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 June 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 August 1, 2003, there were 63.7 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 six months ended June 30, 2003
were reduced by $13.8 million and $8.2 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
June 30, 2003 and December 31, 2002 ...................................................... 3
Condensed Consolidated Statements of Earnings
For the six months and three months ended June 30, 2003 and 2002 ......................... 4
Condensed Consolidated Statements of Changes in Shareholders' Equity
For the six months ended June 30, 2003.................................................... 5
Condensed Consolidated Statements of Cash Flows
For the six months and three months ended June 30, 2003 and 2002 ......................... 6
Notes to Condensed Consolidated Financial Statements........................................... 7
Item 2. Management's Discussion and Analysis........................................................... 21
Item 3. Quantitative and Qualitative Disclosures About Market Risk..................................... 29
Item 4. Controls and Procedures........................................................................ 30
Part II. OTHER INFORMATION
Item 1. Legal Proceedings.............................................................................. 31
Item 4. Submission of Matters to Vote of Security Holders.............................................. 31
Item 6. Exhibits and Reports on Form 8-K............................................................... 32
Signatures....................................................................................................... 32
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)
June 30, 2003 December 31, 2002
------------- -----------------
(restated)
ASSETS
Investments:
Fixed income securities, at market
(cost: 2003 - $976,833; 2002 - $807,772) $ 1,019,438 $ 841,548
Marketable equity securities, at market
(cost: 2003 - $15,118; 2002 - $15,815) 15,120 15,609
Short-term investments, at cost, which approximates market 396,977 307,215
Other investments, at estimated fair value
(cost: 2003 - $2,170; 2002 - $3,264) 2,170 3,264
------------ -----------
Total investments 1,433,705 1,167,636
Cash 16,259 40,306
Restricted cash 224,909 189,396
Premium, claims and other receivables 923,473 753,527
Reinsurance recoverables 863,018 798,934
Ceded unearned premium 230,037 164,224
Ceded life and annuity benefits 78,575 78,951
Deferred policy acquisition costs 89,402 68,846
Goodwill 334,360 335,288
Other assets 162,428 107,043
------------ -----------
TOTAL ASSETS $ 4,356,166 $ 3,704,151
============ ===========
LIABILITIES
Loss and loss adjustment expense payable $ 1,305,123 $ 1,155,290
Life and annuity policy benefits 78,575 78,951
Reinsurance balances payable 230,924 166,659
Unearned premium 497,770 331,050
Deferred ceding commissions 69,034 49,963
Premium and claims payable 825,159 730,801
Notes payable 311,639 230,027
Accounts payable and accrued liabilities 85,361 78,503
------------ -----------
Total liabilities 3,403,585 2,821,244
SHAREHOLDERS' EQUITY
Common stock, $1.00 par value; 250.0 million shares authorized;
(shares issued and outstanding: 2003 - 63,188; 2002 - 62,358) 63,188 62,358
Additional paid-in capital 429,868 416,406
Retained earnings 431,911 383,378
Accumulated other comprehensive income 27,614 20,765
------------ -----------
Total shareholders' equity 952,581 882,907
------------ -----------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 4,356,166 $ 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 six months ended June 30, For the three months ended June 30,
2003 2002 2003 2002
---- ---- ---- ----
(restated) (restated)
REVENUE
Net earned premium $ 345,914 $ 226,105 $ 183,492 $ 114,627
Fee and commission income 74,226 69,764 44,108 35,817
Net investment income 22,871 17,984 11,873 9,290
Net realized investment gain 184 1,169 205 667
Other operating income 5,116 2,140 4,240 677
--------- --------- --------- ---------
Total revenue 448,311 317,162 243,918 161,078
EXPENSE
Loss and loss adjustment expense 220,112 136,083 120,080 67,752
Operating expense:
Policy acquisition costs, net 65,869 42,288 33,957 21,339
Compensation expense 42,861 33,515 22,361 16,838
Other operating expense 27,196 22,805 13,518 10,776
--------- --------- --------- ---------
Total operating expense 135,926 98,608 69,836 48,953
Interest expense 3,596 4,841 1,914 2,463
--------- --------- --------- ---------
Total expense 359,634 239,532 191,830 119,168
--------- --------- --------- ---------
Earnings before income tax provision 88,677 77,630 52,088 41,910
Income tax provision 31,942 27,566 19,120 15,128
--------- --------- --------- ---------
Net earnings $ 56,735 $ 50,064 $ 32,968 $ 26,782
========= ========= ========= =========
BASIC EARNINGS PER SHARE DATA:
Earnings per share $ 0.90 $ 0.81 $ 0.52 $ 0.43
========= ========= ========= =========
Weighted average shares outstanding 62,753 62,087 62,867 62,236
========= ========= ========= =========
DILUTED EARNINGS PER SHARE DATA:
Earnings per share $ 0.89 $ 0.80 $ 0.52 $ 0.43
========= ========= ========= =========
Weighted average shares outstanding 63,667 62,805 63,990 62,889
========= ========= ========= =========
Cash dividends declared, per share $ 0.13 $ 0.125 $ 0.065 $ 0.0625
========= ========= ========= =========
See Notes to Condensed Consolidated Financial Statements.
4
HCC Insurance Holdings, Inc. and Subsidiaries
Condensed Consolidated Statements of Changes in Shareholders' Equity
For the six months ended June 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 -- -- 56,735 -- 56,735
Other comprehensive income -- -- -- 6,849 6,849
---------
Comprehensive income 63,584
778 shares of common stock issued for
exercise of options, including tax
benefit of $2,323 778 13,514 -- -- 14,292
Issuance of 52 shares of
contractually issuable common stock 52 (52) -- -- --
Cash dividends declared, $0.13 per share -- -- (8,202) -- (8,202)
-------- ---------- --------- -------- ---------
BALANCE AS OF JUNE 30, 2003 $ 63,188 $ 429,868 $ 431,911 $ 27,614 $ 952,581
======== ========== ========= ======== =========
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 six months ended For the three months ended
June 30, June 30,
2003 2002 2003 2002
---- ---- ---- ----
(restated) (restated)
Cash flows from operating activities:
Net earnings $ 56,735 $ 50,064 $ 32,968 $ 26,782
Adjustments to reconcile net earnings to
net cash provided by operating activities:
Change in premium, claims and other
receivables (169,946) (37,451) (107,729) (46,737)
Change in reinsurance recoverables (64,084) 30,036 (17,052) 29,419
Change in ceded unearned premium (65,813) (39,310) (41,382) (36,822)
Change in loss and loss adjustment
expense payable 149,833 (35,164) 70,912 (52,264)
Change in reinsurance balances payable 64,265 38,459 35,430 35,312
Change in unearned premium 166,720 68,379 110,496 56,241
Change in premium and claims payable,
net of restricted cash 58,845 (41,378) 18,965 13,441
Depreciation and amortization expense 5,564 5,378 2,588 2,631
Other, net (2,847) 7,669 (7,795) 5,577
--------- --------- --------- ---------
Cash provided by operating activities 199,272 46,682 97,401 33,580
Cash flows from investing activities:
Sales of fixed income securities 123,181 154,164 27,952 85,853
Maturity or call of fixed income securities 69,086 19,691 41,728 9,879
Sales of equity securities 1,165 3,417 182 2,228
Other proceeds 16,846 -- 16,846 --
Change in short-term investments (89,563) 41,502 58,636 42,695
Cost of securities acquired (407,875) (287,100) (243,638) (194,149)
Earnout payments for purchase of subsidiaries (4,079) -- (4,079) --
Purchases of property and equipment (3,135) (2,838) (1,612) (1,513)
--------- --------- --------- ---------
Cash used by investing activities (294,374) (71,164) (103,985) (55,007)
Cash flows from financing activities:
Proceeds from notes payable, net of costs 134,845 40,000 -- 40,000
Sale of common stock, net of costs 11,969 9,261 8,238 2,691
Payments on notes payable (67,622) (13,269) (95) (10,742)
Dividends paid and other, net (8,137) (8,944) (4,076) (3,877)
--------- --------- --------- ---------
Cash provided by financing activities 71,055 27,048 4,067 28,072
--------- --------- --------- ---------
Net change in cash (24,047) 2,566 (2,517) 6,645
Cash at beginning of period 40,306 16,891 18,776 12,812
--------- --------- --------- ---------
CASH AT END OF PERIOD $ 16,259 $ 19,457 $ 16,259 $ 19,457
========= ========= ========= =========
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 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 $13.8
million for the first six months of 2003 ($2.9 million for the three
months ended June 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 six months ended June 30, 2003:
Net earnings, as previously reported $ 64,937 $ 1.03 $ 1.02
Effect of adjustment on operations for the period (4,312) (0.07) (0.07)
Cumulative adjustment (3,890) (0.06) (0.06)
--------- ------- -------
Net earnings, as reported herein $ 56,735 $ 0.90 $ 0.89
========= ======= =======
For the three months ended June 30, 2003:
Net earnings, as previously reported $ 34,662 $ 0.55 $ 0.54
Effect of adjustment on operations for the period (1,694) (0.03) (0.02)
--------- ------- -------
Net earnings, as reported herein $ 32,968 $ 0.52 $ 0.52
========= ======= =======
During the fourth quarter of 2002, we completed three acquisitions. The
results of operations of these entities are included in our
consolidated financial statements beginning on the effective date of
each transaction. Thus, our condensed consolidated statements of
earnings and cash flows for the six and three months ended June 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 two 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 six months and three months ended June 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 income. 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 six months ended For the three months ended
June 30, June 30,
2003 2002 2003 2002
---- ---- ---- ----
Reported net earnings $ 56,735 $ 50,064 $ 32,968 $ 26,782
Stock-based compensation using
fair value method, net of income tax (3,871) (2,283) (1,932) (1,198)
-------- -------- -------- --------
Pro forma net earnings $ 52,864 $ 47,781 $ 31,036 $ 25,584
======== ======== ======== ========
Reported basic earnings per share $ 0.90 $ 0.81 $ 0.52 $ 0.43
Fair value stock-based compensation (0.06) (0.04) (0.03) (0.02)
-------- -------- -------- --------
Pro forma basic earnings per share $ 0.84 $ 0.77 $ 0.49 $ 0.41
======== ======== ======== ========
Reported diluted earnings per share $ 0.89 $ 0.80 $ 0.52 $ 0.43
Fair value stock-based compensation (0.06) (0.04) (0.03) (0.02)
-------- -------- -------- --------
Pro forma diluted earnings per share $ 0.83 $ 0.76 $ 0.49 $ 0.41
======== ======== ======== ========
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) 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 six months ended June 30, 2003:
Direct business $ 654,610 $ 538,255 $ 335,912
Reinsurance assumed 202,117 153,833 168,660
Reinsurance ceded (413,135) (346,174) (284,460)
--------------- --------------- ---------------
NET AMOUNTS $ 443,592 $ 345,914 $ 220,112
=============== =============== ===============
For the six months ended June 30, 2002:
Direct business $ 436,780 $ 378,086 $ 261,158
Reinsurance assumed 116,840 104,996 29,266
Reinsurance ceded (295,958) (256,977) (154,341)
--------------- --------------- ---------------
NET AMOUNTS $ 257,662 $ 226,105 $ 136,083
=============== =============== ===============
For the three months ended June 30, 2003:
Direct business $ 357,830 $ 282,384 $ 168,696
Reinsurance assumed 119,449 91,885 116,833
Reinsurance ceded (226,188) (190,777) (165,449)
--------------- --------------- ---------------
NET AMOUNTS $ 251,091 $ 183,492 $ 120,080
=============== =============== ===============
For the three months ended June 30, 2002:
Direct business $ 244,690 $ 193,527 $ 117,942
Reinsurance assumed 61,162 55,468 10,166
Reinsurance ceded (170,462) (134,368) (60,356)
--------------- --------------- ---------------
NET AMOUNTS $ 135,390 $ 114,627 $ 67,752
=============== =============== ===============
10
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(2) REINSURANCE, CONTINUED
The table below represents the composition of reinsurance recoverables
in our condensed consolidated balance sheets:
June 30, 2003 December 31, 2002
------------- -----------------
Reinsurance recoverable on paid losses $ 109,506 $ 108,104
Reinsurance recoverable on outstanding losses 440,459 437,162
Reinsurance recoverable on incurred but not reported losses 322,649 260,810
Reserve for uncollectible reinsurance (9,596) (7,142)
---------- ----------
TOTAL REINSURANCE RECOVERABLES $ 863,018 $ 798,934
========== ==========
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.
June 30, 2003 December 31, 2002
------------- -----------------
Payables to reinsurers $ 334,190 $ 235,727
Letters of credit 150,314 141,490
Cash deposits 9,102 9,384
---------- ----------
TOTAL CREDITS $ 493,606 $ 386,601
========== ==========
The tables below present the calculation of net reserves, net unearned
premium and net deferred policy acquisition costs:
June 30, 2003 December 31, 2002
------------- -----------------
Loss and loss adjustment expense payable $1,305,123 $ 1,155,290
Reinsurance recoverable on outstanding losses (440,459) (437,162)
Reinsurance recoverable on incurred but not reported losses (322,649) (260,810)
---------- ----------
NET RESERVES $ 542,015 $ 457,318
========== ==========
Unearned premium $ 497,770 $ 331,050
Ceded unearned premium (230,037) (164,224)
---------- ----------
NET UNEARNED PREMIUM $ 267,733 $ 166,826
========== ==========
Deferred policy acquisition costs $ 89,402 $ 68,846
Deferred ceding commissions (69,034) (49,963)
---------- ----------
NET DEFERRED POLICY ACQUISITION COSTS $ 20,368 $ 18,883
========== ==========
11
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(2) REINSURANCE, CONTINUED
We have a reserve of $9.6 million as of June 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 attack 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 June 30, 2003, our
insurance companies had initiated two litigation proceedings against
reinsurers. As of such date, our insurance companies had an aggregate
amount of $5.7 million which had not been paid to us under the
agreements and we estimate that there could be up to an additional $8.7
million of incurred losses and loss expenses and other balances which
could become due under the subject agreements.
(3) 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. During the second quarter of 2003 we
reclassified one of our subsidiaries, which was acquired in December
2002, from the underwriting agency segment to the intermediary segment
in order to better match our segment presentation with the way we make
decisions and assess performance. This reclassification has been made
in all 2003 tables presented. 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.
12
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(3) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED
Insurance Underwriting Other
Company Agency Intermediary Operations Corporate Total
------- ------ ------------ ---------- --------- -----
For the six months ended June 30, 2003:
Revenue:
Domestic $284,796 $ 27,815 $ 11,530 $ 4,654 $ 786 $329,581
Foreign 101,273 1,275 16,182 -- -- 118,730
Inter-segment -- 45,198 2,901 -- -- 48,099
---------------------------------------------------------------------------
TOTAL SEGMENT REVENUE $386,069 $ 74,288 $ 30,613 $ 4,654 $ 786 496,410
==============================================================
Inter-segment revenue (48,099)
--------
CONSOLIDATED TOTAL REVENUE $448,311
========
Net earnings:
Domestic $ 31,960 $ 19,090 $ 3,017 $ 1,933 $ 478 $ 56,478
Foreign 7,201 1,901 3,039 -- -- 12,141
---------------------------------------------------------------------------
TOTAL SEGMENT NET EARNINGS $ 39,161 $ 20,991 $ 6,056 $ 1,933 $ 478 68,619
==============================================================
Inter-segment eliminations (11,884)
--------
CONSOLIDATED NET EARNINGS $ 56,735
========
Other items:
Net investment income $ 20,227 $ 1,242 $ 591 $ 8 $ 803 $ 22,871
Depreciation and amortization 1,617 1,463 1,077 327 1,080 5,564
Interest expense (benefit) 25 3,411 1,790 387 (2,017) 3,596
Capital expenditures 1,231 668 888 -- 348 3,135
Income tax provision 19,201 13,130 3,660 868 1,085 37,944
Inter-segment eliminations (6,002)
--------
CONSOLIDATED INCOME TAX PROVISION $ 31,942
========
13
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(3) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED
Insurance Underwriting Other
Company Agency Intermediary Operations Corporate Total
------- ------ ------------ ---------- --------- -----
For the six months ended June 30, 2002:
Revenue:
Domestic $224,058 $ 35,529 $ 12,452 $ 605 $ 790 $273,434
Foreign 33,948 591 9,189 -- -- 43,728
Inter-segment -- 17,266 405 -- -- 17,671
---------------------------------------------------------------------------
TOTAL SEGMENT REVENUE $258,006 $ 53,386 $ 22,046 $ 605 $ 790 334,833
===============================================================
Inter-segment revenue (17,671)
--------
CONSOLIDATED TOTAL REVENUE $317,162
========
Net earnings:
Domestic $ 30,239 $ 11,399 $ 2,884 $ 295 $ 1,296 $ 46,113
Foreign 2,740 257 1,268 -- -- 4,265
---------------------------------------------------------------------------
TOTAL SEGMENT NET EARNINGS $ 32,979 $ 11,656 $ 4,152 $ 295 $ 1,296 50,378
===============================================================
Inter-segment eliminations (314)
--------
CONSOLIDATED NET EARNINGS $ 50,064
========
Other items:
Net investment income $ 15,974 $ 1,330 $ 464 $ 27 $ 189 $ 17,984
Depreciation and amortization 1,518 3,111 170 66 513 5,378
Interest expense (benefit) 73 3,880 1,288 -- (400) 4,841
Capital expenditures 1,007 800 695 -- 336 2,838
Income tax provision 16,014 7,305 3,581 52 792 27,744
Inter-segment eliminations (178)
--------
CONSOLIDATED INCOME TAX PROVISION $ 27,566
========
14
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(3) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED
Insurance Underwriting Other
Company Agency Intermediary Operations Corporate Total
------- ------ ------------ ---------- --------- -----
For the three months ended June 30, 2003:
Revenue:
Domestic $147,560 $ 17,297 $ 6,559 $ 4,207 $ 785 $176,408
Foreign 56,951 2,374 8,185 -- -- 67,510
Inter-segment -- 20,301 753 -- -- 21,054
--------------------------------------------------------------------------
TOTAL SEGMENT REVENUE $204,511 $ 39,972 $15,497 $ 4,207 $ 785 264,972
==============================================================
Inter-segment revenue (21,054)
--------
CONSOLIDATED TOTAL REVENUE $243,918
========
Net earnings:
Domestic $ 15,987 $ 10,345 $ 1,475 $ 2,523 $ 697 $ 31,027
Foreign 3,814 1,415 1,197 -- -- 6,426
--------------------------------------------------------------------------
TOTAL SEGMENT NET EARNINGS $ 19,801 $ 11,760 $ 2,672 $ 2,523 $ 697 37,453
==============================================================
Inter-segment eliminations (4,485)
--------
CONSOLIDATED NET EARNINGS $ 32,968
========
Other items:
Net investment income $ 10,197 $ 581 $ 319 $ 4 $ 772 $ 11,873
Depreciation and amortization 796 87 776 88 841 2,588
Interest expense (benefit) 16 1,599 1,152 194 (1,047) 1,914
Capital expenditures 791 151 587 -- 83 1,612
Income tax provision 10,440 7,570 1,365 1,150 327 20,852
Inter-segment eliminations (1,732)
--------
CONSOLIDATED INCOME TAX PROVISION $ 19,120
========
15
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(3) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED
Insurance Underwriting Other
Company Agency Intermediary Operations Corporate Total
------- ------ ------------ ---------- --------- -----
For the three months ended June 30, 2002:
Revenue:
Domestic $113,961 $18,131 $ 7,314 $ 312 $ 177 $139,895
Foreign 17,153 84 3,946 -- -- 21,183
Inter-segment -- 8,823 148 -- -- 8,971
--------------------------------------------------------------------------
TOTAL SEGMENT REVENUE $131,114 $27,038 $11,408 $ 312 $ 177 170,049
===============================================================
Inter-segment revenue (8,971)
--------
CONSOLIDATED TOTAL REVENUE $161,078
========
Net earnings (loss):
Domestic $ 15,875 $ 6,164 $ 2,319 $ 230 $ (52) $ 24,536
Foreign 2,204 (1) 124 -- -- 2,327
--------------------------------------------------------------------------
TOTAL SEGMENT NET EARNINGS (LOSS) $ 18,079 $ 6,163 $ 2,443 $ 230 $ (52) 26,863
===============================================================
Inter-segment eliminations (81)
--------
CONSOLIDATED NET EARNINGS $ 26,782
========
Other items:
Net investment income $ 8,282 $ 615 $ 242 $ 7 $ 144 $ 9,290
Depreciation and amortization 760 1,504 84 16 267 2,631
Interest expense (benefit) -- 1,894 644 -- (75) 2,463
Capital expenditures 505 376 405 -- 227 1,513
Income tax provision 8,695 4,168 1,880 61 343 15,147
Inter-segment eliminations (19)
--------
CONSOLIDATED INCOME TAX PROVISION $ 15,128
========
16
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(3) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED
The following tables present selected revenue items by line of business
for the periods indicated:
For the six months ended June 30, For the three months ended June 30,
2003 2002 2003 2002
---- ---- ---- ----
Group life, accident and health $ 147,509 $ 105,805 $ 75,526 $ 54,238
Diversified financial products 44,818 7,277 26,512 4,574
London market account 66,457 32,521 37,081 16,269
Aviation 48,237 50,754 24,355 25,571
Other specialty lines of business 19,081 8,982 9,553 5,347
----------- ----------- ----------- -----------
326,102 205,339 173,027 105,999
Discontinued lines of business 19,812 20,766 10,465 8,628
----------- ----------- ----------- -----------
NET EARNED PREMIUM $ 345,914 $ 226,105 $ 183,492 $ 114,627
=========== =========== =========== ===========
Group life, accident and health $ 41,474 $ 47,512 $ 21,529 $ 24,683
Property and casualty 32,752 22,252 22,579 11,134
----------- ----------- ----------- -----------
FEE AND COMMISSION INCOME $ 74,226 $ 69,764 $ 44,108 $ 35,817
=========== =========== =========== ===========
17
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(4) 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 six months ended June 30, For the three months ended June 30,
2003 2002 2003 2002
---- ---- ---- ----
Net earnings $ 56,735 $ 50,064 $ 32,968 $ 26,782
=========== =========== ========== ===========
Reconciliation of shares outstanding:
Shares of common stock outstanding
at period end 63,188 62,232 63,188 62,232
Effect of common shares issued
during the period (435) (197) (321) (48)
Common shares contractually issuable in
the future -- 52 -- 52
----------- ----------- ---------- -----------
Weighted average common
shares outstanding 62,753 62,087 62,867 62,236
Additional dilutive effect of
outstanding options (as determined by the
application of the treasury stock
method) 914 718 1,123 653
----------- ----------- ---------- -----------
Weighted average shares and
potential common shares outstanding 63,667 62,805 63,990 62,889
=========== =========== ========== ===========
Anti-dilutive shares not included
in computation 499 364 174 416
=========== =========== ========== ===========
18
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(5) NOTES PAYABLE
The table below shows the composition of our notes payable as shown in
our condensed consolidated balance sheets.
June 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 14,188 4,576
---------- ----------
TOTAL NOTES PAYABLE $ 311,639 $ 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 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,
which is 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 is
available to assist in financing future acquisitions and strategic
investments and for general corporate purposes.
19
HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands, except per share data, continued)
(6) SUPPLEMENTAL INFORMATION
For the six months ended June 30, For the three months ended June 30,
2003 2002 2003 2002
---- ---- ---- ----
Interest paid $ 2,721 $ 2,417 $ 290 $ 347
Income tax paid 32,102 13,020 26,171 11,455
Comprehensive income 63,584 55,132 40,640 35,011
Ceding commissions netted with
policy acquisition costs 54,313 38,398 29,934 18,981
(7) COMMITMENTS AND CONTINGENCIES
In addition to the matters discussed in Note (2) 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.
20
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 $13.8 million for
the first six months of 2003 ($2.9 million for the three months ended June 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 six months ended June 30, 2003:
Net earnings, as previously reported $ 64,937 $ 1.03 $ 1.02
Effect of adjustment on operations for the period (4,312) (0.07) (0.07)
Cumulative adjustment (3,890) (0.06) (0.06)
---------- -------- -------
Net earnings, as reported herein $ 56,735 $ 0.90 $ 0.89
========== ======== =======
For the three months ended June 30, 2003:
Net earnings, as previously reported $ 34,662 $ 0.55 $ 0.54
Effect of adjustment on operations for the period (1,694) (0.03) (0.02)
---------- -------- -------
Net earnings, as reported herein $ 32,968 $ 0.52 $ 0.52
========== ======== =======
Results of Operations
Six months ended June 30, 2003 versus six months ended June 30, 2002
Total revenue increased 41% to $448.3 million for the first six months of 2003
from $317.2 million for the same period in 2002. The revenue increase resulted
from premium rate increases, increased business in all segments and subsidiaries
acquired during 2002.
Net investment income increased 27% to $22.9 million for the first six months of
2003 from $18.0 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 $199.3 million for the first six
months of 2003 compared to $46.7 million for the same period in 2002, continuing
a trend of increasing operating cash flow that began in 2002. The majority
21
of the increase in cash flow from operations results from increased earnings and
net premium flow 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 six months of 2003 our annualized, weighted average, tax equivalent yield
was 4.3% compared to 4.2% for the same period in 2002.
Compensation expense increased to $42.9 million during the first six months of
2003 from $33.5 million for the same period in 2002. Most of this increase is
due to subsidiaries acquired during 2002.
Other operating expense increased to $27.2 million during the first six months
of 2003 compared to $22.8 million in 2002, again primarily due to subsidiaries
acquired during 2002. Currency gains amounted to $0.8 million during the first
six months of 2003 compared to gains of $0.4 million during the same period in
2002. In addition, in 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 six months of 2003 our insurance company subsidiaries incurred unusually
high special assessments from certain states and state agencies of $5.4 million
compared to $1.0 million during the same period in 2002. Assessments of this
magnitude are not expected in the future.
Interest expense was $3.6 million for the first six months of 2003 compared to
$4.8 million for the same period in 2002. Included in the 2002 amount is $2.2
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 $0.2 million in 2003 related to our 1.3%
convertible notes, which were issued in March 2003. Partially offsetting the
decrease in amortization is the interest 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 the additional
interest expense from our 1.3% convertible notes.
Income tax expense was $31.9 million for the first six months of 2003 compared
to $27.6 million for the same period in 2002. Our effective tax rate was 36.0%
in the 2003 period compared to 35.5% in 2002. The increased rate results from a
reduction of the positive effect of tax exempt interest net of a reduction of
the effect of state income taxes as our income before tax increases, especially
in our insurance companies which are generally not subject to state income
taxes, as well as immaterial adjustments made to refine our various tax accrual
amounts.
Net earnings increased 13% to $56.7 million, or $0.89 per diluted share, for the
first six months of 2003 from $50.1 million, or $0.80 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 in
2002.
As of June 30, 2003, total assets exceeded $4.3 billion, shareholders' equity
was $952.6 million and book value per share was $15.08, up from $14.15 as of
December 31, 2002.
22
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 six months ended June 30, 2003:
Group life, accident and health $ 283,482 $ 157,353 $ 147,509 63.7%
Diversified financial products 250,426 82,214 44,818 47.9
London market account 140,152 102,554 66,457 52.8
Aviation 108,960 51,204 48,237 63.6
Other specialty lines of business 46,056 38,706 19,081 73.7
----------- ------------ ------------ -----
829,076 432,031 326,102 59.9
Discontinued lines of business 27,651 11,561 19,812 125.6
----------- ------------ ------------ -----
TOTALS $ 856,727 $ 443,592 $ 345,914 63.6%
=========== ============ ============
Expense Ratio 25.3
-----
Combined Ratio 88.9%
======
For the six months ended June 30, 2002:
Group life, accident and health $ 245,659 $ 107,028 $ 105,805 62.7%
Diversified financial products 58,369 15,133 7,277 30.2
London market account 116,053 61,939 32,521 45.6
Aviation 104,104 52,054 50,754 53.0
Other specialty lines of business 9,884 8,965 8,982 114.6
----------- ------------ ------------ -----
534,069 245,119 205,339 58.7
Discontinued lines of business 19,551 12,543 20,766 74.9
----------- ------------ ------------ -----
TOTALS $ 553,620 $ 257,662 $ 226,105 60.2%
=========== ============ ============
Expense Ratio 25.7
-----
Combined Ratio 85.9%
=====
Gross written premium increased 55% to $856.7 million for the first six months
of 2003 from $553.6 million for the same period in 2002. All of the lines of
business showed some increase as a result of increases in premium rates as well
as organic growth, but 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 six months of 2003 increased 72% to $443.6
million and net earned premium increased 53% to $345.9 million. The increase in
premium is expected to continue throughout 2003 and into 2004.
Loss and loss adjustment expense was $220.1 million for the first six months of
2003 compared to $136.1 million for the same period in 2002. The net loss ratio
was 63.6% for the first six months of 2003 compared to 60.2% for the same period
in 2002. Prior year net reserve deficiency included in loss and loss adjustment
expense approximated $9.8 million for the first six months of 2003 compared to a
redundancy of $1.9 million for the same period in 2002. For the same periods,
the gross loss ratio was 72.9% in 2003 compared to 60.1% in 2002. During the
first six 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.
This had the effect of
23
increasing our aggregate gross loss ratio by 9.3%. During the first six months
of 2002, we reduced our gross losses from the September 11 terrorist attacks by
$21.5 million, which had the effect of reducing our gross loss ratio by 4.5%. As
these assumed reinsurance contracts and September 11 losses were substantially
reinsured, there was no material effect on our net losses.
The net loss experience in the diversified financial products line of business
increased in 2003 as a result of a change in the mix of business as the line
expands rapidly and our conservative reserving philosophy on new 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 from the first six months of 2002, due in
part to some unusually large losses. Loss experience in the other specialty
lines improved in 2003 compared to the prior year as it approached its expected
level. The loss ratio in the discontinued lines of business increased in the
first six months of 2003 primarily due to prior year reserve development as we
increased reserves towards the mid-point of the actuarial range.
Policy acquisition costs, which are net of commissions on reinsurance ceded,
increased to $65.9 million during the first six months of 2003, from $42.3
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 $39.2 million in the first
six months of 2003 from $33.0 million for the same period in 2002 due to
increased premium volume from rate increases, organic growth, a subsidiary
acquired in 2002 and continuing profitable underwriting results somewhat offset
by strengthening of prior period reserves and unusually high assessments from
certain states and state agencies. We expect this growth to continue into 2004.
Underwriting Agencies
Revenue from our underwriting agencies (primarily fee income) increased 39% to
$74.3 million for the first six months of 2003 compared to $53.4 million for the
same period in 2002. This growth was both from acquisitions made during 2002 and
from internal growth, partially offset by decreases from underwriting agencies
consolidated into our insurance companies during prior years. Net earnings in
this segment increased to $21.0 million in the first six months of 2003 from
$11.7 million in 2002 for the same reasons. We expect this growth to continue
into 2004.
Intermediaries
Revenue from our intermediaries (primarily commission income) increased 39% to
$30.6 million for the first six months of 2003 compared to $22.0 million for the
same period in 2002 due to improved market conditions, growth in non-affiliated
business and an acquisition made during 2002. Net earnings of our intermediaries
increased to $6.1 million for the first six months of 2003 compared to $4.2
million for the same period of 2002 for the same reasons. We expect this growth
to continue into 2004.
24
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, as well
as 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 net earnings of the corporate segment were $0.5 million for the first six
months of 2003 compared to $1.3 million for the same period in 2002. The
decrease 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 June 30, 2003 versus quarter ended June 30, 2002
Total revenue increased 51% to $243.9 million for the second quarter of 2003
from $161.1 million for the same period in 2002. The revenue increase resulted
from premium rate increases, increased business in all segments and subsidiaries
acquired during 2002.
Net investment income increased 28% to $11.9 million for the second quarter of
2003 from $9.3 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 $97.4 million for the second
quarter of 2003 compared to $33.6 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 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 second quarter of 2003 our annualized, weighted average,
tax equivalent yield was 4.4% compared to 4.1% for the same period in 2002.
Compensation expense increased to $22.4 million during the second quarter of
2003 from $16.8 million for the same period in 2002. Most of this increase is
due to subsidiaries acquired during 2002.
Other operating expense increased to $13.5 million during the second quarter of
2003 compared to $10.8 million in 2002, again primarily due to subsidiaries
acquired during 2002. Currency gains amounted to $0.8 million during the second
quarter of 2003 compared to gains of $0.6 million during the same period in
2002. In addition, in 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
second quarter of 2003 our insurance company subsidiaries incurred unusually
high special assessments from certain states and state agencies of $3.0 million
compared to $0.6 million during the same period in 2002. Assessments of this
magnitude are not expected in the future.
Interest expense was $1.9 million for the second quarter of 2003 compared to
$2.5 million for the same period in 2002. Included in the 2002 amount is $1.1
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 $0.2 million in 2003 related to our 1.3%
convertible notes, which were issued in March 2003. Partially offsetting the
decrease in amortization is the interest on mortgage debt from a real estate
partnership we are now consolidating with our adoption of FIN No. 46 during 2003
and the additional interest expense from our 1.3% convertible notes.
25
Income tax expense was $19.1 million for the second quarter of 2003 compared to
$15.1 million for the same period in 2002. Our effective tax rate was 36.7% in
the 2003 quarter compared to 36.1% in 2002. The increased rate results from a
reduction of the positive effect of tax exempt interest net of a reduction of
the effect of state income taxes as our income before tax increases, especially
in our insurance companies which are generally not subject to state income
taxes, as well as immaterial adjustments made to refine our various tax accrual
amounts.
Net earnings increased 23% to $33.0 million, or $0.52 per diluted share, for the
second quarter of 2003 from $26.8 million, or $0.43 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 in
2002.
As of June 30, 2003, total assets exceeded $4.3 billion, shareholders' equity
was $952.6 million and book value per share was $15.08, up from $14.46 as of
March 31, 2003.
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 June 30, 2003:
Group life, accident and health $ 144,162 $ 81,168 $ 75,526 63.7%
Diversified financial products 143,106 48,907 26,512 50.8
London market account 79,434 65,322 37,081 61.3
Aviation 64,429 30,525 24,355 61.9
Other specialty lines of business 25,176 21,256 9,553 81.2
--------- --------- --------- -----
456,307 247,178 173,027 61.9
Discontinued lines of business 20,972 3,913 10,465 123.7
--------- --------- --------- -----
TOTALS $ 477,279 $ 251,091 $ 183,492 65.4%
========= ========= =========
Expense Ratio 23.7
-----
Combined Ratio 89.1%
=====
For the three months ended June 30, 2002:
Group life, accident and health $ 122,755 $ 55,208 $ 54,238 63.2%
Diversified financial products 42,556 7,792 4,574 26.8
London market account 68,508 33,403 16,269 46.6
Aviation 59,990 29,421 25,571 47.7
Other specialty lines of business 5,682 5,384 5,347 128.7
--------- --------- --------- -----
299,491 131,208 105,999 58.7
Discontinued lines of business 6,361 4,182 8,628 64.6
--------- --------- --------- -----
TOTALS $ 305,852 $ 135,390 $ 114,627 59.1%
========= ========= =========
Expense Ratio 25.3
-----
Combined Ratio 84.4%
=====
26
Gross written premium increased 56% to $477.3 million for the second quarter of
2003 from $305.9 million for the same period in 2002. All of the lines of
business showed some increase as a result of increases in premium rates as well
as organic growth, but 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 second quarter of 2003 increased 85% to $251.1
million and net earned premium increased 60% to $183.5 million. The increase in
premium is expected to continue throughout 2003 and into 2004.
Loss and loss adjustment expense was $120.1 million for the second quarter of
2003 compared to $67.8 million for the same period in 2002. The net loss ratio
was 65.4% for the second quarter of 2003 compared to 59.1% for the same period
in 2002. Prior year net reserve deficiency included in loss and loss adjustment
expense approximated $8.5 million for the second quarter of 2003 compared to a
redundancy of $0.2 million for the same period in 2002. For the same periods,
the gross loss ratio was 76.3% in 2003 compared to 51.5% in 2002. During the
second quarter of 2003, we increased our gross losses by $61.1 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.
This had the effect of increasing our aggregate gross loss ratio by 13.2%.
During the second quarter of 2002, we reduced our gross losses from the
September 11 terrorist attacks by $21.5 million which had the effect of reducing
our gross loss ratio by 8.6%. As these assumed reinsurance contracts and
September 11 losses were substantially reinsured, there was no material effect
on our net losses.
The net loss experience in the diversified financial products line of business
increased in 2003 as a result of a change in the mix of business as the line
expands rapidly and our conservative reserving philosophy on new 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 slightly from the second quarter of 2002,
due in part to some unusually large losses. Loss experience in the other
specialty lines improved in 2003 compared to the prior year as it approached its
expected level. The loss ratio in the discontinued lines of business increased
in the second quarter of 2003 primarily due to prior year reserve development as
we increased reserves towards the mid-point of the actuarial range.
Policy acquisition costs, which are net of commissions on reinsurance ceded,
increased to $34.0 million during the second quarter of 2003, from $21.3 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 $19.8 million in the second
quarter of 2003 from $18.1 million for the same period in 2002 due to increased
premium volume from rate increases, organic growth, a subsidiary acquired in
2002 and continuing profitable underwriting results somewhat offset by
strengthening of prior period reserves and unusually high assessments from
certain states and state agencies. We expect this growth to continue into 2004.
Underwriting Agencies
Revenue from our underwriting agencies (primarily fee income) increased 48% to
$40.0 million for the second quarter of 2003 compared to $27.0 million for the
same period in 2002. This growth was both from acquisitions made during 2002 and
from internal growth, partially offset by decreases from underwriting agencies
consolidated into our insurance companies during prior years. Net earnings in
this segment increased to $11.8 million in the second quarter of 2003 from $6.2
million in 2002 for the same reasons and we expect this growth to continue into
2004.
27
Intermediaries
Revenue from our intermediaries (primarily commission income) increased 36% to
$15.5 million for the second quarter of 2003 compared to $11.4 million for the
same period in 2002 due to improved market conditions, growth in non-affiliated
business and from an acquisition made in 2002. Net earnings of our
intermediaries increased to $2.7 million for the second quarter of 2003 compared
to $2.4 million for the same period of 2002 for the same reasons. We expect this
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 as well as
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 net earnings of the corporate segment were $0.7 million for the second
quarter of 2003 compared to net loss of $0.1 million for the same period in
2002. This increase resulted from the difference between quarters in investment
income, the interest expense allocated to subsidiaries and the $1.3 million
currency conversion gain in 2003. These items were partially offset by increases
in compensation and depreciation expense between years.
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 $242.0 million, or 20%, during the first six
months of 2003 and totaled $1.4 billion as of June 30, 2003, of which $413.2
million was cash and short-term investments. The increase in investments
resulted from the positive operating cash flows and part of the proceeds from
the 1.3% convertible notes discussed below.
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
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, which is being
amortized from the issue
28
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 is available to assist in financing future acquisitions and strategic
investments and for general corporate purposes.
Reinsurance recoverables increased during the first six months of 2003 due 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.
We have a reserve of $9.6 million as of June 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 attack 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
June 30, 2003, our insurance companies had initiated two litigation proceedings
against reinsurers. As of such date, our insurance companies had an aggregate
amount of $5.7 million which had not been paid to us under the agreements and we
estimate that there could be up to an additional $8.7 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.
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.
29
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.
30
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
In addition to the matters discussed in Note (2) 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 4. Submission of Matters to Vote of Security Holders
On May 15, 2003, we held our 2003 Annual Meeting of
Shareholders. At such time the following item was submitted to
a vote of shareholders through the solicitation of proxies:
Election of Directors.
The following persons were elected to serve on the Board of
Directors until the 2004 Annual Meeting of Shareholders or
until their successors have been duly elected and qualified.
The Directors received the votes set forth opposite their
respective names:
VOTES
NAME FOR WITHHELD
--------------------- ---------- ---------
Stephen L. Way 47,098,431 4,427,340
Frank J. Bramanti 47,642,448 3,883,323
Patrick B. Collins 46,835,903 4,689,868
James R. Crane 46,831,878 4,693,893
J. Robert Dickerson 46,836,778 4,688,993
Edward H. Ellis, Jr. 47,642,023 3,883,748
James C. Flagg, Ph.D. 46,835,693 4,690,078
Allan W. Fulkerson 47,643,080 3,882,691
Walter J. Lack 46,831,778 4,693,993
Michael A. F. Roberts 46,830,114 4,695,657
31
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
On May 8, 2003, we reported on Form 8-K our
announcement of financial results for the first
quarter of 2003.
On May 12, 2003, we reported on Form 8-K/A an
amendment to our announcement of financial results
for the first quarter of 2003.
On June 25, 2003, we furnished on Form 8-K the text
materials used for presentations at various investor
conferences.
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
32
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.