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 Quarter Ended September 30, 2006.
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 is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer þ		Accelerated filer o		Non-accelerated filer 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 November 30, 2006, there were approximately 111.7 million shares of common stock, $1.00 par value issued and outstanding.

 

 

HCC INSURANCE HOLDINGS, INC.
TABLE OF CONTENTS

						Page
Part I.		FINANCIAL INFORMATION
		Item 1.		Financial Statements Condensed Consolidated Balance Sheets — September 30, 2006 and December 31, 2005 (unaudited)			5
				Condensed Consolidated Statements of Earnings — Nine months and three months ended September 30, 2006 and 2005 (As restated) (unaudited)			6
				Condensed Consolidated Statement of Changes in Shareholders’ Equity — Nine months ended September 30, 2006 (unaudited)			7
				Condensed Consolidated Statements of Cash Flows — Nine months and three months ended September 30, 2006 and 2005 (As restated) (unaudited)			8
				Notes to Condensed Consolidated Financial Statements (unaudited)			9
		Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			32
		Item 3.		Quantitative and Qualitative Disclosures About Market Risk			47
		Item 4.		Controls and Procedures			48
Part II.		OTHER INFORMATION
		Item 1.		Legal Proceedings			50
		Item 1A.		Risk Factors			50
		Item 6.		Exhibits			50
Signatures							51
Consent of Independent Public Accountants
Certification by Chief Executive Officer
Certification by Chief Financial Officer
Certification with Respect to Quarterly Report

EXPLANATORY NOTE — LATE FILING OF QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2006

A Special Committee of our Board of Directors conducted an investigation of our past stock option granting practices and announced its findings on November 17, 2006. Because we did not know the financial impact of the Special Committee’s investigation, we were not able to timely file our quarterly report on Form 10-Q for our third quarter ended September 30, 2006. We have completed calculating the financial effect utilizing the results of the investigation and are now filing this Form 10-Q for our third quarter. See Note 2 “Restatement of Financial Statements” of the notes to the Condensed Consolidated Financial Statements and Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Restatement of Financial Statements” for more information on the investigation and its financial effects.

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, acquisitions, capital expenditures, goals, 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, 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 effects of emerging claim and coverage issues;
	•		the effects of extensive governmental regulation of the insurance industry;
	•		potential credit risk with brokers;
	•		our increased retention of risk, which could expose us to greater potential losses;
	•		the adequacy of reinsurance protection;
	•		the ability or 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 in the future;
	•		attraction and retention of qualified employees;
	•		fluctuations in the fixed income securities market, which may reduce the value of our investment assets;
	•		our ability to successfully expand our business through the acquisition of insurance-related companies;
	•		our ability to receive dividends from our insurance company subsidiaries in needed amounts;
	•		fluctuations in foreign exchange rates;
	•		failures of our information technology systems, which could adversely affect our business;

	•		developments in the SEC’s informal inquiry related to our past practices in connection with grants of stock options;
	•		potential issues related to the effects of Sections 409A and 162(m) of the Internal Revenue Code and any expenses associated therewith;
	•		changes to improve our internal controls related to the process of granting, documenting and accounting for stock option awards;
	•		additional expenses and taxes associated with our stock option investigation and related matters;
	•		potential litigation that could result from our stock option investigation;
	•		the ability of our Executive Officers to define and implement a strategic business plan; and
	•		our ability to cure all defaults or events of default under our outstanding loan agreements.

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 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 at the date made and we will not update these forward-looking statements unless the securities laws require us to do so. In light of these risks, uncertainties and assumptions, any forward-looking events discussed in this report may not occur.

HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

(unaudited, in thousands except per share data)

		September 30,				December 31,
		2006				2005
ASSETS
Investments:
Fixed income securities, at fair value (amortized cost: 2006 — $2,840,047; 2005 — $2,277,139)		$	2,840,610			$	2,268,624
Short-term investments, at cost, which approximates fair value			673,406				839,581
Other investments, at fair value (cost: 2006 - $275,644; 2005 - $144,897)			290,363				149,223
Total investments			3,804,379				3,257,428
Cash			59,638				73,935
Restricted cash and cash investments			171,501				170,978
Premium, claims and other receivables			867,127				884,654
Reinsurance recoverables			1,305,952				1,361,983
Ceded unearned premium			244,003				239,416
Ceded life and annuity benefits			72,429				73,415
Deferred policy acquisition costs			181,111				156,253
Goodwill			554,430				532,947
Other assets			283,669				277,791
Total assets		$	7,544,239			$	7,028,800
LIABILITIES
Loss and loss adjustment expense payable		$	2,907,626			$	2,813,720
Life and annuity policy benefits			72,429				73,415
Reinsurance balances payable			139,384				176,954
Unearned premium			924,518				807,109
Deferred ceding commissions			67,231				67,886
Premium and claims payable			684,660				753,859
Notes payable			393,167				309,543
Accounts payable and accrued liabilities			394,016				335,879
Total liabilities			5,583,031				5,338,365
SHAREHOLDERS’ EQUITY
Common stock, $1.00 par value; 250.0 million shares authorized (shares issued and outstanding: 2006 — 111,491; 2005 — 110,803)			111,491				110,803
Additional paid-in capital			786,759				762,170
Retained earnings			1,029,318				798,388
Accumulated other comprehensive income			33,640				19,074
Total shareholders’ equity			1,961,208				1,690,435
Total liabilities and shareholders’ equity		$	7,544,239			$	7,028,800

See Notes to Condensed Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Statements of Earnings

(unaudited, in thousands except per share data)

		Nine months ended								Three months ended
		September 30,								September 30,
		2006				2005				2006				2005
						(As restated)								(As restated)
REVENUE
Net earned premium		$	1,204,941			$	995,901			$	421,050			$	338,058
Fee and commission income			104,409				100,999				38,862				32,073
Net investment income			108,959				70,039				36,205				24,998
Net realized investment gain (loss)			(1,193	)			2,038				304				38
Other operating income			59,071				26,116				20,276				16,864
Total revenue			1,476,187				1,195,093				516,697				412,031
EXPENSE
Loss and loss adjustment expense, net			689,122				679,932				236,030				295,768
Policy acquisition costs, net			231,012				187,696				78,203				65,708
Other operating expense			156,279				137,077				59,277				41,206
Interest expense			7,912				5,848				3,475				2,070
Total expense			1,084,325				1,010,553				376,985				404,752
Earnings from continuing operations before income tax expense			391,862				184,540				139,712				7,279
Income tax expense on continuing operations			130,319				59,091				46,455				574
Earnings from continuing operations			261,543				125,449				93,257				6,705
Earnings from discontinued operations, net of income tax expense			—				707				—				707
Net earnings		$	261,543			$	126,156			$	93,257			$	7,412
Basic earnings per share data:
Earnings from continuing operations		$	2.35			$	1.20			$	0.84			$	0.06
Earnings from discontinued operations			—				0.01				—				0.01
Net earnings per share		$	2.35			$	1.21			$	0.84			$	0.07
Weighted average shares outstanding			111,198				104,617				111,359				105,623
Diluted earnings per share data:
Earnings from continuing operations		$	2.24			$	1.16			$	0.80			$	0.06
Earnings from discontinued operations			—				0.01				—				0.01
Net earnings per share		$	2.24			$	1.17			$	0.80			$	0.07
Weighted average shares outstanding			116,986				108,003				117,003				109,818
Cash dividends declared, per share		$	0.275			$	0.207			$	0.100			$	0.075

See Notes to Condensed Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Statement of Changes in Shareholders’ Equity

Nine months ended September 30, 2006

(unaudited, in thousands except per share data)

														Accumulated
						Additional								other				Total
		Common				paid-in				Retained				comprehensive				shareholders'
		stock				capital				earnings				income				equity
Balance at December 31, 2005		$	110,803			$	762,170			$	798,388			$	19,074			$	1,690,435
Net earnings			—				—				261,543				—				261,543
Other comprehensive income			—				—				—				14,566				14,566
Comprehensive income			—				—				—				—				276,109
Issuance of 688 shares for exercise of options, including tax benefit of $3,291			688				14,285				—				—				14,973
Stock-based compensation			—				10,304				—				—				10,304
Cash dividends declared, $0.275 per share			—				—				(30,613	)			—				(30,613	)
Balance at September 30, 2006		$	111,491			$	786,759			$	1,029,318			$	33,640			$	1,961,208

See Notes to Condensed Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(unaudited, in thousands)

		Nine months ended								Three months ended
		September 30,								September 30,
		2006				2005				2006				2005
						(As restated)								(As restated)
Cash flows from operating activities:
Net earnings		$	261,543			$	126,156			$	93,257			$	7,412
Adjustments to reconcile net earnings to net cash provided by operating activities:
Change in premium, claims and other receivables			36,626				(74,007	)			46,924				16,604
Change in reinsurance recoverables			56,031				(145,305	)			47,336				(126,291	)
Change in ceded unearned premium			(4,587	)			60,509				(5,722	)			14,648
Change in loss and loss adjustment expense payable			93,906				521,365				(10,815	)			396,478
Change in reinsurance balances payable			(37,509	)			(23,906	)			(14,803	)			15,744
Change in unearned premium			113,638				42,994				10,559				17,458
Change in premium and claims payable, net of restricted cash			(78,293	)			30,585				(61,071	)			15,049
Change in trading portfolio			(99,193	)			(54,654	)			(14,702	)			(16,600	)
Depreciation and amortization expense			12,242				11,063				4,598				3,703
Stock-based compensation expense			9,463				1,920				3,373				750
Other, net			(4,161	)			(43,466	)			831				(10,538	)
Cash provided by operating activities			359,706				453,254				99,765				334,417
Cash flows from investing activities:
Sales of fixed income securities			184,175				163,841				20,078				49,071
Maturity or call of fixed income securities			174,758				133,391				57,060				34,923
Cost of securities acquired			(958,822	)			(733,400	)			(167,437	)			(235,256	)
Change in short-term investments			171,198				36,234				(47,658	)			(145,482	)
Sale of strategic investment			40,354				7,758				22,991				7,758
Payments for purchase of subsidiaries, net of cash received			(55,290	)			(44,288	)			(17,833	)			(9,407	)
Sale of subsidiary			—				10,448				—				10,448
Other, net			(8,612	)			(14,627	)			(3,515	)			(3,249	)
Cash used by investing activities			(452,239	)			(440,643	)			(136,314	)			(291,194	)
Cash flows from financing activities:
Issuance of notes payable			140,000				36,000				101,000				3,000
Payments on notes payable			(56,346	)			(37,554	)			(45,097	)			(23,089	)
Sale of common stock			14,973				32,684				5,313				3,847
Dividends paid			(27,774	)			(19,606	)			(11,126	)			(7,890	)
Other			7,383				(3,814	)			1,755				—
Cash provided (used) by financing activities			78,236				7,710				51,845				(24,132	)
Net increase (decrease) in cash			(14,297	)			20,321				15,296				19,091
Cash at beginning of period			73,935				69,933				44,342				71,163
Cash at end of period		$	59,638			$	90,254			$	59,638			$	90,254

See Notes to Condensed Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables 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, underwriting agencies and reinsurance brokers. We provide specialized property and casualty, surety, and group life, accident and health insurance coverages and related agency and reinsurance brokerage services to commercial customers and individuals. We market our products both directly to customers and through a network of independent brokers, producers and agents. Our lines of business include diversified financial products (which includes directors’ and officers’ liability, professional indemnity, employment practices liability and surety); group life, accident and health; aviation; London market account (which includes energy, marine, property, and accident and health); and other specialty lines of insurance. We operate primarily in the United States, the United Kingdom, Spain and Bermuda, 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 (generally accepted accounting principles) 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 presentation 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 audited consolidated financial statements and related notes. The condensed consolidated balance sheet at December 31, 2005 was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles.
		Management must make estimates and assumptions that affect amounts reported in our financial statements and in disclosures of contingent assets and liabilities. Ultimate results could differ from those estimates. We have reclassified certain amounts in our 2005 condensed consolidated financial statements to conform to the 2006 presentation. The reclassifications included the elimination of certain intercompany premium receivable and premium payable balances and reclassification of the corresponding lines in our 2005 condensed statements of cash flows. None of these reclassifications had an effect on our consolidated net earnings, shareholders’ equity or cash flows.
		During 2006 and 2005, we completed several acquisitions. The results of operations of the acquired 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 for the nine months and three months ended September 30, 2006 and 2005 do not contain any operations of the entities acquired in 2006 or 2005 prior to their acquisition date.
		Large Loss Events
		During the third quarter of 2005, catastrophic events occurred related to two major hurricanes, Katrina and Rita, and two minor ones (collectively, the 2005 hurricanes). We recognized a pre-tax loss, after reinsurance, of $74.4 million in our insurance company segment in that quarter with respect to the 2005 hurricanes. This loss included $53.7 million recorded in loss and loss adjustment expense and $20.7 million for premiums to reinstate our excess of loss reinsurance protection, which reduced net earned premium. Net earnings were reduced $48.3 million, or $0.45 per diluted share.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

		Also during the third quarter of 2005, we reached agreements with various reinsurers to commute certain reinsurance recoverables related to our discontinued accident and health line of business. The reinsurers paid us $119.6 million of cash, which was less than the related recoverables, in consideration for discounting the recoverables and reassuming the associated loss reserves. We recorded a pre-tax loss of $26.0 million, which was included in loss and loss adjustment expense in our insurance company segment. Net earnings were reduced $16.9 million, or $0.16 per diluted share.
		Income Tax
		For the nine months ended September 30, 2006 and 2005, 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 tax-exempt municipal bond interest, state income taxes and a special $2.1 million U.S. repatriation tax benefit in 2005.
		Recent Accounting Change
		The Financial Accounting Standards Board (FASB) has issued FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes. Effective January 1, 2007, FIN 48 clarifies the accounting for uncertain income tax positions. We are currently reviewing the requirements of FIN 48 to determine the effect it will have on our consolidated financial statements.
		The FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”), which clarified the definition of fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurement. SFAS 157 does not require any new fair value measurements and eliminates inconsistencies in guidance found in various prior accounting pronouncements. SFAS 157 will be effective for us on January 1, 2008. We are currently assessing whether the adoption of SFAS 157 will have an impact on our consolidated financial statements.
		The Securities and Exchange Commission has issued Staff Accounting Bulletin (SAB) No.108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. SAB 108 establishes a standard approach for quantifying the materiality of errors to current and prior period financial statements. SAB 108’s guidelines must be applied in the fourth quarter, and adjustments, if any, will be recorded either by restating prior year financial statements or recording a cumulative effect adjustment as of January 1, 2006. We believe the requirements of SAB 108 will have no effect on our consolidated financial statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

(2)		RESTATEMENT OF FINANCIAL STATEMENTS
		In light of published reports concerning the pricing of stock options and the timing of stock option grants at numerous other companies, in the second quarter of 2006 we undertook a voluntary internal review of our past practices related to grants of stock options. The voluntary review by our management concluded that the actual accounting measurement dates for certain past stock option grants differed from the originally stated grant dates, which were also utilized as the measurement dates for such awards. In August 2006, our Board of Directors formed a Special Committee of independent directors to commence an investigation of our past stock option granting practices for the period 1995 through 2005. The Special Committee was composed of the members of the Audit Committee of the Board of Directors. The Special Committee retained the law firm of Skadden, Arps, Slate, Meagher & Flom, LLP as its independent legal counsel and LECG as forensic accountants to aid in the investigation.
		On November 17, 2006, we announced that the Special Committee had made certain determinations as a result of its review of our past stock option granting practices. The Special Committee found that we had used incorrect accounting measurement dates for stock option grants covering a significant number of employees and members of our Board of Directors during the period 1997 through 2005 and that certain option grants were retroactively priced. Additionally, at the direction of the Special Committee, we reviewed our stock option granting practices from 1992, the year of our initial public stock offering, through 1994 and in 2006 and found incorrect measurement dates due to retroactive pricing were used in 2006. In substantially all of these instances, the price on the actual measurement date was higher than the price on the stated grant date; thus recipients of the options could exercise at a strike price lower than the actual measurement date price. To determine the actual measurement dates, the Special Committee utilized the following sources of information:

	•		The dates on documentation such as e-mails, regulatory form filings, acquisition agreements and other correspondence;
	•		The date that the relevant stock option grant was entered into Equity Edge, our stock option tracking and accounting system;
	•		Requirements of Accounting Principles Board (APB) No. 25, Accounting for Stock Issued to Employees, and related interpretations; and
	•		Guidance from the Office of Chief Accountant of the Securities and Exchange Commission (SEC) contained in a letter dated September 19, 2006.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

		The Special Committee concluded that mis-priced option grants, the effect of which, together with certain other adjustments, resulted in a cumulative net decrease in shareholders’ equity at December 31, 2005 of $3.3 million, affected all levels of employees. The Special Committee found that Stephen L. Way, Chief Executive Officer, retroactively priced options, that he should have known he was granting options in a manner that conflicted with our stock option plans and public statements, and that this constituted a failure to align the stock option granting process with our stock option plans and public statements. Although finding his actions were inconsistent with the duties and obligations of a chief executive officer of a publicly-traded company, the Special Committee also found that Mr. Way’s motivation appeared to be the attraction and retention of talent and to provide employees with the best option price. The Special Committee also concluded that Christopher L. Martin, Executive Vice President and General Counsel, was aware that options were being retroactively priced in a manner inconsistent with applicable plan terms and the procedures memoranda that he had prepared, that granting in-the-money options had accounting implications, and that he did not properly document our Compensation Committee’s informal delegation of authority to Mr. Way. The Special Committee also found that there was no evidence that Mr. Way or Mr. Martin intended to falsify the consolidated financial statements.
		Before the Board of Directors reviewed the results of the investigation, the Chairman of the Compensation Committee tendered his resignation from the Board of Directors on November 8, 2006. After reviewing the results of the investigation, the Board of Directors determined that it would be appropriate to accept the resignations of Mr. Way and Mr. Martin, which both tendered on November 17, 2006. Mr. Way will remain a director of HCC and serve as the non-executive Chairman of the Board of Directors and has entered into a consulting agreement with us to assist in the transition of leadership and to provide strategic guidance. We have entered into agreements with Mr. Way and Mr. Martin which, among other things, require them to disgorge an amount equal to the difference between the actual measurement date prices determined by HCC and the prices at which these individuals exercised mis-priced options since 1997.
		As a result of the determinations of the Special Committee and because the resulting cumulative charge would be material to the second quarter and full year 2006 consolidated net earnings, we concluded that we needed to amend our 2005 Annual Report filed with the SEC on Form 10-K and our first quarter 2006 quarterly report filed with the SEC on Form 10-Q, to restate our consolidated financial statements and disclosures. However, the impact of the restatement in any of the restated periods is not material. The amended Forms 10-K/A and 10-Q/A have been filed with the SEC. We made the restatement in accordance with generally accepted accounting principles to record the following:

	•		Non-cash compensation expense for the difference between the stock price on the stated grant date and the actual measurement date and for the fluctuations in stock price in certain instances where variable accounting should have been applied.
	•		Other adjustments that were not recorded in the originally filed financial statements due to their immateriality. These minor adjustments primarily relate to fee and commission income, loss and loss adjustment expense, policy acquisition costs and other operating expense. In addition, balance sheet reclassifications have been recorded to appropriately present certain reinsurance recoverables and payables.
	•		Related tax effects associated with the recognition of non-cash compensation expense and other adjustments as well as additional taxes that may be due and payable.

We have not amended any of our other previously filed annual reports on Form 10-K or quarterly reports on Form 10-Q for the periods affected by the restatement other than noted above. For this reason, the consolidated financial statements and related financial information contained in such previously filed reports should no longer be relied upon.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

		We were unable to timely file our quarterly reports on Form 10-Q for the quarters ended June 30, 2006 and September 30, 2006, primarily due to not knowing the financial impact of the Special Committee’s investigation. We have also restated the June 30, 2005 and September 30, 2005 financial statements included in our quarterly reports on Form 10-Q for the respective 2006 quarters.
		Based on the determinations of the Special Committee and our voluntary internal review, we identified a number of occasions during the period 1997 through 2005 and into 2006 on which we used an incorrect measurement date for financial accounting and reporting purposes for options granted. In accordance with Accounting Principles Board (APB) No. 25, Accounting for Stock Issued to Employees, and its related interpretations, we should have recorded compensation expense related to these options for the excess of the market price of our stock on the actual measurement date over the exercise price of the option. For periods commencing January 1, 2006, compensation expense is being recognized in accordance with Statement of Financial Accounting Standards (SFAS) No. 123(R) (revised), Share-Based Payment. However, we determined an incremental amount related to the mis-priced options must be recorded.
		The types of errors identified were as follows:

	•		We determined that many block grants to employees during the period 1997 through 2005 were subject to a retroactive look-back period. In all such cases, the price of our stock at the end of the look-back period, which was generally 30 days or less, was higher than the price of our stock on the stated grant date.
	•		In addition to being subject to the retroactive pricing discussed above, we determined that the strike price of block grants in 1999, 2002 and 2005 was determined prior to the final determination of the identity of the employee and/or the number of options to be granted. Further, proper approval, in most cases, had not been given until after the grant date. In all such cases, the price of our stock at the time when all required determinations were final and proper approval had been obtained was higher than the price of our stock on the stated grant date. The time lag between the stated grant date and the finalization of the awards was typically 30-45 days, except in the case of the 2002 grant which was finalized several months subsequent to the stated grant date.
	•		For the period from 1997 to 2005 and into 2006, we determined that there was a regular practice of granting options to newly hired employees and existing employees being promoted after the end of a 30-45 day period following the hire or promotion date. This practice included the use of the 30-45 day period as a look-back period during which the date with the lowest price during that period was selected as the stated grant date.
	•		In several instances, grants to senior executives were determined at a date subsequent to the stated grant date. In most cases, this resulted from extended negotiations of employment agreements and, in some cases, administrative delays. In virtually all cases, the price of our stock at the time the grants were made and properly approved was higher than the price of our stock on the stated grant date.
	•		In a few cases, options were granted and then repriced downward. As a result, variable accounting should have been applied to these options.
	•		We lacked timely or adequate documentation to support the stated grant date in the case of certain of the above errors.

The gross compensation expense recorded to correct the above errors was a non-cash charge and had no impact on our reported net revenue, cash, cash flow or shareholders’ equity.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

		In connection with the investigation, we determined that a number of executive officers received in-the-money options. If such options are ultimately determined to be in-the-money grants for tax purposes, pursuant to Section 162(m) of the Internal Revenue Code and, if in the year of exercise the officers’ compensation, including proceeds from options exercised, exceeded $1.0 million, we would not be entitled to a tax deduction for any amount in excess of such $1.0 million for officers covered by Section 162(m). We estimate the tax effect of the deduction was $4.6 million, substantially all of which was recorded as a reduction to shareholders’ equity.
		There were immaterial adjustments that were not made in the originally filed consolidated financial statements. We have taken the opportunity presented by this restatement to record these adjustments, which amounted to a net $2.4 million increase in earnings from continuing operations before income tax expense, for the years 2001 through 2005.
		The increase (decrease) on net earnings of each type of adjustment was as follows (in thousands):

						Non-cash
		Net earnings				stock option
		as previously				compensation												Total				Net earnings
		reported				expense				Other				Tax effect				adjustments				as restated
Nine months ended September 30, 2005		$	129,326			$	(2,193	)		$	(2,453	)		$	1,476			$	(3,170	)		$	126,156
Three months ended September 30, 2005		$	7,950			$	(803	)		$	—			$	265			$	(538	)		$	7,412

		The restatement adjustments reduced previously reported diluted net earnings per share by $0.03 and $0.00 for the nine and three months ended September 30, 2005, respectively.
		Enacted October 22, 2004, Section 409A of the Internal Revenue Code significantly changed the rules for nonqualified deferred compensation plans. Section 409A imposes certain restrictions and taxes on stock awards that constitute deferred compensation. Section 409A relates specifically to the personal tax liabilities of our employees that have received discounted options. We are currently reviewing the implications of Section 409A on grants awarded with intrinsic value that vested after December 31, 2004 and modifications made to existing grants after October 3, 2004 along with potential remedial actions.
		As of December 15, 2006, we have paid direct costs of approximately $6.0 million, of which $2.5 million was incurred through September 30, 2006, for costs associated with the Special Committee’s investigation and additional related professional services and consulting fees associated with the restatement effort.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands, except per share data)

The following table sets forth the impact of the above adjustments and the related tax effects on our historical statements of earnings for the nine and three months ended September 30, 2005.

		Nine Months ended September 30, 2005												Three Months ended September 30, 2005
		As previously												As previously
		reported				Adjustments				As restated				reported				Adjustments				As restated
REVENUE
Net earned premium		$	995,901			$	—			$	995,901			$	338,058			$	—			$	338,058
Fee and commission income			102,452				(1,453	)			100,999				32,073				—				32,073
Net investment income			70,039				—				70,039				24,998				—				24,998
Net realized investment gain			2,038				—				2,038				38				—				38
Other operating income			26,116				—				26,116				16,864				—				16,864
Total revenue			1,196,546				(1,453	)			1,195,093				412,031				—				412,031
EXPENSE
Loss and loss adjustment expense, net			679,932				—				679,932				295,768				—				295,768
Policy acquisition costs, net			185,696				2,000				187,696				65,708				—				65,708
Other operating expense			135,884				1,193				137,077				40,403				803				41,206
Interest expense			5,848				—				5,848				2,070				—				2,070
Total expense			1,007,360				3,193				1,010,553				403,949				803				404,752
Earnings from continuing operations before income tax expense			189,186				(4,646	)			184,540				8,082				(803	)			7,279
Income tax expense on continuing operations			60,567				(1,476	)			59,091				839				(265	)			574
Earnings from continuing operations			128,619				(3,170	)			125,449				7,243				(538	)			6,705
Earnings from discontinued operations, net of income taxes			707				—				707				707				—				707
Net earnings		$	129,326			$	(3,170	)		$	126,156			$	7,950			$	(538	)		$	7,412
Basic earnings per share data:
Earnings from continuing operations		$	1.23			$	(0.03	)		$	1.20			$	0.07			$	(0.01	)		$	0.06
Earnings from discontinued operations			0.01				—				0.01				0.01				—				0.01
Net earnings		$	1.24			$	(0.03	)		$	1.21			$	0.08			$	(0.01	)		$	0.07
Weighted average shares outstanding			104,617				—				104,617				105,623				—				105,623
Diluted earnings per share data:
Earnings from continuing operations		$	1.19			$	(0.03	)		$	1.16			$	0.06			$	—			$	0.06
Earnings from discontinued operations			0.01				—				0.01				0.01				—				0.01
Net earnings		$	1.20			$	(0.03	)		$	1.17			$	0.07			$	—			$	0.07
Weighted average shares outstanding			108,003				—				108,003				109,818				—				109,818

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands, except per share data)

The restatement did not impact our net cash flows from operating, investing, or financing activities. However, certain items within net cash provided by operating activities were affected by the restatement adjustments. The following table shows the effect of the restatement on our previously reported cash flows:

		Nine months ended								Three months ended
		September 30, 2005								September 30, 2005
		As previously								As previously
		reported				As restated				reported				As restated
Net earnings		$	129,326			$	126,156			$	7,950			$	7,412
Adjustments to reconcile net earnings to net cash provided by operating activities:
Change in premium, claims and other receivables			(37,538	)			(74,007	)			39,121				16,604
Change in reinsurance recoverables			(156,477	)			(145,305	)			(138,947	)			(126,291	)
Change in ceded unearned premium			65,591				60,509				14,648				14,648
Change in reinsurance balances payable			(34,966	)			(23,906	)			15,744				15,744
Change in premium and claims payable, net of restricted cash			3,728				30,585				5,188				15,049
Stock-based compensation expense			—				1,920				—				750
Other, net			(37,178	)			(43,466	)			(10,326	)			(10,538	)

In connection with the preparation of our restated financial statements, we also determined that the pro forma disclosures for stock-based compensation expense for the nine and three months ended September 30, 2005 required under Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation included in Note 3 of the Notes to Condensed Consolidated Financial Statements, were incorrect. Specifically, the errors related to the effect on the consolidated financial statements resulting from the improper application of APB No. 25 to certain stock option transactions and the use of assumptions for determining the fair value of our stock options on the date of grant. We have corrected these errors in Note 3 to the consolidated financial statements. These corrections do not affect our consolidated balance sheets, consolidated statements of earnings or consolidated statements of cash flows for any period.

The following table presents the effect of these corrections on our pro forma calculation of our net income and earnings per share for the nine months and three months ended September 30, 2005:

		Nine months ended								Three months ended
		September 30, 2005								September 30, 2005
		As previously								As previously
		reported				As restated				reported				As restated
Reported net earnings		$	129,326			$	126,156			$	7,950			$	7,412
Stock-based compensation included in reported net earnings, net of income taxes			—				1,576				—				538
Stock-based compensation using fair value method, net of income taxes			(4,617	)			(5,585	)			(1,927	)			(2,247	)
Pro forma net earnings		$	124,709			$	122,147			$	6,023			$	5,703
Reported basic earnings per share		$	1.24			$	1.21			$	0.08			$	0.07
Fair value stock-based compensation			(0.05	)			(0.04	)			(0.02	)			(0.02	)
Pro forma basic earnings per share		$	1.19			$	1.17			$	0.06			$	0.05
Reported diluted earnings per share		$	1.20			$	1.17			$	0.07			$	0.07
Fair value stock-based compensation			(0.05	)			(0.04	)			(0.02	)			(0.02	)
Pro forma diluted earnings per share		$	1.15			$	1.13			$	0.05			$	0.05

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands, except per share data)

(3)		STOCK OPTIONS
		Our stock option plans, the 2004 Flexible Incentive Plan and 2001 Flexible Incentive Plan, are administered by the Compensation Committee of the Board of Directors. Options granted under these plans may be used to purchase one share of our common stock. The plans require that all options be granted at fixed exercise prices at the market price of our common stock on the grant date and do not allow repricing of options. Options vest over a period of up to seven years, which is the requisite service period, and expire four to ten years after grant date.
		Statement of Financial Accounting Standards (SFAS) No. 123(R), Share-Based Payment, requires companies to charge the fair value of stock-based compensation to earnings. Effective January 1, 2006, we adopted SFAS 123(R) using the modified prospective method. We are recognizing compensation expense in 2006 and thereafter based on our unvested stock options granted before January 1, 2006 and all options granted after that date. We use the Black-Scholes single option pricing model to determine the fair value of an option on its grant date and expense that value on a straight-line basis over the option’s vesting period. We made no modifications to our stock option plans in conjunction with our adoption of SFAS 123(R). In 2005, we accounted for stock options granted to employees in accordance with Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. The 2005 and prior period financial statements were not restated to reflect the implementation of SFAS 123(R).
		In the first nine months of 2006, we expensed $9.5 million ($6.8 million after-tax or $0.06 per diluted share) of stock-based compensation, after the effect of the deferral and amortization of related policy acquisition costs. We expensed $3.4 million ($2.4 million after-tax or $0.02 per diluted share) in the third quarter of 2006. At September 30, 2006, there was approximately $33.0 million of total unrecognized compensation expense related to unvested options that is expected to be recognized over a weighted-average period of three years. In 2006, we expect to recognize $12.9 million of expense, including the amortization of deferred policy acquisition costs, related to stock-based compensation for options currently outstanding.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

The table below shows the weighted-average fair value of options granted and the related weighted-average assumptions used in the Black-Scholes model. The risk-free interest rate is based on the U.S. Treasury rate that most closely approximates each option’s expected term. We based our expected volatility on the historical volatility of our stock over a period matching each option’s expected term. Our dividend yield is based on an average of our historical dividend payments divided by the stock price. We used historical exercise patterns by grant type to estimate the expected option life.

		Nine months ended September 30,								Three months ended September 30,
		2006				2005				2006				2005
						(As restated)								(As restated)
Fair value of options granted		$	7.05			$	8.86			$	6.74			$	9.11
Risk free interest rate			4.7	%			4.0	%			5.1	%			4.1	%
Expected volatility			21.9	%			32.0	%			21.4	%			32.0	%
Expected dividend yield			1.1	%			1.1	%			1.3	%			1.2	%
Expected option life		3.7 years				4.8 years				4.1 years				4.8 years

The following table details our stock option activity during the nine months ended September 30, 2006.

						Weighted-				Weighted-
						average				average				Aggregate
		Number				exercise				contractual				intrinsic
		of shares				price				life				value
Outstanding, beginning of year			8,219			$	20.71
Granted			748				31.66
Exercised			(690	)			16.97
Forfeited and expired			(145	)			20.89
Outstanding, end of period			8,132				22.03			3.9 years				$	88,305
Exercisable, end of period			2,458				19.55			3.1 years					32,750

The aggregate intrinsic value (the amount by which the fair value of the underlying stock exceeds the exercise price) of options exercised during the first nine months of 2006 and 2005 was $10.4 million and $21.9 million, respectively. At September 30, 2006, 11.8 million shares of our common stock were authorized and reserved for the exercise of options, of which 8.1 million shares were reserved for options previously granted and 3.7 million shares were reserved for future issuance.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

		Exercise of options during the first nine months of 2006 and 2005 resulted in cash receipts of $11.7 million and $32.7 million, respectively. We generally recognize a tax benefit when our employees exercise options. SFAS 123(R) requires that we report the tax benefit related to the excess of the tax deductible amount over the recognized compensation expense as financing cash flow, rather than as operating cash flow under APB 25. We recorded a $3.3 million benefit as financing cash flow in the first nine months of 2006 and $3.4 million as operating cash flow in the first nine months of 2005.
		Prior to the adoption of SFAS 123(R), we accounted for stock-based compensation using the intrinsic value method prescribed in APB Opinion No. 25 and related interpretations. Under APB Opinion No. 25, compensation cost was measured as of the date the number of shares and exercise price became fixed. The terms of an award were generally fixed on the date of grant, requiring the stock option to be accounted for as a fixed award. For fixed awards, compensation expense was measured as the excess, if any, of the quoted market price of our stock at the date of grant over the exercise price of the option granted. Compensation expense for fixed awards, if any, was recognized ratably over the vesting period using the straight-line single option method.
		If the number of shares or exercise price was not fixed upon the date of grant, the award was accounted for as a variable award until the number of shares or the exercise price became fixed, or until the award was exercised, canceled, or expired unexercised. For variable awards, intrinsic value was remeasured each period and was equal to the fair market value of our stock as of the end of the reporting period less the grant exercise price. As a result, the amount of compensation expense or benefit to be recognized each period fluctuated based on changes in our closing price from the end of the previous reporting period to the end of the current reporting period. In cases when our closing stock price did not exceed the recipient’s exercise price, no compensation expense resulted. Compensation expense for variable awards, if any, was recognized in accordance with FIN No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plan, An Interpretation of APB Opinions No. 15 and 25.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

		We accounted for modifications to stock options under APB No. 25, as subsequently interpreted by FIN No. 44. Modifications included, but were not limited to, acceleration of vesting, extension of the exercise period following termination of employment and/or continued vesting while not providing substantive services. Compensation expense for modified awards was recorded in the period of modification for the intrinsic value of the vested portion of the award, including vesting that occurred while not providing substantive services, after the date of modification. The intrinsic value of the award was the difference between the fair market value of our common stock on the date of modification and the recipient’s exercise price.
		Stock options issued to non-employees were accounted for in accordance with the provisions of SFAS No. 123 and EITF No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. Compensation expense for stock options issued to non-employees was valued using the Black-Scholes model and was amortized over the vesting period in accordance with FIN No. 28.
		Prior to adoption of SFAS 123(R), we were required to disclose the effect on net earnings and earnings per share if we had used the fair value method of SFAS No. 123, Accounting for Stock-Based Compensation, to value stock options. The effect on our consolidated financial results in 2005 if we had valued our options using the fair value method under SFAS 123 and the assumptions listed above is as follows:

		Nine months				Three months
		ended September 30,				ended September 30,
		2005				2005
		(As restated)				(As restated)
Reported net earnings		$	126,156			$	7,412
Stock-based compensation included in reported net earnings, net of income taxes			1,576				538
Stock-based compensation using fair value method, net of income taxes			(5,585	)			(2,247	)
Pro forma net earnings		$	122,147			$	5,703
Reported basic earnings per share		$	1.21			$	0.07
Fair value stock-based compensation			(0.04	)			(0.02	)
Pro forma basic earnings per share		$	1.17			$	0.05
Reported diluted earnings per share		$	1.17			$	0.07
Fair value stock-based compensation			(0.04	)			(0.02	)
Pro forma diluted earnings per share		$	1.13			$	0.05

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

(4)		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 primary 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.

										Loss and loss
		Written				Earned				adjustment
		premium				premium				expense
										(As restated)
Nine months ended September 30, 2006
Primary business		$	1,399,831			$	1,326,392			$	756,316
Reinsurance assumed			228,382				205,139				112,321
Reinsurance ceded			(329,099	)			(326,590	)			(179,515	)
Net amounts		$	1,299,114			$	1,204,941			$	689,122
Nine months ended September 30, 2005
Primary business		$	1,322,105			$	1,260,309			$	977,749
Reinsurance assumed			217,897				225,010				202,306
Reinsurance ceded			(432,559	)			(489,418	)			(500,123	)
Net amounts		$	1,107,443			$	995,901			$	679,932
Three months ended September 30, 2006
Primary business		$	467,499			$	459,826			$	280,133
Reinsurance assumed			68,602				69,543				29,198
Reinsurance ceded			(113,520	)			(108,319	)			(73,301	)
Net amounts		$	422,581			$	421,050			$	236,030
Three months ended September 30, 2005
Primary business		$	458,029			$	431,573			$	513,382
Reinsurance assumed			67,418				74,146				103,473
Reinsurance ceded			(153,749	)			(167,661	)			(321,087	)
Net amounts		$	371,698			$	338,058			$	295,768

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

		Ceding commissions netted with policy acquisition costs in the condensed consolidated statements of earnings were $35.1 million in the first nine months of 2006 and $80.6 million in the first nine months of 2005.
		The table below shows the components of reinsurance recoverables in our condensed consolidated balance sheets.

		September 30,				December 31,
		2006				2005
						(As restated)
Reinsurance recoverable on paid losses		$	164,681			$	93,837
Reinsurance recoverable on outstanding losses			615,486				636,225
Reinsurance recoverable on incurred but not reported losses			540,178				644,062
Reserve for uncollectible reinsurance			(14,393	)			(12,141	)
Total reinsurance recoverables		$	1,305,952			$	1,361,983

		Our reserve for uncollectible reinsurance covers potential collectibility issues, including disputed amounts and associated expenses. While we believe the reserve is adequate based on information currently available, conditions may change or additional information might be obtained which may require us to change the reserve in the future. 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.
		We limit the liquidity exposure related to our reinsurance recoverables 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. Additionally, our U.S. domiciled insurance companies require their reinsurers not authorized by the respective states of domicile of our insurance companies to collateralize their reinsurance obligations due to us. The table below shows the amounts of letters of credit and cash deposits held by us as collateral, plus other credits available for potential offset.

		September 30,				December 31,
		2006				2005
Payables to reinsurers		$	254,530			$	291,826
Letters of credit			348,103				350,135
Cash deposits			58,985				64,150
Total credits		$	661,618			$	706,111

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

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

		September 30,				December 31,
		2006				2005
						(As restated)
Loss and loss adjustment expense payable		$	2,907,626			$	2,813,720
Reinsurance recoverable on outstanding losses			(615,486	)			(636,225	)
Reinsurance recoverable on incurred but not reported losses			(540,178	)			(644,062	)
Net reserves		$	1,751,962			$	1,533,433
Unearned premium		$	924,518			$	807,109
Ceded unearned premium			(244,003	)			(239,416	)
Net unearned premium		$	680,515			$	567,693
Deferred policy acquisition costs		$	181,111			$	156,253
Deferred ceding commissions			(67,231	)			(67,886	)
Net deferred policy acquisition costs		$	113,880			$	88,367

(5)		EARNINGS PER SHARE
		The following table details the numerator and denominator used in the earnings per share calculations.

		Nine months ended								Three months ended
		September 30,								September 30,
		2006				2005				2006				2005
						(As restated)								(As restated)
Net earnings		$	261,543			$	126,156			$	93,257			$	7,412
Weighted average common shares outstanding			111,198				104,617				111,359				105,623
Dilutive effect of outstanding options (determined using the treasury stock method)			1,558				1,584				1,511				1,636
Dilutive effect of convertible debt (determined using the treasury stock method)			4,230				1,802				4,133				2,559
Weighted average common shares and potential common shares outstanding			116,986				108,003				117,003				109,818
Anti-dilutive stock options not included in treasury stock method computation			2,823				680				1,803				13