
and other operating expenses of our underwriting agency subsidiaries
representing acquisition costs have been classified as policy acquisition
costs to be offset by the portion of ceding commissions which represent the
reimbursement of those acquisition costs. Such reclassifications had no
effect on our net earnings, shareholders' equity or cash flows.
9
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(2) ACQUISITION
On July 1, 2003, we completed the acquisition of the CUL Group of
companies, which included Covenant Underwriters Ltd., an underwriting
agency, and Continental Underwriters Ltd., an intermediary. The companies
were acquired to diversify into a new specialty line of business. This
business combination has been recorded using the purchase method of
accounting. The results of operations of these companies have been included
in our consolidated financial statements beginning on the effective date of
the transaction. We are still in the process of completing the purchase
price allocation for this acquisition, as we are still gathering some of
the information needed to make the required calculations. The consideration
paid and the inclusion of the acquired company's financial information in
our consolidated financial statements is not material to our financial
position or results of operations.
(3) REINSURANCE
In the normal course of business our insurance companies cede a portion of
their premium to non-affiliated domestic and foreign reinsurers through
treaty and facultative reinsurance agreements. Although the ceding of
reinsurance does not discharge the primary insurer from liability to its
policyholder, our insurance companies participate in such agreements for
the purpose of limiting their loss exposure, protecting them against
catastrophic loss and diversifying their business. The following table
represents the effect of such reinsurance transactions on premium and loss
and loss adjustment expense:
Loss and Loss
Written Earned Adjustment
Premium Premium Expense
------- ------- -------
For the nine months ended September 30, 2003:
Direct business $ 1,010,186 $ 846,450 $ 505,110
Reinsurance assumed 289,581 230,988 267,609
Reinsurance ceded (633,640) (542,084) (433,654)
------------- ------------ ------------
NET AMOUNTS $ 666,127 $ 535,354 $ 339,065
============= ============ ============
For the nine months ended September 30, 2002:
Direct business $ 674,258 $ 586,386 $ 389,359
Reinsurance assumed 177,826 162,304 71,321
Reinsurance ceded (449,856) (386,291) (239,434)
------------- ------------ ------------
NET AMOUNTS $ 402,228 $ 362,399 $ 221,246
============= ============ ============
10
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(3) REINSURANCE, CONTINUED
Loss and Loss
Written Earned Adjustment
Premium Premium Expense
------- ------- -------
For the three months ended September 30, 2003:
Direct business $ 355,576 $ 308,195 $ 169,198
Reinsurance assumed 87,464 77,155 98,949
Reinsurance ceded (220,505) (195,910) (149,194)
---------- ---------- -----------
NET AMOUNTS $ 222,535 $ 189,440 $ 118,953
========== ========== ===========
For the three months ended September 30, 2002:
Direct business $ 237,478 $ 208,300 $ 128,201
Reinsurance assumed 60,986 57,308 42,055
Reinsurance ceded (153,898) (129,314) (85,093)
---------- ---------- -----------
NET AMOUNTS $ 144,566 $ 136,294 $ 85,163
========== ========== ===========
The table below represents the composition of reinsurance recoverables in our
condensed consolidated balance sheets:
September 30, 2003 December 31, 2002
------------------ -----------------
Reinsurance recoverable on paid losses $ 94,800 $ 108,104
Reinsurance recoverable on outstanding losses 466,033 437,162
Reinsurance recoverable on incurred but not reported losses 357,719 260,810
Reserve for uncollectible reinsurance (11,910) (7,142)
------------ ------------
TOTAL REINSURANCE RECOVERABLES $ 906,642 $ 798,934
============ ============
11
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(3) REINSURANCE, CONTINUED
Our insurance companies require their reinsurers not authorized by the
respective states of domicile of our insurance companies to collateralize
the reinsurance obligations due to us. The table below shows amounts held
by us as collateral plus other credits available for potential offset.
September 30, 2003 December 31, 2002
------------------ -----------------
Payables to reinsurers $ 355,579 $ 235,727
Letters of credit 170,371 141,490
Cash deposits 11,233 9,384
------------ ------------
TOTAL CREDITS $ 537,183 $ 386,601
============ ============
The tables below present the calculation of net reserves, net unearned premium
and net deferred policy acquisition costs:
September 30, 2003 December 31, 2002
------------------ -----------------
Loss and loss adjustment expense payable $ 1,406,843 $ 1,155,290
Reinsurance recoverable on outstanding losses (466,033) (437,162)
Reinsurance recoverable on incurred but not reported losses (357,719) (260,810)
-------------- -------------
NET RESERVES $ 583,091 $ 457,318
============== =============
Unearned premium $ 558,701 $ 331,050
Ceded unearned premium (255,401) (164,224)
-------------- -------------
NET UNEARNED PREMIUM $ 303,300 $ 166,826
============== =============
Deferred policy acquisition costs $ 100,393 $ 68,846
Deferred ceding commissions (75,815) (49,963)
-------------- -------------
NET DEFERRED POLICY ACQUISITION COSTS $ 24,578 $ 18,883
============== =============
We have a reserve of $11.9 million as of September 30, 2003 for potential
collectibility issues and associated expenses related to reinsurance
recoverables. The adverse economic environment in the worldwide insurance
industry, the decline in the market value of investments in equity
securities and the terrorist attacks on September 11, 2001 have placed
great pressure on certain reinsurers and the results of their operations.
Ultimately, these conditions could affect reinsurers' solvency.
Historically, there have been insolvencies following a period of
competitive pricing in the industry. We limit our exposure by holding
funds, letters of credit or other security such that net balances due are
significantly less than the gross balances shown in our condensed
consolidated balance sheets. While we believe that the reserve is adequate
based on currently available information, conditions may change or
additional information might be obtained which may result in a future
change in the reserve. We periodically review our financial exposure to the
reinsurance market and the level of our reserve and continue to take
actions in an attempt to mitigate our exposure to possible loss.
12
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(3) REINSURANCE, CONTINUED
A number of reinsurers have delayed or suspended the payment of amounts
recoverable under certain reinsurance contracts to which we are a party.
Such delays have affected, although not materially to date, the investment
income of our insurance companies, but not to any extent their liquidity.
In some instances, the reinsurers have withheld payment without reference
to a substantive basis for the delay or suspension. In other cases, the
reinsurers have claimed they are not liable for payment to us of all or
part of the amounts due under the applicable reinsurance agreement. We
believe these claims are substantially without merit and expect to collect
the full amounts recoverable. We are currently in negotiations with most of
these parties, but if such negotiations do not result in a satisfactory
resolution of the matters in question, we may seek or be involved in a
judicial or arbitral determination of these matters. In some cases, the
final resolution of such disputes through arbitration or litigation may
extend over several years. In this regard, as of September 30, 2003, our
insurance companies had initiated one litigation proceeding against
reinsurers. As of such date, our insurance companies had an aggregate
amount of $6.1 million which had not been paid to us under the agreements
and we estimate that there could be up to an additional $7.7 million of
incurred losses and loss expenses and other balances which could become due
under the subject agreements.
(4) SEGMENT AND GEOGRAPHIC INFORMATION
The performance of each segment is evaluated based upon net earnings and is
calculated after tax and after all corporate expense allocations, purchase
price allocations and intercompany eliminations have been charged or
credited to the individual segments. The following tables show information
by business segment and geographic location. Geographic location is
determined by physical location of our offices and does not represent the
location of insureds or reinsureds from whom the business was generated.
The revenues within our underwriting agency and intermediary segments for
2002, have been reclassified to be consistent with the 2003 presentation.
This reclassification did not change segment total revenue or segment net
earnings from amounts previously reported. Certain reinsurance proceeds of
our insurance subsidiaries have also been reclassified to revenue to be
consistent with the classification in the condensed consolidated financial
statements.
13
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(4) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED
Insurance Underwriting Other
Company Agency Intermediary Operations Corporate Total
------- ------ ------------ ---------- --------- -----
For the nine months ended September 30, 2003:
Revenue:
Domestic $440,214 $ 47,231 $ 16,792 $ 7,576 $ 898 $ 512,711
Foreign 157,222 3,332 25,403 -- -- 185,957
Inter-segment -- 66,251 4,252 -- -- 70,503
--------------------------------------------------------------------------------
TOTAL SEGMENT REVENUE $597,436 $ 116,814 $ 46,447 $ 7,576 $ 898 769,171
======== ========= ========= ========= =========
Inter-segment revenue (70,503)
---------
CONSOLIDATED TOTAL REVENUE $ 698,668
=========
Net earnings:
Domestic $ 48,942 $ 29,873 $ 3,754 $ 3,710 $ 49 $ 86,328
Foreign 12,166 3,079 6,263 -- -- 21,508
--------------------------------------------------------------------------------
TOTAL SEGMENT NET EARNINGS $ 61,108 $ 32,952 $ 10,017 $ 3,710 $ 49 107,836
======== ========= ========= ========= =========
Inter-segment eliminations (14,735)
---------
CONSOLIDATED NET EARNINGS $ 93,101
=========
Other items:
Net investment income $ 30,832 $ 2,135 $ 965 $ 33 $ 903 $ 34,868
Depreciation and amortization 2,468 2,983 1,307 380 1,347 8,485
Interest expense (benefit) 47 4,989 2,449 581 (2,569) 5,497
Capital expenditures 2,211 715 1,498 -- 15,836 20,260
Income tax provision 29,750 22,030 5,353 1,554 1,287 59,974
Inter-segment eliminations (7,604)
---------
CONSOLIDATED INCOME TAX PROVISION $ 52,370
=========
14
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(4) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED
Insurance Underwriting Other
Company Agency Intermediary Operations Corporate Total
------- ------ ------------ ---------- --------- -----
For the nine months ended September 30, 2002:
Revenue:
Domestic $ 346,123 $ 52,500 $ 18,485 $ 1,335 $ 774 $ 419,217
Foreign 64,648 510 13,827 -- -- 78,985
Inter-segment -- 26,875 796 -- -- 27,671
-----------------------------------------------------------------------------------
TOTAL SEGMENT REVENUE $ 410,771 $ 79,885 $ 33,108 $ 1,335 $ 774 525,873
========= ========= ========= ========= =========
Inter-segment revenue (27,671)
-----------
CONSOLIDATED TOTAL REVENUE $ 498,202
===========
Net earnings:
Domestic $ 42,873 $ 17,270 $ 4,658 $ 750 $ 1,309 $ 66,860
Foreign 5,137 300 2,406 -- -- 7,843
-----------------------------------------------------------------------------------
TOTAL SEGMENT NET EARNINGS $ 48,010 $ 17,570 $ 7,064 $ 750 $ 1,309 74,703
========= ========= ========= ========= =========
Inter-segment eliminations (370)
-----------
CONSOLIDATED NET EARNINGS $ 74,333
===========
Other items:
Net investment income $ 24,713 $ 2,144 $ 731 $ 34 $ 159 $ 27,781
Depreciation and amortization 2,241 4,585 256 77 774 7,933
Interest expense (benefit) 127 5,748 1,931 -- (914) 6,892
Capital expenditures 1,510 1,155 1,041 -- 242 3,948
Income tax provision 23,375 11,682 5,165 364 631 41,217
Inter-segment eliminations (189)
-----------
CONSOLIDATED INCOME TAX PROVISION $ 41,028
===========
15
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(4) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED
Insurance Underwriting Other
Company Agency Intermediary Operations Corporate Total
------- ------ ------------ ---------- --------- -----
For the three months ended September 30, 2003:
Revenue:
Domestic $ 155,418 $ 19,416 $ 5,262 $ 2,922 $ 112 $ 183,130
Foreign 55,949 2,057 9,221 -- -- 67,227
Inter-segment -- 21,053 1,351 -- -- 22,404
----------------------------------------------------------------------------------
TOTAL SEGMENT REVENUE $ 211,367 $ 42,526 $ 15,834 $ 2,922 $ 112 272,761
========= ========= ========= ========= =========
Inter-segment revenue (22,404)
---------
CONSOLIDATED TOTAL REVENUE $ 250,357
=========
Net earnings (loss):
Domestic $ 16,982 $ 10,783 $ 737 $ 1,777 $ (429) $ 29,850
Foreign 4,965 1,178 3,224 -- -- 9,367
----------------------------------------------------------------------------------
TOTAL SEGMENT NET EARNINGS (LOSS) $ 21,947 $ 11,961 $ 3,961 $ 1,777 $ (429) 39,217
========= ========= ========= ========= =========
Inter-segment eliminations (2,851)
---------
CONSOLIDATED NET EARNINGS $ 36,366
=========
Other items:
Net investment income $ 10,605 $ 893 $ 374 $ 25 $ 100 $ 11,997
Depreciation and amortization 851 1,520 230 53 267 2,921
Interest expense (benefit) 22 1,578 659 194 (552) 1,901
Capital expenditures 980 47 610 -- 15,488 17,125
Income tax provision 10,549 8,900 1,693 686 202 22,030
Inter-segment eliminations (1,602)
---------
CONSOLIDATED INCOME TAX PROVISION $ 20,428
=========
16
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(4) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED
Insurance Underwriting Other
Company Agency Intermediary Operation Corporate Total
------- ------ ------------ --------- --------- -----
For the three months ended September 30, 2002:
Revenue:
Domestic $ 122,065 $ 16,971 $ 6,033 $ 730 $ (16) $ 145,783
Foreign 30,700 (81) 4,638 -- -- 35,257
Inter-segment -- 9,609 391 -- -- 10,000
--------------------------------------------------------------------------
TOTAL SEGMENT REVENUE $ 152,765 $ 26,499 $ 11,062 $ 730 $ (16) 191,040
=========== =========== =========== ======== ========
Inter-segment revenue (10,000)
---------
CONSOLIDATED TOTAL REVENUE $ 181,040
=========
Net earnings:
Domestic $ 12,634 $ 5,871 $ 1,774 $ 455 $ 13 $ 20,747
Foreign 2,397 43 1,138 -- -- 3,578
--------------------------------------------------------------------------
TOTAL SEGMENT NET EARNINGS $ 15,031 $ 5,914 $ 2,912 $ 455 $ 13 24,325
=========== =========== =========== ======== ========
Inter-segment eliminations (56)
---------
CONSOLIDATED NET EARNINGS $ 24,269
=========
Other items:
Net investment income $ 8,739 $ 814 $ 267 $ 7 $ (30) $ 9,797
Depreciation and amortization 723 1,474 86 11 261 2,555
Interest expense (benefit) 54 1,868 643 -- (514) 2,051
Capital expenditures 503 355 346 -- (94) 1,110
Income tax provision (benefit) 7,361 4,377 1,584 312 (161) 13,473
Inter-segment eliminations (11)
---------
CONSOLIDATED INCOME TAX PROVISION $ 13,462
=========
17
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(4) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED
The following tables present selected revenue items by line of business for
the periods indicated:
For the nine months ended For the three months ended
September 30, September 30,
2003 2002 2003 2002
---- ---- ---- ----
Group life, accident and health $ 220,253 $ 170,155 $ 72,744 $ 64,350
Diversified financial products 80,399 14,030 35,581 6,753
London market account 101,733 62,305 35,276 29,784
Aviation 72,779 76,599 24,542 25,845
Other specialty lines of business 35,833 13,347 16,752 4,365
----------- ------------- ------------- -------------
510,997 336,436 184,895 131,097
Discontinued lines of business 24,357 25,963 4,545 5,197
----------- ------------- ------------- -------------
NET EARNED PREMIUM $ 535,354 $ 362,399 $ 189,440 $ 136,294
=========== ============= ============= =============
Group life, accident and health $ 60,017 $ 69,175 $ 18,543 $ 21,663
Property and casualty 59,828 34,417 27,076 12,165
----------- ------------- ------------- -------------
FEE AND COMMISSION INCOME $ 119,845 $ 103,592 $ 45,619 $ 33,828
=========== ============= ============= =============
18
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(5) EARNINGS PER SHARE
Basic earnings per share is based on the weighted average number of common
shares outstanding during the period divided into net earnings. Diluted
earnings per share is based on the weighted average number of common shares
outstanding plus the potential common shares outstanding during the period
divided into net earnings. Outstanding common stock options, when dilutive,
are considered to be potential common shares for the purpose of the diluted
calculation. The treasury stock method is used to calculate potential
common shares due to options. Contingent shares to be issued are included
in the earnings per share computation when the underlying conditions for
issuance have been met.
The following table provides a reconciliation of the denominators used in
the earnings per share calculations:
For the nine months ended For the three months ended
September 30, September 30,
2003 2002 2003 2002
---- ---- ---- ----
Net earnings $ 93,101 $ 74,333 $ 36,366 $ 24,269
========== ============ =========== ===========
Reconciliation of shares outstanding:
Shares of common stock outstanding
at period end 63,805 62,294 63,805 62,294
Effect of common shares issued
during the period (727) (176) (88) (11)
Common shares contractually issuable
in the future -- 52 -- 52
---------- ------------ ----------- -----------
Weighted average common
shares outstanding 63,078 62,170 63,717 62,335
Additional dilutive effect of
outstanding options (as determined
by the application of the treasury
stock method) 1,028 671 1,168 536
---------- ------------ ----------- -----------
Weighted average shares and
potential common shares
outstanding 64,106 62,841 64,885 62,871
========== ============ =========== ===========
Anti-dilutive shares not included
in computation 352 415 -- 1,216
========== ============ =========== ===========
19
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(6) NOTES PAYABLE
The table below shows the composition of our notes payable as shown in our
condensed consolidated balance sheets.
September 30, 2003 December 31, 2002
------------------ -----------------
1.3% Convertible notes $ 125,000 $ --
2% Convertible notes 172,451 172,451
$200 million revolving loan facility -- 53,000
Other debt 13,054 4,576
----------- ----------
TOTAL NOTES PAYABLE $ 310,505 $ 230,027
=========== ==========
In a public offering on March 25, 2003, we sold an aggregate $125.0 million
principal amount of 1.3% convertible notes due in 2023. Each one thousand
dollar principal amount of notes is convertible into 29.4377 shares of our
common stock, which represents an initial conversion price of $33.97 per
share. The initial conversion price is subject to change under certain
conditions. Interest is to be paid by us on April 1 and October 1 each
year, commencing October 1, 2003. Holders may surrender notes for
conversion into shares of our common stock if, as of the last day of the
preceding calendar quarter, the closing sale price of our common stock for
at least 20 consecutive trading days during the period of 30 consecutive
trading days ending on the last trading day of that quarter is more than
130% ($44.16 per share) of the conversion price per share of our common
stock. We can redeem the notes for cash at any time on or after April 4,
2009. Holders of the notes may require us to repurchase the notes on April
1, 2009, 2014 and 2019 at a price equal to the principal amount of the
notes plus accrued and unpaid interest. If the holders require us to
repurchase these notes, we may choose to pay the purchase price in cash, in
shares of our common stock, or in a combination thereof. We paid $3.2
million in underwriting discounts and expenses in connection with this
offering. The underwriting discounts and expenses are being amortized from
the issue date until April 1, 2009. We used $66.0 million of the proceeds
from this offering to pay down existing indebtedness under our bank
facility, while the remainder was used to assist in financing acquisitions
and strategic investments and for general corporate purposes.
20
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(7) SUPPLEMENTAL INFORMATION
For the nine months ended For the three months ended
September 30, September 30,
2003 2002 2003 2002
---- ---- ---- ----
Interest paid $ 5,744 $ 4,568 $ 3,023 $ 2,151
Income tax paid 54,000 23,045 21,898 10,025
Comprehensive income 97,323 90,921 33,739 35,789
Ceding commissions netted with
policy acquisition costs 81,930 61,482 27,617 23,084
(8) COMMITMENTS AND CONTINGENCIES
In addition to the matters discussed in Note (3) Reinsurance, we are party
to numerous lawsuits and other proceedings that arise in the normal course
of our business. Many of such lawsuits and other proceedings involve claims
under policies that we underwrite as an insurer or reinsurer, the
liabilities for which, we believe, have been adequately included in our
loss reserves. Also, from time to time, we are a party to lawsuits and
other proceedings which relate to disputes over contractual relationships
with third parties, or which involve alleged errors and omissions on the
part of our subsidiaries. In addition, we are presently engaged in
litigation initiated by the appointed liquidator of a former reinsurer
concerning payments made to us prior to the date of the appointment of the
liquidator. The disputed payments were made by the now insolvent reinsurer
in connection with a commutation agreement. Our understanding is that such
litigation is one of a number of similar actions brought by the liquidator.
We intend to vigorously contest the action. We do not believe the
resolution of any of these matters, some of which include allegations of
damages of material amounts, will have a material adverse effect on our
financial condition, results of operations or cash flows.
21
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
This Form 10-Q/A has amended our previously filed Form 10-Q to reflect a
restatement to change the basis upon which the fee and commission income of our
underwriting agency and intermediary subsidiaries are accounted. This
restatement relates only to business underwritten by our underwriting agencies
or placed by our intermediaries that passes through one of our affiliated
insurance companies to an unrelated reinsurance company. This income had
previously been recognized at the later of the effective date of a policy, the
date when the premium could be reasonably established or the date when
substantially all the services relating to the insurance placement had been
rendered to the client. This income is now recognized pro rata over the term of
the underlying policy. The cumulative effect of the restatement related to prior
years, $3.9 million, which is recorded in the first quarter of 2003, is not
material to prior years or 2003. The effect of the change only became material
in 2003 as a result of recent acquisitions. The change is a timing difference
which generally reverses over a twelve month period. The restatement does not
impact the overall amount of fees and commissions ultimately earned or
previously collected in cash. Additionally, it does not change the net earnings
of our reporting segments but, rather, results solely from changes to the
consolidating entries made in the preparation of our condensed consolidated
financial statements. Likewise, it does not change cash flow from operations.
The effect of the restatement on revenue was a reduction of $17.2 million for
the first nine months of 2003 ($3.4 million for the three months ended September
30, 2003). This amount includes $6.5 million associated with the cumulative
effect of the restatement related to prior years. The tables below show the
effect on net earnings and earnings per share.
Earnings per share
Amount Basic Diluted
------ ----- -------
For the nine months ended September 30, 2003:
Net earnings, as previously reported $ 103,288 $ 1.64 $ 1.61
Effect of adjustment on operations for the period (6,297) (0.10) (0.10)
Cumulative adjustment (3,890) (0.06) (0.06)
----------- --------- --------
Net earnings, as reported herein $ 93,101 $ 1.48 $ 1.45
=========== ========= ========
For the three months ended September 30, 2003:
Net earnings, as previously reported $ 38,351 $ 0.60 $ 0.59
Effect of adjustment on operations for the period (1,985) (0.03) (0.03)
----------- --------- --------
Net earnings, as reported herein $ 36,366 $ 0.57 $ 0.56
=========== ========= ========
During the past year we completed four acquisitions. The results of operations
of these entities are included in our condensed consolidated financial
statements beginning on the effective date of each acquisition. Thus, our
condensed consolidated statements of earnings and cash flows do not contain any
activity generated by these entities for periods prior to their acquisition.
22
Results of Operations
Nine months ended September 30, 2003 versus nine months ended September 30, 2002
Total revenue increased 40% to $698.7 million for the first nine months of 2003
from $498.2 million for the same period in 2002. The revenue increase resulted
from premium rate increases, acquisitions and increased business in all
segments. Subsidiaries acquired during the past year accounted for $73.4 million
in revenue during the first nine months of 2003.
Net investment income increased 26% to $34.9 million for the first nine months
of 2003 from $27.8 million for the same period in 2002. This increase was due to
the higher level of invested assets resulting primarily from cash flow generated
by operating activities and from the insurance company we acquired in December,
2002. Cash flow from operating activities was $325.9 million for the first nine
months of 2003 compared to $122.8 million for the same period in 2002,
continuing a trend of increasing operating cash flow that began in 2002. The
majority of the increase in cash flow from operations results from increased
earnings and net premium flow, less paid losses and loss adjustment costs, into
our insurance companies. We expect the positive cash flow provided by operating
activities to continue, most of which will increase invested assets and thus the
related investment income. If market interest rates were to rise, the growth in
investment income would be accelerated as our current portfolio has a relatively
short average duration and would be available to be invested on a longer term
basis to take advantage of higher rates. For the first nine months of 2003 our
annualized, weighted average, tax equivalent yield was 4.0% compared to 4.5% for
the same period in 2002.
Compensation expense increased to $64.5 million during the first nine months of
2003 from $49.6 million for the same period in 2002. Subsidiaries acquired
during the past year accounted for the majority of the increase. The remaining
increase is mostly due to larger bonus and incentive compensation accruals,
based on increased earnings.
Other operating expense increased to $41.2 million during the first nine months
of 2003 compared to $34.8 million in 2002. Again, most of the increase is due to
subsidiaries acquired during the past year. Currency gains amounted to $1.7
million during the first nine months of 2003 compared to gains of $0.5 million
during the same period in 2002. During 2003 there was a one-time currency gain
of $1.3 million from the settlement of an advance of funds to an unaffiliated
entity. During the first nine months of 2003 our insurance company subsidiaries
incurred unusually high special assessments of $6.0 million from certain states
and state agencies compared to $1.8 million during the same period in 2002.
Assessments of this magnitude are not expected in the future.
Interest expense was $5.5 million for the first nine months of 2003 compared to
$6.9 million for the same period in 2002. Included in the 2002 amount is $2.9
million representing the amortization of underwriting discounts and expenses,
which were fully amortized in 2002, related to the issuance of our 2%
convertible notes compared to $0.3 million in 2003 related to our 1.3%
convertible notes, which were issued in March 2003. Partially offsetting the
decrease in amortization is the $0.6 million in interest expense on mortgage
debt from a real estate partnership we are now consolidating with our adoption
of Financial Accounting Standards Board Interpretation ("FIN") No. 46 during
2003 and an additional $0.8 million interest expense from our 1.3% convertible
notes.
Income tax expense was $52.4 million for the first nine months of 2003 compared
to $41.0 million for the same period in 2002. Our effective tax rate was 36.0%
in the 2003 period compared to 35.6% in 2002. The increased rate results from
tax-exempt interest income being a lower percentage of consolidated pre-tax
earnings as well as immaterial adjustments made to refine our various tax
accrual amounts.
Net earnings increased 25% to $93.1 million, or $1.45 per diluted share, for the
first nine months of 2003 from $74.3 million, or $1.18 per diluted share, for
the same period in 2002. The increase in net earnings resulted from continuing
good margins on increasing revenue and the effect of acquisitions consummated
during the past year.
23
As of September 30, 2003, total assets exceeded $4.6 billion, shareholders'
equity was $996.3 million and book value per share was $15.61, up 10% from
$14.15 as of December 31, 2002.
SEGMENTS
Insurance Companies
The following tables provide information by line of business (amounts in
thousands):
Gross Net Net Net
written Written Earned Loss
premium Premium Premium Ratio
------- ------- ------- -----
For the nine months ended September 30, 2003:
Group life, accident and health $ 426,162 $ 233,589 $ 220,253 63.8%
Diversified financial products 400,190 134,417 80,399 47.3
London market account 189,062 135,941 101,733 52.9
Aviation 165,280 75,765 72,779 63.6
Other specialty lines of business 87,393 72,641 35,833 83.1
------------ ------------ ------------ -----
1,268,087 652,353 510,997 60.4
Discontinued lines of business 31,680 13,774 24,357 125.6
------------ ------------ ------------ -----
TOTALS $ 1,299,767 $ 666,127 $ 535,354 63.3%
============ ============ ============
Expense Ratio 25.5
-----
Combined Ratio 88.8%
=====
For the nine months ended September 30, 2002:
Group life, accident and health $ 378,563 $ 176,519 $ 170,155 61.5%
Diversified financial products 113,830 28,730 14,030 42.8
London market account 162,399 91,954 62,305 44.1
Aviation 153,908 75,741 76,599 51.5
Other specialty lines of business 16,454 13,253 13,347 111.8
------------ ------------ ------------ -----
825,154 386,197 336,436 57.2
Discontinued lines of business 26,930 16,031 25,963 111.0
------------ ------------ ------------ -----
TOTALS $ 852,084 $ 402,228 $ 362,399 61.1%
============ ============ ============
Expense Ratio 26.2
-----
Combined Ratio 87.3%
=====
24
Gross written premium increased 53% to $1.3 billion for the first nine months of
2003 from $852.1 million for the same period in 2002. All of the lines of
business showed some increase as a result of higher premium rates as well as
organic growth. The largest growth was in the diversified financial products
line of business, which our insurance companies began writing in 2002. Net
written premium for the first nine months of 2003 increased 66% to $666.1
million and net earned premium increased 48% to $535.4 million for the same
reasons plus an increase in retentions in selected areas. The increase in
premium is expected to continue into 2004.
The table below shows the composition of net incurred loss and loss adjustment
expense for the nine months ended September 30, 2003 and 2002 (amounts in
thousands):
2003 2002
---------------------------- -------------------------
Amount Loss Ratio Amount Loss Ratio
------ ---------- ------ ----------
Deficiency / (redundancy) $ 10,447 1.9% $ (4,137) (1.1)%
All other incurred loss and
loss adjustment expense 328,618 61.4 225,383 62.2
---------- ---- ---------- ----
Net incurred loss and loss
adjustment expense $ 339,065 63.3% $ 221,246 61.1%
========== ==== ========== ====
The net loss ratio in the diversified financial products line of business
increased in 2003 as a result of a change in the mix of business to components
with a somewhat higher loss ratio. The London market account's net loss ratio
was negatively affected in 2003 due to an increase in reserves in the accident
and health category, some of which was adverse development from prior accident
years. The net loss ratio in the aviation line of business increased due to
unusually good loss experience in 2002 compared to a more expected loss ratio in
2003. Loss experience in the other specialty lines improved in 2003 compared to
the prior year as experience approached its expected level. The loss ratio in
the discontinued lines of business increased in the first nine months of 2003
following reserve additions resulting from our ongoing review of outstanding
claims.
For the nine months ended September 30, the gross loss ratio was 71.7% in 2003
compared to 61.5% in 2002. During the first nine months of 2003, we increased
our gross losses by $76.1 million on certain assumed accident and health
reinsurance contracts reported in the discontinued line of business due to our
processing of additional information received and our continuing evaluation of
reserves related to this business. Also during the 2003 period, we incurred a
$30.0 million gross loss on a large warehouse fire and reduced gross losses on
another discontinued program by $14.3 million based on revised current
information. During the first nine months of 2002, we reduced our gross losses
from the September 11 terrorist attacks by $21.5 million and our gross loss from
Total Oil Company loss by $14.0 million to its ultimate settlement amount. As
all these losses were substantially reinsured, there was no material effect on
our net losses. The table below shows the composition of gross incurred loss and
loss adjustment expense for the nine months ended September 30, 2003 and 2002
(amounts in thousands):
2003 2002
--------------------------- ----------------------------
Amount Loss Ratio Amount Loss Ratio
------------- ---------- ----------- ----------
September 11 terrorist attacks $ -- --% $ (21,500) (2.9)%
Total Oil Company loss -- -- (14,000) (1.9)
Accident and health adjustment 76,115 7.0 -- --
Discontinued program adjustment (14,332) (1.3) -- --
Large warehouse fire 30,000 2.8 -- --
All other incurred loss and
loss adjustment expense 680,936 63.2 496,180 66.3
------------- ---- ----------- ----
Gross incurred loss and loss
adjustment expense $ 772,719 71.7% $ 460,680 61.5%
============= ==== =========== ====
25
Policy acquisition costs, which are net of commissions on insurance ceded,
increased to $102.9 million during the first nine months of 2003, from $70.4
million in the same period in 2002. This increase is in proportion to the
increase in net earned premium.
Net earnings of our insurance companies increased to $61.1 million in the first
nine months of 2003 from $48.0 million for the same period in 2002 due to
increased premium volume from rate increases, organic growth and continuing
profitable underwriting results somewhat offset by unusually high special
assessments from certain states and state agencies during the first nine months
of 2003.
Underwriting Agencies
Revenue from our underwriting agencies (primarily fee income) increased 46% to
$116.8 million for the first nine months of 2003 compared to $79.9 million for
the same period in 2002. This increase resulted from both acquisitions made
during the past year and our existing underwriting agencies, which are seeing
growth in several areas. Net earnings in this segment increased to $33.0 million
in the first nine months of 2003 from $17.6 million in 2002 for the same
reasons. We expect growth to continue into 2004.
Intermediaries
Revenue from our intermediaries (primarily commission income) increased 40% to
$46.4 million for the first nine months of 2003 compared to $33.1 million for
the same period in 2002. The growth resulted principally from acquisitions made
during the past year. Net earnings of our intermediaries increased to $10.0
million for the first nine months of 2003 compared to $7.1 million for the same
period of 2002 for the same reasons. We expect growth to continue into 2004.
Other Operations
The other operations segment saw an increase in revenue and segment net income
due to income from our strategic investment in Argonaut Group, Inc. made in
March 2003 and gains in our strategic investment and trading accounts. Also,
segment revenue increased as a result of the initial consolidation of a real
estate partnership to comply with FIN No. 46. Period to period comparisons may
vary substantially depending on strategic investments, trading activities or
dispositions in any given period.
Corporate
The decrease in segment earnings between periods resulted from the difference in
intersegment income tax adjustments and the adjustment of certain accruals to
their ultimate liability, which positively affected the 2002 period. There was
also an increase in compensation expense during 2003, offsetting reduced net
interest expense and currency conversion gains.
Quarter ended September 30, 2003 versus quarter ended September 30, 2002
Total revenue increased 38% to $250.4 million for the third quarter of 2003 from
$181.0 million for the same period in 2002. The revenue increase resulted from
premium rate increases and increased business in all segments. Subsidiaries
acquired during the past year accounted for $28.0 million in revenue during the
third quarter of 2003.
Net investment income increased 22% to $12.0 million for the third quarter of
2003 from $9.8 million for the same period in 2002. This increase was due to the
higher level of invested assets resulting primarily from cash flow generated by
operating activities and from the insurance company we acquired in December,
2002. Cash flow from operating activities was $126.6 million for the third
quarter of 2003 compared to $76.1 million for the same period in 2002,
continuing a trend of increasing operating cash flow that began in 2002. The
majority of the increase in cash flow from operations results from increased
earnings and net premium flow, less paid losses
26
and loss adjustment costs, into our insurance companies. We expect the positive
cash flow provided by operating activities to continue, most of which will
increase invested assets and thus the related investment income. If market
interest rates were to rise, the growth in investment income would be
accelerated as our current portfolio has a relatively short average duration and
would be available to be invested on a longer term basis to take advantage of
higher rates. For the third quarter of 2003 our annualized, weighted average,
tax equivalent yield was 3.8% compared to 4.6% for the same period in 2002.
Compensation expense increased to $21.6 million during the third quarter of 2003
from $16.1 million for the same period in 2002. Subsidiaries acquired during the
past year accounted for the majority of the increase.
Other operating expense increased to $14.0 million during the third quarter of
2003 compared to $12.0 million in 2002. The increase is due principally to
subsidiaries acquired during the past year.
Interest expense was $1.9 million for the third quarter of 2003 compared to $2.1
million for the same period in 2002. Included in the 2002 amount is $0.7 million
representing the amortization of underwriting discounts and expenses, which were
fully amortized in 2002, related to the issuance of our 2% convertible notes
compared to $0.1 million in 2003 related to our 1.3% convertible notes, which
were issued in March 2003. Partially offsetting the decrease in amortization is
the $0.2 million in interest expense on mortgage debt from a real estate
partnership we are now consolidating with our adoption of FIN No. 46 during 2003
and an additional $0.4 million interest expense from our 1.3% convertible notes.
Income tax expense was $20.4 million for the third quarter of 2003 compared to
$13.5 million for the same period in 2002. Our effective tax rate was 36.0% in
the 2003 quarter compared to 35.7% in 2002. The increased rate results primarily
from tax-exempt interest income being a lower percentage of consolidated pre-tax
earnings.
Net earnings increased 50% to $36.4 million, or $0.56 per diluted share, for the
third quarter of 2003 from $24.3 million, or $0.39 per diluted share, for the
same period in 2002. The increase in net earnings resulted from continuing good
margins on increasing revenue and the effect of acquisitions consummated during
the past year.
As of September 30, 2003, total assets exceeded $4.6 billion, shareholders'
equity was $996.3 million and book value per share was $15.61, up from $15.08 as
of June 30, 2003.
27
SEGMENTS
Insurance Companies
The following tables provide information by line of business (amounts in
thousands):
Gross Net Net Net
written Written Earned Loss
premium Premium Premium Ratio
------------ ------------ ------------ -----
For the three months ended September 30, 2003:
Group life, accident and health $ 142,680 $ 76,236 $ 72,744 64.1%
Diversified financial products 149,764 52,203 35,581 46.7
London market account 48,910 33,387 35,276 53.0
Aviation 56,320 24,561 24,542 63.6
Other specialty lines of business 41,337 33,935 16,752 93.8
------------ ------------ ------------ -----
439,011 220,322 184,895 61.3
Discontinued lines of business 4,029 2,213 4,545 125.4
------------ ------------ ------------ -----
TOTALS $ 443,040 $ 222,535 $ 189,440 62.8%
============ ============ ============
Expense Ratio 25.8
-----
Combined Ratio 88.6%
=====
FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2002:
Group life, accident and health $ 132,904 $ 69,491 $ 64,350 59.5%
Diversified financial products 55,461 13,597 6,753 56.3
London market account 46,346 30,015 29,784 42.4
Aviation 49,804 23,687 25,845 48.5
Other specialty lines of business 6,570 4,288 4,365 106.1
------------ ------------ ------------ -----
291,085 141,078 131,097 54.8
Discontinued lines of business 7,379 3,488 5,197 255.3
------------ ------------ ------------ -----
TOTALS $ 298,464 $ 144,566 $ 136,294 62.5%
============ ============ ============
Expense Ratio 27.1
-----
Combined Ratio 89.6%
=====
Gross written premium increased 48% to $443.0 million for the third quarter of
2003 from $298.5 million for the same period in 2002. All of the lines of
business showed some increase as a result of higher premium rates as well as
organic growth. The largest growth was in the diversified financial products
line of business, which our insurance companies began writing in 2002. Net
written premium for the third quarter of 2003 increased 54% to $222.5 million
and net earned premium increased 39% to $189.4 million for the same reasons plus
an increase in retentions in selected areas. The increase in premium is expected
to continue into 2004.
28
The table below shows the composition of net incurred loss and loss adjustment
expense for the three months ended September 30, 2003 and 2002 (amounts in
thousands):
2003 2002
------------------------------- ------------------------------
Amount Loss Ratio Amount Loss Ratio
------ ---------- ------ ----------
Deficiency / (redundancy) $ 617 0.3% $ (2,207) (1.6)%
All other incurred loss and
loss adjustment expense 118,336 62.5 87,370 64.1
------------- ---- ------------- ----
Net incurred loss and loss
adjustment expense $ 118,953 62.8% $ 85,163 62.5%
============= ==== ============= ====
The net loss ratio in the diversified financial products line of business
decreased in 2003 as a result of a change in the mix of business. The London
market account's net loss ratio was negatively affected in 2003 due to an
increase in reserves in the accident and health category, some of which was
adverse development from prior accident years. The net loss ratio in the
aviation line of business increased due to unusually good loss experience in
2002 compared to a more expected loss ratio in 2003. Loss experience in the
other specialty lines improved in 2003 compared to the prior year, as experience
approached its expected level. The loss ratio in the discontinued lines of
business remains high following reserve additions resulting from our ongoing
review of outstanding claims.
For the third quarter, the gross loss ratio was 69.6% in 2003 compared to 64.1%
in 2002. During the third quarter of 2003, we incurred a $30.0 million gross
loss on a large warehouse fire and reduced gross losses on a discontinued
program by $14.3 million based on revised current information. During the third
quarter of 2002, we reduced our gross losses from the Total Oil Company loss by
$14.0 million to its ultimate settlement amount. As all these losses were
substantially reinsured, there was no material effect on our net losses. The
table below shows the composition of gross incurred loss and loss adjustment
expense for the three months ended September 30, 2003 and 2002 (amounts in
thousands):
2003 2002
------------------------------- ----------------------------
Amount Loss Ratio Amount Loss Ratio
------ ---------- ------ ----------
Total Oil Company loss $ -- --% $ (14,000) (5.3)%
Discontinued program adjustment (14,332) (3.7) -- --
Large warehouse fire 30,000 7.8 -- --
All other incurred loss and
loss adjustment expense 252,479 65.5 184,256 69.4
------------- ----- ------------- ----
Gross incurred loss and loss
adjustment expense $ 268,147 69.6% $ 170,256 64.1%
============= ===== ============= ====
Policy acquisition costs, which are net of commissions on reinsurance ceded,
increased to $37.0 million during the third quarter of 2003, from $28.1 million
in the same period in 2002. This increase is in proportion to the increase in
net earned premium.
Net earnings of our insurance companies increased to $21.9 million in the third
quarter of 2003 from $15.0 million for the same period in 2002 due to increased
premium volume from rate increases, organic growth and continuing profitable
underwriting results.
29
Underwriting Agencies
Revenue from our underwriting agencies (primarily fee income) increased 60% to
$42.5 million for the third quarter of 2003 compared to $26.5 million for the
same period in 2002. This increase resulted both from acquisitions made during
the past year and our existing underwriting agencies, which are seeing growth in
several areas. Net earnings in this segment increased to $12.0 million in the
third quarter of 2003 from $5.9 million in 2002 for the same reasons. We expect
growth to continue into 2004.
Intermediaries
Revenue from our intermediaries (primarily commission income) increased 43% to
$15.8 million for the third quarter of 2003 compared to $11.1 million for the
same period in 2002. The growth resulted principally from acquisitions made
during the past year. Net earnings of our intermediaries increased to $4.0
million for the third quarter of 2003 compared to $2.9 million for the same
period of 2002 for the same reasons. We expect growth to continue in 2004.
Other Operations
The other operations segment saw an increase in revenue and segment net income
due to income from our strategic investment in Argonaut Group, Inc. made in
March 2003 and gains in our strategic investment and trading accounts. Also,
segment revenue increased as a result of the initial consolidation of a real
estate partnership to comply with FIN No. 46. Period to period comparisons may
vary substantially depending on strategic investments, trading activities or
dispositions in any given period.
Corporate
The decrease in segment earnings between periods resulted from differences in
compensation and income tax expense.
Liquidity and Capital Resources
We receive substantial cash from premiums, reinsurance recoverables, management
fees and commission income and, to a lesser extent, investment income and
proceeds from sales and redemptions of investments and other assets. Our
principal cash outflows are for the payment of claims and loss adjustment
expenses, payment of premiums to reinsurers, purchase of investments, debt
service, policy acquisition costs, operating expenses, income and other taxes
and dividends. Variations in operating cash flows can occur due to timing
differences in either the payment of claims and the collection of related
recoverables or the collection of receivables and the payment of related payable
amounts.
We maintain a substantial level of cash and liquid short-term investments which
are used to meet anticipated payment obligations. Our consolidated cash and
investment portfolio increased $334.3 million, or 28% , during the first nine
months of 2003 and totaled $1.5 billion as of September 30, 2003, of which
$455.4 million was cash and short-term investments. The increase in investments
resulted from the positive operating cash flows.
In a public offering on March 25, 2003, we sold an aggregate $125.0 million
principal amount of 1.3% convertible notes due in 2023. Each one thousand dollar
principal amount of notes is convertible into 29.4377 shares of our common
stock, which represents an initial conversion price of $33.97 per share. The
initial conversion price is subject to change under certain conditions. Interest
is to be paid by us on April 1 and October 1 each year, commencing October 1,
2003. Holders may surrender notes for conversion into shares of our common stock
if, as of the last day of the preceding calendar quarter, the closing sale price
of our common stock for at least 20 consecutive trading days during the period
of 30 consecutive trading days ending on the last trading day of that quarter is
more than 130% ($44.16 per share) of the conversion price per share of our
common stock. We can redeem the notes for cash at any time on or after April 4,
2009. Holders of the notes may require us to repurchase the notes on April 1,
2009, 2014 and 2019 at a price equal to the principal amount of the notes
30
plus accrued and unpaid interest. If the holders require us to repurchase these
notes, we may choose to pay the purchase price in cash, in shares of our common
stock, or in a combination thereof. We paid $3.2 million in underwriting
discounts and expenses in connection with this offering. The underwriting
discounts and expenses are being amortized from the issue date until April 1,
2009. We used $66.0 million of the proceeds from this offering to pay down
existing indebtedness under our bank facility, while the remainder was used to
assist in financing acquisitions and strategic investments and for general
corporate purposes.
Reinsurance recoverables increased during the first nine months of 2003 due
principally to the increase in reinsurance recoverables on incurred but not
reported losses. A significant portion of this increase comes from the
diversified financial products line of business, new in 2002, which is more
heavily reinsured than our other lines of business. The increase in gross losses
on certain assumed contracts in the discontinued line of business also
contributed to the increase. The increase in reinsurance recoverable on
outstanding losses results principally from a $30.0 million loss incurred in the
third quarter of 2003 which was substantially reinsured.
We have a reserve of $11.9 million as of September 30, 2003 for potential
collectibility issues and associated expenses related to reinsurance
recoverables. The adverse economic environment in the worldwide insurance
industry, the decline in the market value of investments in equity securities
and the terrorist attacks on September 11, 2001 have placed great pressure on
certain reinsurers and the results of their operations. Ultimately, these
conditions could affect reinsurers' solvency. Historically, there have been
insolvencies following a period of competitive pricing in the industry. We limit
our exposure by holding funds, letters of credit or other security such that net
balances due are significantly less than the gross balances shown in our
condensed consolidated balance sheets. While we believe that the reserve is
adequate based on currently available information, conditions may change or
additional information might be obtained which may result in a future change in
the reserve. We periodically review our financial exposure to the reinsurance
market and the level of our reserve and continue to take actions in an attempt
to mitigate our exposure to possible loss.
A number of reinsurers have delayed or suspended the payment of amounts
recoverable under certain reinsurance contracts to which we are a party. Such
delays have affected, although not materially to date, the investment income of
our insurance companies, but not to any extent their liquidity. In some
instances, the reinsurers have withheld payment without reference to a
substantive basis for the delay or suspension. In other cases, the reinsurers
have claimed they are not liable for payment to us of all or part of the amounts
due under the applicable reinsurance agreement. We believe these claims are
substantially without merit and expect to collect the full amounts recoverable.
We are currently in negotiations with most of these parties, but if such
negotiations do not result in a satisfactory resolution of the matters in
question, we may seek or be involved in a judicial or arbitral determination of
these matters. In some cases, the final resolution of such disputes through
arbitration or litigation may extend over several years. In this regard, as of
September 30, 2003, our insurance companies had initiated one litigation
proceeding against reinsurers. As of such date, our insurance companies had an
aggregate amount of $6.1 million which had not been paid to us under the
agreements and we estimate that there could be up to an additional $7.7 million
of incurred losses and loss expenses and other balances which could become due
under the subject agreements.
We believe that our operating cash flows, short-term investments, bank facility
and shelf registration on file with the United States Securities and Exchange
Commission will provide sufficient sources of liquidity to meet our operating
needs for the foreseeable future.
Critical Accounting Policies
We have made no changes in our methods of application of our critical accounting
policies from the information provided in our Annual Report on Form 10-K for the
year ended December 31, 2002.
31
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, 2002.
ITEM 4. CONTROLS AND PROCEDURES
a. Evaluation of disclosure controls and procedures.
Within the 90 days prior to the date of this report, we carried out an
evaluation of the effectiveness of the design and operation of our
disclosure controls and procedures pursuant to Exchange Act Rule
13a-15. This evaluation was performed under the supervision of, and
with the participation of, our management, including the Chief
Executive Officer and Chief Financial Officer. Based upon that
evaluation, our Chief Executive Officer and Chief Financial Officer
concluded that our disclosure controls and procedures are effective in
timely alerting them to material information relating to HCC Insurance
Holdings, Inc. and its subsidiaries required to be included in our
periodic SEC filings.
b. Changes in internal controls.
There have been no changes in our internal controls or in other factors
which could materially affect internal controls over financial
reporting subsequent to the date we carried out our evaluation.
32
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
In addition to the matters discussed in Note (3) Reinsurance, we are
party to numerous lawsuits and other proceedings that arise in the
normal course of our business. Many of such lawsuits and other
proceedings involve claims under policies that we underwrite as an
insurer or reinsurer, the liabilities for which, we believe, have been
adequately included in our loss reserves. Also, from time to time, we
are a party to lawsuits and other proceedings which relate to disputes
over contractual relationships with third parties, or which involve
alleged errors and omissions on the part of our subsidiaries. In
addition, we are presently engaged in litigation initiated by the
appointed liquidator of a former reinsurer concerning payments made to
us prior to the date of the appointment of the liquidator. The disputed
payments were made by the now insolvent reinsurer in connection with a
commutation agreement. Our understanding is that such litigation is one
of a number of similar actions brought by the liquidator. We intend to
vigorously contest the action. We do not believe the resolution of any
of these matters, some of which include allegations of damages of
material amounts, will have a material adverse effect on our financial
condition, results of operations or cash flows.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
31.1 Certification by Chief Executive Officer.
31.2 Certification by Chief Financial Officer.
32.1 Certification with respect to quarterly report.
(b) Reports on Form 8-K
During the third quarter we did not file any reports on Form
8-K. On August 7, 2003, we furnished a report on Form 8-K
including our announcement of financial results for the second
quarter of 2003.
33
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)
March 1, 2004 /s/ Stephen L. Way
----------------- --------------------------------------
(Date) Stephen L. Way, Chairman of the Board
Chief Executive Officer and President
March 1, 2004 /s/ Edward H. Ellis, Jr.
----------------- --------------------------------------
(Date) Edward H. Ellis, Jr., Executive Vice
President and Chief Financial Officer
34
INDEX TO EXHIBITS
31.1 Certification by Chief Executive Officer.
31.2 Certification by Chief Financial Officer.
32.1 Certification with respect to quarterly report.