10-Q 1 h89808e10-q.txt HCC INSURANCE HOLDINGS, INC. 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [ X ] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the Quarter Ended June 30, 2001. [ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 from _______ to __________ Commission file number 0-20766 ------------------------------------------------------- HCC Insurance Holdings, Inc. -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) Delaware 76-0336636 -------------------------------------------------------------------------------- (State or other jurisdiction of (IRS Employer incorporation or organization) 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 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 6, 2001, there were 59,026,563 shares of common stock, $1.00 par value issued and outstanding. 2 HCC INSURANCE HOLDINGS, INC. INDEX
PAGE NO. -------- Part I. FINANCIAL INFORMATION Item 1. Condensed Consolidated Balance Sheets June 30, 2001 and December 31, 2000....................................... 3 Condensed Consolidated Statements of Earnings For the six months ended June 30, 2001 and 2000........................... 4 Condensed Consolidated Statements of Earnings For the three months ended June 30, 2001 and 2000......................... 5 Condensed Consolidated Statements of Changes in Shareholders' Equity For the six months ended June 30, 2001 and for the year ended December 31, 2000.............................................. 6 Condensed Consolidated Statements of Cash Flows For the six months ended June 30, 2001 and 2000........................... 8 Notes to Condensed Consolidated Financial Statements........................ 9 Item 2. Management's Discussion and Analysis........................................ 23 Item 3. Quantitative and Qualitative Disclosures About Market Risk.................. 29 Part II. OTHER INFORMATION........................................................... 30
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 future capital expenditures, business strategies, competitive strengths, goals, growth of our businesses 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 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 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, the forward-looking events discussed in this report may not occur. 2 3 HCC Insurance Holdings, Inc. and Subsidiaries Condensed Consolidated Balance Sheets
June 30, 2001 December 31, 2000 --------------- ----------------- (Unaudited) ASSETS Investments: Fixed income securities, at market (cost: 2001 $461,837,000; 2000 $422,821,000) $ 474,059,000 $ 433,844,000 Marketable equity securities, at market (cost: 2001 $10,452,000; 2000 $8,896,000) 11,197,000 6,282,000 Short-term investments, at cost, which approximates market 242,044,000 263,805,000 Other investments, at cost, which approximates fair value 7,527,000 7,182,000 --------------- --------------- Total investments 734,827,000 711,113,000 Cash 4,298,000 13,991,000 Restricted cash and cash investments 131,583,000 101,738,000 Premium, claims and other receivables 638,470,000 586,721,000 Reinsurance recoverables 842,823,000 789,412,000 Ceded unearned premium 109,844,000 114,469,000 Ceded life and annuity benefits 84,505,000 86,760,000 Deferred policy acquisition costs 38,925,000 39,108,000 Property and equipment, net 39,394,000 39,438,000 Goodwill 260,367,000 266,015,000 Other assets 11,666,000 18,995,000 --------------- --------------- TOTAL ASSETS $ 2,896,702,000 $ 2,767,760,000 =============== =============== LIABILITIES Loss and loss adjustment expense payable $ 1,001,384,000 $ 944,117,000 Life and annuity policy benefits 84,505,000 86,760,000 Reinsurance balances payable 107,725,000 130,746,000 Unearned premium 205,829,000 190,550,000 Deferred ceding commissions 26,096,000 30,013,000 Premium and claims payable 646,853,000 594,852,000 Notes payable 53,456,000 212,133,000 Accounts payable and accrued liabilities 44,022,000 47,659,000 --------------- --------------- Total liabilities 2,169,870,000 2,236,830,000 SHAREHOLDERS' EQUITY Common stock, $1.00 par value; 250,000,000 shares authorized; (shares issued and outstanding: 2001 59,025,813; 2000 51,342,006) 59,026,000 51,342,000 Additional paid-in capital 354,034,000 196,999,000 Retained earnings 306,250,000 277,876,000 Accumulated other comprehensive income 7,522,000 4,713,000 --------------- --------------- Total shareholders' equity 726,832,000 530,930,000 --------------- --------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 2,896,702,000 $ 2,767,760,000 =============== ===============
See Notes to Condensed Consolidated Financial Statements. 3 4 HCC Insurance Holdings, Inc. and Subsidiaries Condensed Consolidated Statements of Earnings (Unaudited)
For the six months ended June 30, --------------------------------------- 2001 2000 -------------- -------------- REVENUE Net earned premium $ 155,609,000 $ 135,010,000 Management fees 29,635,000 53,809,000 Commission income 24,792,000 25,696,000 Net investment income 20,508,000 18,195,000 Net realized investment loss (360,000) (4,372,000) Other operating income 5,464,000 14,556,000 -------------- -------------- Total revenue 235,648,000 242,894,000 EXPENSE Loss and loss adjustment expense 96,969,000 101,941,000 Operating expense: Policy acquisition costs, net 12,253,000 15,502,000 Compensation expense 35,466,000 43,376,000 Other operating expense 27,540,000 27,999,000 -------------- -------------- Net operating expense 75,259,000 86,877,000 Interest expense 5,161,000 10,336,000 -------------- -------------- Total expense 177,389,000 199,154,000 -------------- -------------- Earnings before income tax provision 58,259,000 43,740,000 Income tax provision 22,823,000 17,156,000 -------------- -------------- Earnings before cumulative effect of accounting change 35,436,000 26,584,000 Cumulative effect of accounting change, net of deferred tax effect of $1,335,000 -- (2,013,000) -------------- -------------- NET EARNINGS $ 35,436,000 $ 24,571,000 ============== ============== BASIC EARNINGS PER SHARE DATA: Earnings before accounting change $ 0.63 $ 0.53 Cumulative effect of accounting change -- (0.04) -------------- -------------- NET EARNINGS $ 0.63 $ 0.49 ============== ============== Weighted average shares outstanding 56,374,000 50,462,000 ============== ============== DILUTED EARNINGS PER SHARE DATA: Earnings before accounting change $ 0.61 $ 0.52 Cumulative effect of accounting change -- (0.04) -------------- -------------- NET EARNINGS $ 0.61 $ 0.48 ============== ============== Weighted average shares outstanding 57,793,000 50,906,000 ============== ============== Cash dividends declared, per share $ 0.12 $ 0.10 ============== ==============
See Notes to Condensed Consolidated Financial Statements. 4 5 HCC Insurance Holdings, Inc. and Subsidiaries Condensed Consolidated Statements of Earnings (Unaudited)
For the three months ended June 30, --------------------------------------- 2001 2000 -------------- -------------- REVENUE Net earned premium $ 83,688,000 $ 71,654,000 Management fees 13,885,000 24,548,000 Commission income 10,151,000 10,863,000 Net investment income 9,876,000 9,946,000 Net realized investment gain (loss) 464,000 (3,969,000) Other operating income 2,492,000 7,905,000 -------------- -------------- Total revenue 120,556,000 120,947,000 EXPENSE Loss and loss adjustment expense 48,427,000 53,132,000 Operating expense: Policy acquisition costs, net 7,979,000 6,181,000 Compensation expense 16,847,000 21,092,000 Other operating expense 13,125,000 13,891,000 -------------- -------------- Net operating expense 37,951,000 41,164,000 Interest expense 1,814,000 5,315,000 -------------- -------------- Total expense 88,192,000 99,611,000 -------------- -------------- Earnings before income tax provision 32,364,000 21,336,000 Income tax provision 12,106,000 8,156,000 -------------- -------------- NET EARNINGS $ 20,258,000 $ 13,180,000 ============== ============== BASIC EARNINGS PER SHARE DATA: Earnings per share $ 0.34 $ 0.26 ============== ============== Weighted average shares outstanding 58,998,000 50,525,000 ============== ============== DILUTED EARNINGS PER SHARE DATA: Earnings per share $ 0.34 $ 0.26 ============== ============== Weighted average shares outstanding 60,470,000 51,083,000 ============== ============== Cash dividends declared, per share $ 0.06 $ 0.05 ============== ==============
See Notes to Condensed Consolidated Financial Statements. 5 6 HCC Insurance Holdings, Inc. and Subsidiaries Condensed Consolidated Statements of Changes in Shareholders' Equity For the six months ended June 30, 2001 and for the year ended December 31, 2000
Accumulated Additional other Total Common paid-in Retained comprehensive shareholders' stock capital earnings income (loss) equity ------------- ------------- ------------- ------------- -------------- BALANCE AS OF DECEMBER 31, 1999 $49,836,000 $175,363,000 $235,932,000 $(2,692,000) $458,439,000 Net earnings -- -- 55,468,000 -- 55,468,000 Other comprehensive income -- -- -- 7,405,000 7,405,000 ------------ Comprehensive income 62,873,000 1,266,701 shares of common stock issued upon exercise of options, including tax benefit of $3,627,000 1,266,000 19,596,000 -- -- 20,862,000 Issuance of 144,973 shares of contractually issuable common stock 145,000 (145,000) -- -- -- Issuance of 94,500 shares of contingently issuable common stock 95,000 1,145,000 -- -- 1,240,000 Contractual grant of pooled company common stock by a shareholder prior to acquisition -- 1,040,000 -- -- 1,040,000 Dividends to shareholders of pooled company prior to acquisition -- -- (2,593,000) -- (2,593,000) Cash dividends declared, $0.22 per share -- -- (10,931,000) -- (10,931,000) ----------- ------------ ------------ ------------ ------------ BALANCE AS OF DECEMBER 31, 2000 $51,342,000 $196,999,000 $277,876,000 $ 4,713,000 $530,930,000 =========== ============ ============ ============ ============
See Notes to Condensed Consolidated Financial Statements. 6 7 HCC Insurance Holdings, Inc. and Subsidiaries Condensed Consolidated Statements of Changes in Shareholders' Equity For the six months ended June 30, 2001 and for the year ended December 31, 2000 (Unaudited) (continued)
Accumulated Additional other Total Common paid-in Retained comprehensive shareholders' stock capital earnings income equity ------------- ------------- ------------- ------------- -------------- BALANCE AS OF DECEMBER 31, 2000 $51,342,000 $196,999,000 $277,876,000 $ 4,713,000 $530,930,000 Net earnings -- -- 35,436,000 -- 35,436,000 Other comprehensive income -- -- -- 2,809,000 2,809,000 ------------ Comprehensive income 38,245,000 6,900,000 shares of common stock issued in public offering, net of costs 6,900,000 145,641,000 -- -- 152,541,000 630,869 shares of common stock issued upon exercise of options, including tax benefit of $1,964,000 631,000 10,629,000 -- -- 11,260,000 Issuance of 113,906 shares of contractually issuable common stock 114,000 (114,000) -- -- -- Issuance of 39,032 shares of contingently issuable common stock 39,000 879,000 -- -- 918,000 Cash dividends declared, $0.12 per share -- -- (7,062,000) -- (7,062,000) ----------- ------------ ------------ ------------ ------------ BALANCE AS OF JUNE 30, 2001 $59,026,000 $354,034,000 $306,250,000 $ 7,522,000 $726,832,000 =========== ============ ============ ============ ============
See Notes to Condensed Consolidated Financial Statements. 7 8 HCC Insurance Holdings, Inc. and Subsidiaries Condensed Consolidated Statements of Cash Flows (Unaudited)
For the six months ended June 30, -------------------------------------- 2001 2000 ------------- ------------- Cash flows from operating activities: Net earnings $ 35,436,000 $ 24,571,000 Adjustments to reconcile net earnings to net cash provided by operating activities: Change in premium, claims and other receivables (51,749,000) 24,845,000 Change in reinsurance recoverables (53,411,000) (8,003,000) Change in ceded unearned premium 4,625,000 (1,763,000) Change in loss and loss adjustment expense payable 57,267,000 28,191,000 Change in reinsurance balances payable (23,021,000) (2,071,000) Change in unearned premium 15,279,000 12,353,000 Change in premium and claims payable, net of restricted cash 22,156,000 (21,545,000) Change in accounts payable and accrued liabilities (3,622,000) (21,648,000) Net realized investment loss 360,000 4,372,000 Gains on sales of other operating investments -- (2,951,000) Depreciation and amortization expense 9,299,000 9,199,000 Other, net 3,917,000 5,864,000 ------------- ------------- Cash provided by operating activities 16,536,000 51,414,000 Cash flows from investing activities: Sales of fixed income securities 71,128,000 32,085,000 Maturity or call of fixed income securities 20,654,000 23,747,000 Sales of equity securities 2,471,000 6,538,000 Dispositions of other operating investments -- 20,503,000 Change in short-term investments 21,761,000 (49,544,000) Cash paid for companies acquired, net of cash received -- (9,880,000) Cost of securities acquired (135,512,000) (87,061,000) Purchases of property and equipment and other, net (2,991,000) (3,660,000) ------------- ------------- Cash used by investing activities (22,489,000) (67,272,000) Cash flows from financing activities: Proceeds from notes payable -- 24,000,000 Sale of common stock, net of costs 161,837,000 3,188,000 Payments on notes payable (158,500,000) (23,000,000) Dividends paid (7,077,000) (4,903,000) ------------- ------------- Cash used by financing activities (3,740,000) (715,000) ------------- ------------- Net change in cash (9,693,000) (16,573,000) Cash at beginning of period 13,991,000 26,825,000 ------------- ------------- CASH AT END OF PERIOD $ 4,298,000 $ 10,252,000 ============= =============
See Notes to Condensed Consolidated Financial Statement 8 9 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) (1) GENERAL INFORMATION As used in this report, unless otherwise required by the context, the terms "we," "us," "our" and the "Company" refer to HCC Insurance Holdings, Inc. and its consolidated subsidiaries, and the term "HCC" refers only to HCC Insurance Holdings, Inc. We provide property and casualty and accident and health insurance coverages, underwriting agency and intermediary services, and other insurance related services both to commercial customers and individuals. We concentrate our activities in selected narrowly defined lines of business. We operate primarily in the United States and the United Kingdom, although some of our operations have a broader international scope. We underwrite insurance on both a direct basis, where we insure a risk in exchange for a premium, and on a reinsurance basis, where we insure all or a portion of another insurance company's risk in exchange for all or portion of the premium. We market our insurance products both directly to customers and through a network of independent or affiliated agents and brokers. Our lines of business include accident and health, aviation, marine, medical stop-loss, offshore energy, property and workers' compensation insurance. Basis of Presentation The unaudited condensed consolidated financial statements have been prepared in conformity with generally accepted accounting principles 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 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 consolidated financial statements and related notes. The condensed consolidated balance sheet as of December 31, 2000, and the condensed consolidated statement of changes in shareholders' equity for the year then ended were derived from audited financial statements, restated for the pooling-of-interests described below, but do not include all disclosures required by generally accepted accounting principles. On January 19, 2001, we acquired all of the outstanding shares of Schanen Consulting Corporation and its operating subsidiary, Schanen Consulting Group, L.L.C. (collectively "Schanen"), an insurance intermediary, in exchange for 996,805 shares of our common stock. This business combination has been recorded using the pooling-of-interests method of accounting and, accordingly, our condensed consolidated financial statements have been restated to include the accounts and operations of Schanen for all periods presented. Separate total revenue and net earnings of the combined entities for the six months ended June 30, 2000 are presented in the following table:
Revenue Net Earnings -------------- ------------- Amounts as previously reported $ 239,178,000 $ 23,033,000 Schanen 3,716,000 1,538,000 -------------- ------------- AMOUNTS AS RESTATED $ 242,894,000 $ 24,571,000 ============== =============
9 10 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) (1) GENERAL INFORMATION, CONTINUED Revenue Recognition In the fourth quarter of 2000 and effective January 1, 2000, we changed certain of our revenue recognition methods for our underwriting agencies and intermediaries to agree with guidance contained in SEC Staff Accounting Bulletin Number 101 ("SAB 101") entitled "Revenue Recognition in Financial Statements." The after-tax cumulative non-cash charge resulting from the adoption of SAB 101 was $2.0 million. As required by this accounting guidance, we have restated the results for the first six months of 2000 for the cumulative effect of the change in accounting. The change did not have a material effect on earnings before cumulative effect of accounting change for any period presented. Income Tax For the six months ended June 30, 2001 and 2000, 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, non-deductible goodwill amortization and tax exempt municipal bond interest. Since its acquisition, Schanen has become part of our consolidated Federal income tax return and is subject to certain state income taxes. However, prior to its acquisition by us, Schanen was not subject to income tax. Foreign Currency We underwrite risks which are denominated in a number of foreign currencies. As a result, we have receivables and payables in foreign currencies and we establish and maintain loss reserves with respect to our insurance policies in their respective currencies. Our net earnings could be impacted by exchange rate fluctuations affecting these balances. On a limited basis, we also enter into foreign currency forward contracts as a hedge against foreign currency fluctuations. Our subsidiaries operating in London have revenue streams primarily in U.S. Dollars and Canadian Dollars ("CAD") but their expenses are paid in British Pound Sterling ("GBP"). To mitigate our foreign exchange risk, we entered into foreign currency forward contracts expiring at staggered times through December 31, 2001. The foreign currency forward contracts are used to convert currency at a known rate in an amount which approximates average monthly expenses. This permits us to limit the foreign currency exchange risk of the recurring monthly expenses. In the future, we may continue to limit our exposure to currency fluctuations through the use of foreign currency forward contracts. We utilize these foreign currency forward contracts strictly as a hedge against existing exposure to foreign currency fluctuations rather than as a form of speculation or trading. We adopted Statement of Financial Accounting Standards ("SFAS") No. 133 entitled "Accounting for Derivative Instruments and Hedging Activities" effective January 1, 2001. To the extent the foreign exchange forward contracts qualify for hedge accounting treatment, the gain or loss due to changes in their fair value is recognized in accumulated other comprehensive income until realized, at which time the gain or loss is recognized along with the offsetting loss or gain on the hedged item. To the extent the foreign currency forward contracts do not qualify for hedge accounting treatment, the gain or loss due to changes in fair value is recognized in the consolidated statements of earnings, but is generally offset by changes in value of the underlying exposure. The cumulative effect adjustment due to this change in accounting is not 10 11 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued) (1) GENERAL INFORMATION, CONTINUED material to our financial position, results of operations or cash flows. Since we utilize derivatives or hedging strategies on a limited basis, we do not expect the adoption of SFAS No. 133 to be material on an ongoing basis. Effects of Recent Accounting Pronouncements SFAS No. 141 entitled "Business Combinations" was issued in June, 2001 and became effective July 1, 2001. SFAS No. 141 requires that all business combinations be accounted for using the purchase method of accounting, which requires that acquisitions be recorded at fair value as of the date of acquisition. The pooling-of-interests method of accounting allowed under prior standards, which reflected business combinations using historical financial information, is now prohibited. SFAS No. 142 entitled "Goodwill and Other Intangible Assets" was also issued in June, 2001, in concert with SFAS No. 141. SFAS No. 142 becomes effective for us on January 1, 2002. On that date goodwill will no longer be amortized, but will be tested for impairment using a fair value approach. Currently existing goodwill ($260.4 million at June 30, 2001) will continue to be amortized through December 31, 2001. We will not amortize any goodwill recorded by us from an acquisition consummated during the remainder of 2001. SFAS No. 142 requires goodwill to be tested for impairment at a level referred to as a reporting unit, generally one level lower than our reportable segments. SFAS No. 142 requires us to perform the first goodwill impairment test on all reporting units within six months of adoption. The first step is to compare the fair value with the book value of a reporting unit. If the fair value of a reporting unit is less than its book value, the second step will be to calculate the impairment loss, if any. We will recognize any impairment loss from the initial adoption of SFAS No. 142 as a change in accounting principle. After the initial adoption, goodwill of a reporting unit will be tested for impairment on an annual basis and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. SFAS No. 142 is not expected to have a material effect on our financial position or cash flows, but it will impact our results of operations. We are reviewing SFAS No. 142 to determine the effect, if any, of the initial goodwill impairment testing. During the year ended December 31, 2000 and the six months ended June 30, 2001, we recorded goodwill amortization of $13.0 million and $6.3 million, respectively. These amounts would not have been recorded under SFAS No. 142. Subsequent Events During July, 2001 we signed letters of intent to acquire all of the outstanding shares of two specialty underwriting agencies: ASU International, Inc. and Marshall Rattner, Inc, which is the parent company of Professional Indemnity Agency, Inc. Both transactions are expected to be completed during the third quarter of 2001. 11 12 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued) (1) GENERAL INFORMATION, CONTINUED Reclassifications Certain amounts in our 2000 condensed consolidated financial statements have been reclassified to conform to the 2001 presentation. Such reclassifications had no effect on our net earnings, shareholders' equity or cash flows. (2) PUBLIC OFFERING AND NOTES PAYABLE On March 6, 2001, we sold 6.9 million shares of our common stock in a public offering at a price of $23.35 per share. Net proceeds from the offering amounted to $152.5 million after deducting underwriting discounts, commissions and offering expenses and were used to pay down our bank facility. The table below shows the composition of our notes payable as shown in our condensed consolidated balance sheets:
June 30, 2001 December 31, 2000 ------------- ----------------- Acquisition notes $ 4,456,000 $ 4,633,000 Bank facility 49,000,000 207,500,000 ------------ ------------- NET AMOUNTS $ 53,456,000 $ 212,133,000 ============ =============
On December 17, 1999, we entered into a $300.0 million Revolving Loan Facility with a group of banks. At our request, the amount available under the facility was reduced to $200.0 million by an amendment signed on June 6, 2001. Interest expense includes a charge of $596,000 related to the write off of prepaid loan fees in connection with the amendment. We can borrow up to the maximum allowed by the facility on a revolving basis until the facility expires on December 18, 2004. Outstanding advances under the facility bear interest at agreed upon rates. The facility is collateralized in part by the pledge of the stock of two of our principal insurance companies, Houston Casualty Company and Avemco Insurance Company, and by the stock of and guarantees entered into by our principal underwriting agency and intermediary subsidiaries. The facility agreement contains certain restrictive covenants, including minimum net worth requirements for us and certain of our subsidiaries, restrictions on certain extraordinary corporate actions, notice requirements for certain material occurrences and required maintenance of specified financial ratios. We believe that the restrictive covenants and our obligations that are contained in the facility agreement are typical for financing arrangements comparable to our facility. As of June 30, 2001, the weighted average interest rate on the facility debt outstanding was 4.7%. 12 13 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued) (3) REINSURANCE In the normal course of business, our insurance companies cede a substantial portion of their premium through quota share, surplus, excess of loss and facultative reinsurance agreements. Although the ceding of reinsurance does not discharge the primary insurer from liability to its policyholders, the subsidiaries participate in such agreements for the purposes of limiting their loss exposure, protecting them against catastrophic loss and diversifying their business. Most of the reinsurance assumed by our insurance companies was underwritten directly by one of our underwriting agencies, but was issued by other non-affiliated insurance companies in order to satisfy licensing, contractual or other requirements. The following tables represent the effect of such reinsurance transactions on net premium and loss and loss adjustment expense:
Loss and Loss Written Earned Adjustment Premium Premium Expense ------------- ------------- -------------- For the six months ended June 30, 2001: Direct business $ 405,386,000 $ 397,062,000 $ 274,895,000 Reinsurance assumed 118,322,000 109,076,000 156,165,000 Reinsurance ceded (345,619,000) (350,529,000) (334,091,000) ------------- ------------- ------------- NET AMOUNTS $ 178,089,000 $ 155,609,000 $ 96,969,000 ============= ============= ============= For the six months ended June 30, 2000: Direct business $ 299,375,000 $ 290,691,000 $ 208,523,000 Reinsurance assumed 171,903,000 175,394,000 160,842,000 Reinsurance ceded (328,698,000) (331,075,000) (267,424,000) ------------- ------------- ------------- NET AMOUNTS $ 142,580,000 $ 135,010,000 $ 101,941,000 ============= ============= =============
13 14 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued) (3) REINSURANCE, CONTINUED
Loss and Loss Written Earned Adjustment Premium Premium Expense ------------- ------------- -------------- For the three months ended June 30, 2001: Direct business $ 223,434,000 $ 200,652,000 $ 144,829,000 Reinsurance assumed 71,060,000 57,597,000 55,961,000 Reinsurance ceded (188,910,000) (174,561,000) (152,363,000) ------------- ------------- ------------- NET AMOUNTS $ 105,584,000 $ 83,688,000 $ 48,427,000 ============= ============= ============= For the three months ended June 30, 2000: Direct business $ 154,750,000 $ 152,274,000 $ 113,296,000 Reinsurance assumed 109,390,000 97,276,000 100,701,000 Reinsurance ceded (182,220,000) (177,896,000) (160,865,000) ------------- ------------- ------------- NET AMOUNTS $ 81,920,000 $ 71,654,000 $ 53,132,000 ============= ============= =============
The table below represents the approximate composition of reinsurance recoverables in our condensed consolidated balance sheets:
June 30, 2001 December 31, 2000 ------------- ----------------- Reinsurance recoverable on paid losses $ 93,547,000 $ 99,224,000 Reinsurance recoverable on outstanding losses 442,305,000 376,778,000 Reinsurance recoverable on IBNR 311,953,000 317,467,000 Reserve for uncollectible reinsurance (4,982,000) (4,057,000) ------------- ------------- TOTAL REINSURANCE RECOVERABLES $ 842,823,000 $ 789,412,000 ============= =============
14 15 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued) (3) REINSURANCE, CONTINUED Our insurance companies require their reinsurers not authorized by the respective states of domicile of our insurance companies to collateralize the reinsurance obligations due to us. The table below shows amounts held by us as collateral plus other credits available for potential offset.
June 30, 2001 December 31, 2000 ------------- ----------------- Payables to reinsurers $179,988,000 $ 200,591,000 Letters of credit 132,512,000 142,494,000 Cash deposits 24,155,000 23,813,000 ------------- ------------- TOTAL CREDITS $336,655,000 $ 366,898,000 ============= =============
We have a reserve of $5.0 million as of June 30, 2001 for potential collectibility issues related to reinsurance recoverables. The adverse economic environment in the worldwide insurance industry has placed great pressure on 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, such as the marketplace has experienced for the last several years. Therefore, while we believe that the reserve is adequate based on current available information, conditions may change or additional information might be obtained that would affect our estimate of the adequacy of the level of the reserve and which may result in a future increase or decrease in the reserve. We continually review our financial exposure to the reinsurance market and continue to take actions to protect our shareholders' equity. 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, though not materially to date, the investment income of our insurance companies, but not to any extent their liquidity. We limit our liquidity exposure by holding funds, letters of credit or other security such that net balances due are significantly less than the gross balances shown on our condensed consolidated balance sheets. In addition, a number of reinsurers have claimed they are not liable for payment to us and, in one or more cases, we have sought arbitration or filed lawsuits to resolve these matters. We believe these claims are without merit and expect to collect the full amount recoverable. We are currently in negotiations with most of these parties. If such negotiations do not result in a satisfactory resolution of the matters in question, we will seek a judicial or arbitral determination of these matters. (4) SEGMENT AND GEOGRAPHIC INFORMATION (AMOUNTS IN THOUSANDS) The performance of each segment is evaluated based upon net earnings before cumulative effect of accounting change 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. 15 16 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued) (4) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED (AMOUNTS IN THOUSANDS) All segment information for 2000 has been restated to include the accounts and operations of Schanen in the intermediary segment. Effective January 1, 2001, we consolidated the operations of three of our underwriting agencies into the operations of our insurance companies. Policies incepting on or after January 1, 2001, along with associated expenses, will be reported in the insurance company segment. The administration of all policies incepting before January 1, 2001, which are now in run off, along with associated expenses, will continue to be reported in the underwriting agency segment. This consolidation will affect the comparability of segment information between periods.
Insurance Underwriting Other company agency Intermediary operations Corporate Total ---------- ------------ ------------ ---------- --------- --------- For the six months ended June 30, 2001: Revenue: Domestic $ 154,204 $ 31,792 $ 12,854 $ 4,421 $ 98 $ 203,369 Foreign 17,302 1,321 13,656 -- -- 32,279 Inter-segment -- 10,433 135 1,289 -- 11,857 --------- -------- -------- ------- ------- --------- Total segment revenue $ 171,506 $ 43,546 $ 26,645 $ 5,710 $ 98 247,505 ========= ======== ======== ======= ======= Inter-segment revenue (11,857) --------- CONSOLIDATED TOTAL REVENUE $ 235,648 ========= Net earnings: Domestic $ 20,659 $ 8,102 $ 2,742 $ 886 $ 372 $ 32,761 Foreign (293) 648 1,518 -- -- 1,873 --------- -------- -------- ------- ------- --------- TOTAL SEGMENT NET EARNINGS $ 20,366 $ 8,750 $ 4,260 $ 886 $ 372 34,634 ========= ======== ======== ======= ======= Inter-segment eliminations 802 --------- CONSOLIDATED NET EARNINGS $ 35,436 ========= Other items: Net investment income $ 15,324 $ 3,233 $ 1,717 $ 59 $ 175 $ 20,508 Depreciation and amortization 2,734 4,285 1,947 109 224 9,299 Interest expense 17 2,502 2,034 -- 608 5,161 Capital expenditures 1,679 450 369 66 427 2,991 Income tax provision 8,905 7,221 4,318 554 1,348 22,346 Inter-segment eliminations 477 --------- CONSOLIDATED INCOME TAX PROVISION $ 22,823 =========
16 17 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued) (4) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED (AMOUNTS IN THOUSANDS)
Insurance Underwriting Other company agency Intermediary operations Corporate Total ---------- ------------ ------------ ---------- --------- --------- For the six months ended June 30, 2000: Revenue: Domestic $ 141,531 $ 54,477 $ 15,824 $ 13,971 $ 445 $ 226,248 Foreign 2,379 2,775 11,492 -- -- 16,646 Inter-segment -- 6,121 94 715 -- 6,930 --------- -------- -------- -------- ------- --------- Total segment revenue $ 143,910 $ 63,373 $ 27,410 $ 14,686 $ 445 249,824 ========= ======== ======== ======== ======= Inter-segment revenue (6,930) --------- CONSOLIDATED TOTAL REVENUE $ 242,894 ========= Net earnings (loss): Domestic $ 10,000 $ 12,168 $ 6,073 $ 3,033 $(3,051) $ 28,223 Foreign (2,360) 632 574 -- -- (1,154) --------- -------- -------- -------- ------- --------- Total segment net earnings (loss) $ 7,640 $ 12,800 $ 6,647 $ 3,033 $(3,051) 27,069 ========= ======== ======== ======== ======= Inter-segment eliminations (485) Cumulative effect of accounting change (2,013) --------- CONSOLIDATED NET EARNINGS $ 24,571 ========= Other items: Net investment income $ 12,679 $ 3,368 $ 1,623 $ 244 $ 281 $ 18,195 Depreciation and amortization 1,636 5,590 1,470 218 285 9,199 Interest expense 10 4,686 2,615 -- 3,025 10,336 Capital expenditures 1,668 2,063 271 157 116 4,275 Income tax provision (benefit) 1,654 10,776 3,870 1,704 (547) 17,457 Inter-segment eliminations (301) Cumulative effect of accounting change (1,335) --------- CONSOLIDATED INCOME TAX PROVISION $ 15,821 =========
17 18 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued) (4) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED (AMOUNTS IN THOUSANDS)
Insurance Underwriting Other company agency Intermediary operations Corporate Total ---------- ------------ ------------ ---------- --------- --------- For the three months ended June 30, 2001: Revenue: Domestic $ 82,076 $ 14,762 $ 5,779 $ 1,989 $ (14) $ 104,592 Foreign 10,192 698 5,074 -- -- 15,964 Inter-segment -- 5,912 60 730 -- 6,702 --------- -------- -------- -------- ------- --------- Total segment revenue $ 92,268 $ 21,372 $ 10,913 $ 2,719 $ (14) 127,258 ========= ======== ======== ======== ======= Inter-segment revenue (6,702) --------- CONSOLIDATED TOTAL REVENUE $ 120,556 ========= Net earnings (loss): Domestic $ 13,557 $ 4,084 $ 767 $ 370 $ 427 $ 19,205 Foreign 361 400 (106) -- -- 655 --------- -------- -------- -------- ------- --------- Total segment net earnings $ 13,918 $ 4,484 $ 661 $ 370 $ 427 19,860 ========= ======== ======== ======== ======= Inter-segment eliminations 398 --------- CONSOLIDATED NET EARNINGS $ 20,258 ========= Other items: Net investment income $ 7,630 $ 1,418 $ 702 $ 21 $ 105 $ 9,876 Depreciation and amortization 1,334 2,230 1,061 73 80 4,778 Interest expense (benefit) 14 1,154 941 -- (295) 1,814 Capital expenditures 994 139 228 18 313 1,692 Income tax provision 6,510 3,982 936 244 198 11,870 Inter-segment eliminations 236 --------- CONSOLIDATED INCOME TAX PROVISION $ 12,106 =========
18 19 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued) (4) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED (AMOUNTS IN THOUSANDS)
Insurance Underwriting Other company agency Intermediary operations Corporate Total ---------- ------------ ------------ ---------- --------- --------- For the three months ended June 30, 2000: Revenue: Domestic $ 73,891 $ 24,804 $ 6,535 $ 7,792 $ 191 $ 113,213 Foreign 932 1,617 5,185 -- -- 7,734 Inter-segment -- 3,937 56 364 -- 4,357 --------- -------- -------- -------- ------- --------- Total segment revenue $ 74,823 $ 30,358 $ 11,776 $ 8,156 $ 191 125,304 ========= ======== ======== ======== ======= Inter-segment revenue (4,357) --------- CONSOLIDATED TOTAL REVENUE $ 120,947 ========= Net earnings (loss): Domestic $ 6,296 $ 5,191 $ 1,986 $ 2,067 $(1,398) $ 14,142 Foreign (1,091) 540 (193) -- -- (744) --------- -------- -------- -------- ------- --------- Total segment net earnings (loss) $ 5,205 $ 5,731 $ 1,793 $ 2,067 $(1,398) 13,398 ========= ======== ======== ======== ======= Inter-segment eliminations (218) --------- CONSOLIDATED NET EARNINGS $ 13,180 ========= Other items: Net investment income $ 6,851 $ 1,928 $ 856 $ 131 $ 180 $ 9,946 Depreciation and amortization 847 2,761 853 111 180 4,752 Interest expense 5 2,404 1,330 -- 1,576 5,315 Capital expenditures 958 919 99 40 60 2,076 Income tax provision (benefit) 1,380 5,099 1,137 1,234 (567) 8,283 Inter-segment eliminations (127) --------- CONSOLIDATED INCOME TAX PROVISION $ 8,156 =========
19 20 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued) (4) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED (AMOUNTS IN THOUSANDS) The following tables present revenue by line of business within each operating segment for the periods indicated:
For the six months ended June 30, For the three months ended June 30, --------------------------------- ----------------------------------- 2001 2000 2001 2000 ------------- ------------- -------------- --------------- Insurance company: Accident and health $ 21,170 $ 26,668 $ 11,762 $ 16,518 Aviation 42,278 36,415 21,936 18,450 Marine and offshore energy 3,934 3,102 2,089 1,167 Medical stop-loss 65,604 49,550 34,900 26,067 Property 6,687 2,519 3,796 1,348 Workers' compensation 11,733 9,509 7,496 6,049 Other lines of business 4,203 7,247 1,709 2,055 ------------ ------------ ------------ ---------- TOTAL NET EARNED PREMIUM $ 155,609 $ 135,010 $ 83,688 $ 71,654 ============ ============ ============ ========== Underwriting agency: Life and accident and health $ 25,026 $ 39,093 $ 11,649 $ 17,498 Property and casualty 4,609 14,716 2,236 7,050 ------------ ------------ ------------ ---------- TOTAL MANAGEMENT FEES $ 29,635 $ 53,809 $ 13,885 $ 24,548 ============ ============ ============ ========== Intermediary: Life and accident and health $ 19,503 $ 19,351 $ 8,212 $ 8,520 Property and casualty 5,289 6,345 1,939 2,343 ------------ ------------ ------------ ---------- TOTAL COMMISSION INCOME $ 24,792 $ 25,696 $ 10,151 $ 10,863 ============ ============ ============ ==========
20 21 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued) (5) EARNINGS PER SHARE Basic earnings per share is based on the weighted average number of common shares outstanding during the period divided into net earnings. Diluted earnings per share is based on the weighted average number of common shares outstanding plus the potential common shares outstanding during the period divided into net earnings. Outstanding common stock options, when dilutive, are considered to be potential common shares for the purpose of the diluted calculation. The treasury stock method is used to calculate potential common shares due to options. Contingent shares to be issued are included in the earnings per share computation only when the underlying conditions for issuance have been met. The following table provides the reconciliations for the denominators used in the earnings per share calculations (amounts in thousands):
For the six months ended June 30, For the three months ended June 30, --------------------------------- ----------------------------------- 2001 2000 2001 2000 ------------- ------------- -------------- --------------- Net earnings $ 35,436 $ 24,571 $ 20,258 $ 13,180 ============ ============ ============ ========== Reconciliation of number of shares outstanding: Shares of common stock outstanding at period end 59,026 50,383 59,026 50,383 Effect of common shares issued during the period (2,807) (190) (183) (127) Common shares contractually issuable in the future 155 269 155 269 ------------ ------------ ------------ ---------- Weighted average shares outstanding 56,374 50,462 58,998 50,525 Additional dilutive effect of outstanding options (as determined by the application of the treasury stock method) 1,419 444 1,472 558 ------------ ------------ ------------ ---------- WEIGHTED AVERAGE COMMON SHARES AND POTENTIAL COMMON SHARES OUTSTANDING 57,793 50,906 60,470 51,083 ============ ============ ============ ==========
21 22 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued) (5) EARNINGS PER SHARE, CONTINUED As of June 30, 2001, there were approximately 150,000 options that were not included in the computation of diluted earnings per share because to do so would have been antidilutive. There are 244,468 shares of our common stock to be issued if certain conditions are met as of December 31, 2001, or in subsequent years. These shares were not included in the earnings per share computation because the conditions for issuance have not yet been met. (6) SUPPLEMENTAL INFORMATION Supplemental information for the six months ended June 30, 2001 and 2000, is summarized below:
2001 2000 -------------- -------------- Interest paid $ 7,285,000 $ 7,498,000 Income tax paid 8,597,000 5,123,000 Comprehensive income 38,245,000 25,748,000 Ceding commissions netted with policy acquisition costs 100,638,000 101,116,000
Supplemental information for the three months ended June 30, 2001 and 2000, is summarized below:
2001 2000 -------------- -------------- Comprehensive income $ 19,313,000 $ 14,456,000 Ceding commissions netted with policy acquisition costs 47,876,000 54,416,000
(7) COMMITMENTS AND CONTINGENCIES 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. We believe the resolution of such lawsuits will not have a material adverse effect on our financial condition, results of operations or cash flows. See also Note (3) concerning the collection of reinsurance recoverables. 22 23 MANAGEMENT'S DISCUSSION AND ANALYSIS Results of Operations Six months ended June 30, 2001 versus six months ended June 30, 2000 Total revenue was $235.6 million for the first six months of 2001 compared to $242.9 million for the same period in 2000. The increase in the insurance company segment revenue resulting from increased business, greater retention levels and higher investment income was offset primarily by a reduction in the underwriting agency segment revenue as we consolidated the operations of three of our underwriting agencies into the operations of our insurance companies on January 1, 2001. We anticipate that total revenue for the full year 2001 will increase compared to 2000 as earned premium continues to grow. Net investment income increased 13% to $20.5 million for the first six months of 2001 from $18.2 million for the same period in 2000. This increase was due to the higher level of invested assets partially offset by the recent decrease in interest rates. We expect positive operating cash flow to continue, thereby increasing invested assets and investment income, but the increase could be substantially offset by the effect of lower interest rates. Compensation expense decreased to $35.5 million in the first six months of 2001 from $43.4 million for the same period in 2000. The decrease is due principally to the disposition of non-core subsidiaries and the subsequent closing or reduction of some operations of an acquired company during 2000. Other operating expense in 2001 was also reduced for the same reasons, but to a much lesser extent, and the decrease was offset by a general increase in expense in our operating subsidiaries as business increased. Other operating expenses for the first six months of 2000 also included a credit of $789,000 reflecting the reversal of some restructuring charges recorded during the previous year, whereas during the first six months of 2001, we recorded $176,000 in merger expense resulting from an acquisition. Interest expense was $5.2 million for the first six months of 2001, down from $10.3 million for the same period in 2000. This decrease was the result of our using the proceeds from our March, 2001 public offering to substantially reduce our debt, as well as lower interest rates. Also, during the first six months of 2001, we recorded a $596,000 non-cash pre-tax charge to expense prepaid loan fees in connection with the amendment of our bank facility. Income tax expense on earnings before the change in accounting was $22.8 million for the first six months of 2001 compared to $17.2 million for the same period in 2000. Our effective tax rate was 39% for the first six months of both 2001 and 2000. Net earnings before the change in accounting increased 33% to $35.4 million, or $0.61 per share, for the first six months of 2001 from $26.6 million, or $0.52 per share, for the same period in 2000. This increase results from a substantial improvement in the underwriting performance of the insurance company segment and increased investment income. Our book value per share was $12.28 as of June 30, 2001, up substantially from $10.29 as of December 31, 2000. 23 24 SEGMENTS Insurance Companies Gross written premium increased 11% to $523.7 million for the first six months of 2001 from $471.3 million for the same period in 2000 due to strong growth in medical stop-loss, accident and health, and property premium, as rates continue to rise, partially offset by a planned decrease in aviation premium and discontinued lines. Net written premium for the first six months of 2001 increased 25% to $178.1 million from $142.6 million for the same period in 2000, as our insurance companies have increased the volume of business written, primarily in the medical stop-loss and aviation lines of business, as well as retentions on many of their lines of business as underwriting profit returns. Net earned premium increased 15% to $155.6 million for the same reasons. The increase in net written premium and net earned premium is expected to continue. Loss and loss adjustment expense was $97.0 million for the first six months of 2001 compared to $101.9 million for the same period in 2000. The GAAP net loss ratio decreased substantially to 62% for the first six months of 2001 from 76% for the same period in 2000, due to overall improved underwriting results, particularly in the medical stop-loss and aviation lines of business. The GAAP gross loss ratio was 85% in the first six months of 2001 compared to 79% for the same period in 2000 and was adversely effected by a gross loss of approximately $55.0 million due to the destruction of the Petrobras 36 oil production platform. Excluding this one claim, our GAAP gross loss ratio would have improved to 74% for the first six months of 2001. The Petrobras claim was substantially reinsured and did not have a material effect on our net loss ratio or earnings. The GAAP combined ratio was 90% in the first six months of 2001 compared to 99% for the same period in 2000. Policy acquisition costs, which are net of ceding commissions on reinsurance ceded, decreased to $12.3 million during the first six months of 2001, compared to $15.5 million for the same period in 2000. This is principally due to the higher policy issuance fees, which are recorded as a reduction in acquisition costs, charged by our insurance companies on certain lines of business during 2001. This reduction in costs is partially offset by the increase in policy acquisition costs resulting from higher earned premium. Net earnings of our insurance companies increased 167% to $20.4 million in the first six months of 2001 from $7.6 million for the same period in 2000, primarily due to the substantial improvement in underwriting performance. Underwriting Agencies Management fees decreased to $29.6 million for the first six months of 2001, compared to $53.8 million for the same period in 2000. Much of the decrease is the result of our consolidation of the operations of three of our underwriting agencies into the operations of our insurance companies effective January 1, 2001. Additional decreases are due to lines of business either sold or discontinued and increased retentions of our insurance companies. Net earnings of our underwriting agencies decreased to $8.8 million for the first six months of 2001 from $12.8 million for the same period in 2000 for the same reasons. Intermediaries Commission income was $24.8 million for the first six months of 2001, compared to $25.7 million for the same period in 2000. Net earnings of our intermediary segment decreased to $4.3 million for the first six months of 2001 compared to $6.6 million for the same period of 2000. This difference is caused by the fact that Schanen was not subject to income taxes during 2000 and the mix of business, which had a lower gross margin during the current period compared to the prior year period. Other Operations The decrease in other operating revenue to $5.5 million for the first six months of 2001 from $14.6 million for the same period in 2000 results principally from the disposition or closure of certain operations during 2000. Net earnings of other operations decreased to $886,000 in 2001 from $3.0 million in 2000 for the same reasons. 24 25 Period to period comparisons may vary substantially depending on other operating investments, or dispositions thereof, in any given period. Corporate Net income of the corporate segment was $372,000 for the first six months of 2001, compared to a net loss of $3.1 million for the same period in 2000. This resulted from the reduction of interest expense not allocated to the operating segments as we reduced our debt using the proceeds from the March, 2001 public offering. In addition, the 2000 period also included the costs of the closing of some operations of an acquired company. Three months ended June 30, 2001 versus three months ended June 30, 2000 Total revenue was $120.6 million for the second quarter of 2001 compared to $120.9 million for the same period in 2000. The increase in the insurance company segment revenue resulting from increased business and greater retention levels was offset primarily by a reduction in the underwriting agency segment revenue as we consolidated the operations of three of our underwriting agencies into the operations of our insurance companies on January 1, 2001. Total revenue was higher in the second quarter of 2001 compared to the first quarter of 2001 and we anticipate this trend to continue as earned premium grows. Net investment income was unchanged at $9.9 million for the second quarter of 2001 compared to the same period in 2000. This was due to the higher level of invested assets offset by the recent decrease in interest rates. Operating cash flow was negative in the second quarter of 2001, but much improved over the same period in 2000. This was caused by timing differences between the receipt of receivables and payment of the related payables, particularly in our underwriting agency and intermediary segments. We expect positive operating cash flow to return in the third quarter, thereby increasing invested assets and investment income, but the increase could be substantially offset by the effect of lower interest rates. Compensation expense decreased to $16.8 million during the second quarter of 2001 from $21.1 million for the same period in 2000. The decrease is due principally to the disposition of non-core subsidiaries and the subsequent closing or reduction of some operations of an acquired company during 2000. Other operating expense in 2001 was also reduced for the same reasons, but to a much lesser extent, and the decrease was offset by a general increase in expense in our operating subsidiaries as business increased. Interest expense was $1.8 million for the second quarter of 2001, down from $5.3 million for the same period in 2000. This decrease was the result of our using the proceeds from our March, 2001 public offering to substantially reduce our debt, as well as lower interest rates. Also, during the second quarter of 2001, we recorded a $596,000 non-cash pre-tax charge to expense prepaid loan fees in connection with the amendment of our bank facility. Income tax expense was $12.1 million for the second quarter of 2001 compared to $8.2 million for the same period in 2000. Our effective tax rate was 37% in the 2001 quarter compared to 38% in 2000. Net earnings increased 54% to $20.3 million, or $0.34 per share, for the second quarter of 2001 from $13.2 million, or $0.26 per share, for the same period in 2000. This increase results from a substantial improvement in the underwriting performance of the insurance company segment. Our book value per share was $12.28 as of June 30, 2001, up from $11.98 as of March 31, 2001. 25 26 SEGMENTS Insurance Companies Gross written premium increased 11% to $294.4 million for the second quarter of 2001 from $264.1 million for the same period in 2000 due to strong growth in medical stop-loss, accident and health, and property premium, as rates continue to rise, partially offset by a planned decrease in aviation premium and discontinued lines. Net written premium for the second quarter of 2001 increased 29% to $105.6 million from $81.9 million for the same period in 2000, as our insurance companies have increased the volume of business written, primarily in the medical stop-loss and aviation lines of business, as well as retentions on many of their lines of business as underwriting profit returns. Net earned premium increased 17% to $83.7 million for the same reasons. The increase in net written premium and net earned premium is expected to continue. Loss and loss adjustment expense was $48.4 million for the second quarter of 2001 compared to $53.1 million for the same period in 2000. The GAAP net loss ratio decreased substantially to 58% for the second quarter of 2001 from 74% for the same period in 2000, due to overall improved underwriting results, particularly in the medical stop-loss and aviation lines of business. The GAAP gross loss ratio was 78% in the second quarter of 2001 compared to 86% for the same period in 2000. The GAAP combined ratio was 84% in the second quarter of 2001 compared to 95% for the same period in 2000. Policy acquisition costs, which are net of ceding commissions on reinsurance ceded, increased to $8.0 million during the second quarter of 2001, compared to $6.2 million for the same period in 2000. This is principally due to the increase in policy acquisition costs resulting from higher earned premium. Net earnings of our insurance companies increased 167% to $13.9 million in the second quarter of 2001 from $5.2 million for the same period in 2000, primarily due to the substantial improvement in underwriting performance. Underwriting Agencies Management fees decreased to $13.9 million for the second quarter of 2001, compared to $24.5 million for the same period in 2000. Much of the decrease is the result of our consolidation of the operations of three of our underwriting agencies into the operations of our insurance companies effective January 1, 2001. Additional decreases are due to lines of business either sold or discontinued and increased retentions of our insurance companies. Net earnings of our underwriting agencies decreased to $4.5 million in the second quarter of 2001 from $5.7 million for the same period in 2000 for the same reasons. Intermediaries Commission income was $10.2 million for the second quarter of 2001, compared to $10.9 million for the same period in 2000. Net earnings of our intermediary segment decreased to $661,000 for the second quarter of 2001 compared to $1.8 million for the same period of 2000. This difference is caused by the fact that Schanen was not subject to income taxes during 2000 and the mix of business, which had a lower gross margin during the current quarter compared to the prior year quarter. Other Operations The decrease in other operating revenue to $2.5 million during the second quarter of 2001 from $7.9 million for the same period in 2000 results principally from the disposition or closure of certain operations during 2000. Net earnings of other operations decreased to $370,000 in 2001 from $2.1 million in 2000 for the same reasons. Quarter to quarter comparisons may vary substantially depending on other operating investments, or dispositions thereof, in any given period. 26 27 Corporate Net income of the corporate segment was $427,000 for the second quarter of 2001, compared to a net loss of $1.4 million for the same period in 2000. This resulted from the reduction of interest expense not allocated to the operating segments as we reduced our debt using the proceeds from the March, 2001 public offering. Acquisitions and Subsequent Events On January 19, 2001 we acquired all of the outstanding shares of Schanen Consulting Corporation and its operating subsidiary, Schanen Consulting Group, L.L.C. (collectively "Schanen"), an insurance intermediary, in a business combination recorded using the pooling-of-interests method of accounting and, accordingly, our historical condensed consolidated financial statements have been restated to include the accounts and operations of Schanen for all periods presented. During July, 2001 we signed letters of intent to acquire all of the outstanding shares of two specialty underwriting agencies: ASU International, Inc. and Marshall Rattner, Inc., which is the parent company of Professional Indemnity Agency, Inc. Both transactions are expected to be completed during the third quarter of 2001. Liquidity and Capital Resources We receive substantial cash from premiums, collection of reinsurance recoverables, management fee 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 limit our liquidity exposure by holding funds, letters of credit and other security such that net balances due to us are generally less than the gross balances shown in our condensed consolidated balance sheets. 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 $14.0 million, or 2% since December 31, 2000, and totaled $739.1 million as of June 30, 2001, of which $246.3 million was cash and short-term investments. The increase in investments resulted from operating cash flows which continue to be strong. The operating cash flow for the first six months of 2000 was exceptionally high in relation to 2001 because of the receipt of $53.2 million from a reinsurance commutation. On March 6, 2001, we sold 6.9 million shares of our common stock in a public offering at a price of $23.35 per share. Net proceeds from the offering amounted to $152.5 million after deducting underwriting discounts, commissions and estimated offering expenses and were used to pay down our bank facility. On December 17, 1999, we entered into a $300.0 million Revolving Loan Facility with a group of banks. At our request, the amount available under the facility was reduced to $200.0 million by an amendment signed on June 6, 2001. We can borrow up to the maximum amount allowed by the facility on a revolving basis until the facility expires on December 18, 2004. Outstanding advances under the facility bear interest at agreed upon rates. The facility is collateralized in part by the pledge of the stock of two of our principal insurance companies, Houston Casualty Company and Avemco Insurance Company, and by the stock of and guarantees entered into by our principal underwriting agency and intermediary subsidiaries. The facility agreement contains certain restrictive covenants, including minimum net worth requirements for us and certain of our subsidiaries, restrictions on certain extraordinary corporate actions, notice requirements for certain material occurrences and required maintenance of specified financial ratios. We believe that the restrictive covenants and our obligations that are contained in the facility agreement are typical for financing arrangements comparable to our facility. As of June 30, 2001, total debt outstanding under the facility was $49.0 million with a weighted average interest rate of 4.7%. 27 28 Effective January 1, 2001, the State of Maryland changed the amount of dividend that domestic insurance companies may pay without prior regulatory approval in any twelve-month period. The new limitation for Avemco Insurance Company is the lesser of its statutory net income for the prior calendar year or 10% of its statutory policyholders' surplus as of the prior year end. During 2001, Avemco Insurance Company will have an ordinary dividend capacity of approximately $8.6 million. We continue to collect our receivables and recoverables generally in the ordinary course of business and we have not incurred and do not expect to incur any significant liquidity difficulties as a result of the level of gross amounts due. However, 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, though not materially to date, the investment income of our insurance companies, but not to any extent their liquidity. We limit our liquidity 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. In addition, a number of reinsurers have claimed they are not liable for payment to us and, in one or more cases, we have sought arbitration or filed lawsuits to resolve these matters. We believe these claims are without merit and expect to collect the full amount recoverable. We are currently in negotiations with most of these parties. If such negotiations do not result in a satisfactory resolution of the matters in question, we will seek a judicial or arbitral determination of these matters. Loss and loss adjustment expense payable increased $57.3 million between December 31, 2000 and June 30, 2001 due primarily to the Petrobras loss. Because the Petrobras loss is substantially reinsured, reinsurance recoverables also increased during the first six months of 2001. The Petrobras loss was paid during July, 2001 and all the related reinsurance recoverables have now been collected. We believe that our operating cash flows, short-term investments and bank facility will provide sufficient sources of liquidity to meet our operating needs for the foreseeable future. Effects of Recent Accounting Pronouncements We adopted Statement of Financial Accounting Standards ("SFAS") No. 133 entitled "Accounting for Derivative Instruments and Hedging Activities" effective January 1, 2001. The cumulative effect adjustment due to this change in accounting is not material to our financial position, results of operations or cash flows. Since we utilize derivatives or hedging strategies on a limited basis, we do not expect the adoption of SFAS No. 133 to be material on an ongoing basis. SFAS No. 141 entitled "Business Combinations" was issued in June, 2001 and became effective July 1, 2001. SFAS No. 141 requires that all business combinations be accounted for using the purchase method of accounting, which requires that acquisitions be recorded at fair value as of the date of acquisition. The pooling-of-interests method of accounting allowed under prior standards, which reflected business combinations using historical financial information, is now prohibited. SFAS No. 142 entitled "Goodwill and Other Intangible Assets" was also issued in June, 2001, in concert with SFAS No. 141. SFAS No. 142 becomes effective for us on January 1, 2002. On that date goodwill will no longer be amortized, but will be tested for impairment using a fair value approach. Currently existing goodwill ($260.4 million at June 30, 2001) will continue to be amortized through December 31, 2001. We will not amortize any goodwill recorded by us from an acquisition consummated during the remainder of 2001. SFAS No. 142 requires goodwill to be tested for impairment at a level referred to as a reporting unit, generally one level lower than our reportable segments. SFAS No. 142 requires us to perform the first goodwill impairment test on all reporting units within six months of adoption. The first step is to compare the fair value with the book value of a reporting unit. If the fair value of a reporting unit is less than its book value, the second step will be to calculate the impairment loss, if any. We will recognize any impairment loss from the initial adoption of SFAS No. 142 as a change in accounting principle. After the initial adoption, goodwill of a reporting unit will be tested for impairment on an annual basis and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. 28 29 SFAS No. 142 is not expected to have a material effect on our financial position or cash flows, but it will impact our results of operations. We are reviewing SFAS No. 142 to determine the effect, if any, of the initial goodwill impairment testing. During the year ended December 31, 2000 and the six months ended June 30, 2001, we recorded goodwill amortization of $13.0 million and $6.3 million, respectively. These amounts would not have been recorded under SFAS No. 142. 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" of our Annual Report on Form 10-K for the year ended December 31, 2000. 29 30 PART II - OTHER INFORMATION Item 1. Legal Proceedings 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. We believe the resolution of such lawsuits will not have a material adverse effect on our financial condition, results of operations or cash flows. See also Note (3) concerning the collection of reinsurance recoverables. Item 4. Submission of Matters to Vote of Security Holders On May 24, 2001 the Company held its 2001 Annual Meeting of Shareholders. At such time the following items were submitted to a vote of shareholders through the solicitation of proxies: (a) Classification of the Board of Directors. Shareholders were requested to approve an amendment to the Company's Amended Restated Certificate of Incorporation to classify the Directors in three classes to serve initially as follows: Class I - to serve until the Annual Meeting of the Shareholders in 2002; Class II - to serve until the Annual Meeting of the Shareholders in 2003; and Class III - to serve until the Annual Meeting of the Shareholders in 2004; and to provide that thereafter each class of directors shall serve for a three year term, each to serve in such capacity until his successor is duly elected and qualified. The amendment was not approved by the shareholders, who voted 22,594,771 shares in favor, 25,236,297 shares against, and 123,634 shares abstained. (b) Election of Directors. The following persons were elected to serve on the Board of Directors until the 2002 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:
NAME FOR AGAINST ABSTAINED ---- --- ------- --------- Stephen L. Way 42,499,274 0 9,577,724 Frank J. Bramanti 42,223,471 0 9,853,527 Marvin P. Bush 49,830,987 0 2,246,011 Patrick B. Collins 49,372,116 0 2,704,882 James R. Crane 49,830,717 0 2,246,281 J. Robert Dickerson 49,830,666 0 2,246,332 Edward H. Ellis, Jr. 42,223,471 0 9,853,527 James C. Flagg, Ph.D. 49,817,907 0 2,259,091 Edwin H. Frank, III 48,945,794 0 3,131,204 Allan W. Fulkerson 48,737,530 0 3,339,468 Walter J. Lack 48,741,730 0 3,335,268 Stephen J. Lockwood 48,442,681 0 3,634,317 John N. Molbeck, Jr. 42,339,471 0 9,737,527
30 31 (c) Adoption of the 2001 Flexible Incentive Plan. Shareholders were requested to approve the adoption of the 2001 Flexible Incentive Plan. The plan was approved by the shareholders, who voted 29,631,129 shares in favor, 18,250,036 against, and 73,537 abstained. (d) Authorization to Issue 50,000,000 Shares of Preferred Stock. Shareholders were requested to approve an amendment to the Company's Amended Restated Certificate of Incorporation to authorize the issuance of 50,000,000 shares of Preferred Stock. The amendment was not approved by the shareholders, who voted 22,352,025 shares in favor, 25,506,304 shares against, and 96,373 abstained. (e) Ratification of PricewaterhouseCoopers LLP. Shareholders were requested to ratify the appointment of PricewaterhouseCoopers LLP, as independent auditors for the Company and its subsidiaries for the year ended December 31, 2001. Such appointment was approved by the shareholders, who voted 51,405,932 shares in favor, 651,093 shares against, and 19,973 shares abstained. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits None. (b) Reports on Form 8-K On May 11, 2001, we filed a report on Form 8-K related to our announcement of financial results for the first quarter 2001. On June 14, 2001, we filed a report on Form 8-K related to two items: o Our announcement of restated financial statements as of December 31, 2000 and 1999 and for the three years ended December 31, 2000. This was necessitated by the acquisition of Schanen in a business combination recorded using the pooling-of-interests method of accounting. o Our announcement of a second amendment to our loan agreement with a group of banks. 31 32 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) August 14, 2001 /s/ Stephen L. Way -------------------------- -------------------------------------------------- (Date) Stephen L. Way, Chairman of the Board and Chief Executive Officer August 14, 2001 /s/ Edward H. Ellis, Jr. -------------------------- -------------------------------------------------- (Date) Edward H. Ellis, Jr., Senior Vice President and Chief Financial Officer 32