-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, FuTy55qWBNEwiPFJubApHks8aR6jI1+Fz2cbVP+lr12v6VEUcbUn1lpCUpLfwgwk MTNvVllENIsgP/iZL93jEw== 0000950129-03-001610.txt : 20030328 0000950129-03-001610.hdr.sgml : 20030328 20030327184649 ACCESSION NUMBER: 0000950129-03-001610 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 14 CONFORMED PERIOD OF REPORT: 20021231 FILED AS OF DATE: 20030328 FILER: COMPANY DATA: COMPANY CONFORMED NAME: HCC INSURANCE HOLDINGS INC/DE/ CENTRAL INDEX KEY: 0000888919 STANDARD INDUSTRIAL CLASSIFICATION: FIRE, MARINE & CASUALTY INSURANCE [6331] IRS NUMBER: 760336636 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 001-13790 FILM NUMBER: 03622221 BUSINESS ADDRESS: STREET 1: 13403 NORTHWEST FRWY CITY: HOUSTON STATE: TX ZIP: 77040-6094 BUSINESS PHONE: 7136907300 10-K 1 h03402e10vk.txt HCC INSURANCE HOLDINGS, INC.- DECEMBER 31, 2002 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 --------------------- FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. [ ] TRANSACTION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002
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, 77040-6094 HOUSTON, TEXAS (Zip Code) (Address of principal executive offices)
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) (713) 690-7300 SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED: ------------------- ------------------------------------------ Common Stock, $1.00 Par Value New York Stock Exchange
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: NONE 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 (the "Act") 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (sec.229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes [X] No [ ] The aggregate market value on June 28, 2002 (the last business day of the Registrant's most recently completed second fiscal quarter), of the voting stock held by non-affiliates of the Registrant was approximately $1.6 billion. For purposes of the determination of the above stated amount, only directors and executive officers are presumed to be affiliates, but neither the Registrant nor any such person concede that they are affiliates of the Registrant. The number of shares outstanding of the Registrant's Common Stock, $1.00 par value, as of March 14, 2003 was 62.7 million. Documents incorporated by reference: Information called for in Part III of this Form 10-K is incorporated by reference to the Registrant's definitive Proxy Statement to be filed within 120 days of the close of the Registrant's fiscal year in connection with the Registrant's annual meeting of shareholders. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- TABLE OF CONTENTS HCC INSURANCE HOLDINGS, INC.
PAGE ---- PART I. Item 1. Business.................................................... 2 Item 2. Properties.................................................. 30 Item 3. Legal Proceedings........................................... 30 Item 4. Submission of Matters to a Vote of Security Holders......... 30 PART II. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters......................................... 31 Item 6. Selected Financial Data..................................... 31 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations................................... 33 Item 7A. Quantitative and Qualitative Disclosure About Market Risk... 50 Item 8. Financial Statements and Supplementary Data................. 51 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures................................... 51 PART III. Item 10. Directors and Executive Officers of the Registrant.......... 51 Item 11. Executive Compensation...................................... 51 Item 12. Security Ownership of Certain Beneficial Owners and Management.................................................. 52 Item 13. Certain Relationships and Related Transactions.............. 52 Item 14. Controls and Procedures..................................... 52 PART IV. Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K......................................................... 53 Signatures ............................................................ 54
This report on Form 10-K 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. 1 PART I ITEM 1. BUSINESS TERMINOLOGY HCC Insurance Holdings, Inc. is a Delaware corporation, which was formed in 1991. Its predecessor corporation was formed in 1974. Our principal executive offices are located at 13403 Northwest Freeway, Houston, Texas 77040 and our telephone number is (713) 690-7300. We maintain an Internet web-site at www.hcch.com. The reference to our Internet web-site address does not constitute the incorporation by reference of the information contained at this site in this report. We will make available, free of charge through publication on our Internet web-site, a copy of our Annual Report on Form 10-K and quarterly reports on Form 10-Q and any current reports on Form 8-K or amendments to those reports, filed or furnished to the Securities and Exchange Commission as soon as reasonably practicable after we have filed or furnished such materials with the Securities and Exchange Commission. As used in this report, unless otherwise required by the context, the terms "we," "us" and "our" refer to HCC Insurance Holdings, Inc. and its consolidated subsidiaries, and the term "HCC" refers only to HCC Insurance Holdings, Inc. All trade names or trademarks appearing in this report are the property of their respective holders. RISK FACTORS The following factors as well as other information contained in this report should be considered. IF WE CANNOT OBTAIN ADEQUATE REINSURANCE PROTECTION FOR THE RISKS WE HAVE UNDERWRITTEN, WE WILL EITHER BE EXPOSED TO GREATER LOSSES FROM THESE RISKS OR WE WILL REDUCE THE LEVEL OF BUSINESS WE UNDERWRITE, WHICH WILL REDUCE OUR REVENUES. We purchase reinsurance for significant amounts of risk underwritten by our insurance companies, especially catastrophe risks. We also purchase reinsurance on risks underwritten by others which we reinsure through a retrocession agreement. Market conditions beyond our control determine the availability and cost of the reinsurance protection we purchase, which may affect the level of our business and profitability. For instance, the natural attrition of reinsurers who exit lines of business, or who curtail their writings, for economic or other reasons, reduces the capacity of the reinsurance market, causing rates to rise. In addition, the historical results of reinsurance programs and the availability of capital also affect the availability of reinsurance. Our reinsurance facilities are generally subject to annual renewal. We cannot assure you that we can maintain our current reinsurance facilities or that we can obtain other reinsurance facilities in adequate amounts and at favorable rates. Further, we cannot determine what the effect of catastrophic losses will have on the reinsurance market in general and on our ability to obtain reinsurance in adequate amounts and at favorable rates in particular. If we are unable to renew our expiring facilities or to obtain new reinsurance facilities, either our net exposures would increase or, if we are unwilling to bear an increase in net exposures, we would have to reduce the level of our underwriting commitments, especially catastrophe exposed risks. Either of these potential developments could have a material adverse effect on our business. The lack of available reinsurance may also adversely affect our ability to generate fee and commission income in our underwriting agency and reinsurance intermediary operations. A reinsurance intermediary structures and arranges reinsurance between insurers seeking to cede insurance risks and reinsurers willing to assume such risks. IF THE COMPANIES THAT PROVIDE OUR REINSURANCE DO NOT PAY ALL OF OUR CLAIMS, WE COULD INCUR SEVERE LOSSES. We purchase reinsurance by transferring, or ceding, part of the risk we have assumed to a reinsurance company in exchange for part of the premium we receive in connection with the risk. The part of the risk we retain for our own account is known as the retention. Although reinsurance makes the reinsurer liable to us to the extent the risk is transferred or ceded to the reinsurer, it does not relieve us, the reinsured, of our full liability to our policyholders, never the amount above our retention. Accordingly, we bear credit risk with 2 respect to our reinsurers. We cannot assure you that our reinsurers will pay all of our reinsurance claims, or that they will pay our claims on a timely basis. If we become liable for risks we have ceded to reinsurers or if our reinsurers cease to meet their obligations to us, whether because they are in a weakened position as a result of the incurred losses or otherwise, our financial position, results of operations and cash flows could be materially adversely affected. IF WE ARE UNSUCCESSFUL IN COMPETING AGAINST LARGER OR MORE WELL-ESTABLISHED BUSINESS RIVALS, OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION WILL BE ADVERSELY AFFECTED. In our specialty insurance operations, we compete in narrowly-defined niche classes of business such as the insurance of private aircraft (aviation), and employer sponsored, self-insured medical plans (medical stop-loss), as distinguished from such general lines of business as automobile or homeowners insurance. We compete with a large number of other companies in our selected lines of business, including: American International Group and U.S. Aviation Insurance Group (a subsidiary of Berkshire Hathaway, Inc.) in our aviation line of business; SAFECO Corporation and Hartford Life, Inc. in our group life, accident and health line of business; Underwriters at Lloyd's and ACE Limited in our London market account line of business and The Chubb Corporation and Travelers Property Casualty Corp. in our global financial products line of business. We face competition both from specialty insurance companies, underwriting agencies and intermediaries as well as from diversified financial services companies that are significantly larger than we are and that have significantly greater financial, marketing and other resources than we do. Some of these competitors also have longer experience and more market recognition than we do. In addition to competition in the operation of our business, we face competition from a variety of sources in attracting and retaining qualified employees. We cannot assure you that we will maintain our current competitive position in the markets in which we operate, or that we will be able to expand our operations into new markets. If we fail to do so, our business could be materially adversely affected. BECAUSE WE ARE A PROPERTY AND CASUALTY INSURER, UNFORESEEN CATASTROPHIC LOSSES MAY ADVERSELY AFFECT OUR RESULTS OF OPERATIONS, LIQUIDITY AND FINANCIAL CONDITION. Property and casualty insurers are subject to claims arising out of catastrophes that may have a significant effect on their results of operations, liquidity and financial condition. Catastrophic losses have had a significant impact on our results. Catastrophes can be caused by various events, including hurricanes, windstorms, earthquakes, hailstorms, explosions, severe winter weather and fires and may include man-made events, such as the September 11, 2001 terrorist attack on the World Trade Center. The incidence, frequency and severity of catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. Most catastrophes are restricted to small geographic areas; however, hurricanes, earthquakes and terrorist attacks may produce significant damage in large, heavily populated areas. Catastrophes can cause losses in a variety of our property and casualty lines, and most of our past catastrophe-related claims have resulted from hurricanes and earthquakes; however, as a result of the September 11, 2001 terrorist attack, we experienced the largest single loss to our insurance company operations in our history. Insurance companies are not permitted to reserve for a catastrophe until it has occurred. In 2003, we estimate that approximately 10% of our current business may be affected by catastrophes. It is therefore possible that a catastrophic event or multiple catastrophic events could have material adverse effect upon our results of operations, liquidity and financial condition. BECAUSE WE OPERATE INTERNATIONALLY, FLUCTUATIONS IN CURRENCY EXCHANGE RATES MAY AFFECT OUR RECEIVABLE AND PAYABLE BALANCES AND OUR RESERVES, WHICH MAY ADVERSELY AFFECT OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION. We underwrite insurance coverages which are denominated in a number of foreign currencies, and we establish and maintain our loss reserves with respect to these policies in their respective currencies. Our net earnings could be adversely affected by exchange rate fluctuations, which would adversely affect receivable and payable balances and reserves. Our principal area of exposure relates to fluctuations in exchange rates 3 between the major European currencies (particularly the British pound sterling and the Euro) and the U.S. dollar. Consequently, a change in the exchange rate between the U.S. dollar and the British pound sterling or the Euro could have an adverse effect on our net earnings. On a limited basis, we enter into foreign currency forward contracts as a hedge against foreign currency fluctuations. The foreign currency forward contracts are used to convert U.S. dollars at a known rate in an amount that approximates or is less than monthly British pound sterling expenses of certain of our London operations. Thus, the effect of these transactions is to limit the foreign currency exchange risk of the recurring monthly expenses. We use these foreign currency forward contracts strictly as a cash flow hedge against existing exposure to foreign currency fluctuations rather than as a form of speculative or trading investment. IF WE FAIL TO COMPLY WITH EXTENSIVE STATE, FEDERAL AND FOREIGN REGULATIONS, WE WILL BE SUBJECT TO PENALTIES, WHICH MAY INCLUDE FINES AND SUSPENSION AND WHICH MAY ADVERSELY AFFECT OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION. We are subject to extensive governmental regulation and supervision. Most insurance regulations are designed to protect the interests of policyholders rather than shareholders and other investors. This regulation, generally administered by a department of insurance in each state in which we do business, relates to, among other things: - approval of policy forms and premium rates; - standards of solvency, including risk-based capital measurements (which are a measure developed by the National Association of Insurance Commissioners and used by state insurance regulators to identify insurance companies that potentially are inadequately capitalized); - licensing of insurers and their agents; - restrictions on the nature, quality and concentration of investments; - restrictions on the ability of our insurance companies to pay dividends to us; - restrictions on transactions between insurance companies and their affiliates; - restrictions on the size of risks insurable under a single policy; - requiring deposits for the benefit of policyholders; - requiring certain methods of accounting; - periodic examinations of our operations and finances; - prescribing the form and content of records of financial condition required to be filed; and - requiring reserves for unearned premium, losses and other purposes. State insurance departments also conduct periodic examinations of the affairs of insurance companies and require the filing of annual and other reports relating to the financial condition of insurance companies, holding company issues and other matters. Recently adopted federal financial services modernization legislation is expected to lead to additional federal regulation of the insurance industry in the coming years. Also, foreign governments regulate our international operations. Our business depends on compliance with applicable laws and regulations and our ability to maintain valid licenses and approvals for our operations. Some regulatory authorities have relatively broad discretion to grant, renew, or revoke licenses and approvals. Regulatory authorities may deny or revoke licenses for various reasons, including the violation of regulations. In some instances, we follow practices based on our interpretations of regulations, or those that we believe to be generally followed by the industry, which may be different from the requirements or interpretations of regulatory authorities. If we do not have the requisite licenses and approvals and do not comply with applicable regulatory requirements, the insurance regulatory authorities could preclude or temporarily suspend us from carrying on some or all of our activities or otherwise penalize us. That type of 4 action could have a material adverse effect on our business. Also, changes in the level of regulation of the insurance industry (whether federal, state or foreign), or changes in laws or regulations themselves or interpretations by regulatory authorities, could have a material adverse effect on our business. IF THE RATING AGENCIES DOWNGRADE OUR COMPANY OR OUR INSURANCE COMPANIES, OUR RESULTS OF OPERATIONS AND COMPETITIVE POSITION IN THE INDUSTRY MAY SUFFER. Ratings have become an increasingly important factor in establishing the competitive position of insurance companies. Our insurance companies are rated by A.M. Best Company, Inc. and Standard & Poor's Corporation. A.M. Best Company, Inc. and Standard & Poor's Corporation ratings reflect their opinions of an insurance company's and insurance holding company's financial strength, operating performance, strategic position, and ability to meet its obligations to policyholders, and are not evaluations directed to investors. Our ratings are subject to periodic review by A.M. Best Company, Inc. and Standard & Poor's Corporation and the continued retention of those ratings cannot be assured. If our ratings are reduced from their current levels by A.M. Best Company, Inc. and/or Standard & Poor's Corporation, our results of operations could be adversely affected. OUR LOSS RESERVES ARE BASED ON AN ESTIMATE OF OUR FUTURE LIABILITY. IF ACTUAL CLAIMS PROVE TO BE GREATER THAN OUR RESERVES, OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION MAY BE ADVERSELY AFFECTED. We maintain loss reserves to cover our estimated liability for unpaid losses and loss adjustment expenses, including legal and other fees as well as a portion of our general expenses, for reported and unreported claims incurred as of the end of each accounting period. Reserves do not represent an exact calculation of liability. Rather, reserves represent an estimate of what we expect the ultimate settlement and administration of claims will cost. These estimates, which generally involve actuarial projections, are based on our assessment of facts and circumstances then known, as well as estimates of future trends in claims severity, frequency, judicial theories of liability and other factors. These variables are affected by both internal and external events, such as changes in claims handling procedures, inflation, judicial trends and legislative changes. Many of these items are not directly quantifiable in advance. Additionally, there may be a significant reporting lag between the occurrence of the insured event and the time it is reported to us. The inherent uncertainties of estimating reserves are greater for certain types of liabilities, particularly those in which the various considerations affecting the type of claim are subject to change and in which long periods of time may elapse before a definitive determination of liability is made. Reserve estimates are continually refined in a regular and ongoing process as experience develops and further claims are reported and settled. Adjustments to reserves are reflected in the results of the periods in which such estimates are changed. Because setting reserves is inherently uncertain, there can be no assurance that current reserves will prove adequate in light of subsequent events. WE INVEST A SIGNIFICANT AMOUNT OF OUR ASSETS IN FIXED INCOME SECURITIES THAT HAVE EXPERIENCED MARKET FLUCTUATIONS. FLUCTUATIONS IN THE FAIR MARKET VALUE OF FIXED INCOME SECURITIES MAY GREATLY REDUCE THE VALUE OF OUR INVESTMENT PORTFOLIO, AND AS A RESULT, OUR FINANCIAL CONDITION MAY SUFFER. As of December 31, 2002, $841.5 million of our $1.2 billion investment portfolio was invested in fixed income securities. The fair market value of these fixed income securities and the related investment income fluctuate depending on general economic and market conditions. With respect to our investments in fixed income securities, the fair market value of these investments generally increases or decreases in an inverse relationship with fluctuations in interest rates, while net investment income realized by us from future investments in fixed income securities will generally increase or decrease with interest rates. In addition, actual net investment income and/or cash flows from investments that carry prepayment risk (such as mortgage-backed and other asset-backed securities) may differ from those anticipated at the time of investment as a result of interest rate fluctuations. An investment has prepayment risk when there is a risk that the timing of cash flows that result from the repayment of principal might occur earlier than anticipated because of declining interest rates or later than anticipated because of rising interest rates. Although we maintain an investment grade portfolio (96% are rated "A" or better), our fixed income securities are also subject to credit risk. If any of the issuers of our fixed income securities suffer financial set backs, the ratings on the fixed income securities could fall (with a concurrent fall in market value) and, in a worst case scenario, the issuer 5 could default on its financial obligations. Historically, the impact of market fluctuations has affected our financial statements. Because all of our fixed income securities are classified as available for sale, changes in the fair market value of our securities are reflected in our other comprehensive income. Similar treatment is not available for liabilities. Therefore, interest rate fluctuations could adversely affect our shareholders' equity, total comprehensive income and/or our cash flows. Unrealized pre-tax net investment gains on investments in fixed-income securities were $22.0 million, $0.7 million and $11.9 million for the years ended December 31, 2002, 2001 and 2000, respectively. IF STATES DRASTICALLY INCREASE THE ASSESSMENT OUR INSURANCE COMPANIES ARE REQUIRED TO PAY, OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION WILL SUFFER. Our insurance companies are subject to assessments in most states where we are licensed for the provision of funds necessary for the settlement of covered claims under certain policies provided by impaired, insolvent or failed insurance companies or for the issuance of insurance policies to "high risk" or otherwise uninsured individuals. Maximum contributions required by law in any one year vary by state and have historically been between 1% and 2% of annual premiums written. We cannot predict with certainty the amount of future assessments. Significant assessments could have a material adverse effect on our financial condition or results of operations. IF WE ARE UNABLE TO OBTAIN DIVIDENDS IN NEEDED AMOUNTS FROM OUR INSURANCE COMPANIES AS A RESULT OF REGULATORY RESTRICTIONS, WE MAY NOT BE ABLE TO MEET OUR DEBT, DIVIDEND, AND EXPENSE OBLIGATIONS. Our principal assets are the shares of capital stock of our insurance companies. We may rely on dividends from our insurance companies to meet our obligations for paying principal and interest on outstanding debt obligations, dividends to shareholders and corporate expenses. The payment of dividends by our insurance companies is subject to regulatory restrictions and will depend on the surplus and future earnings of these subsidiaries, as well as the regulatory restrictions. As a result, should our other sources of funds prove to be inadequate, we may not be able to receive dividends from our insurance companies at times and in amounts necessary to meet our obligations. BUSINESS OVERVIEW We provide group life, accident and health and property and casualty insurance coverages, underwriting agency and intermediary services both to commercial customers and individuals. We concentrate our activities in selected narrowly defined specialty lines of business. We operate primarily in the United States, the United Kingdom and Spain, although some of our operations have a broader international scope. We underwrite insurance both on 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 a portion of the premium. We market our insurance products both directly to customers and through a network of independent or affiliated agents and brokers. Since our founding, we have been consistently profitable, generally reporting annual increases in gross written premium and total revenue. During the period 1998 through 2001, we had an average statutory combined ratio of 103.2% versus the less favorable 109.8% (source: A.M. Best Company, Inc.) recorded by the U.S. property and casualty insurance industry overall. During the period 1998 through 2002, our gross written premium increased from $498.3 million to $1.2 billion, an increase of 133% while net written premium increased 348% from $121.9 million to $545.9 million. During this period, our revenue increased from $310.4 million to $669.4 million, an increase of 116%. During the period December 31, 1998 through December 31, 2002, our shareholders' equity increased from $440.4 million to $882.9 million, a 100% increase. During the same period, our assets increased from $1.7 billion to $3.7 billion, a 117% increase. 6 Our insurance companies are risk-bearing and focus their underwriting activities on providing insurance and/or reinsurance in the following lines of business: - group life, accident and health - aviation - London market account - global financial products - other specialty lines In the United States, Avemco Insurance Company, U.S. Specialty Insurance Company and HCC Life Insurance Company operate on an admitted, or licensed, basis. Houston Casualty Company and HCC Specialty Insurance Company operate on a surplus lines basis as a non-admitted, or unlicensed, insurer offering insurance coverage not otherwise available from an admitted insurer in the relevant state. Houston Casualty Company operates a registered branch office in London and offers insurance in the United Kingdom and selected other countries. Houston Casualty Company Europe Seguros y Reaseguros S.A., which does business as HCC Europe, operates from its Madrid, Spain offices and offers insurance throughout the European Union and in selected other countries. Our operating insurance companies are rated "A+ (Superior)" (2nd of 16 ratings) by A.M. Best Company , Inc. and "AA (Very Strong)" (3rd of 22 ratings) by Standard and Poor's Corporation, two nationally recognized independent rating agencies. These ratings are intended to provide an independent opinion of an insurer's ability to meet its obligations to policyholders and are not evaluations directed at investors. Our underwriting agencies underwrite on behalf of our insurance companies and other insurance companies. They receive fees for these services and do not bear any of the insurance risk of the companies for which they underwrite. Our underwriting agencies generate revenues based entirely on management fees and profit commissions and specialize in life, accident and health, contingency (including contest indemnification, event cancellation, and weather coverages), directors and officers liability, individual disability (for athletes and other high profile individuals), kidnap and ransom, professional liability and other specialty lines of business. Our principal underwriting agencies are ASU International, LLC, Dickson Manchester & Company Limited, HCC Benefits Corporation, HCC Global Financial Products and Professional Indemnity Agency, Inc. Our intermediaries provide insurance and reinsurance brokerage services for our insurance companies and our clients, and receive fees for their services. Our intermediaries do not bear any of the insurance risks of their client companies. They earn commission income and to a lesser extent fees for certain services, generally paid by the insurance and reinsurance companies with whom the business is placed. These operations consist of consulting with clients by providing information about insurance coverage and marketing, placing and negotiating particular insurance risks. Our intermediaries specialize in developing and marketing employee benefit plans on a retail basis and in placing reinsurance for life, accident and health, and property and casualty lines of business. Our principal intermediaries are HCC Employee Benefits, Inc., HCC Risk Management, Inc. and Rattner Mackenzie Limited. OUR STRATEGY Our business philosophy as an insurer is to maximize underwriting profits while limiting risk in order to preserve shareholders' equity and maximize earnings. We concentrate our insurance writings in selected, narrowly defined lines of business where we believe we can achieve an underwriting profit. We market our insurance products both directly to customers and through independent or affiliated agents and brokers. The property and casualty insurance industry and individual lines of business within the industry are cyclical in that there are times when a large number of companies offer insurance on certain lines of business, 7 causing premiums to trend downward, and other times where insurance companies decide to limit their writings in certain lines of business or suffer from excessive losses, which results in an increase in premiums for those companies that continue to write insurance in those lines of business. In our insurance company operations, we believe our operational flexibility, which permits us to shift the focus of our insurance underwriting activity amongst our various lines of business and also to shift the emphasis from our insurance risk-bearing business to our non-insurance fee-based business, as well as our experienced underwriting personnel and access to, and expertise in, the reinsurance marketplace allow us to implement a strategy of emphasizing more profitable lines of business during periods of increased premium rates and de-emphasizing less profitable lines of business during periods of severe competition. In addition, we believe that our underwriting agencies and intermediaries complement our insurance underwriting activities. Our ability to utilize affiliated insurers, underwriting agencies and intermediaries permits us to retain a greater portion of the gross revenue derived from written premium. Reinsurance enables us to transfer part of the risk we have underwritten through the process of ceding this risk to a reinsurance company in exchange for part of the premium we receive in connection with the risk. We purchase reinsurance to limit the net loss to our insurance companies from both individual and catastrophic risks. The amount of reinsurance we purchase varies by, among other things, the particular risks inherent in the policies underwritten, the pricing of reinsurance and the competitive conditions within the relevant line of business. In 2002, due to a continuing hardening of the insurance market, premium rates increased in varying amounts across all of our lines of business, substantially improving our underwriting profitability. We anticipate continued underwriting profitability during 2003. In response to these changing market conditions, we plan to continue to expand the underwriting activities in our insurance company operations. We also acquire or make strategic investments in companies that present an opportunity for future profits or for enhancement of our business. We expect to continue to acquire complementary businesses. We believe that we can enhance acquired businesses through the synergies created by our underwriting capabilities and our other operations. However, our business plan is shaped by our underlying business philosophy, which is to maximize underwriting profit, while preserving shareholders' equity. As a result, our primary objective is to increase net earnings rather than market share or gross written premium. In our ongoing operations, we will continue to: - emphasize the underwriting of lines of business in which premium rates, the availability and cost of reinsurance, and market conditions warrant; - limit our net loss exposure to our insurance companies from a catastrophe loss through the use of reinsurance; and - review the potential acquisition of specialty insurance operations and other strategic investments. INDUSTRY SEGMENT INFORMATION Financial information concerning our operations by industry segment is set forth in the Consolidated Financial Statements and the Notes thereto. RECENT ACQUISITIONS We have made a series of strategic acquisitions that have furthered our overall business strategy. Our recent transactions are described below: On October 22, 2001, we acquired all of the outstanding shares of Marshall Rattner, Inc. Marshall Rattner, Inc. is a holding company for Professional Indemnity Agency, Inc. and its related companies. We paid $63.0 million in cash and 300,000 shares of our common stock for the Marshall Rattner, Inc./ Professional Indemnity Agency, Inc. acquisition. Professional Indemnity Agency, Inc. is an underwriting agency specializing in the errors and omissions, kidnap and ransom and professional liability areas. 8 On October 30, 2001, we acquired all of the outstanding shares of ASU International, Inc. and the membership interests in its affiliate, ASU International, LLC. We paid $29.2 million for the ASU International, LLC acquisition. ASU International, LLC is an underwriting agency specializing in contingency and disability insurance. We may pay additional amounts in the future based upon the attainment of certain earnings benchmarks through December 31, 2004. On October 1, 2002, we acquired all of the outstanding member interests of MAG Global Financial Products, LLC. We paid $6.9 million for the MAG Global Financial Products, LLC acquisition. MAG Global Financial Products, LLC is an underwriting agency specializing in directors and officers liability, professional liability and errors and omissions insurance. MAG Global Financial Products, LLC has been renamed HCC Global Financial Products, LLC. We may pay additional amounts in the future based upon the attainment of certain earnings benchmarks through September, 2007. On December 24, 2002, we acquired all of the outstanding shares of Manchester Dickson Holdings Limited, the parent Company of Dickson Manchester & Company Limited. We paid $17.0 million for the Dickson Manchester & Company Limited acquisition. Dickson Manchester & Company Limited is an underwriting agency and Lloyd's broker specializing in U.K. professional liability products. We may pay additional amounts in the future based upon the attainment of certain earnings benchmarks through December 31, 2005. On December 31, 2002, we acquired all of the outstanding shares of St. Paul Holdings Limited. St. Paul Holdings Limited is a holding company for St. Paul Espana Compania de Seguros y Reaseguros S.A., a Spanish insurer. We paid $18.9 million for the St. Paul acquisition, subject to adjustment based upon the finalization of the closing date balance sheet. St. Paul Espana writes foreign surety, directors and officers liability and professional liability insurance in Spain and other countries in the European Union. St. Paul Espana now operates as HCC Europe. We continue to evaluate possible acquisition candidates and we may complete additional acquisitions during 2003. Any future acquisitions will be designed to expand and strengthen our existing lines of business and perhaps provide access to additional specialty sectors, which we expect to contribute to our overall growth. 9 INSURANCE COMPANY OPERATIONS LINES OF BUSINESS This table shows our insurance companies' total premium written, otherwise known as gross written premium, by line of business and the percentage of each line to total gross written premium for the years indicated (dollars in thousands):
2002 2001 2000 ---------------- ---------------- -------------- Group life, accident and health........................ $ 503,263 44% $ 502,086 49% $422,384 43% Aviation........................ 212,518 18 198,015 20 191,089 20 London market account........... 199,816 17 133,579 13 83,521 9 Global financial products....... 178,653 15 46 -- -- -- Other specialty lines........... 32,563 3 15,556 2 15,906 2 ---------- --- ---------- --- -------- --- 1,126,813 97 849,282 84 712,900 74 Discontinued lines of business...................... 32,436 3 160,793 16 254,557 26 ---------- --- ---------- --- -------- --- Total gross written premium.................. $1,159,249 100% $1,010,075 100% $967,457 100% ========== === ========== === ======== ===
This table shows our insurance companies' actual premium retained, otherwise known as net written premium, by line of business and the percentage of each line to total net written premium for the years indicated (dollars in thousands):
2002 2001 2000 -------------- -------------- -------------- Group life, accident and health.... $244,554 45% $146,220 39% $109,005 38% Aviation........................... 99,826 18 98,249 26 79,794 28 London market account.............. 113,925 21 54,056 15 22,292 8 Global financial products.......... 43,731 8 44 -- -- -- Other specialty lines.............. 25,621 5 14,346 4 14,552 5 -------- --- -------- --- -------- --- 527,657 97 312,915 84 225,643 79 Discontinued lines of business..... 18,254 3 60,043 16 58,145 21 -------- --- -------- --- -------- --- Total net written premium..... $545,911 100% $372,958 100% $283,788 100% ======== === ======== === ======== ===
UNDERWRITING We underwrite direct business produced through independent agents and brokers, affiliated intermediaries, and by direct marketing efforts. Our insurance companies write facultative, or individual account, reinsurance, as well as a treaty reinsurance business. GROUP LIFE, ACCIDENT AND HEALTH We write medical stop-loss business for employer-sponsored, self-insured health plans. Our medical stop-loss insurance provides coverages to companies, associations and public entities that elect to self-insure their employee's medical coverage for losses within specified levels, allowing them to manage the risk of excessive health insurance exposure by limiting aggregate and specific losses to a predetermined amount. We also underwrite a small program of group life insurance offered to our insureds as complement to our medical stop-loss products. Our underwriting agency, HCC Benefits Corporation, produces and underwrites this business on behalf of our insurance companies. We first began writing this business in our insurance companies in 1997 and gross written premium and net written premium have increased as a result of greater participation by our insurance companies, primarily HCC Life Insurance Company and Avemco Insurance Company. In 1999, we acquired The Centris Group, Inc., doubling our gross written premium to approximately $400.0 million. HCC Benefits Corporation began underwriting this business in 1980 and has grown both internally and through acquisitions during the past five years. We maintain reinsurance on a proportional basis, where we share a 10 proportional part of the original premium and losses with reinsurers, and believe that these risks carry a relatively low level of catastrophe exposure. We began writing alternative workers' compensation and occupational accident insurance in 1996. We transfer liability, premium and loss with respect to this business on a non-proportional basis above our net retention to reinsurers. The business is currently written through U.S. Specialty Insurance Company. We maintain specific reinsurance on an excess of loss basis and we believe there is a relatively low level of catastrophe exposure in this business. AVIATION We are a market leader in the aviation insurance industry. We insure general aviation risks, both domestically and internationally, including: - antique and vintage military aircraft - cargo operations - commuter airlines - corporate aircraft - fixed base operations - military and law enforcement aircraft - private aircraft owners and pilots - rotor wing aircraft We offer coverages that include hulls, engines, avionics and other systems, liabilities, war, cargo and other ancillary coverages. At this time, we do not generally insure major airlines, major manufacturers or satellites. Insurance claims related to general aviation business tend to be seasonal, with the majority of the claims being incurred during the spring and summer months. We have been underwriting aviation risks through Houston Casualty Company since 1981 and in 1997 purchased Avemco Insurance Company, one of the largest writers of personal aircraft insurance in the United States. Avemco Insurance Company has been insuring aviation risks since 1959. Our aviation premium has remained relatively stable since 1998, during which time it returned to underwriting profitability. Our aviation gross written premium for 2002 was $212.5 million. We maintain reinsurance on both a proportional and excess of loss basis and believe that the aviation risks we underwrite carry a relatively low level of catastrophe exposures. LONDON MARKET ACCOUNT Our London market account business consists of marine, energy, property and accident and health business and is underwritten by Houston Casualty Company's London branch office. We underwrite marine risks for oceangoing vessels as well as inland, coastal trading and fishing vessels. The marine risks we write include hull, liabilities and marine cargo. We have underwritten marine risks on both a direct and reinsurance basis since 1984, and currently write a relatively small book of business due to the competitive state of the market. In 2002, our gross written premium was $8.8 million. We have been underwriting energy risks since 1988, which include: - drilling rigs - natural gas facilities - petrochemical plants - pipelines - gas production and gathering platforms - refineries We underwrite physical damage, liabilities and business interruption. Rates have been relatively low during the past few years at levels where underwriting profitability has been difficult to obtain. As a result, we have underwritten offshore energy risks on a very selective basis, striving for quality rather than quantity. During 2001 and 2002 we have seen rate increases that are encouraging and we expect this trend to continue in 2003. In 2002, gross written premium was $68.3 million. 11 We underwrite property business specializing in risks of large, often multinational, corporations, covering a variety of commercial risks including: - factories - hotels - industrial plants - office buildings - retail locations - utilities The insurance we offer includes business interruption, physical damage and catastrophe risks including flood and earthquake. We have written property business since 1986, and due to severe competition, our gross written premium declined to $45.0 million in 2001 and $40.8 million in 2002. We began writing London market accident and health risks in 1996 including: trip accident, medical and disability and have steadily increased premiums. Our gross written premium was $81.9 million in 2002. Our London market account business is reinsured both proportionally and on an excess of loss basis where we transfer liability, premium and loss on a non-proportional basis, for individual and catastrophe risks, above our net retention of risk to reinsurers. Catastrophe exposure is more concentrated in our energy and property lines of business. GLOBAL FINANCIAL PRODUCTS We underwrite a variety of financial insurance risks in our global financial products line of business. These risks include: - directors and officers liability - employment practices liability - errors and omissions - surety We began to underwrite this line of business with our acquisition of Professional Indemnity Agency, Inc. in October, 2001 and have substantially increased our level of business in this area through our October, 2002 acquisition of HCC Global Financial Products, LLC and December, 2002 acquisitions of Dickson Manchester & Company Limited and HCC Europe. Each of the acquired entities has substantial experience in their respective specialty within this line of business. In 2002, we experienced substantial rate increases throughout this line of business generally caused by high profile corporate governance issues in U.S. public companies. Gross written premium rose dramatically to $178.6 million compared to $46 thousand in 2001. We maintain reinsurance on our global financial products line of business on both a proportional and excess of loss basis. Although individual losses have potential severity, there is a relatively low risk of catastrophe exposure. OTHER SPECIALTY LINES In addition to the above, we underwrite various other specialty lines of business, of which individual premiums by line of business are not at this time significant to our overall results of operations. PRINCIPAL INSURANCE COMPANIES Our operating insurance companies are rated "A+ (Superior)" (2nd of 16 ratings) by A.M. Best Company , Inc. and "AA (Very Strong)" (3rd of 22 ratings) by Standard and Poor's Corporation, two nationally recognized independent rating agencies. These ratings are intended to provide an independent opinion of an insurer's ability to meet its obligations to policyholders and are not evaluations directed at investors. 12 HOUSTON CASUALTY COMPANY Houston Casualty Company is our principal insurance company subsidiary. Houston Casualty Company operates worldwide and is domiciled and licensed in Texas and operates on a surplus lines basis in 49 states. Houston Casualty Company receives business through independent agents and brokers, our underwriting agencies and intermediaries, and other insurance and reinsurance companies. Houston Casualty Company writes aviation, London market account, global financial products and other specialty lines business. Houston Casualty Company's 2002 gross written premium was $490.2 million. HOUSTON CASUALTY COMPANY -- LONDON Houston Casualty Company operates a full branch office in the United Kingdom. Houston Casualty Company established its London branch operation in order to more closely align its underwriting operations with the London market, a historical focal point for much of the business that Houston Casualty Company underwrites. Houston Casualty Company-London underwrites global financial products and London market account business. HCC LIFE INSURANCE COMPANY HCC Life Insurance Company is an Indiana-domiciled life insurance company and a subsidiary of Houston Casualty Company. It operates as a group life, accident and health insurer on an admitted basis in 41 states and the District of Columbia. HCC Life Insurance Company is an issuing carrier for HCC Benefits Corporation. HCC Life Insurance Company's gross written premium in 2002 was $326.1 million. U.S. SPECIALTY INSURANCE COMPANY U.S. Specialty Insurance Company is a Texas-domiciled property and casualty insurance company. It is a direct subsidiary of Houston Casualty Company. U.S. Specialty Insurance Company operates on an admitted basis throughout the United States, primarily writing aviation, group life, accident and health and global financial products business. U.S. Specialty Insurance Company acts as an issuing carrier for certain business underwritten by our underwriting agencies. U.S. Specialty Insurance Company's gross written premium in 2002 was $143.9 million. AVEMCO INSURANCE COMPANY Avemco Insurance Company is a Maryland-domiciled property and casualty insurer, and is operating as a direct market underwriter of aviation business on an admitted basis throughout the United States. Avemco Insurance Company is also an issuing carrier for group life, accident and health business underwritten by our underwriting agencies and an unaffiliated underwriting agency. Avemco Insurance Company's gross written premium in 2002 was $203.1 million. HCC SPECIALTY INSURANCE COMPANY HCC Specialty Insurance Company is an Oklahoma domiciled company. HCC Specialty Insurance Company operates on a surplus lines basis in Texas and writes global financial products and other specialty lines business produced by our underwriting agencies. HCC Specialty Insurance Company's gross written premium in 2002 was $1.7 million. HCC EUROPE HCC Europe was acquired on December 31, 2002. HCC Europe is a Spanish insurer and underwrites global financial products business throughout the European Union and in selected other countries. We also intend to utilize HCC Europe as an issuing carrier for the business produced by our underwriting agencies. 13 UNDERWRITING AGENCY OPERATIONS Our underwriting agencies act on behalf of affiliated and non-affiliated insurance companies and provide insurance underwriting management and claims administration services. Our underwriting agencies do not assume any insurance or reinsurance risk themselves and generate revenues based entirely on management fees and profit commissions. These subsidiaries are in a position to direct and control business that they produce. Our insurance companies serve as policy issuing companies for the majority of the business written by our underwriting agencies. In instances where our insurance companies are not the policy issuing company, our insurance companies may reinsure the business written by the underwriting agencies. Management fees generated by our underwriting agencies in 2002 amounted to $77.1 million. LINES OF BUSINESS This table shows our underwriting agencies' revenue by line of business for the years indicated (dollars in thousands):
2002 2001 2000 ------------- ------------- ------------- Life, accident and health............. $44,615 58% $47,857 77% $70,536 73% Property and casualty................. 32,467 42 13,938 23 25,522 27 ------- --- ------- --- ------- --- Total management fees....... $77,082 100% $61,795 100% $96,058 100% ======= === ======= === ======= ===
HCC BENEFITS CORPORATION HCC Benefits Corporation has its home office in Atlanta, Georgia and regional offices in Costa Mesa, California; Wakefield, Massachusetts; Minneapolis, Minnesota; and Dallas, Texas. HCC Benefits Corporation underwrites group life, accident and health business on behalf of affiliated insurance companies. PROFESSIONAL INDEMNITY AGENCY, INC. We acquired Professional Indemnity Agency, Inc. in October, 2001. Professional Indemnity Agency, Inc., with its home office in Mount Kisco, New York and a branch office in San Francisco, California, acts as an underwriting manager for global financial products business on behalf of affiliated and unaffiliated insurance companies. ASU INTERNATIONAL, LLC We acquired ASU International, LLC in October, 2001. ASU International, LLC, with its home office in Woburn, Massachusetts and a branch office in London, England acts as an underwriting manager for group life, accident and health and other specialty lines of business on behalf of affiliated and unaffiliated insurance companies. HCC GLOBAL FINANCIAL PRODUCTS, LLC We acquired HCC Global Financial Products, LLC in October, 2002. HCC Global Financial Products, LLC was formerly known as MAG Global Financial Products, LLC and has offices in Farmington, Connecticut, Houston, Texas, Jersey City, New Jersey, Barcelona, Spain and London, England. HCC Global Financial Products, LLC acts as an underwriting manager for global financial products business on behalf of affiliated insurance companies. DICKSON MANCHESTER & COMPANY LIMITED We acquired Dickson Manchester & Company Limited in December, 2002. Dickson Manchester & Company Limited is an underwriting agency and Lloyd's broker based in London, England and underwrites global financial products business on behalf of affiliated and unaffiliated insurance companies. 14 INTERMEDIARY OPERATIONS Our intermediaries provide a variety of services, including marketing, placing, consulting on and servicing insurance risks for their clients, which include medium to large corporations, unaffiliated and affiliated insurance and reinsurance companies and other risk taking entities. The intermediaries earn commission income and to a lesser extent fees for certain services, generally paid by the underwriters with whom the business is placed. Some of these risks may be initially underwritten by our insurance companies, which may retain a portion of the risk. Commission income generated by our intermediaries in 2002 amounted to $41.6 million. This table shows our intermediaries' revenue by line of business for the years indicated (dollars in thousands):
2002 2001 2000 ------------- ------------- ------------- Life, accident and health............. $32,045 77% $33,739 78% $36,795 74% Property and casualty................. 9,527 23 9,673 22 13,091 26 ------- --- ------- --- ------- --- Total commission income..... $41,572 100% $43,412 100% $49,886 100% ======= === ======= === ======= ===
RATTNER MACKENZIE LIMITED Rattner Mackenzie Limited is an intermediary based in London, England with other operations in Bermuda. Rattner Mackenzie Limited is a Lloyd's broker specializing in group life, accident and health reinsurance and some specialty property and casualty lines of business. Rattner Mackenzie Limited is considered a market leader in its core businesses. Rattner Mackenzie Limited serves as an intermediary for reinsurance business placed by unaffiliated and affiliated insurance companies and reinsurance companies and underwriting agencies. HCC EMPLOYEE BENEFITS, INC. HCC Employee Benefits, Inc., with operations in Houston, Texas and Atlanta, Georgia, is a retail insurance agency and consulting firm specializing in group life, accident and health insurance for employee benefit plans of medium and large commercial customers throughout the United States. We acquired Schanen Consulting Corporation of Atlanta, Georgia in January, 2001 and consolidated its operations with those of HCC Employee Benefits, Inc. HCC RISK MANAGEMENT, INC. HCC Risk Management, Inc., based in Houston, Texas, is an intermediary specializing in marketing and servicing large, complicated insurance and reinsurance programs placed on behalf of multinational clients operating in our lines of business. This business is placed with domestic and international insurance companies, including our insurance companies, on a direct basis and through other intermediaries. In addition, HCC Risk Management, Inc. acts as a reinsurance intermediary on behalf of affiliated and unaffiliated insurance companies. OTHER OPERATIONS Our other operations historically consisted of insurance related services offered to our subsidiaries, our reinsurers and unaffiliated entities. The revenue earned from these services primarily consisted of fees or commissions. Additionally, other operating income may be in the form of equity in the earnings of insurance related companies in which we invest, or dividends or gains or losses from the disposition of these investments. Other operating revenue was $7.0 million in 2002, but can vary considerably from period to period depending on investment or disposition activity. 15 REINSURANCE CEDED We purchase reinsurance to reduce our net liability on individual risks, to protect against catastrophe losses and to achieve a desired ratio of net written premium to policyholders' surplus. We purchase reinsurance on both a proportional and an excess of loss basis. The type, cost and limits of reinsurance we purchase can vary from year to year based upon our desired retention levels and the availability of quality reinsurance at an acceptable price. Our reinsurance programs renew throughout the year and during 2002 some of those renewed contained price increases which are not material to our underwriting results. We structure a specific reinsurance program for each line of business we underwrite. We place reinsurance proportionally to cover loss frequency and catastrophe exposure. We obtain reinsurance on an excess of loss basis to cover individual risk severity of loss and catastrophe exposure. Additionally, we may also obtain facultative reinsurance protection on a single risk. Our reinsurance generally does not cover war or terrorism risks, which are excluded from many of our policies. Subsequent to the terrorist attack on September 11, 2001, where possible, we canceled all terrorist coverage under the terms of existing in-force policies, primarily in the property and energy book of the London market account line of business. Our reinsurance protections in these books have been renewed without coverage for acts of terrorism. We thus only have exposure on policies that contained such coverage and are still in force. This exposure is diminishing as these policies expire and with respect to some risks, would be covered by the provisions of the Federal Terrorism Risk Insurance Act of 2002. In our proportional reinsurance programs, we generally receive an overriding (ceding) commission on the premium ceded to reinsurers. This compensates our insurance companies for the direct costs associated with the production of the business, the servicing of the business during the term of the policies ceded and the costs associated with the placement of the related reinsurance. In addition, certain of our reinsurance treaties allow us to share with the reinsurers in any net profits generated under such treaties. Various intermediaries, including HCC Risk Management, Inc. and Rattner Mackenzie Limited, arrange for the placement of this reinsurance coverage on our behalf and are compensated, directly or indirectly, by the reinsurers. We have a reserve of $7.1 million as of December 31, 2002 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 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. 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. 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 consolidated balance sheets. 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 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 December 31, 2002, our insurance companies had initiated two litigation proceedings against reinsurers. As of such date, our insurance companies had an aggregate amount of $5.8 million which had not been paid to us under the agreements and we estimate that there could be up to an additional $10.7 million of incurred losses and loss expenses and other balances due under the subject agreements. 16 OPERATING RATIOS PREMIUM TO SURPLUS RATIO This table shows, for the years indicated, the ratio of statutory gross written premium and net written premium to statutory policyholders' surplus for our property and casualty insurance companies (dollars in thousands):
2002 2001 2000 1999 1998 ---------- ---------- -------- -------- -------- Gross written premium........ $1,163,397 $1,014,833 $972,154 $576,184 $500,962 Net written premium.......... 545,475 371,409 283,947 150,261 123,315 Policyholders' surplus....... 523,807 401,393 326,249 315,474 369,401 Gross written premium ratio...................... 222.1% 252.8% 298.0% 182.6% 135.6% Gross written premium industry average(1)........ * 210.8% 174.1% 154.1% 147.9% Net written premium ratio.... 104.1% 92.5% 87.0% 47.6% 33.4% Net written premium industry average(1)................. * 112.0% 94.4% 85.5% 84.3%
- --------------- (1) Source: A.M. Best Company, Inc. * Not available While there is no statutory requirement regarding a permissible premium to policyholders' surplus ratio, guidelines established by the National Association of Insurance Commissioners provide that a property and casualty insurer's annual statutory gross written premium should not exceed 900% and net written premium should not exceed 300% of its policyholders' surplus. However, industry standards and rating agency criteria place these ratios at 300% and 200%, respectively. Our property and casualty insurance companies have maintained premium to surplus ratios generally lower than such guidelines. COMBINED RATIO IN ACCORDANCE WITH GENERALLY ACCEPTED ACCOUNTING PRINCIPLES The underwriting experience of a property and casualty insurance company is indicated by its combined ratio. Under generally accepted accounting principles, the combined ratio is a combination of the loss ratio in accordance with generally accepted accounting principles, or the ratio of incurred losses and loss adjustment expenses to net earned premium, and the expense ratio in accordance with generally accepted accounting principles, which is the ratio of policy acquisition costs and other underwriting expenses, net of ceding commissions, to net earned premium. Our insurance companies' loss ratios, expense ratios and combined ratios in accordance with generally accepted accounting principles are shown in the following table for the years indicated:
2002 2001 2000 1999 1998 ---- ----- ---- ----- ---- Loss ratio........................................ 60.6% 78.0% 74.2% 77.6% 63.8% Expense ratio..................................... 25.4 25.7 21.0 51.7 21.5 ---- ----- ---- ----- ---- Combined ratio.................................... 86.0% 103.7% 95.2% 129.3% 85.3% ==== ===== ==== ===== ==== Combined ratio excluding the effects of the provision for reinsurance in 1999............... 98.6% =====
COMBINED RATIO IN ACCORDANCE WITH STATUTORY ACCOUNTING PRINCIPLES The combined ratio in accordance with statutory accounting principles is a combination of the loss ratio in accordance with statutory accounting principles, or the ratio of incurred losses and loss adjustment expenses to net earned premium, and the expense ratio in accordance with statutory accounting principles, which is the ratio of policy acquisition costs and other underwriting expenses, net of ceding commissions, to net written 17 premium. Our insurance companies' loss ratios, expense ratios and combined ratios in accordance with statutory accounting principles are shown in the following table for the years indicated:
2002 2001 2000 1999 1998 ---- ----- ----- ----- ----- Loss ratio...................................... 62.0% 78.0% 71.1% 107.1% 67.2% Expense ratio................................... 23.9 23.8 27.0 22.8 15.7 ---- ----- ----- ----- ----- Combined ratio.................................. 85.9% 101.8% 98.1% 129.9% 82.9% ==== ===== ===== ===== ===== Combined ratio excluding the effects of the provision for reinsurance in 1999............. 104.1% ===== Industry average................................ * 115.9% 110.1% 107.8% 105.6%
- --------------- * Not available The ratio data in accordance with statutory accounting principles is not intended to be a substitute for results of operations in accordance with generally accepted accounting principles. The differences between statutory accounting principles and generally accepted accounting principles are described in Note (14) of our consolidated financial statements included in this report. Including this information on the basis of statutory accounting principles is meaningful and useful to allow a comparison of our operating results with those of other companies in the insurance industry. The source of the industry average is A.M. Best Company, Inc. A.M. Best Company, Inc. reports on insurer performance on the basis of statutory accounting principles to provide for more standardized comparisons among individual companies, as well as overall industry performance. RESERVES Applicable insurance laws require us to maintain reserves to cover our estimated ultimate liability for reported and incurred but not reported losses under insurance and reinsurance policies that we wrote and for loss adjustment expenses relating to the investigation and settlement of policy claims. In most cases, we estimate such losses and claims costs through an evaluation of individual claims. However, for some types of claims, we use an average reserving method until more information becomes available to permit an evaluation of individual claims. We establish loss reserves for individual claims by evaluating reported claims on the basis of: - jurisdiction of the occurrence; - our experience with the insured and the line of business and policy provisions relating to the particular type of claim; - our knowledge of the circumstances surrounding the claim; - the information and reports received from ceding insurance companies where applicable; - the potential for ultimate exposure; - the severity of injury or damage; and - the type of loss. We establish loss reserves for incurred but not reported losses based in part on statistical information and in part on industry experience with respect to the probable number and nature of claims arising from occurrences that have not been reported. We also establish our reserves based on predictions of future events, our estimates of future trends in claims severity, and other subjective factors. Insurance companies are not permitted to reserve for a catastrophe until it has occurred. Reserves are recorded on an undiscounted basis, except for reserves acquired in transactions recorded using the purchase method of accounting. The reserves of each of our insurance companies are established in conjunction with and reviewed by our in-house actuarial staff and our reserves in accordance with statutory accounting principles are certified annually by our 18 independent actuaries. PricewaterhouseCoopers LLP certified the reserves of our insurance companies in accordance with statutory accounting principles as of December 31, 2002. With respect to some classes of risks, the period of time between the occurrence of an insured event and the final settlement of a claim may be many years, and during this period it often becomes necessary to adjust the claim estimates either upward or downward. Certain classes of marine and offshore energy and workers' compensation insurance which are or were underwritten by our insurance companies have historically had longer lead times between the occurrence of an insured event, reporting of the claim, and final settlement. In such cases, we are forced to estimate reserves over long periods of time with the possibility of several adjustments to reserves. Other classes of insurance that we underwrite, such as most aviation, property and medical stop-loss, historically have shorter lead times between the occurrence of an insured event, reporting of the claim and final settlement. Reserves with respect to these classes are, therefore, less likely to be adjusted. The reserving process is intended to reflect the impact of inflation and other factors affecting loss payments by taking into account changes in historical payment patterns and perceived trends. However, there is no precise method for the subsequent evaluation of the adequacy of the consideration given to inflation, or to any other specific factor, or to the way one factor may impact another. We underwrite, directly and through reinsurance, risks which are denominated in a number of foreign currencies, and therefore maintain loss reserves with respect to these policies in the respective currencies. These reserves are subject to exchange rate fluctuations, which may have an effect on our earnings. We may attempt to limit our exposure to future currency fluctuations through the use of foreign currency forward contracts. The loss development triangles below show changes in our reserves in subsequent years from the prior loss estimates based on experience as of the end of each succeeding year on the basis of generally accepted accounting principles. The estimate is increased or decreased as more information becomes known about the frequency and severity of losses for individual years. A redundancy means the original estimate was higher than the current estimate; a deficiency means that the current estimate is higher than the original estimate. The first line of each loss development triangle presents, for the years indicated, our gross or net reserve liability including the reserve for incurred but not reported losses. The first section of each table shows, by year, the cumulative amounts of loss and loss adjustment expense paid as of the end of each succeeding year. The second section sets forth the re-estimates in later years of incurred losses, including payments, for the years indicated. The "cumulative redundancy (deficiency)" represents, as of the date indicated, the difference between the latest re-estimated liability and the reserves as originally estimated. 19 This loss development triangle shows development in loss reserves on a gross basis (in thousands):
2002 2001 2000 1999 1998 1997 1996 1995 1994 ---------- ---------- -------- -------- -------- -------- -------- -------- -------- Balance sheet reserves:.... $1,155,290 $1,130,748 $944,117 $871,104 $460,511 $275,008 $229,049 $200,756 $170,957 Reserve adjustments from acquisition and disposition of subsidiaries.............. -- (66,571) (32,437) (136) -- -- -- -- ---------- ---------- -------- -------- -------- -------- -------- -------- -------- Adjusted reserves....... 1,155,290 1,130,748 877,546 838,667 460,375 275,008 229,049 200,756 170,957 Cumulative paid as of: One year later............ 388,722 400,279 424,379 229,746 160,324 119,453 118,656 97,580 Two years later........... 537,354 561,246 367,512 209,724 179,117 167,459 143,114 Three years later......... 611,239 419,209 241,523 193,872 207,191 166,541 Four years later.......... 435,625 259,067 212,097 214,046 192,540 Five years later.......... 262,838 223,701 226,762 195,930 Six years later........... 225,595 233,831 202,844 Seven years later......... 235,236 208,112 Eight years later......... 209,056 Nine years later.......... Ten years later........... Re-estimated liability as of: End of year............... 1,155,290 1,130,748 877,546 838,667 460,375 275,008 229,049 200,756 170,957 One year later............ 1,107,588 922,080 836,775 550,409 308,501 252,236 243,259 186,898 Two years later........... 925,922 868,438 545,955 316,250 249,013 248,372 207,511 Three years later......... 854,987 547,179 304,281 250,817 247,053 214,738 Four years later.......... 537,968 305,022 247,245 248,687 220,695 Five years later.......... 295,975 249,853 248,559 217,892 Six years later........... 243,015 250,176 219,196 Seven years later......... 246,661 219,002 Eight years later......... 219,478 Nine years later.......... Ten years later........... Cumulative redundancy (deficiency).............. $ 23,160 $(48,376) $(16,320) $(77,593) $(20,967) $(13,966) $(45,905) $(48,521) 1993 1992 -------- --------- Balance sheet reserves:.... $144,178 $ 129,503 Reserve adjustments from acquisition and disposition of subsidiaries.............. -- -- -------- --------- Adjusted reserves....... 144,178 129,503 Cumulative paid as of: One year later............ 82,538 83,574 Two years later........... 126,290 130,379 Three years later......... 157,509 158,973 Four years later.......... 176,472 182,193 Five years later.......... 195,269 192,512 Six years later........... 197,147 213,052 Seven years later......... 203,075 215,280 Eight years later......... 207,474 221,403 Nine years later.......... 208,049 225,706 Ten years later........... 226,143 Re-estimated liability as of: End of year............... 144,178 129,503 One year later............ 163,967 162,827 Two years later........... 183,015 176,817 Three years later......... 203,137 194,419 Four years later.......... 211,546 215,531 Five years later.......... 218,182 222,746 Six years later........... 214,498 234,115 Seven years later......... 216,820 231,269 Eight years later......... 216,627 233,995 Nine years later.......... 216,542 233,865 Ten years later........... 233,921 Cumulative redundancy (deficiency).............. $(72,364) $(104,418)
The gross redundancy for 2001 resulted from the following items: - A $21.5 million reduction in gross losses from the September 11 terrorist attack and a $14.0 million reduction in gross losses from the Total Oil Company loss. Both of these losses were substantially reinsured and thus they had no material net effect. - $36.2 million in negative development due to late reporting of an aggregate program that we no longer write. As this program is substantially reinsured, there was no material net effect. - A $7.7 million charge related to certain business included in discontinued lines. - $31.5 million in other positive development spread across the group life, accident and health, aviation and London market account lines of business. On average these losses were 55% ceded, which created net positive development of approximately $14.5 million. The gross deficiencies reflected in the table for 2000 and 1999 result from late reported loss information received during 2001. These losses primarily came from assumed reinsurance business written by one of our insurance companies. However, as these policies were substantially reinsured, there was no material effect to our net earnings. The gross deficiencies reflected in the table for the years prior to 1999 result from three principal conditions: - The development of large claims on individual policies which were either reported late or for which reserves were increased as subsequent information became available. However, as these policies were substantially reinsured, there was no material effect to our net earnings. 20 - During 1999, in connection with the insolvency of one of our reinsurers and the commutation of all liabilities with another, we re-evaluated all loss reserves and incurred but not reported loss reserves related to business placed with these reinsurers to determine the ultimate losses we might conservatively expect. These reserves were then used as the basis for the determination of the provision for reinsurance recorded in 1999. - For the years prior to 1997, the runoff of the retrocessional excess of loss business, which we underwrote between 1988 and 1991, experienced gross development. This development was due primarily to the delay in reporting of losses by the London insurance market, coupled with the unprecedented number of catastrophe losses during that period. This business was substantially reinsured and there was no material effect to our net earnings. This loss development triangle shows development in loss reserves on a net basis (in thousands):
2002 2001 2000 1999 1998 1997 1996 1995 1994 ---------- ---------- ---------- -------- -------- -------- -------- -------- -------- Gross reserves............. $1,155,290 $1,130,748 $ 944,117 $871,104 $460,511 $275,008 $229,049 $200,756 $170,957 Less reinsurance recoverables.............. 697,972 817,651 694,245 597,498 341,599 155,374 111,766 101,497 95,279 ---------- ---------- ---------- -------- -------- -------- -------- -------- -------- Reserves, net of reinsurance............... 457,318 313,097 249,872 273,606 118,912 119,634 117,283 99,259 75,678 Reserve adjustments from acquisition and disposition of subsidiaries.............. -- -- (6,048) (3,343) (410) -- -- -- -- Effect on loss reserves of 1999 write off of reinsurance recoverables.............. -- -- -- -- 63,851 15,008 2,636 1,442 51 ---------- ---------- ---------- -------- -------- -------- -------- -------- -------- Adjusted reserves, net of reinsurance............... 457,318 313,097 243,824 270,263 182,353 134,642 119,919 100,701 75,729 Cumulative paid, net of reinsurance, as of: One year later............ 126,019 102,244 145,993 56,052 48,775 47,874 41,947 36,500 Two years later........... 139,659 174,534 103,580 64,213 66,030 56,803 49,283 Three years later......... 185,744 113,762 80,227 72,863 64,798 56,919 Four years later.......... 121,293 81,845 81,620 67,355 60,441 Five years later.......... 84,986 81,968 72,627 61,781 Six years later........... 82,681 73,501 66,591 Seven years later......... 73,792 66,410 Eight years later......... 66,749 Nine years later.......... Ten years later........... Re-estimated liability, net of reinsurance, as of: End of year............... 457,318 313,097 243,824 270,263 182,353 134,642 119,919 100,701 75,729 One year later............ 306,318 233,111 260,678 186,967 120,049 116,145 95,764 72,963 Two years later........... 222,330 254,373 175,339 116,745 101,595 94,992 74,887 Three years later......... 244,650 171,165 110,673 97,353 85,484 76,474 Four years later.......... 163,349 107,138 95,118 80,890 73,660 Five years later.......... 103,243 93,528 79,626 69,528 Six years later........... 91,413 79,968 70,642 Seven years later......... 78,614 70,278 Eight years later......... 70,060 Nine years later.......... Ten years later........... Cumulative redundancy (deficiency).............. $ 6,779 $ 21,494 $ 25,613 $ 19,004 $ 31,399 $ 28,506 $ 22,087 $ 5,669 1993 1992 -------- -------- Gross reserves............. $144,178 $129,503 Less reinsurance recoverables.............. 82,289 81,075 -------- -------- Reserves, net of reinsurance............... 61,889 48,428 Reserve adjustments from acquisition and disposition of subsidiaries.............. -- -- Effect on loss reserves of 1999 write off of reinsurance recoverables.............. -- -- -------- -------- Adjusted reserves, net of reinsurance............... 61,889 48,428 Cumulative paid, net of reinsurance, as of: One year later............ 29,258 18,978 Two years later........... 41,207 32,733 Three years later......... 46,576 36,536 Four years later.......... 51,536 38,480 Five years later.......... 53,110 40,327 Six years later........... 53,879 40,550 Seven years later......... 58,353 41,133 Eight years later......... 58,713 45,552 Nine years later.......... 60,658 45,837 Ten years later........... 47,693 Re-estimated liability, net of reinsurance, as of: End of year............... 61,889 48,428 One year later............ 59,659 45,812 Two years later........... 60,079 44,964 Three years later......... 62,224 46,129 Four years later.......... 64,377 48,993 Five years later.......... 64,103 50,785 Six years later........... 59,408 50,585 Seven years later......... 60,960 46,071 Eight years later......... 60,729 47,629 Nine years later.......... 62,874 47,407 Ten years later........... 49,460 Cumulative redundancy (deficiency).............. $ (985) $ (1,032)
We believe that our loss reserves are adequate to provide for all material net incurred losses. 21 The following table provides a reconciliation of the gross liability of loss and loss adjustment expenses on the basis of generally accepted accounting principles in the United States for the three years ended December 31, 2002 (in thousands):
2002 2001 2000 ---------- ---------- -------- Reserves for loss and loss adjustment expense at beginning of year............................... $1,130,748 $ 944,117 $871,104 Reserve adjustments from acquisition and disposition of subsidiaries..................... 82,289 (69,725) 1,709 Incurred loss and loss adjustment expense: Provision for loss and loss adjustment expense for claims occurring in the current year..... 627,412 1,019,311 775,538 Increase (decrease) in estimated loss and loss adjustment expense for claims occurring in prior years(1)............................... (23,160) 44,534 (1,892) ---------- ---------- -------- Incurred loss and loss adjustment expense......... 604,252 1,063,845 773,646 ---------- ---------- -------- Loss and loss adjustment expense payments for claims occurring during: Current year.................................... 273,277 407,210 277,963 Prior years..................................... 388,722 400,279 424,379 ---------- ---------- -------- Loss and loss adjustment expense payments......... 661,999 807,489 702,342 ---------- ---------- -------- Reserves for loss and loss adjustment expense at end of the year................................. $1,155,290 $1,130,748 $944,117 ========== ========== ========
- --------------- (1) Changes in loss and loss adjustment expense reserves (on the basis of generally accepted accounting principles) for losses occurring in prior years reflect the gross effect of the resolution of losses for other than the reserve value and the subsequent adjustments of loss reserves. This table provides a reconciliation of the liability for loss and loss adjustment expense, net of reinsurance ceded, on the basis of generally accepted accounting principles in the United States for the three years ended December 31, 2002 (in thousands):
2002 2001 2000 -------- -------- -------- Reserves for loss and loss adjustment expense at beginning of year.................................. $313,097 $249,872 $273,606 Reserve adjustments from acquisition and disposition of subsidiaries.................................... 79,558 285 514 Incurred loss and loss adjustment expense: Provision for loss and loss adjustment expense for claims occurring in the current year............ 313,270 278,103 208,055 Increase (decrease) in estimated loss and loss adjustment expense for claims occurring in prior years(2)........................................ (6,779) (10,713) (9,585) -------- -------- -------- Incurred loss and loss adjustment expense............ 306,491 267,390 198,470 -------- -------- -------- Loss and loss adjustment expense payments for claims occurring during: Current year....................................... 115,809 102,206 76,725 Prior years........................................ 126,019 102,244 145,993 -------- -------- -------- Loss and loss adjustment expense payments............ 241,828 204,450 222,718 -------- -------- -------- Reserves for loss and loss adjustment expense at end of the year........................................ $457,318 $313,097 $249,872 ======== ======== ========
22 - --------------- (2) Changes in loss and loss adjustment expense reserves (on the basis of generally accepted accounting principles) for losses occurring in prior years reflect the net effect of the resolution of losses for other than the reserve value and the subsequent adjustments of loss reserves. Although we experienced a gross loss deficiency during 2001, the business was substantially reinsured and, therefore, there was no material effect to our insurance companies on a net loss basis. During 2002, we had net loss and loss adjustment expense redundancy of $6.8 million relating to prior year losses compared to redundancies of $10.7 million in 2001 and $9.6 million in 2000. The 2002 redundancy resulted from a deficiency of $7.7 million due to a third quarter charge related to certain business included in discontinued lines, offset by a net redundancy of $14.5 million from all other sources. Deficiencies and redundancies in the reserves occur as we continually review our loss reserves with our actuaries, increasing or reducing loss reserves as a result of such reviews and as losses are finally settled and claims exposures are reduced. We believe we have provided for all material net incurred losses. We have no material exposure to environmental pollution losses, because Houston Casualty Company only began writing business in 1981 and its policies normally contain pollution exclusion clauses which limit pollution coverage to "sudden and accidental" losses only, thus excluding intentional (dumping) and seepage claims. Policies issued by HCC Life Insurance Company, Avemco Insurance Company and U.S. Specialty Insurance Company, because of the types of risks covered, are not considered to have significant environmental exposures. We do not expect to experience any material development in reserves for environmental pollution claims. Likewise, we have no material exposure to asbestos claims. INVESTMENTS Insurance company investments must comply with applicable regulations which prescribe the type, quality and concentration of investments. These regulations permit investments, within specified limits and subject to certain qualifications, in federal, state and municipal obligations, corporate bonds, and preferred and common equity securities. As of December 31, 2002, we had $1.2 billion of investment assets. The majority of our investment assets are held by our insurance companies. All of our securities are classified as available for sale and are recorded at market value. Our investment policy is determined by our Board of Directors and our Investment and Finance Committee and is reviewed on a regular basis. We continue to engage a nationally prominent investment advisor, New England Asset Management, a subsidiary of Berkshire Hathaway, Inc., to oversee our investments and to make recommendations to our Board's Investment and Finance Committee. Although we generally intend to hold fixed income securities to maturity, we regularly re-evaluate our position based upon market conditions. As of December 31, 2002, our fixed income securities had a weighted average maturity of 4.2 years and a weighted average duration of 3.5 years. Our financial statements reflect an unrealized gain on fixed income securities available for sale as of December 31, 2002, of $33.8 million. We have maintained a substantial level of cash and liquid short-term instruments in our insurance companies in order to maintain the ability to fund losses of our insureds. Our underwriting agencies and intermediaries typically have short-term investments, which are fiduciary funds held on behalf of others. As of December 31, 2002, we had cash and short-term investments of approximately $347.5 million, of which $239.6 million were in our underwriting agencies and intermediaries. 23 This table shows a profile of our investments. The table shows the average amount of investments, income earned, and the yield thereon for the periods indicated (dollars in thousands):
2002 2001 2000 ---------- -------- -------- Average investments, at cost........................ $1,005,541 $789,860 $643,721 Net investment income(1)............................ 37,769 39,638 39,836 Average short-term yield(1)......................... 2.2% 4.3% 6.6% Average long-term yield(1).......................... 4.8% 5.6% 6.1% Average long-term tax equivalent yield(1)........... 5.4% 6.4% 7.4% Weighted average combined tax equivalent yield(1)... 4.6% 5.6% 7.1%
- --------------- (1) Excluding realized and unrealized capital gains and losses. This table summarizes, by type, the estimated market value of our investments as of December 31, 2002 (dollars in thousands):
PERCENT OF AMOUNT TOTAL ---------- ---------- Short-term investments...................................... $ 307,215 26% U.S. Treasury securities.................................... 96,546 8 Obligations of states, municipalities and political subdivisions.............................................. 49,230 4 Special revenue fixed income securities..................... 210,238 18 Corporate fixed income securities........................... 244,276 21 Asset-backed and mortgage-backed securities................. 149,873 13 Foreign government securities............................... 91,385 8 Marketable equity securities................................ 15,609 2 Other investments........................................... 3,264 -- ---------- --- TOTAL INVESTMENTS................................. $1,167,636 100% ========== ===
This table summarizes, by rating, the market value of our investments in fixed income securities as of December 31, 2002 (dollars in thousands):
PERCENT OF AMOUNT TOTAL -------- ---------- AAA......................................................... $469,841 56% AA.......................................................... 159,447 19 A........................................................... 179,726 21 BBB......................................................... 32,534 4 -------- --- TOTAL FIXED INCOME SECURITIES..................... $841,548 100% ======== ===
24 The table set forth below indicates the expected maturity distribution of the estimated market value of our fixed income securities as of December 31, 2001 (dollars in thousands):
PERCENT OF AMOUNT TOTAL -------- ---------- One year or less............................................ $ 66,673 8% One year to five years...................................... 326,561 39 Five years to ten years..................................... 135,984 16 Ten years to fifteen years.................................. 82,488 10 More than fifteen years..................................... 79,969 9 -------- --- Securities with fixed maturities.......................... 691,675 82 Asset-backed and mortgage-backed securities................. 149,873 18 -------- --- TOTAL FIXED INCOME SECURITIES..................... $841,548 100% ======== ===
The weighted average life of our structured securities is five years. The value of our portfolio of fixed income securities is inversely correlated to changes in market interest rates. In addition, some of our fixed income securities have call or prepayment options. This could subject us to a reinvestment risk should interest rates fall or issuers call their securities and we are forced to invest the proceeds at lower interest rates. We mitigate this risk by investing in securities with varied maturity dates, so that only a portion of the portfolio will mature at any point in time. Some of our asset-backed securities are subject to re-evaluation and additional specialized impairment tests. Under this guidance, these securities have to be written down in value if certain tests are met. Any write down is recouped prospectively through net investment income, if contractual cash flows are ultimately received. The total amount of securities held by us as of December 31, 2002 that would be subject to these tests and potential write downs is $9.4 million. 2% CONVERTIBLE NOTES AND BANK LOAN In a public offering on August 23, 2001, we issued an aggregate $172.5 million principal amount of 2% Convertible Notes due in 2021. Our debt securities are rated A by Standard & Poor's (3rd of 10 ratings). Each $1 thousand principal amount of notes is convertible into 31.25 shares of our common stock, which represents an initial conversion price of $32.00 per share. The initial conversion price is subject to change under certain conditions. Interest is to be paid by us on March 1 and September 1 each year. Holders may surrender notes for conversion into shares of our common stock in any calendar quarter if, as of the last day of the preceding calendar quarter, the closing sale price of our common stock for at least 20 trading days in the period of 30 consecutive trading days ending on the last trading day of the quarter is more than 120% ($38.40 per share) of the conversion price per share of our common stock on the last trading day of the quarter. We can redeem the notes for cash at any time on or after September 1, 2006. Holders of the notes may require us to repurchase the notes on September 1, 2004, 2006, 2008, 2011 and 2016. If the holders exercise this option, we may choose to pay the purchase price in cash, in shares of our common stock, or a combination thereof. On September 1, 2002, the first repurchase date of the notes, $49 thousand of the notes were tendered to us and we repurchased them with cash. We used the proceeds from this offering to repay our remaining indebtedness under our bank facility, assist in financing the recent acquisitions, make a $60.0 million capital contribution to our insurance companies and for general corporate purposes. 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 on June 6, 2001. We can borrow up to the maximum allowed by the facility on a revolving basis until the facility expires on December 17, 2004. The facility is collateralized in part by the pledge of our insurance companies stock and guarantees entered into by our underwriting agencies and intermediaries. The facility agreement contains certain restrictive covenants, which we believe are typical for similar financing arrangements. As of December 31, 2002, there was an outstanding balance of $53.0 million on this facility bearing interest at an average interest rate of 3.2%. 25 REGULATION The business of insurance is extensively regulated by the government. At this time, the insurance business in the United States is regulated primarily by the individual states. However, a form of federal financial services modernization legislation enacted in 1999 is expected to result in additional federal regulation of the insurance industry. In addition, some insurance industry trade groups are actively lobbying for legislation that would allow an option for a separate federal charter for insurance companies. The full extent to which the federal government will determine to directly regulate the business of insurance has not been determined by lawmakers. Also, various foreign governments regulate our international operations. Our business depends on our compliance with applicable laws and regulations and our ability to maintain valid licenses and approvals for our operations. We devote a significant effort toward obtaining and maintaining our licenses and compliance with a diverse and complex regulatory structure. In all jurisdictions, the applicable laws and regulations are subject to amendment or interpretation by regulatory authorities. Generally, regulatory authorities are vested with broad discretion to grant, renew and revoke licenses and approvals and to implement regulations governing the business and operations of insurers and insurance agents. INSURANCE COMPANIES Our insurance companies, in common with other insurers, are subject to regulation and supervision by the states and by other jurisdictions in which they do business. Regulation by the states varies, but generally involves regulatory and supervisory powers of a state insurance official. The regulation and supervision of our insurance operations relates primarily to: - approval of policy forms and premium rates; - licensing of insurers and their agents; - periodic examinations of our operations and finances; - prescribing the form and content of records of financial condition required to be filed; - requiring deposits for the benefit of policyholders; - requiring certain methods of accounting; - requiring reserves for unearned premium, losses and other purposes; - restrictions on the ability of our insurance companies to pay dividends to us; - restrictions on the nature, quality and concentration of investments; - restrictions on transactions between insurance companies and their affiliates; - restrictions on the size of risks insurable under a single policy; and - standards of solvency, including risk-based capital measurements (which is a measure developed by the National Association of Insurance Commissioners and used by state insurance regulators to identify insurance companies that potentially are inadequately capitalized.) In general, state insurance regulations are intended primarily for the protection of policyholders rather than shareholders. The state insurance departments monitor compliance with regulations through periodic reporting procedures and examinations. The quarterly and annual financial reports to the state insurance regulators utilize accounting principles which are different from the generally accepted accounting principles we use in our reports to shareholders. Statutory accounting principles, in keeping with the intent to assure the protection of policyholders, are generally based on a liquidation concept while generally accepted accounting principles are based on a going-concern concept. Houston Casualty Company is domiciled in Texas. It operates on an admitted basis in Texas and may write reinsurance on all lines of business that it may write on a direct basis. Houston Casualty Company is an 26 accredited reinsurer in 39 states and an approved surplus lines insurer or is otherwise permitted to write surplus lines insurance in 49 states, three United States territories and the District of Columbia. When a reinsurer obtains accreditation from a particular state, insurers within that state are permitted to obtain statutory credit for risks ceded to the reinsurer. Surplus lines insurance is offered by non-admitted companies on risks which are not insured by admitted companies. All surplus lines insurance is required to be written through licensed surplus lines insurance brokers, who are required to be knowledgeable of and follow specific state laws prior to placing a risk with a surplus lines insurer. Houston Casualty Company's branch office in London, England is subject to regulation by regulatory authorities in the United Kingdom. Avemco Insurance Company is domiciled in Maryland and operates as a licensed admitted insurer in all states and the District of Columbia. U.S. Specialty Insurance Company is domiciled in Texas and operates as a licensed admitted insurer in all states and the District of Columbia. HCC Life Insurance Company is domiciled in Indiana, and operates as a licensed admitted insurer in 41 states and the District of Columbia. HCC Specialty Insurance Company is domiciled in Oklahoma and operates on a surplus lines basis in Texas. HCC Europe is domiciled in Spain and operates on the equivalent of an "admitted" basis throughout the European Union and operates in selected other countries as permitted under local regulations. State insurance regulations also affect the payment of dividends and other distributions by insurance companies to their shareholders. Generally, insurance companies are limited by these regulations to the payment of dividends above a specified level. Dividends in excess of those thresholds are "extraordinary dividends" and subject to prior regulatory approval. UNDERWRITING AGENCIES AND INTERMEDIARIES In addition to the regulation of insurance companies, the states impose licensing and other requirements on the insurance agency and service operations of our other subsidiaries. These regulations relate primarily to: - advertising and business practice rules; - contractual requirements; - financial security; - licensing as agents, brokers, intermediaries, managing general agents or third party administrators; - limitations on authority; and - recordkeeping requirements. The manner of operating our underwriting agency and intermediary activities in particular states may vary according to the licensing requirements of the particular state, which may require, among other things, that we operate in the state through a local corporation. In a few states, licenses are issued only to individual residents or locally-owned business entities. In such cases, we may have arrangements with residents or business entities licensed to act in the state. The majority of states, however, have recently enacted legislation in response to the Federal Gramm-Leach-Bliley Act that streamlines and makes more uniform the licensing requirements. STATUTORY ACCOUNTING PRINCIPLES The principal differences between statutory accounting principles and generally accepted accounting principles, the method by which we report our financial results to our shareholders are: - a liability is recorded for certain reinsurance recoverables under statutory accounting principles, whereas under generally accepted accounting principles there is no such provision unless the recoverables are deemed to be doubtful of collectibility; - under statutory accounting principles, life insurance companies record investment related liabilities, the asset valuation reserve and interest maintenance reserve, whereas there is not such liability under generally accepted accounting principles; 27 - certain assets which are considered "non-admitted assets" are eliminated from a balance sheet prepared in accordance with statutory accounting principles but are included in a balance sheet prepared in accordance with generally accepted accounting principles; - only some of the deferred tax assets are recognized under statutory accounting principles; - fixed-income investments classified as available for sale are recorded at market value for generally accepted accounting principles and at amortized cost under statutory accounting principles; - outstanding losses and unearned premium are recorded on a gross basis under generally accepted accounting principles and on a net basis under statutory accounting principles; and - under statutory accounting principles, policy acquisition costs are expensed as incurred and under generally accepted accounting principles such costs are deferred and amortized to expense as the related premium is earned. The National Association of Insurance Commissioners adopted Statements of Statutory Accounting Principles in March, 1998, which became effective on January 1, 2001, through their adoption by the individual states. The cumulative effect of codification increased the statutory policyholders' surplus of our insurance companies by approximately $8.9 million. Our use of statutory accounting practices prescribed by state regulatory authorities caused a $1.5 million increase in our insurance companies' aggregate statutory policyholders' surplus as of December 31, 2002 compared to amounts that would have been recorded under the codification rules of the National Association of Insurance Commissioners. The statutory policyholders' surplus of each of our insurance companies is significantly in excess of regulatory risk-based capital requirements. INSURANCE HOLDING COMPANY ACTS Because we are an insurance holding company, we are subject to the insurance holding company system regulatory requirements of the states of Arkansas, Indiana, Maryland, Oklahoma and Texas. Under these regulations, we are required to report information regarding our capital structure, financial condition and management. We are also required to provide prior notice to, or seek the prior approval of insurance regulatory authorities of certain agreements and transactions between our affiliated companies. These agreements and transactions must satisfy certain regulatory requirements. RISK-BASED CAPITAL The National Association of Insurance Commissioners has developed a formula for analyzing insurance companies called risk-based capital. The risk-based capital formula is intended to establish minimum capital thresholds that vary with the size and mix of a company's business and assets. It is designed to identify companies with capital levels that may require regulatory attention. As of December 31, 2002, each of our domestic insurance companies' total adjusted capital is significantly in excess of the authorized control level risk-based capital. INSURANCE REGULATORY INFORMATION SYSTEM The National Association of Insurance Commissioners has also developed a rating system, the Insurance Regulatory Information System, primarily intended to assist state insurance departments in overseeing the financial condition of all insurance companies operating within their respective states. The Insurance Regulatory Information System consists of eleven key financial ratios that address various aspects of each insurer's financial condition and stability. Our insurance companies' Insurance Regulatory Information System ratios generally fall within the usual prescribed ranges except in satisfactorily explainable circumstances such as when there is a large reinsurance transaction, capital change, merger or planned growth. 28 TERRORISM RISK INSURANCE ACT In 2002, the Federal Terrorism Risk Insurance Act was enacted for the purpose of ensuring the availability of insurance coverage for terrorist acts in the United States. The law establishes a financial "backstop" program through the end of 2005 to assist the commercial property and casualty insurance industry in providing coverage related to future acts of terrorism within the United States. Under the Terrorism Risk Insurance Act of 2002, we are required to offer terrorism coverage to our commercial policyholders in certain lines of business written in the United States, for which we may, when warranted, charge an additional premium. The policyholders may or may not accept such coverage. This law also established a deductible that each insurer would have to meet before U.S. Federal reimbursement would occur. For 2003, our deductible is approximately $11.2 million based on 7% of 2002 subject premium as defined under the applicable regulations. Thereafter, the Federal government would provide reimbursement for 90% of our insured, covered insured losses up to the maximum amount set out in the Act. PENDING OR PROPOSED LEGISLATION In recent years, state legislatures have considered or enacted laws that modify and, in many cases, increase state authority to regulate insurance companies and insurance holding company systems. State insurance regulators are members of the National Association of Insurance Commissioners, which seeks to promote uniformity of, and to enhance the state regulation of, insurance. In addition, the National Association of Insurance Commissioners and state insurance regulators, as part of the National Association of Insurance Commissioners' state insurance department accreditation program and in response to new federal laws, have re-examined existing state laws and regulations, specifically focusing on insurance company investments, issues relating to the solvency of insurance companies, licensing and market conduct issues, streamlining agent licensing and policy form approvals, adoption of privacy rules for handling policyholder information, interpretations of existing laws, the development of new laws, and the definition of extraordinary dividends. In recent years, a variety of measures have been proposed at the federal level to reform the current process of federal and state regulation of the financial services industries in the United States, which include the banking, insurance and securities industries. These measures, which are often referred to as financial services modernization, have as a principal objective the elimination or modification of current regulatory barriers to cross-industry combinations involving banks, securities firms and insurance companies. A form of financial services modernization legislation was enacted at the federal level in 1999 through the Gramm-Leach-Bliley Act. That federal legislation was expected to have significant implications on the banking, insurance and securities industries and to result in more cross-industry consolidations among banks, insurance companies and securities firms and increased competition in many of the areas of our operations. Such wide-spread cross-industry consolidation has not occurred to date. It also mandated the adoption of laws allowing reciprocity among the states in the licensing of agents and, along with other federal laws, mandated the adoption of laws and regulations dealing with the protection of the privacy of policyholder information. Also, the federal government has conducted investigations of the current condition of the insurance industry in the United States to determine whether to impose overall federal regulation of insurers. In the past several years there have been a number of recommendations that the industry's anti-trust exemption be removed and the industry placed under federal regulation. If so, we believe state regulation of the insurance business would likely continue. This could result in an additional layer of federal regulation. We do not know at this time the full extent to which these federal or state legislative or regulatory initiatives will or may affect our operations, and no assurance can be given that they would not, if adopted, have a material adverse effect on our business or its results of operations. EMPLOYEES As of December 31, 2002 we had 1,096 employees. The employees include six executive officers, 24 senior management, 94 management and 972 other personnel. Of this number, 353 are employed by our insurance companies, 501 are employed by our underwriting agencies, 128 are employed by our intermediaries, and 114 are employed at the corporate headquarters and elsewhere. We are not a party to any collective 29 bargaining agreement and have not experienced work stoppages or strikes as a result of labor disputes. We consider our employee relations to be good. ITEM 2. PROPERTIES Our principal and executive offices are located in Houston, Texas, in a building owned by Houston Casualty Company. We also maintain offices in over 25 locations elsewhere in the United States, England and Spain. The majority of these additional locations are in leased facilities. Our principal office facilities are as follows:
SUBSIDIARY LOCATION SQ. FT. LEASE TERMINATION DATE - ---------- -------- ------- ---------------------- HCC Insurance Holdings, Inc. and Houston Casualty Company Houston, Texas 51,000 Owned Houston Casualty Company Houston, Texas 77,000 Owned Avemco Insurance Company Frederick, Maryland 40,000 Owned U.S. Specialty Insurance Company Aviation Division Dallas, Texas 40,000 Leased* Professional Indemnity Agency, Inc. Mount Kisco, New York 38,000 Owned
- --------------- * Lease termination date is March 31, 2004 ITEM 3. LEGAL PROCEEDINGS In addition to the matters discussed in the Reinsurance Ceded section contained in Item 1, Business, 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 believe the resolution of any such lawsuits will not have a material adverse effect on our financial condition, results of operations or cash flows. We have received substantial assessments from a state health insurance association, which was established by the state to provide health insurance to "high-risk" or otherwise uninsured individuals within that state. The expenses of the association are currently funded principally through assessments on insurers. With the current assessment, the association changed the calculation method for the amount of the assessment, which resulted in a significant increase in the amount of our assessment ($5.2 million). We and other insurers are presently contesting the change in the assessment methodology. We believe we will receive relief from the current assessment and that any amount we may ultimately have to pay will not be material to our financial position and results of operations, after taking into consideration credits we would receive against other taxes in the state. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during the fourth quarter of 2002. 30 PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS PRICE RANGE OF COMMON STOCK Our common stock trades on the New York Stock Exchange under the ticker symbol "HCC". The intra-day high and low sales prices for quarterly periods during the period January 1, 2001 through December 31, 2002, as reported by the New York Stock Exchange were as follows:
2002 2001 --------------- --------------- HIGH LOW HIGH LOW ------ ------ ------ ------ First quarter...................................... $28.95 $24.90 $26.88 $20.50 Second quarter..................................... 28.50 24.70 29.65 23.26 Third quarter...................................... 26.60 19.11 26.67 21.21 Fourth quarter..................................... 25.70 22.37 29.20 25.15
On March 14, 2003, the last reported sales price of our common stock as reported by the New York Stock Exchange was $25.25 per share. SHAREHOLDERS We have one class of authorized capital stock: 250.0 million shares of common stock, par value $1.00 per share. As of March 14, 2003, there were 62.7 million shares of issued and outstanding common stock held by 924 shareholders of record; however, we believe there are in excess of 12,000 beneficial owners. DIVIDEND POLICY Beginning in June, 1996, we announced a planned quarterly program of paying cash dividends to shareholders. We paid a cash dividend of $0.02 per share in July, 1996 and in each succeeding quarter through the first quarter of 1997. We have increased the quarterly cash dividend in each year and beginning in September, 2002, our quarterly dividend was $0.065 per share. Our Board of Directors may review our dividend policy from time to time, and any determination with respect to future dividends will be made in light of regulatory and other conditions at that time, including our earnings, financial condition, capital requirements, loan covenants, and other related factors. Under the terms of our bank loan, we are prohibited from paying dividends in excess of an agreed upon maximum amount in any fiscal year. That limitation should not affect our ability to pay dividends in a manner consistent with our past practice and current expectations. ITEM 6. SELECTED FINANCIAL DATA The selected consolidated financial data set forth below has been derived from the Consolidated Financial Statements. All information contained herein should be read in conjunction with the Consolidated Financial Statements, the related notes thereto and Management's Discussion and Analysis of Financial Condition and Results of Operations included elsewhere in this Report. 31
FOR THE YEARS ENDED DECEMBER 31, (IN THOUSANDS, EXCEPT PER SHARE DATA)(1) ---------------------------------------------------- 2002 2001 2000 1999 1998 -------- -------- -------- -------- -------- STATEMENT OF EARNINGS DATA: Revenue Net earned premium........................ $505,521 $342,787 $267,647 $141,362 $143,100 Management fees........................... 77,082 61,795 96,058 90,713 74,045 Commission income......................... 41,572 43,412 49,886 58,233 40,804 Net investment income..................... 37,769 39,638 39,836 30,946 29,342 Net realized investment gain (loss)....... 453 393 (5,321) (4,164) 845 Other operating income.................... 6,985 17,436 25,497 28,475 22,268 -------- -------- -------- -------- -------- Total revenue..................... 669,382 505,461 473,603 345,565 310,404 Expense Loss and loss adjustment expense, net..... 306,491 267,390 198,470 109,650 91,302 Operating expense: Policy acquisition costs, net........ 63,274 27,923 23,743 8,177 10,978 Compensation expense................. 80,495 69,762 83,086 79,196 57,227 Provision for reinsurance............ -- -- -- 43,462 -- Other operating expense.............. 47,642 71,119 53,274 53,273 36,558 -------- -------- -------- -------- -------- Total operating expense........... 191,411 168,804 160,103 184,108 104,763 Interest expense.......................... 8,301 8,884 20,347 12,964 6,021 -------- -------- -------- -------- -------- Total expense..................... 506,203 445,078 378,920 306,722 202,086 -------- -------- -------- -------- -------- Earnings before income tax provision....................... 163,179 60,383 94,683 38,843 108,318 Income tax provision...................... 57,351 30,186 37,202 12,271 35,208 -------- -------- -------- -------- -------- Net earnings before accounting change.......................... 105,828 30,197 57,481 26,572 73,110 Cumulative effect of accounting change(2)... -- -- (2,013) -- -- -------- -------- -------- -------- -------- Net earnings...................... $105,828 $ 30,197 $ 55,468 $ 26,572 $ 73,110 ======== ======== ======== ======== ======== BASIC EARNINGS PER SHARE DATA: Earnings before accounting change...... $ 1.70 $ 0.52 $ 1.13 $ 0.53 $ 1.49 Cumulative effect of accounting change(2)............................ -- -- (0.04) -- -- -------- -------- -------- -------- -------- Net earnings........................... $ 1.70 $ 0.52 $ 1.09 $ 0.53 $ 1.49 ======== ======== ======== ======== ======== Weighted average shares outstanding.... 62,225 58,321 50,742 50,058 48,917 ======== ======== ======== ======== ======== DILUTED EARNINGS PER SHARE DATA: Earnings before accounting change...... $ 1.68 $ 0.51 $ 1.11 $ 0.52 $ 1.46 Cumulative effect of accounting change(2)............................ -- -- (0.04) -- -- -------- -------- -------- -------- -------- Net earnings........................... $ 1.68 $ 0.51 $ 1.07 $ 0.52 $ 1.46 ======== ======== ======== ======== ======== Weighted average shares outstanding.... 62,936 59,619 51,619 50,646 49,933 ======== ======== ======== ======== ======== Cash dividends declared, per share.......... $ 0.255 $ 0.245 $ 0.22 $ 0.20 $ 0.16 ======== ======== ======== ======== ======== Amounts adjusted for the non-amortization of goodwill(3): Adjusted net earnings.................. $105,828 $ 41,584 $ 67,302 $ 31,980 $ 74,856 ======== ======== ======== ======== ======== Adjusted basic earnings per share...... $ 1.70 $ 0.71 $ 1.33 $ 0.64 $ 1.53 ======== ======== ======== ======== ======== Adjusted diluted earnings per share.... $ 1.68 $ 0.70 $ 1.30 $ 0.63 $ 1.50 ======== ======== ======== ======== ========
32
DECEMBER 31, (IN THOUSANDS, EXCEPT PER SHARE DATA) -------------------------------------------------------------- 2002 2001 2000 1999 1998 ---------- ---------- ---------- ---------- ---------- BALANCE SHEET DATA: Total investments................ $1,167,636 $ 885,659 $ 711,113 $ 581,322 $ 525,646 Premium, claims and other receivables.................... 753,527 665,965 609,716 636,671 382,885 Reinsurance recoverables......... 798,934 899,128 789,412 736,485 372,672 Ceded unearned premium........... 164,224 71,140 114,469 133,657 149,568 Goodwill and intangible assets... 350,086 328,815 266,015 263,687 88,043 Total assets..................... 3,704,151 3,219,120 2,790,755 2,679,737 1,709,643 Loss and loss adjustment expense payable........................ 1,155,290 1,130,748 944,117 871,104 460,511 Unearned premium................. 331,050 179,530 190,550 188,524 201,050 Notes payable.................... 230,027 181,928 212,133 242,546 121,600 Shareholders' equity............. 882,907 763,453 530,930 458,439 440,430 Book value per share(4).......... 14.15 12.40 10.29 9.12 8.94
- --------------- (1) Certain amounts in the 2001, 2000, 1999, and 1998 selected consolidated financial data have been reclassified to conform to the 2002 presentation. Such reclassifications had no effect on our net earnings, shareholders' equity, or cash flows. (2) During 2000, we changed certain of our revenue recognition methods for our underwriting agencies and intermediaries to agree to guidance contained in Securities and Exchange Commission's Staff Accounting Bulletin Number 101 entitled "Revenue Recognition in Financial Statements". See Note (1) in the Notes to Consolidated Financial Statements. (3) During 2002, we adopted Statement of Financial Accounting Standards ("SFAS") No. 142 entitled "Goodwill and Other Intangible Assets", which required that goodwill and indefinite-lived intangible assets no longer be amortized. The adjusted amounts presented are amounts that we would have reported had we adopted SFAS No. 142 on January 1, 1998. (4) Book value per share is calculated by dividing the sum of outstanding shares plus contractually issuable shares into total shareholders' equity. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW We primarily receive our revenue from earned premium derived from our insurance company operations, management fees generated by our underwriting agency operations, commission income produced by our intermediary operations, investment income from all of our operations and other operating income. Our core underwriting activities involve providing group life, accident and health, aviation, London market account, global financial products and other specialty lines of business, each of which is marketed by our insurance companies and our underwriting agencies either directly to customers or through a network of independent or affiliated agents and brokers. During the past several years, we have substantially increased our shareholders' equity through issuing equity securities and through retaining our earnings, thereby enabling us to increase the underwriting capacity of our insurance companies. With this additional equity, we increased underwriting activity across many of our lines of business, emphasizing lines of business and individual opportunities with the most favorable underwriting characteristics at a particular point in the insurance cycle. As an insurer, we also purchase reinsurance for each of our lines of business. We purchase different types of reinsurance in amounts we consider appropriate for each of our lines of business based upon market conditions and the level of risk we wish to retain. 33 Market conditions improved during 2000, 2001 and 2002 across all of our lines of business. This improvement accelerated after the September 11, 2001 terrorist attack and highly publicized corporate governance failures and continued throughout 2002 with significant rate increases particularly evident in our global financial products line of business. We plan to continue to expand our underwriting activities, in response to these hardening market conditions. During 2001 and 2002 we acquired the following companies in transactions that were recorded using the purchase method of accounting. Accordingly, the results of operations and cash flows of these companies are included in our underwriting results beginning on the effective date of each transaction.
COMPANY SEGMENT EFFECTIVE DATE ACQUIRED - ------- ------------------- ----------------------- Professional Indemnity Agency, Inc. Underwriting Agency October 22, 2001 ASU International, LLC Underwriting Agency October 30, 2001 HCC Global Financial Products LLC (formerly MAG Global Financial Products) Underwriting Agency October 1, 2002 Dickson Manchester & Company Limited Underwriting Agency December 24, 2002 HCC Europe, (formerly St. Paul Espana) Insurance Company December 31, 2002
RESULTS OF OPERATIONS The following table sets forth certain premium revenue information for the three years ended December 31, 2002 (in thousands):
2002 2001 2000 ---------- ---------- --------- Direct........................................... $ 904,737 $ 783,124 $ 676,730 Reinsurance assumed.............................. 254,512 226,951 290,727 ---------- ---------- --------- Gross written premium.......................... 1,159,249 1,010,075 967,457 Reinsurance ceded................................ (613,338) (637,117) (683,669) ---------- ---------- --------- Net written premium............................ 545,911 372,958 283,788 Change in unearned premium....................... (40,390) (30,171) (16,141) ---------- ---------- --------- Net earned premium............................. $ 505,521 $ 342,787 $ 267,647 ========== ========== =========
The following table sets forth the relationships of certain income statement items as a percent of total revenue for the three years ended December 31, 2002:
2002 2001 2000 ----- ----- ----- Net earned premium.......................................... 75.5% 67.8% 56.5% Management fees............................................. 11.5 12.2 20.3 Commission income........................................... 6.2 8.6 10.5 Net investment income....................................... 5.7 7.8 8.4 Net realized investment gain (loss)......................... 0.1 0.1 (1.1) Other operating income...................................... 1.0 3.5 5.4 ----- ----- ----- Total revenue............................................. 100.0 100.0 100.0 Loss and loss adjustment expense, net....................... 45.8 52.9 41.9 Net operating expense....................................... 28.6 33.4 33.8 Interest expense............................................ 1.2 1.7 4.3 ----- ----- ----- Earnings before income tax provision...................... 24.4 12.0 20.0 Income tax provision........................................ 8.6 6.0 7.9 ----- ----- ----- Net earnings before accounting change..................... 15.8% 6.0% 12.1% ===== ===== =====
34 Year Ended December 31, 2002 Versus Year Ended December 31, 2001 Total revenue increased 32% to $669.4 million for 2002 from $505.5 million in 2001. The revenue increase in the insurance company segment resulted from organic growth in our existing lines of business, the addition of our new global financial products line of business, and increased premium retention. The revenue in the underwriting agency segment increased due to organic growth and acquisitions made in 2002 and late 2001, but the increase was partially offset by reduced revenue in the intermediary and other operations segments as a result of market conditions and the sale or other disposition of various operations in 2001. Net investment income decreased to $37.8 million for 2002 from $39.6 million in 2001. This decrease was due to the reduction in interest rates, substantially offset by the higher level of invested assets which resulted from cash flow provided by operating activities and capital contributions made to our insurance company subsidiaries. We expect investment assets to continue to increase which, even without an increase in market interest rates, should produce a growth in investment income in 2003. The year 2001 was adversely affected as we experienced the largest loss to our insurance company operations in our history due to the terrorist attack on September 11, with incurred net losses of $35.0 million. In 2001, we also recorded a charge totaling $37.3 million related to our primary workers' compensation line of business and other lines of business that we decided to cease writing. Included in this charge was $15.0 million related to the impairment of goodwill associated with our primary workers' compensation line of business. Compensation expense increased to $80.5 million during 2002 from $69.8 million in 2001. Much of this increase was due to the underwriting agency subsidiaries acquired in 2002 and late 2001, somewhat offset by a decrease from operations sold or otherwise disposed of during late 2001 and efficiencies gained from the consolidation of certain of our underwriting agencies into our insurance company operations. Other operating expense decreased to $47.6 million during 2002 compared to $71.1 million in 2001, primarily as a result of the reduction in the amortization of goodwill, operations sold or disposed of, somewhat offset by the effect of acquisitions in 2002 and late 2001, and the goodwill impairment charge in 2001. Currency conversion gains amount to $1.2 million in 2002 compared to $0.3 million in 2001. Interest expense was $8.3 million for 2002 compared to $8.9 million in 2001. Included in 2002 is $2.9 million representing the amortization of underwriting discounts and other costs of our August 2001 issuance of 2% convertible notes, compared to $1.5 million of similar amortization in 2001. These costs were fully amortized at the end of August 2002. Income tax expense was $57.4 million for 2002 compared to $30.2 million in 2001. Our effective tax rate was 35.1% in 2002. The unusually high tax rate for 2001 results from the write off related to the impairment of goodwill, which was not deductible for income tax purposes. Net earnings increased to $105.8 million, or $1.68 per diluted share, for 2002 from $30.2 million, or $0.51 per diluted share, in 2001. The increase in net earnings resulted from increased revenue and an improved underwriting performance by the insurance company segment, net of a charge in 2002 related to a discontinued line of business ($5.0 million or $0.08 per share). Other events affecting the comparison include losses from the September 11 terrorist attack recorded during 2001 ($22.8 million or $0.38 per share), the charge for lines of business we decided to cease writing during 2001 ($29.6 million or $0.50 per share) and the amortization of goodwill in 2001, ($11.4 million or $0.19 per share) prior to our adoption of SFAS No. 142. Our book value per share was $14.15 as of December 31, 2002, up from $12.40 as of December 31, 2001. Net earnings and the unrealized gain on available for sale securities contributed to the increase in book value per share. 35 SEGMENTS INSURANCE COMPANIES The following tables provide information by line of business (in thousands):
GROSS NET NET NET WRITTEN WRITTEN EARNED LOSS PREMIUM PREMIUM PREMIUM RATIO ---------- -------- -------- ----- For the year ended December 31, 2002: Group life, accident and health............. $ 503,263 $244,554 $240,070 62.2% Aviation.................................... 212,518 99,826 100,960 46.3 London market account....................... 199,816 113,925 89,260 51.5 Global financial products................... 178,653 43,731 23,102 46.4 Other specialty lines....................... 32,563 25,621 22,337 101.1 ---------- -------- -------- ----- 1,126,813 527,657 475,729 57.8 Discontinued lines.......................... 32,436 18,254 29,792 105.0 ---------- -------- -------- ----- TOTALS...................................... $1,159,249 $545,911 $505,521 60.6% ========== ======== ======== Expense ratio............................... 25.4 ----- Combined ratio.............................. 86.0% ===== For the year ended December 31, 2001: Group life, accident and health............. $ 502,086 $146,220 $143,851 67.5% Aviation.................................... 198,015 98,249 91,377 62.5 London market account....................... 133,579 54,056 43,360 59.4 Global financial products................... 46 44 4 25.0 Other specialty lines....................... 15,556 14,346 15,120 73.5 ---------- -------- -------- ----- 849,282 312,915 293,712 65.1 Discontinued lines.......................... 160,793 60,043 49,075 155.5 ---------- -------- -------- ----- TOTALS...................................... $1,010,075 $372,958 $342,787 78.0% ========== ======== ======== Expense ratio............................... 25.7 ----- Combined ratio.............................. 103.7% =====
Gross written premium increased 15% to $1.2 billion for 2002 from $1.0 billion in 2001. This increase was 33% before the discontinued lines of business. The increase resulted from organic growth and premium rate increases in our London market account line of business, plus our global financial products line of business not previously written, offset by the decrease in discontinued lines of business. Gross written premium is expected to continue to increase in 2003. Net written premium for 2002 increased 46% to $545.9 million from $373.0 million in 2001, as our insurance companies have increased their overall retentions, in addition to the effect of the changes in gross premium described above. Net earned premium also increased 47% to $505.5 million for the same reasons. Increases in net written and net earned premiums were 69% and 62%, respectively, before the discontinued lines of business. Increases in net written and net earned premium are expected to continue in 2003. Net loss and loss adjustment expense was $306.5 million for 2002 compared to $267.4 million in 2001. The 2001 net loss expense included $35.0 million from the September 11 terrorist attack and $18.8 million from the charge for lines of business we decided to cease writing. Because of these items and generally better underwriting results in 2002 as a result of higher pricing and improved policy terms and conditions, the net loss ratio was greatly improved at 60.6% for 2002 compared to 78.0% in 2001, on substantially increased earned premiums. The loss ratios for the continuing lines, with the exception of the specialty lines, also improved for 36 these reasons. The loss ratio in the other specialty lines increased as a result of some adverse development on policies, which were subsequently not renewed. During the third quarter of 2002, we also recorded a charge in the amount of $7.7 million related to certain business included in discontinued lines. This business was acquired as part of our purchase of The Centris Group, Inc. in 1999 and was of a type that we have not historically written. The gross loss ratio was 58.6% in 2002 compared to 105.5% in 2001. The 2001 gross loss ratio was high because we recorded gross losses of $55.0 million due to the Petrobras production platform, $141.0 million due to the September 11 terrorist attack and $49.0 million due to the Total Oil Company loss. Additionally, in 2002, as a result of further evaluation, we reduced our gross losses from the September 11 terrorist attack by $21.5 million and reduced the gross losses from the Total loss by $14.0 million. Offsetting this positive gross development was $36.2 million of negative development due to late reporting of an aggregate program that we no longer write. As the adjustments related to gross losses that were substantially reinsured, there was no material net effect. During 2002, we had net loss and loss adjustment expense redundancy of $6.8 million relating to prior year losses compared to a redundancy of $10.7 million in 2001 and we had gross loss and loss adjustment expense redundancy of $23.2 million compared to a deficiency of $44.5 million in 2001. The gross deficiency for 2001 resulted from late reported loss information received during 2001, primarily from assumed reinsurance business written by one of our insurance companies. There was no material net effect on our earnings as that business was substantially reinsured. The deficiencies and redundancies result from our continued review of our loss reserves with our actuaries and the increase or reduction of reserves as losses are finally settled and claims exposures are reduced. We continue to believe we have provided for all material net incurred losses. The tables below show the composition of net and gross incurred loss and loss adjustment expense (amounts in thousands):
NET INCURRED LOSS AND LOSS ADJUSTMENT EXPENSE --------------------------------------------- 2002 2001 --------------------- --------------------- AMOUNT LOSS RATIO AMOUNT LOSS RATIO -------- ---------- -------- ---------- September 11 terrorist attack.................. $ -- --% $ 35,000 10.2% 2001 charge for lines of business we ceased writing...................................... -- -- 18,799 5.5 2002 third quarter charge...................... 7,674 1.5 -- -- Other prior year development................... (14,453) (2.9) (11,963) (3.5) All other incurred loss and loss adjustment expense...................................... 313,270 62.0 225,554 65.8 -------- ---- -------- ---- Net incurred loss and loss adjustment expense...................................... $306,491 60.6% $267,390 78.0% ======== ==== ======== ====
GROSS INCURRED LOSS AND LOSS ADJUSTMENT EXPENSE ----------------------------------------------- 2002 2001 --------------------- ----------------------- AMOUNT LOSS RATIO AMOUNT LOSS RATIO -------- ---------- ---------- ---------- September 11 terrorist attack................ $(21,500) (2.1)% $ 140,962 14.0% Petrobras production platform................ -- -- 55,000 5.4 Total Oil Company loss....................... (14,000) (1.4) 49,000 4.9 2001 charge for lines of business we ceased writing.................................... -- -- 36,784 3.6 2002 third quarter charge.................... 7,674 0.8 -- -- Aggregate program development................ 36,170 3.5 -- -- Other prior year development................. (31,504) (3.1) 40,367 4.0 All other incurred loss and loss adjustment expense.................................... 627,412 60.9 741,732 73.6% -------- ---- ---------- ----- Gross incurred loss and loss adjustment expense.................................... $604,252 58.6% $1,063,845 105.5% ======== ==== ========== =====
Policy acquisition costs, which are net of commissions on reinsurance ceded, increased to $63.3 million during 2002, from $27.9 million in 2001. This increase is due to the higher earned premium and the reduction 37 in ceding commissions as a result of our retaining more business. Included in the 2001 amount is $2.2 million from the charge for lines of business we decided to cease writing. The expense ratio was substantially unchanged at 25.4% for 2002 compared to 2001 which, when added to our greatly improved loss ratio, produced a substantially lower combined ratio of 86.0% for 2002 compared to 103.7% in 2001. Net earnings of our insurance companies increased to $68.2 million in 2002 from a net loss of $2.9 million in 2001, due to increased revenue and improved underwriting results in 2002. The 2001 results include the effects from the terrorist attack on September 11 and the charge for lines of business we decided to cease writing. There was $2.1 million (net of income tax) of goodwill amortization recorded in 2001. Barring future catastrophic events, we expect this trend to continue into 2003. UNDERWRITING AGENCIES Management fees increased 25% to $77.1 million for 2002, compared to $61.8 million in 2001. The underwriting agencies acquired in 2002 and late 2001 accounted for much of the increase together with organic growth, partially offset by a decrease in management fees from our other underwriting agencies as we continued the consolidation of certain other underwriting agency operations into our insurance companies. Net earnings of our underwriting agencies increased to $25.3 million for 2002 from $17.2 million in 2001 as a result of increased revenue and the adoption of SFAS No. 142, somewhat offset by the integration of certain underwriting agencies into our insurance companies. There was $5.9 million (net of income tax) of goodwill amortization recorded in 2001. We expect further improvement in 2003 due to our acquisitions in late 2002 and organic growth. INTERMEDIARIES Commission income decreased to $41.6 million for 2002, compared to $43.4 million in 2001 due to general market conditions and less ceded reinsurance being placed on behalf of our insurance companies as they increased their retentions. Net earnings of our intermediaries decreased to $7.6 million for 2002 compared to $8.7 million in 2001. There was $3.4 million (net of income tax) of goodwill amortization recorded in 2001 compared to none in 2002 due to the adoption of SFAS No. 142. We anticipate returning to growth in commission income in 2003 as our non-affiliated business grows. OTHER OPERATIONS The decrease in other operating income to $7.0 million during 2002 from $17.4 million in 2001 was principally due to the disposition or closure of certain operations during 2001 and the resultant gains totaling $8.2 million from certain of those dispositions. Net earnings of other operations decreased to $3.1 million in 2002 from $7.1 million in 2001 for the same reasons. Period to period comparisons may vary substantially depending on other operating investments or dispositions thereof in any given period. We anticipate new strategic investments and possibly a service company acquisition in 2003, which would provide growth in this revenue. CORPORATE The net income of the corporate segment was $2.9 million for 2002 compared to a net loss of $1.0 million in 2001. This improvement resulted from lower interest expense due primarily to lower interest rates. Year Ended December 31, 2001 Versus Year Ended December 31, 2000 Total revenue increased 7% to $505.5 million for 2001 compared to 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. 38 Net investment income was $39.6 million for 2001 compared to $39.8 million in 2000. The positive effect on investment income of our higher level of invested assets was offset by a significant decrease in interest rates in 2001. During 2001, we recorded a net realized investment gain of $0.4 million, compared to a loss of $5.3 million in 2000. During 2001 we recognized a $2.4 million realized loss from the write down of five investments to their estimated fair market value compared to a similar write down of $5.1 million from one equity investment during 2000. The loss from write downs during 2001 was offset by other gains recorded on investments sold. During 2001, we experienced three significant gross losses. The largest loss was as a result of the terrorist attack on September 11, which produced the biggest loss to our insurance company operations in our history. Although we had no involvement in the insurance coverages of the airlines involved, we had significant exposure in our accident and health reinsurance account. Our estimates of ultimate exposure were developed through a review of policy coverages, consideration of the effect on the estimate if the attack was considered multiple events rather than a single event, and communications from our clients and producers. We also had participations in property coverage on the World Trade Center and some of the surrounding buildings. In addition, we anticipate some claims from other business written in the New York City area. We also received some reported claims and estimates of losses for others. We utilized this information together with known coverage and reinstatement premium information to establish our gross and net losses reserve of $141.0 million and $35.0 million, respectively. A charge for the net amount has been included in our 2001 consolidated financial statements. The other two losses were the Petrobras (Brazilian offshore energy production platform) and Total (chemical factory near Toulouse, France) incidents, which produced gross losses of $55.0 million and $49.0 million, respectively. Because these policies were substantially reinsured, the net losses were not material to our results of operations. During 2001, we recorded a charge totaling $37.3 million related to lines of business that we decided to cease writing, mainly our primary workers' compensation line of business. The composition of this charge is $18.8 million for loss and loss adjustment expense, $2.2 million for net policy acquisition costs and $16.3 million for other operating expense. Included in other operating expense is $15.0 million related to the impairment of goodwill associated with our primary workers' compensation line of business. The fair value of this line of business was calculated based upon the present value of future expected cash flows. Compensation expense decreased to $69.8 million for 2001 from $83.1 million in 2000. The decrease is due principally to the disposition of non-core subsidiaries, the subsequent closing or reduction of some operations of an acquired company and efficiencies gained from the consolidation of some of our underwriting agency operations with those of our insurance companies. Other operating expense for 2001 included $16.3 million from charges related to lines of business that we decided to cease writing. Excluding these charges, other operating expense in 2001 was somewhat reduced for the same reasons as compensation expense, but to a much lesser extent, and the decrease was offset by a general increase in expenses in our operating subsidiaries as business grew. In addition, guarantee fund and other assessments increased $3.5 million in 2001 compared to 2000. Other operating expenses for 2000 also included a credit of $0.8 million reflecting the reversal of some restructuring charges recorded during the previous year, whereas during 2001 we recorded $0.2 million in merger expense resulting from an acquisition. Currency conversion gains amounted to $0.3 million in 2001 compared to losses of $0.3 million in 2000. Interest expense was $8.9 million for 2001 down from $20.3 million in 2000. This decrease resulted from our use of the proceeds from our March, 2001 public offering of common stock and part of our August, 2001 offering of 2% convertible notes to pay off our debt under the bank facility, lower interest rates and the low interest rate on our newly issued convertible notes. Income tax expense on earnings before the change in accounting was $30.2 million for 2001 down from $37.2 million for 2000 primarily due to the reduction in pre-tax income. The unusual effective tax rate for 2001 of 50% , compared to 39% for 2000, primarily results from the charge for the impairment of goodwill, which was not deductible for income tax purposes. 39 Net earnings before the change in accounting was $30.2 million, or $0.51 per diluted share, for 2001 compared to $57.5 million, or $1.11 per diluted share, in 2000 before the cumulative effect of an accounting change. This decrease primarily results from the after tax loss from the September 11 terrorist attack of $22.8 million, or $0.38 per diluted share, and the after tax charge for lines of business we decided to cease writing of $29.6 million, or $0.50 per diluted share. Our book value per share was $12.40 as of December 31, 2001, up substantially from $10.29 as of December 31, 2000. SEGMENTS INSURANCE COMPANIES The following tables provide information by line of business (in thousands):
GROSS NET NET NET WRITTEN WRITTEN EARNED LOSS PREMIUM PREMIUM PREMIUM RATIO ---------- -------- -------- ----- For the year ended December 31, 2001: Group life, accident and health............. $ 502,086 $146,220 $143,851 67.5% Aviation.................................... 198,015 98,249 91,377 62.5 London market account....................... 133,579 54,056 43,360 59.4 Global financial products................... 46 44 4 25.0 Other specialty lines....................... 15,556 14,346 15,120 73.5 ---------- -------- -------- ----- 849,282 312,915 293,712 65.1 Discontinued lines.......................... 160,793 60,043 49,075 155.5 ---------- -------- -------- ----- TOTALS.................................... $1,010,075 $372,958 $342,787 78.0% ========== ======== ======== Expense ratio............................... 25.7 ----- Combined ratio.............................. 103.7% ===== For the year ended December 31, 2000: Group life, accident and health............. $ 422,384 $109,005 $109,077 74.4% Aviation.................................... 191,089 79,794 73,695 70.2 London market account....................... 83,521 22,292 16,234 74.1 Global financial products................... -- -- -- -- Other specialty lines....................... 15,906 14,552 14,552 40.9 ---------- -------- -------- ----- 712,900 225,643 213,558 70.6 Discontinued lines.......................... 254,557 58,145 54,089 88.0 ---------- -------- -------- ----- TOTALS.................................... $ 967,457 $283,788 $267,647 74.2% ========== ======== ======== Expense ratio............................... 21.0 ----- Combined ratio.............................. 95.2% =====
Gross written premium increased to $1.0 billion for 2001 from $967.5 million in 2000 with strong growth in the group life, accident and health and London market account lines of business, as rates continued to rise. Gross written premium growth was not our focus in 2001, as we were able to grow our revenue simply by retaining more of the business. Net written premium for 2001 increased 31% to $373.0 million compared to the previous year, as our insurance companies increased retentions on many of their lines of business as underwriting profitability improved. Net earned premium increased 28% to $342.8 million for the same reason. Increases in net written premium and net earned premium were 39% and 38%, respectively, before the discontinued lines of business. 40 Loss and loss adjustment expense increased to $267.4 million for 2001 compared to $198.5 million in 2000 substantially due to losses and expenses arising from the September 11 loss and the charge related to lines of business we decided to cease writing. The net loss ratio was 78.0% for 2001 compared to 74.2% in 2000. The group life, accident and health, aviation and London market account loss ratios improved, in spite of losses sustained from the September 11, 2001 terrorist attack, due generally to rate increases and better terms and conditions. The other specialty lines loss ratio increased between years as a result of adverse development on policies, which were subsequently not renewed. The discontinued lines loss ratio increased as a result of the charge related to lines of business we decided to cease writing and the September 11, 2001 loss. The gross loss ratio was 105.5% in 2001 compared to 79.4% for 2000. The Petrobras and Total claims were substantially reinsured and did not have a material effect on our net loss ratio or net earnings. The combined ratio was 103.7% in 2001 compared to 95.2% for 2000. The expense ratio increased in 2001 to 25.7% from 21.0% in 2000 principally as a result of reduced ceding commissions as we retained more profitable business. During 2001, we had net loss and loss adjustment expense redundancy of $10.7 million relating to prior year losses compared to a redundancy of $9.6 million in 2000 and we had gross loss and loss adjustment expense deficiency of $44.5 million compared to a redundancy of $1.9 million in 2000. The gross deficiency for 2001 resulted from late reported loss information received during 2001. These losses primarily came from assumed reinsurance business written by one of our insurance companies. The other deficiencies and redundancies result from our continued review of our loss reserves with our actuaries and the increase or reduction of the loss reserves as losses are finally settled and claims exposures are reduced.
NET INCURRED LOSS AND LOSS ADJUSTMENT EXPENSE --------------------------------------------- 2001 2000 --------------------- --------------------- AMOUNT LOSS RATIO AMOUNT LOSS RATIO -------- ---------- -------- ---------- September 11 terrorist attack.................. $ 35,000 10.2% $ -- --% 2001 charge for lines of business we ceased writing...................................... 18,799 5.5 -- -- Other prior year development................... (11,963) (3.5) (9,585) (3.6) All other incurred loss and loss adjustment expense...................................... 225,554 65.8 208,055 77.8 -------- ---- -------- ---- Net incurred loss and loss adjustment expense...................................... $267,390 78.0% $198,470 74.2% ======== ==== ======== ====
GROSS INCURRED LOSS AND LOSS ADJUSTMENT EXPENSE ----------------------------------------------- 2001 2000 ----------------------- --------------------- AMOUNT LOSS RATIO AMOUNT LOSS RATIO ---------- ---------- -------- ---------- September 11 terrorist attack................ $ 140,962 14.0% $ -- --% Petrobras production platform................ 55,000 5.4 -- -- Total Oil Company loss....................... 49,000 4.9 -- -- 2001 charge for lines of business we ceased writing.................................... 36,784 3.6 -- -- Other prior year development................. 40,367 4.0 (1,892) (0.2) All other incurred loss and loss adjustment expense.................................... 741,732 73.6 775,538 79.6 ---------- ----- -------- ---- Gross incurred loss and loss adjustment expense.................................... $1,063,845 105.5% $773,646 79.4% ========== ===== ======== ====
Policy acquisition costs, which are net of ceding commissions on reinsurance ceded, increased somewhat to $27.9 million during 2001 compared to 2000. During 2001, our insurance companies charged higher policy issuance fees on certain lines of business which are recorded as a reduction in acquisition costs. This reduction in costs is offset by the increase in policy acquisition costs resulting from higher earned premium and part of the charge from lines of business we decided to cease writing. The net loss of our insurance companies was $2.9 million in 2001 compared to net income of $24.2 million for 2000. The 2001 results include after tax losses from the September 11 terrorist attack of $22.8 million and the charge for lines of business we decided to cease writing of $29.4 million. 41 UNDERWRITING AGENCIES Management fees decreased to $61.8 million for 2001 compared to $96.1 million 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 exited and increased retentions of our insurance companies. Net earnings of our underwriting agencies decreased to $17.2 million for 2001 from $21.4 million in 2000 for the same reasons. INTERMEDIARIES Commission income was $43.4 million for 2001 compared to $49.9 million in 2000. Commission income decreased due to general market conditions and less ceded reinsurance being placed on behalf of our insurance companies as they increased their retentions. Net earnings of our intermediaries decreased to $8.7 million for 2001 compared to $11.2 million in 2000. The decrease in net earnings was partly caused by our acquisition of The Schanen Consulting Group, LLC which was not subject to income taxes during 2000 prior to our ownership, but reflected in our historical results due to pooling-of-interest accounting, and less commission income as a result of the mix of business, which had a lower gross margin during the current year OTHER OPERATIONS The decrease in other operating revenue to $17.4 million for 2001 from $25.5 million in 2000 results principally from the disposition or closure of certain non-core operations. During 2001, we recorded gains of $8.2 million from the sale of other operating investments compared to $5.7 million for 2000. The increase in gains was somewhat offset by loss of revenue included in the 2000 period related to operations that have since been closed or disposed of. Net earnings of other operations were $7.1 million in 2001 up from $6.0 million in 2000 for the same reasons. Period to period comparisons may vary substantially depending on other operating investments, or dispositions of such investments, in any given period. CORPORATE The net loss of the corporate segment was $1.0 million for 2001 compared to a net loss of $4.7 million in 2000. This improvement resulted from the reduction of interest expense as we paid off our debt under the bank facility by using the proceeds from the March, 2001 public offering of common stock and the August, 2001 offering of 2% convertible notes, lower bank interest rates and the low interest rate on our newly issued 2% convertible notes. Also included in the amounts for 2000 were the costs of the closing of some operations of an acquired company. LIQUIDITY AND CAPITAL RESOURCES We receive substantial cash from premiums, reinsurance recoverables, and 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, and payment of 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 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 $305.4 million, or 34% during 2002, and totaled $1.2 billion as of December 31, 2002, of which $347.5 million was cash and short-term investments. The increase in investments resulted primarily from operating cash flows and the $50.0 million in capital contributions we made to our insurance companies in 2002. Total assets increased to $3.7 billion as of December 31, 2002. 42 Our investment portfolio includes a high percentage of liquid investments and generates a significant amount of investment income, which serves as a source of cash flow. The average tax equivalent yield on investments was 4.6% in 2002, compared to 5.6% in 2001. The weighted average maturity of our fixed income securities is 4.2 years and weighted average duration of the portfolio was 3.5 years, both as of December 31, 2002. Over 96% of our fixed income securities were rated A or better by Standard & Poor's Corporation. The value of our portfolio of fixed income securities is inversely correlated to changes in market interest rates. In addition, some of our fixed income securities have call or prepayment options. This could subject us to reinvestment risk should interest rates fall or issuers call their securities and we reinvest the proceeds at lower interest rates. We mitigate this risk by investing in securities with varied maturity dates, so that only a portion of our portfolio will mature at any point in time. 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 $152.4 million after deducting underwriting discounts, commissions and offering expenses and were used to pay down our bank facility. In a public offering on August 23, 2001, we issued an aggregate $172.5 million principal amount of 2% Convertible Notes due in 2021. Each $1 thousand principal amount of notes is convertible into 31.25 shares of our common stock, which represents an initial conversion price of $32.00 per share. The initial conversion price is subject to change under certain conditions. Interest is to be paid by us on March 1 and September 1 each year. Holders may surrender notes for conversion into shares of our common stock in any calendar quarter if, as of the last day of the preceding calendar quarter, the closing sale price of our common stock for at least 20 trading days in the period of 30 consecutive trading days ending on the last trading day of the quarter is more than 120% ($38.40 per share) of the conversion price per share of our common stock on the last trading day of the quarter. We can redeem the notes for cash at any time on or after September 1, 2006. Holders of the notes may require us to repurchase the notes on September 1, 2004, 2006, 2008, 2011 and 2016. If the holders exercise this option, we may choose to pay the purchase price in cash, in shares of our common stock, or a combination thereof. On September 1, 2002, the first repurchase date of the notes, $49 thousand of the notes were tendered to us and we repurchased them with cash. We used the proceeds from this offering to repay our remaining indebtedness under our bank facility, assist in financing recent acquisitions, make a $60.0 million capital contribution to our insurance companies and for general corporate purposes. 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 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 17, 2004. The facility is collateralized in part by the pledge of our insurance companies' stock and guarantees entered into by our underwriting agencies and intermediaries. The facility agreement contains certain restrictive covenants, which we believe are typical for similar financing arrangements. As of December 31, 2002, there was an outstanding balance of $53.0 million on this facility bearing interest at an average rate of 3.2%. On December 31, 2001 we filed Form S-3 with the United States Securities and Exchange Commission, which provides a shelf registration for an aggregate of $750.0 million of our securities available to be issued. These securities may be debt securities, equity securities or a combination thereof. On March 25, 2003, we sold an aggregate $125.0 million principal amount of 1.3% Convertible Notes due in 2023 in a public offering. Each $1 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. 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. Holders of the notes may require us to repurchase the notes on April 1, 2009, 2014 and 2019. If the holders exercise this option, we may choose to pay the purchase price in cash, in shares of our common stock, or in a combination thereof. We plan to use the 43 proceeds from this offering to pay down existing indebtedness under our bank facility, assist in financing future acquisitions and strategic investments and for general corporate purposes. At December 31, 2002, certain of our subsidiaries maintained revolving lines of credit with a bank in the combined maximum amount of $26.8 million available through December 17, 2004. Advances under the lines of credit are limited to amounts required to fund draws, if any, on letters of credit issued by the bank on behalf of the subsidiaries and short-term direct cash advances. The lines of credit are collateralized by securities having an aggregate market value of up to $33.5 million, the actual amount of collateral at any one time being 125% of the aggregate amount outstanding. Interest on the lines is payable at the bank's prime rate of interest (4.25% at December 31, 2002) for draws on the letters of credit and prime less 1% on short-term cash advances. As of December 31, 2002, letters of credit totaling $12.1 million had been issued to insurance companies by the bank on behalf of our subsidiaries, with total securities of $15.2 million collateralizing the lines. The following is a summary of our contractual cash payment obligations as of December 31, 2002 (in thousands):
PAYMENTS BY DUE DATE -------------------------------------------- TOTAL 2003 2004-2005 2006-2007 THEREAFTER -------- ------- --------- --------- ---------- Convertible notes................. $172,451 $ -- $ -- $ -- $172,451 Bank facility..................... 53,000 -- 53,000 -- -- Other notes payable............... 4,576 2,610 404 404 1,158 Operating leases.................. 29,991 8,687 13,150 6,832 1,322 -------- ------- ------- ------ -------- Total obligations............... $260,018 $11,297 $66,554 $7,236 $174,931 ======== ======= ======= ====== ========
See preceding paragraphs and Notes (6) and (10) in Notes to the Consolidated Financial Statements for additional information concerning these obligations. The convertible notes have various put dates as discussed above. The following is a summary of our various commitments (in thousands) as of December 31, 2002, all of which expire during 2004 or 2005: Outgoing letters of credit.................................. $12,140 Mortgage guarantee.......................................... 11,140 ------- Total commitments......................................... $23,280 =======
We have sold businesses in the past. In connection with these sales, we have provided indemnifications to the buyers, which we believe are typical for transactions of this nature, based upon the type of business sold. Certain of these indemnifications have no limit. It is not possible to estimate the maximum potential amount under these indemnifications as our performance under the indemnifications and our ultimate liability are based upon the occurrence of future events which may or may not occur. We currently have a liability in the amount of $6.2 million recorded for performance under one such indemnification. This indemnification was given by a company we acquired, prior to its acquisition, in connection with a sale of one of its subsidiaries. The principal assets of HCC Insurance Holdings, Inc. are the shares of capital stock of our insurance companies. Historically, we have not relied on dividends from our insurance companies to meet the obligations of the parent holding company, which are primarily outstanding debt and debt service obligations, dividends to shareholders and corporate expenses, but, rather, we have had sufficient cash flow from our underwriting agencies and intermediaries to meet our cash flow requirements. The payment of dividends by our insurance companies is subject to regulatory restrictions and will depend on the surplus and future earnings of these subsidiaries. Property and casualty insurance companies domiciled in the State of Texas are limited in the payment of dividends to their shareholders in any twelve-month period, without the prior written consent of the Commissioner of Insurance, to the greater of statutory net income for the prior calendar year or 10% of their 44 statutory policyholders' surplus as of the prior year end. During 2003, Houston Casualty Company's ordinary dividend capacity will be approximately $40.0 million and U.S. Specialty Insurance Company's ordinary dividend capacity will be approximately $11.0 million. Avemco Insurance Company is limited by the State of Maryland in the amount of dividends which it may pay in any twelve-month period, without prior regulatory approval, to the lesser of its statutory net investment income excluding realized capital gains for the prior calendar year or 10% of its statutory policyholders' surplus as of the prior year end. During 2003, Avemco Insurance Company's ordinary dividend capacity will be zero as a result of a special approved dividend paid in 2002. HCC Life Insurance Company is limited by the laws of the State of Indiana in the amount of dividends it may pay in any twelve-month period, without prior regulatory approval, to the greater of its statutory net gain from operations for the prior calendar year or 10% of its policyholders' surplus as of the prior year end. Dividends may only be paid out of statutory unassigned surplus funds. During 2003, HCC Life Insurance Company's ordinary dividend capacity will be approximately $6.0 million. We have a reserve of $7.1 million as of December 31, 2002 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 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. 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. 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 consolidated balance sheets. 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 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 December 31, 2002, our insurance companies had initiated two litigation proceedings against reinsurers. As of such date, our insurance companies had an aggregate amount of $5.8 million which had not been paid to us under the agreements and we estimate that there could be up to an additional $10.7 million of incurred losses and loss expenses and other balances due under the subject agreements. Regulatory guidelines suggest that a property and casualty insurer's annual statutory gross written premium should not exceed 900% of its statutory policyholders' surplus and net written premium should not exceed 300% of its statutory policyholders' surplus. However, industry standards and rating agency criteria place these ratios at 300% and 200%, respectively. Our property and casualty insurance companies have maintained premium to surplus ratios generally lower than such guidelines. For the year ended December 31, 2002, our statutory gross written premium to policyholders' surplus was 222.1%. For the year ended December 31, 2002, our statutory net written premium to policyholders' surplus was 104.1%. As of December 31, 2002, each of our domestic insurance companies' total adjusted capital was significantly in excess of the authorized control level risk-based capital level prescribed by the National Association of Insurance Commissioners. 45 IMPACT OF INFLATION Our operations, like those of other property and casualty insurers, are susceptible to the effects of inflation, as premiums are established before the ultimate amounts of loss and loss adjustment expense are known. Although we consider the potential effects of inflation when setting premium rates, for competitive reasons, such premiums may not fully offset the effects of inflation. However, because the majority of our business is comprised of lines which have relatively short lead times between the occurrence of an insured event, reporting of the claims to us and the final settlement of the claims, the effects of inflation are minimized. A portion of our revenue is related to healthcare insurance and reinsurance products that are subject to the effects of the underlying inflation of healthcare costs. Such inflation in the costs of healthcare tends to generate increases in premiums for medical stop-loss coverage, resulting in greater revenue, but also higher claim payments. Inflation also may have a negative impact on insurance and reinsurance operations by causing higher claim settlements than may originally have been estimated without an immediate increase in premiums to a level necessary to maintain profit margins. We do not specifically provide for inflation when setting underwriting terms and claim reserves, although we do consider trends. We continually review claim reserves to assess their adequacy and make necessary adjustments. Inflation can also affect interest rates. Any significant increase in interest rates could have a material adverse effect on the market value of our investments. In addition, the interest rate payable under our $200.0 million bank loan fluctuates with that of the market. Any significant increase in interest rates could have a material adverse effect on our earnings, depending on the amount borrowed on our bank facility. FOREIGN EXCHANGE RATE FLUCTUATIONS 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. Our principal area of exposure is with respect to fluctuations in the exchange rates between the major European currencies (particularly the British pound sterling and the Euro) and the U.S. dollar. We constantly monitor the balance between our receivables and payables and loss reserves to mitigate the potential exposure should an imbalance be expected to exist for other than a short period of time. For the year ended December 31, 2002, our gain from currency conversion was $1.2 million compared to a gain of $0.3 million in 2001 and a loss of $0.3 million in 2000. On a limited basis, we enter into foreign currency forward contracts as a hedge against foreign currency fluctuations. Rattner Mackenzie Limited has revenue streams in U.S. dollars and Canadian dollars but incurs expenses in British pound sterling. To mitigate the foreign exchange risk, from time to time we have entered into foreign currency forward contracts expiring at staggered times. As of December 31, 2002, we had no foreign currency forward contracts outstanding. The foreign currency forward contracts are used to convert currency at a known rate in an amount which either approximates or is less than monthly expenses. Thus, the effect of these transactions is to limit the foreign currency exchange risk of the recurring monthly expenses. We utilize these foreign currency forward contracts strictly as a cash flow hedge against existing exposure to foreign currency fluctuations rather than as a form of speculative or trading investment. CRITICAL ACCOUNTING POLICIES The preparation of our consolidated financial statements in conformity with generally accepted accounting principles requires us to make estimates and assumptions when applying our accounting policies. Those of our accounting policies that we consider to be most significant and the estimates and assumptions we make in the application of those accounting policies are discussed below. 46 EARNED PREMIUM, POLICY ACQUISITION COSTS AND CEDING COMMISSIONS All of the property and casualty policies written by our insurance companies qualify as short-duration contracts as defined by current accounting literature. Written premium, net of reinsurance, is primarily included in earnings on a pro rata basis over the lives of the related policies. However, for certain types of business, it is recognized over the period of risk in proportion to the amount of insurance risk provided. Policy acquisition costs, including commissions, taxes, fees and other direct costs of underwriting policies, less ceding commissions allowed by reinsurers, including expense allowances, are deferred and charged or credited to earnings proportionate to the premium earned. Historical and current loss and loss adjustment expense experience and anticipated investment income are considered in determining premium deficiencies and the recoverability of deferred policy acquisition costs. LOSS AND LOSS ADJUSTMENT EXPENSE Our net loss and loss adjustment expense reserves are composed of reserves for reported losses and reserves for incurred but not reported losses less a reduction for reinsurance recoverable related to those reserves. Reserves are recorded on an undiscounted basis, except for reserves acquired in transactions recorded using the purchase method of accounting. The reserves for reported losses related to our direct business and certain reinsurance assumed are initially set by our claims personnel or independent claims adjusters hired by us and subject to our review with a goal of setting the reserves at the ultimate expected loss amount as soon as possible as information becomes available. Reserves for reported losses with respect to other reinsurance assumed are recorded based upon information supplied to us by the ceding company. Our claims personnel monitor these reinsurance assumed reserves on a current basis and audit ceding companies' claims to ascertain that claims are being recorded currently and that net reserves are being set at levels that properly reflect the liability related to the claims. Our actuaries, in conjunction with our claims personnel, determine the amount of our incurred but not reported reserves as well as review the reported claim reserves for positive or adverse development. Reserves are estimates and changed conditions can cause changes in the estimates. However, we believe that our review process is effective such that any required changes are recognized in the period of change as soon as the need for the change is evident. Reinsurance recoverables offset our gross reserves based upon the contractual terms of our reinsurance agreements. Losses in our group life and accident and health, aviation, London market accounts and other specialty lines of business are recorded and paid relatively quickly. There is not a significant amount of long-tailed liability exposure in these lines of business. Therefore, reserves can be determined and recorded with a higher degree of accuracy and significant development should not be expected with respect to losses in these lines of business. There is some reinsurance assumed in these lines of business, but, as discussed above, we monitor the assumed reported losses closely. Losses related to our global financial products line of business are reported relatively quickly but can develop over time as, especially with respect to directors and officers liability business where we write excess of loss risks, reported losses which are adjusted by the primary underwriter on the risk may not initially appear to be serious but can develop and affect our excess layer over time. We believe that we have adequately reserved for this eventuality. Our discontinued line of business contains both direct business and assumed business. Some of the losses in this line are administered by others, subject to our review. It is possible that there can be development in the loss reserves in this line of business as the business is in run off and some of it is subject to late reporting by those administering the claims. We monitor these reserves carefully on a current basis and believe that they are properly set based upon the information we have at this time. We have insignificant exposure to asbestos and environment policy liabilities as we did not begin business until 1981 and the type of business we wrote contained pollution exclusions or was not of the type that subjected us to those types of risks. The table below shows our recorded reserves as of December 31, 2002 (in thousands) by line of business compared to the high and low ends of the reserve range as determined by our reserving actuaries. Based upon 47 our historical reserving techniques and the fact that our net reserves have historically shown positive development, we believe that there will not be any negative development in our consolidated reserves:
RECORDED LOW END OF HIGH END OF RESERVES ACTUARIAL RANGE ACTUARIAL RANGE -------- --------------- --------------- LINES OF BUSINESS Group life, accident and health............... $ 95,130 $ 81,940 $ 98,411 Aviation...................................... 72,345 63,451 76,110 London market accounts........................ 91,824 77,441 95,993 Global financial products..................... 22,035 19,057 24,081 Other specialty lines......................... 15,584 14,031 16,751 -------- -------- -------- 296,918 255,920 311,346 Discontinued lines............................ 160,400 152,006 193,135 -------- -------- -------- Total net reserves......................... $457,318 $407,926 $504,481 ======== ======== ========
REINSURANCE RECOVERABLES We constantly review the collectibility of the reinsurance recoverables of our insurance companies and record a reserve for potentially uncollectible reinsurance. Our estimates utilized to calculate the reserve are evaluated on a current basis but are subject to change and this could affect the level of the reserve required. We believe, based upon periodic detail reviews of our disputed and aged recoverables, that we have sufficiently provided for potential losses that are currently evident. See also Item 3, Legal Proceedings and the Reinsurance Ceded section contained in Item 1, Business. MANAGEMENT FEES AND COMMISSION INCOME When there is no significant future servicing obligation, management fees and commission income from our underwriting agencies and intermediaries, respectively, are recognized on the revenue recognition date, which is the later of the effective date of policy, the date when the premium can be reasonably established, or the date when substantially all the services relating to the insurance placement have been rendered to the client. Profit commissions based upon the profitability of business written are recorded as revenue at the end of each accounting period based upon the respective formula calculation. Such amounts are adjusted should experience change. When additional services are required, the service revenue is deferred and recognized over the service period. We also record an allowance for estimated return commissions which may be required to be paid upon the early termination of policies. These policies are consistent with policies that have become generally accepted accounting principles for insurance agents and brokers and with the Securities and Exchange Commission's Staff Accounting Bulletin Number 101 entitled "Revenue Recognition in Financial Statements." DEFERRED TAXES We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. We regularly review our deferred tax assets for recoverability and establish a valuation allowance based on our history of earnings, expectations for future earnings, taxable income in carry back years and the expected timing of the reversals of existing temporary differences. Although realization is not assured, we believe it is more likely than not that we will be able to realize the benefit of our deferred tax assets, with the exception of the benefit of certain pre-acquisition tax loss carryforwards for which valuation allowances have been provided. If there is a material change in the tax laws such that the actual effective tax rate changes or the time periods within which the underlying temporary differences become taxable or deductible change, we will need to reevaluate our assumptions which could result in a change in the valuation allowance required. 48 VALUATION OF GOODWILL We assess the impairment of goodwill annually or sooner 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. In determining the fair value of a reporting unit, we utilize the expected cash flow approach as set forth in FASB Concepts Statement No. 7. This approach utilizes a risk-free rate of interest, estimates of future cash flows and probabilities as to the occurrence of the future cash flows. We utilize our budgets and projection of future operations based upon historical and expected industry trends to estimate our future cash flows and the probability of their occurring as projected. Based upon our last impairment test, the fair value of each of our reporting units exceeded its carrying amount by a substantial margin. OTHER THAN TEMPORARY IMPAIRMENTS ON INVESTMENTS Declines in the market value of invested assets below cost are evaluated for other than temporary impairment losses on a quarterly basis. Impairment losses for declines in value of fixed maturity investments and equity securities below cost attributable to issuer-specific events are based upon all relevant facts and circumstances for each investment and are recognized when appropriate. For fixed maturity investments with unrealized losses due to market conditions or industry-related events where we have the positive intent and ability to hold the investment for a period of time sufficient to allow a market recovery or to maturity, declines in value below cost are not assumed to be other than temporary. Our policy for equity securities is to recognize impairment losses on specific securities that have had continuous material unrealized losses for more than three consecutive quarters or less, due to market conditions or industry-related events. As of December 31, 2002, we had gross unrealized losses on fixed income and marketable equity securities of $1.5 million (.2% of aggregate market value) compared to $1.7 million (.3% of aggregate market value) as of December 31, 2001. EFFECTS OF RECENT ACCOUNTING PRONOUNCEMENTS Statement of Financial Accounting Standards ("SFAS") No. 146 entitled "Accounting for Costs Associated with Exit or Disposal Activities" was issued in July, 2002 and will become effective for us on January 1, 2003. SFAS No. 146 will spread out the reporting of expenses related to restructurings and is a change to existing guidance. The commitment to a plan to exit an activity or dispose of long-lived assets will no longer be enough to record a one-time charge for most anticipated costs. Instead, companies will record exit or disposal costs when they are incurred and can be measured at fair value and the liability will be subsequently adjusted for changes in estimated cash flow. We do not expect the adoption of SFAS No. 146 to have a material effect on our financial position, results of operations or cash flows. Financial Accounting Standards Board Interpretation ("FIN") No. 45 entitled "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others . . ." was issued on November 25, 2002. The provision for initial recognition and measurement are effective on a prospective basis for guarantees that are issued or modified after December 31, 2002 and disclosure requirements were effective for periods ending after December 15, 2002. We have complied with the disclosure requirements in these financial statements and do not believe that the recognition and measurement provisions will have a material effect on our financial position, results of operations or cash flows. FIN No. 46 entitled "Consolidation of Variable Interest Entities", which is an interpretation of Accounting Research Bulletin No. 51 entitled "Consolidated Financial Statements" addresses consolidation by business enterprises of variable interest entities which have certain characteristics. FIN No. 46 requires consolidation of a qualifying variable interest entity when a party has a controlling financial interest regardless of whether or not the party has a majority voting interest. FIN No. 46 is immediately effective for qualifying variable interest entities created after January 31, 2003 and applicable to such entities created prior to February 1, 2003 by the end of our third fiscal quarter in 2003. We are currently studying FIN No. 46 for applicability to us. At the present time we believe FIN No. 46 will only be applicable to one entity in which we have an investment. We invested in a partnership, which owns a building which is rented to unaffiliated parties, as a long term investment. The partnership is not material to our financial position, results of 49 operations or cash flows. We have a maximum exposure to loss of $14.1 million with respect to this entity as a result of our investment and our guarantee of the partnership's debt. Emerging Issues Task Force ("EITF") Issue No. 00-21 entitled "Revenue Arrangements with Multiple Deliverables" is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003 or alternatively can be applied retroactively. EITF Issue No. 00-21 addressed how to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. EITF Issue No. 00-21 also addresses how arrangement consideration should be measured and allocated to the separate units of accounting in the arrangement. We do not believe that this EITF Issue No. 00-21 will have a material effect on our financial position, results of operations or cash flows as the issues in EITF Issue No. 00-21 have been previously addressed when we adopted Securities and Exchange Commissions' Staff Accounting Bulletin 101. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK Our principal assets and liabilities are financial instruments which are subject to the market risk of potential losses from adverse changes in market rates and prices. Our primary market risk exposures are: interest rate risk on fixed income securities and interest expense on variable rate debt, equity risk on marketable equity securities, credit risk on reinsurance recoverables and foreign currency exchange rate risk. To manage the exposures of our investment risks, we generally invest in investment grade securities with characteristics of duration and liquidity to reflect the underlying characteristics of the insurance liabilities of our insurance companies. We have not historically used derivatives to manage any of our investment related market risks. Caution should be used in evaluating overall market risk utilizing the information below. Actual results could differ materially from estimates below for a variety of reasons, including, among other things: - amounts and balances on which the estimates are based are likely to change over time; - assumptions used in the models may prove to be inaccurate; - market changes could be different from market changes assumed below; and - not all factors and balances are taken into account. INTEREST RATE RISK The value of our portfolio of fixed income securities is inversely correlated to changes in the market interest rates. In addition, some of our fixed income securities have call or prepayment options. This could subject us to reinvestment risk should interest rates fall or issuers call their securities and we reinvest the proceeds at lower interest rates. We attempt to mitigate this risk by investing in securities with varied maturity dates, so that only a portion of the portfolio will mature at any point in time. The fair value of our fixed income securities as of December 31, 2002 was $841.5 million and was $525.4 million as of December 31, 2001. If market interest rates were to change 1%, (e.g. from 5% to 6%) the fair value of our fixed income securities would change approximately $29.5 million as of December 31, 2002. This compares to change in value of $21.0 million as of December 31, 2001 for the same 1% change in market interest rates. The change in fair value was determined using duration modeling assuming no prepayments. Our $200.0 million bank loan is subject to variable interest rates. Thus, our interest expense on this loan is directly correlated to market interest rates. As of December 31, 2002, we had $53.0 million in debt outstanding under the bank loan. At that debt level, the 1% change in market interest rates would have changed interest expense by $0.5 million. As of December 31, 2001, there was no balance outstanding under our bank loan and our 2% convertible notes are not subject to interest rate changes. EQUITY RISK Our portfolio of marketable equity securities is subject to equity price risk due to market changes. The fair value of our marketable equity securities (including the amounts, if any, of insurance related equity 50 securities designated as trading securities and included in other assets) as of December 31, 2002 was $25.7 million, compared to $16.6 million as of December 31, 2001. The balance at December 31, 2002 includes mutual fund securities with a value of $10.5 million. These mutual funds are invested heavily in fixed income securities but represent marketable equity securities for reporting purposes. If the market price of all marketable equity securities were to change by 10% as of these dates, the fair value of our portfolio of marketable equity securities would have changed $2.6 million as of December 31, 2002 and $1.7 million as of December 31, 2001. FOREIGN EXCHANGE RISK The table below shows the net amounts of significant foreign currency balances at December 31, 2002 and 2001 converted to U.S. dollars. It also shows the expected dollar change in fair value that would occur if exchange rates changed 10% from exchange rates in effect at those times (in thousands):
2002 2001 --------------------------- --------------------------- HYPOTHETICAL HYPOTHETICAL U.S. DOLLAR 10% CHANGE U.S. DOLLAR 10% CHANGE EQUIVALENT IN FAIR VALUE EQUIVALENT IN FAIR VALUE ----------- ------------- ----------- ------------- British Pound Sterling.................. $7,617 $762 $2,366 $237 Euro.................................... 3,518 352 313 31 Canadian Dollar......................... 1,815 182 1,651 165
See Foreign Exchange Rate Fluctuations section contained in Item 7, Management's Discussion and Analysis, and Notes (1) and (9) in the Notes to Consolidated Financial Statements for additional information. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and financial statement schedules listed in the accompanying index are filed as part of this Report. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT For information regarding Directors and Executive Officers of the Registrant, reference is made to the Registrant's definitive proxy statement for its Annual Meeting of Shareholders, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 2002, and which is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION For information regarding Executive Compensation, reference is made to the Registrant's definitive proxy statement for its Annual Meeting of Shareholders, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 2002, and which is incorporated herein by reference. 51 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT EQUITY COMPENSATION PLAN INFORMATION
NUMBER OF SECURITIES REMAINING AVAILABLE FOR NUMBER OF SECURITIES WEIGHTED AVERAGE FUTURE ISSUANCE UNDER TO BE ISSUED UPON EXERCISE PRICE OF EQUITY COMPENSATION EXERCISE OF OUTSTANDING PLANS (EXCLUDING OUTSTANDING OPTIONS, OPTIONS, WARRANTS SECURITIES REFLECTED IN PLAN CATEGORY WARRANTS AND RIGHTS AND RIGHTS COLUMN (A)) - ------------- -------------------- ------------------- ----------------------- (A) (B) (C) Equity compensation plans approved by security holders...................... 6.3 million $21.03 0.9 million Equity compensation plans not approved by security holders(1)(2)............. 0.1 million 16.40 -- ----------- ------ ----------- TOTAL.............................. 6.4 million $20.99 0.9 million =========== ====== ===========
- --------------- (1) On December 16, 1999 the Board of Directors of the Company approved the issuance of an aggregate of 35,000 stock options to the then serving members of the Board of Directors. Such options were exercisable upon issuance and were granted on January 5, 2000 at a per share exercise price of $12.0625 (the closing price of HCC's common stock on the NYSE on January 5, 2000) and expire on January 5, 2005. (2) On March 27, 2001, the Compensation Committee of the Board of Directors approved the issuance of 20,000 options to James C. Flagg, a member of the Board of Directors. Such options vest over a period of three years and have an exercise price of $24.00 (the closing price of HCC's Common Stock on the NYSE on March 29, 2001). The options expire March 29, 2007. For additional information regarding Security Ownership of Certain Beneficial Owners and Management, reference is made to the Registrant's definitive proxy statement for its Annual Meeting of Shareholders, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 2002, and which is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For information regarding Certain Relationships and Related Transactions, reference is made to the Registrant's definitive proxy statement for its Annual Meeting of Shareholders, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 2002, and which is incorporated herein by reference. ITEM 14. 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, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, the 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 significant changes in our internal controls or in other factors which could significantly affect internal controls subsequent to the date we carried out our evaluation. 52 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Exhibits The exhibits listed on the accompanying Index to Exhibits are filed as part of this Report. (b) Financial Statement Schedules The financial statements and financial statement schedules listed in the accompanying Index to Consolidated Financial Statements and Schedules are filed as part of this Report. (c) Reports on Form 8-K On November 8, 2002, we reported on Form 8-K our announcement of operating results for the third quarter of 2002. On December 13, 2002, we reported on Form 8-K the text material used for an investors' conference. 53 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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) Dated: March 27, 2003 By: /s/ STEPHEN L. WAY - ------------------------ ---------------------------------------------------- (Stephen L. Way) Chairman of the Board and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
NAME TITLE DATE ---- ----- ---- /s/ STEPHEN L. WAY Chairman of the Board of March 27, 2003 ------------------------------------------------ Directors, Chief Executive Officer -------------- (Stephen L. Way) and President (Principal Executive Officer) /s/ FRANK J. BRAMANTI* Director March 27, 2003 ------------------------------------------------ -------------- (Frank J. Bramanti) /s/ PATRICK B. COLLINS* Director March 27, 2003 ------------------------------------------------ -------------- (Patrick B. Collins) /s/ JAMES R. CRANE* Director March 27, 2003 ------------------------------------------------ -------------- (James R. Crane) /s/ J. ROBERT DICKERSON* Director March 27, 2003 ------------------------------------------------ -------------- (J. Robert Dickerson) /s/ EDWARD H. ELLIS, JR. Director, Executive Vice President March 27, 2003 ------------------------------------------------ and Chief Financial Officer (Chief -------------- (Edward H. Ellis, Jr.) Accounting Officer) /s/ JAMES C. FLAGG, PH.D.* Director March 27, 2003 ------------------------------------------------ -------------- (James C. Flagg, Ph.D.) /s/ EDWIN H. FRANK, III* Director March 27, 2003 ------------------------------------------------ -------------- (Edwin H. Frank, III) /s/ ALLAN W. FULKERSON* Director March 27, 2003 ------------------------------------------------ -------------- (Allan W. Fulkerson) /s/ WALTER J. LACK* Director March 27, 2003 ------------------------------------------------ -------------- (Walter J. Lack)
54
NAME TITLE DATE ---- ----- ---- /s/ MICHAEL A. F. ROBERTS* Director March 27, 2003 ------------------------------------------------ -------------- (Michael A. F. Roberts) *By: /s/ STEPHEN L. WAY March 27, 2003 ----------------------------------------- -------------- Stephen L. Way Attorney-in-fact
55 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES Report of Independent Accountants........................... F-1 Consolidated Balance Sheets at December 31, 2001 and 2000... F-2 Consolidated Statements of Earnings for the three years ended December 31, 2001................................... F-3 Consolidated Statements of Comprehensive Income for the three years ended December 31, 2001....................... F-4 Consolidated Statements of Changes in Shareholders' Equity for the three years ended December 31, 2001............... F-5 Consolidated Statements of Cash Flows for the three years ended December 31, 2001................................... F-6 Notes to Consolidated Financial Statements.................. F-7 SCHEDULES: Report of Independent Accountants on Financial Statement Schedules................................................. S-1 Schedule 1 Summary of Investments other than Investments in Related Parties........................................... S-2 Schedule 2 Condensed Financial Information of Registrant... S-3 Schedule 3 Supplementary Insurance Information............. S-8 Schedule 4 Reinsurance..................................... S-9 Schedule 5 Valuation and Qualifying Accounts............... S-10
Schedules other than those listed above have been omitted because they are either not required, not applicable, or the required information is shown in the Consolidated Financial Statements and related notes thereto or other Schedules. 56 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders HCC Insurance Holdings, Inc. In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of earnings, comprehensive income, changes in shareholders' equity and cash flows present fairly, in all material respects, the financial position of HCC Insurance Holdings, Inc. and its subsidiaries at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Note 1 to the consolidated financial statements, effective January 1, 2000 the Company changed its method of revenue recognition for certain contracts as prescribed by the Securities and Exchange Commission's Staff Accounting Bulletin No. 101 entitled "Revenue Recognition in Financial Statements". Additionally, as discussed in Note 2 to the consolidated financial statements, effective January 1, 2002 the Company changed its method of accounting for goodwill as prescribed by Statement of Financial Accounting Standards No. 142 entitled "Goodwill and Other Intangible Assets". /s/ PricewaterhouseCoopers LLP Houston, Texas March 21, 2003 F-1 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT PER SHARE DATA)
DECEMBER 31, ----------------------- 2002 2001 ---------- ---------- ASSETS Investments: Fixed income securities, at market (cost: 2002 -- $807,772; 2001 -- $513,674).................... $ 841,548 $ 525,428 Marketable equity securities, at market (cost: 2002 -- $15,815; 2001 -- $16,431)...................... 15,609 16,569 Short-term investments, at cost, which approximates market................................................. 307,215 338,904 Other investments, at estimated fair value (cost: 2002 -- $3,264; 2001 -- $4,400)........................ 3,264 4,758 ---------- ---------- Total investments.................................... 1,167,636 885,659 Cash........................................................ 40,306 16,891 Restricted cash and cash investments........................ 189,396 138,545 Premium, claims and other receivables....................... 753,527 665,965 Reinsurance recoverables.................................... 798,934 899,128 Ceded unearned premium...................................... 164,224 71,140 Ceded life and annuity benefits............................. 78,951 83,013 Deferred policy acquisition costs........................... 68,846 32,071 Goodwill.................................................... 335,288 315,318 Other assets................................................ 107,043 111,390 ---------- ---------- Total assets......................................... $3,704,151 $3,219,120 ========== ========== LIABILITIES Loss and loss adjustment expense payable.................... $1,155,290 $1,130,748 Life and annuity policy benefits............................ 78,951 83,013 Reinsurance balances payable................................ 166,659 88,637 Unearned premium............................................ 331,050 179,530 Deferred ceding commissions................................. 49,963 16,681 Premium and claims payable.................................. 749,523 717,159 Notes payable............................................... 230,027 181,928 Accounts payable and accrued liabilities.................... 59,781 57,971 ---------- ---------- Total liabilities.................................... 2,821,244 2,455,667 Shareholders' Equity Common stock, $1.00 par value; 250.0 million shares authorized; (shares issued and outstanding: 2002 -- 62,358; 2001 -- 61,438)........................ 62,358 61,438 Additional paid-in capital................................ 416,406 402,089 Retained earnings......................................... 383,378 293,426 Accumulated other comprehensive income.................... 20,765 6,500 ---------- ---------- Total shareholders' equity........................... 882,907 763,453 ---------- ---------- Total liabilities and shareholders' equity........... $3,704,151 $3,219,120 ========== ==========
See Notes to Consolidated Financial Statements. F-2 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF EARNINGS (IN THOUSANDS, EXCEPT PER SHARE DATA)
FOR THE YEARS ENDED DECEMBER 31, --------------------------------- 2002 2001 2000 --------- --------- --------- REVENUE Net earned premium.......................................... $505,521 $342,787 $267,647 Management fees............................................. 77,082 61,795 96,058 Commission income........................................... 41,572 43,412 49,886 Net investment income....................................... 37,769 39,638 39,836 Net realized investment gain (loss)......................... 453 393 (5,321) Other operating income...................................... 6,985 17,436 25,497 -------- -------- -------- Total revenue.......................................... 669,382 505,461 473,603 EXPENSE Loss and loss adjustment expense, net....................... 306,491 267,390 198,470 Operating expense: Policy acquisition costs, net............................. 63,274 27,923 23,743 Compensation expense...................................... 80,495 69,762 83,086 Other operating expense................................... 47,642 71,119 53,274 -------- -------- -------- Total operating expense................................ 191,411 168,804 160,103 Interest expense............................................ 8,301 8,884 20,347 -------- -------- -------- Total expense.......................................... 506,203 445,078 378,920 -------- -------- -------- Earnings before income tax provision................... 163,179 60,383 94,683 Income tax provision........................................ 57,351 30,186 37,202 -------- -------- -------- Earnings before cumulative effect of accounting change............................................... 105,828 30,197 57,481 Cumulative effect of accounting change, net of deferred tax effect of $1,335................................. -- -- (2,013) -------- -------- -------- NET EARNINGS........................................... $105,828 $ 30,197 $ 55,468 ======== ======== ======== BASIC EARNINGS PER SHARE DATA: Earnings before accounting change...................... $ 1.70 $ 0.52 $ 1.13 Cumulative effect of accounting change................. -- -- (0.04) -------- -------- -------- Net earnings........................................... $ 1.70 $ 0.52 $ 1.09 ======== ======== ======== Weighted average shares outstanding.................... 62,225 58,321 50,742 ======== ======== ======== DILUTED EARNINGS PER SHARE DATA: Earnings before accounting change...................... $ 1.68 $ 0.51 $ 1.11 Cumulative effect of accounting change................. -- -- (0.04) -------- -------- -------- Net earnings........................................... $ 1.68 $ 0.51 $ 1.07 ======== ======== ======== Weighted average shares outstanding.................... 62,936 59,619 51,619 ======== ======== ========
See Notes to Consolidated Financial Statements. F-3 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (IN THOUSANDS, EXCEPT PER SHARE DATA)
FOR THE YEARS ENDED DECEMBER 31, ---------------------------------- 2002 2001 2000 ---------- --------- --------- Net earnings................................................ $105,828 $30,197 $55,468 Other comprehensive income, net of tax: Foreign currency translation adjustment................... 50 (279) (172) Gains (losses) in fair value of foreign currency forward contracts recorded as a cash flow hedge, net of income tax charge (benefit) of $(13) in 2002 and $13 in 2001................................................... (24) 24 -- Investment gains (losses): Investment gains during the year, net of income tax charge of $8,040 in 2002, $1,137 in 2001, and $2,386 in 2000.............................................. 14,533 2,297 4,118 Less reclassification adjustment for (gains) losses included in net earnings, net of income tax (charge) benefit of $(159) in 2002, $(138) in 2001, and $1,862 in 2000.............................................. (294) (255) 3,459 -------- ------- ------- Other comprehensive income................................ 14,265 1,787 7,405 -------- ------- ------- COMPREHENSIVE INCOME................................... $120,093 $31,984 $62,873 ======== ======= =======
See Notes to Consolidated Financial Statements. F-4 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000 (IN THOUSANDS, EXCEPT PER SHARE DATA)
ACCUMULATED ADDITIONAL OTHER TOTAL COMMON PAID-IN RETAINED COMPREHENSIVE SHAREHOLDERS' STOCK CAPITAL EARNINGS INCOME (LOSS) EQUITY ------- ---------- -------- ------------- ------------- BALANCE AS OF DECEMBER 31, 1999...... $49,836 $175,363 $235,932 $(2,692) $458,439 Net earnings......................... -- -- 55,468 -- 55,468 Other comprehensive income........... -- -- -- 7,405 7,405 1,267 shares of common stock issued for exercise of options, including tax benefit of $3,627.............. 1,266 19,596 -- -- 20,862 Issuance of 145 shares of contractually issuable common stock.............................. 145 (145) -- -- -- Issuance of 95 shares of contingently issuable common stock.............. 95 1,145 -- -- 1,240 Contractual grant of pooled company common stock by a shareholder prior to acquisition..................... -- 1,040 -- -- 1,040 Dividends to shareholders of pooled company prior to acquisition....... -- -- (2,593) -- (2,593) Cash dividends declared, $0.22 per share.............................. -- -- (10,931) -- (10,931) ------- -------- -------- ------- -------- BALANCE AS OF DECEMBER 31, 2000...... 51,342 196,999 277,876 4,713 530,930 Net earnings......................... -- -- 30,197 -- 30,197 Other comprehensive income........... -- -- -- 1,787 1,787 6,900 shares of common stock issued in public offering, net of costs... 6,900 145,505 -- -- 152,405 2,715 shares of common stock issued upon exercise of options including income tax benefit of $12,312...... 2,715 50,023 -- -- 52,738 300 shares of common stock issued for purchased companies................ 300 8,031 -- -- 8,331 Issuance of 114 shares of contractually issuable common stock.............................. 114 (114) -- -- -- Issuance of 67 shares of contingently issuable common stock.............. 67 1,645 -- -- 1,712 Cash dividends declared, $0.245 per share.............................. -- -- (14,647) -- (14,647) ------- -------- -------- ------- -------- BALANCE AS OF DECEMBER 31, 2001...... 61,438 402,089 293,426 6,500 763,453 Net earnings......................... -- -- 105,828 -- 105,828 Other comprehensive income........... -- -- -- 14,265 14,265 817 shares of common stock issued for exercise of options, including tax benefit of $4,030.................. 817 14,420 -- -- 15,237 Issuance of 103 shares of contractually issuable common stock.............................. 103 (103) -- -- -- Cash dividends declared, $0.255 per share.............................. -- -- (15,876) -- (15,876) ------- -------- -------- ------- -------- BALANCE AS OF DECEMBER 31, 2002...... $62,358 $416,406 $383,378 $20,765 $882,907 ======= ======== ======== ======= ========
See Notes to Consolidated Financial Statements. F-5 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS, EXCEPT PER SHARE DATA)
FOR THE YEARS ENDED DECEMBER 31, --------------------------------- 2002 2001 2000 --------- --------- --------- Cash flows from operating activities: Net earnings............................................ $ 105,828 $ 30,197 $ 55,468 Adjustments to reconcile net earnings to net cash provided by operating activities: Change in premium, claims and other receivables...... (41,330) (33,976) 30,501 Change in reinsurance recoverables................... 103,870 (191,552) (52,007) Change in ceded unearned premium..................... (88,940) 28,254 19,188 Change in loss and loss adjustment expense payable... (57,747) 262,056 72,311 Change in reinsurance balances payable............... 70,672 (29,837) 17,052 Change in unearned premium........................... 122,811 (1,676) 2,689 Change in premium and claims payable, net of restricted cash.................................... (57,317) 22,530 (20,727) Gains on dispositions of other operating investments........................................ -- (8,171) (5,739) Depreciation, amortization and impairments........... 10,808 34,926 19,908 Other, net........................................... 6,467 (7,011) (820) --------- --------- --------- Cash provided by operating activities.............. 175,122 105,740 137,824 Cash flows from investing activities: Sales of fixed income securities........................ 217,370 140,763 137,175 Maturity or call of fixed income securities............. 53,918 45,754 34,341 Sales of equity securities.............................. 3,958 5,408 7,969 Dispositions of other operating investments............. -- 19,965 27,803 Change in short-term investments........................ 84,799 (43,986) (69,400) Cash paid for companies acquired, net of cash received............................................. (39,227) (95,952) (8,909) Cost of investments acquired............................ (505,099) (292,926) (244,586) Purchases of property and equipment and other........... (5,782) (12,283) (9,535) --------- --------- --------- Cash used by investing activities.................. (190,063) (233,257) (125,142) Cash flows from financing activities: Proceeds from notes payable, net of costs............... 76,000 174,058 26,700 Sale of common stock, net of costs...................... 11,207 192,831 17,235 Payments on notes payable............................... (31,969) (222,116) (57,042) Dividends paid and other, net........................... (16,882) (14,356) (12,409) --------- --------- --------- Cash provided (used) by financing activities....... 38,356 130,417 (25,516) --------- --------- --------- Net change in cash................................. 23,415 2,900 (12,834) Cash as of beginning of year....................... 16,891 13,991 26,825 --------- --------- --------- Cash as of end of year............................. $ 40,306 $ 16,891 $ 13,991 ========= ========= =========
See Notes to Consolidated Financial Statements. F-6 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT PER SHARE DATA) (1) GENERAL INFORMATION AND SIGNIFICANT ACCOUNTING AND REPORTING POLICIES HCC Insurance Holdings, Inc. and its subsidiaries ("we" or "our"), include domestic and foreign property and casualty and life insurance companies, underwriting agencies and intermediaries. Through our subsidiaries, we provide specialized property and casualty and life and health insurance to commercial customers in the areas of group life, accident and health, aviation, our London market account (which includes energy, marine, property and some accident and health), global financial products (which includes directors and officers liability, errors and omissions, employment practices liability and surety) and other specialty lines of insurance. Our principal insurance companies are Houston Casualty Company in Houston, Texas, and London, England; HCC Life Insurance Company in Houston, Texas; U.S. Specialty Insurance Company in Houston, Texas; Avemco Insurance Company in Frederick, Maryland; and HCC Europe in Madrid, Spain. Our underwriting agencies provide underwriting management and claims servicing for insurance and reinsurance companies, in specialized lines of business within the life, accident and health and property and casualty insurance sectors. Our principal agencies are HCC Benefits Corporation in Atlanta, Georgia, Costa Mesa, California, Wakefield, Massachusetts, Minneapolis, Minnesota and Dallas, Texas; ASU International, LLC in Woburn, Massachusetts, and London, England; HCC Global Financial Products, LLC in Farmington, Connecticut, Barcelona, Spain and London, England; Dickson Manchester & Company Limited in London, England; and Professional Indemnity Agency, Inc. in Mount Kisco, New York. Effective January 1, 2001 and 2002, we consolidated the operations of three and one of our agencies, respectively, with certain of our insurance companies. Our intermediaries provide brokerage, consulting and other intermediary services to insurance and reinsurance companies, commercial customers and individuals in the same lines of business as the insurance companies and underwriting agencies operate. Our principal intermediaries are HCC Risk Management Corporation in Houston, Texas; HCC Employee Benefits, Inc. in Houston, Texas and Atlanta, Georgia; and Rattner Mackenzie Limited in London, England. During 2001, we sold the last of our service operations. Our service companies performed various insurance related services for insurance companies. The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires us to make estimates and assumptions. This affects amounts reported in our financial statements and the disclosure of contingent assets and liabilities. Actual results could differ from those estimates. A description of the significant accounting and reporting policies we utilize in preparing our consolidated financial statements is as follows: Principles of Consolidation Our consolidated financial statements include the accounts of all our subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. Investments Fixed income securities and marketable equity securities are classified as available for sale and are carried at quoted market value, if readily marketable, or at management's estimated fair value, if not readily marketable. The change in unrealized gain or loss with respect to these securities is recorded as a component of other comprehensive income, net of the related deferred income tax effects, if any. Fixed income securities available for sale are purchased with the original intent to hold to maturity, but they may be available for sale if market conditions warrant, or if our investment policies dictate, in order to maximize our investment yield. Short-term investments and restricted short-term investments are carried at cost, which approximates market value. F-7 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) For the asset-backed and mortgage-backed securities portion of the fixed income portfolio, we recognize income using a constant effective yield based on anticipated prepayments and the estimated economic life of the securities. When actual prepayments differ significantly from anticipated prepayments, the estimated economic life is recalculated and the remaining unamortized premium or discount is amortized prospectively over the remaining economic life. Some of our asset-backed securities are subject to re-evaluation and additional specialized impairment tests. Under this guidance, these securities have to be written down in value if certain tests are met. Any write down is recouped prospectively through net investment income, if contractual cash flows are ultimately received. The total amount of securities held by us as of December 31, 2002 that would be subject to these tests and potential write down is $9.4 million. The realized gain or loss on investment transactions is determined on an average cost basis and included in earnings on the trade date. When impairment of the value of an investment is considered other than temporary, the decrease in value is reported in earnings as a realized investment loss and a new cost basis is established. Property and Equipment Property and equipment are carried at cost, net of accumulated depreciation and included in other assets on our consolidated balance sheets. Depreciation expense is provided using the straight-line method over the estimated useful lives of the related assets. Amortization of leasehold improvements is provided using the straight-line method over the shorter of the estimated useful life or the term of the respective lease. Costs incurred in developing or purchasing management information systems are capitalized and included in property and equipment. These costs are amortized over their estimated useful lives from the dates the systems are placed in service. Upon disposal of assets, the cost and related accumulated depreciation are removed from the accounts and the resulting gain or loss is included in earnings. Estimated useful lines of major classes of our property and equipment are as follows: buildings and improvements 30-45 years; furniture, fixtures and equipment 3-20 years; management information systems 3-10 years. Depreciation of property and equipment was approximately $7.5 million, $7.0 million and $6.9 million for the years ended December 31, 2002, 2001 and 2000, respectively. We review the carrying value of all long-lived assets, including property and equipment and intangible assets subject to amortization, if the facts and circumstances suggest they may be impaired. If this review indicates that the carrying value will not be recoverable, as determined based on projected undiscounted future cash flows, the carrying value is reduced to its estimated fair value, which is then depreciated or amortized over the remaining useful life, as indicated during the review. Earned Premium, Policy Acquisition Costs and Ceding Commissions All of the property and casualty policies written by our insurance companies qualify as short-duration contracts as defined by current accounting literature. Written premium, net of reinsurance, is primarily included in earnings on a pro rata basis over the lives of the related policies. However, for certain types of business, it is recognized over the period of risk in proportion to the amount of insurance risk provided. Policy acquisition costs, including commissions, taxes, fees and other direct costs of underwriting policies, less ceding commissions allowed by reinsurers, including expense allowances, are deferred and charged or credited to earnings proportionate to the premium earned. Historical and current loss and loss adjustment expense experience and anticipated investment income are considered in determining premium deficiencies and the recoverability of deferred policy acquisition costs. F-8 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) Management Fees and Commission Income When there is no significant future servicing obligation, management fees and commission income from our underwriting agencies and intermediaries, respectively, are recognized on the revenue recognition date, which is the later of the effective date of policy, the date when the premium can be reasonably established, or the date when substantially all the services relating to the insurance placement have been rendered to the client. Profit commissions based upon the profitability of business written are recorded as revenue at the end of each accounting period based upon the respective formula calculation. Such amounts are adjusted should experience change. When additional services are required, the service revenue is deferred and recognized over the service period. We also record an allowance for estimated return commissions which may be required to be paid upon the early termination of policies. Effective January 1, 2000, we changed certain of our revenue recognition methods for our agencies and intermediaries to agree with guidance contained in Securities and Exchange Commission's Staff Accounting Bulletin No. 101 entitled "Revenue Recognition in Financial Statements". Previously, our agencies and intermediaries recognized revenue in conformity with principles that historically had been considered generally accepted accounting principles for insurance agents and brokers. We had recognized return commissions when the event occurred that caused the return and accrued a liability for future servicing costs, when significant, instead of deferring revenue. The after-tax cumulative non-cash charge resulting from the adoption of Staff Accounting Bulletin No. 101 was $2.0 million. Other Operating Income Historically, we have had two primary sources of other operating income, which is included in our other operations segment. The first source is a variety of insurance related services, principally claims adjusting services. This source is not expected to be significant in future years as our last remaining service subsidiary was sold in September, 2001. These revenues were recorded when the service was performed. The second source is income from and gains or losses from the disposition of investments made in this segment. These investments principally consist of positions in insurance related businesses which are synergistic to our business. Income from these investments is recognized as earned or utilizing the equity basis of accounting if the investment qualifies and the gains or losses from the sale of investments are recognized upon consummation of a sale transaction. More recently there has also been a small portfolio of marketable equity securities that have been designated trading securities and included in other assets on our consolidated balance sheets. Realized gains and losses, unrealized gains and losses and dividend income on these trading securities are all included in other operating income. Premium and Other Receivables We use the gross method for reporting receivables and payables on brokered transactions. We review the collectibility of our receivables on a current basis and provide an allowance for doubtful accounts if we deem that there are accounts which are doubtful of collection. The amount of the allowance as of December 31, 2002 and 2001 was $2.3 million and $2.8 million, respectively. Our estimate of the level of the allowance could change as conditions change in the future. Loss and Loss Adjustment Expense Payable Loss and loss adjustment expense payable by our insurance companies is based on estimates of payments to be made for reported losses, incurred but not reported losses and anticipated receipts from salvage and subrogation. Reserves are recorded on an undiscounted basis, except for reserves acquired in transactions recorded using the purchase method of accounting. The discount on those reserves is not material. Estimates for reported losses are based on all available information, including reports received from ceding companies on F-9 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) assumed business. Estimates for incurred but not reported losses are based both on our experience and the industry's experience. While we believe that amounts included in our financial statements are adequate, such estimates may be more or less than the amounts ultimately paid when the claims are settled. We continually review the estimates with our actuaries and any changes are reflected in the period of the change. Reinsurance We record all reinsurance recoverables and ceded unearned premiums as assets and deferred ceding commissions as a liability. All such amounts are recorded in a manner consistent with the underlying reinsured contracts. We also record a reserve for uncollectible reinsurance. Our estimates utilized to calculate the reserve are subject to change and this could affect the level of the reserve required. Goodwill and Intangible Assets In connection with our acquisition of subsidiaries prior to July 1, 2001, accounted for as purchases, the excess of cost over fair value of net assets acquired was being amortized using the straight-line method over periods from twenty to forty years. This amortization was discontinued effective December 31, 2001 in accordance with Statement of Financial Accounting Standards ("SFAS") No. 142 entitled "Goodwill and Other Intangible Assets." Goodwill resulting from acquisitions completed on or after July 1, 2001 was also not being amortized in accordance with SFAS No. 142. See Note (2) for the effects of these changes. Other identified intangible assets are amortized over their respective useful lives. Prior to our adoption of SFAS No. 142, our accounting policy regarding the assessment of the recoverability of the carrying value of goodwill was to review the carrying value of the assets if the facts and circumstances suggested that it might be impaired. If this review indicated that the carrying value would not be recoverable, as determined based on projected undiscounted future cash flows, the carrying value was reduced to its estimated fair value. With our adoption of SFAS No. 142, beginning January 1, 2002, we assess the impairment of goodwill annually or sooner 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. In determining the fair value of a reporting unit, we utilize the expected cash flow approach as set forth in FASB Concepts Statement No. 7. This approach utilizes a risk-free rate of interest, estimates of future cash flows and probabilities as to the occurrence of the future cash flows. We utilize our budgets and projection of future operations based upon historical and expected industry trends to estimate our future cash flows and the probability of their occurring as projected. Based upon our last impairment test, the fair value of each of our reporting units exceeded its carrying amount by a substantial margin. Cash and Short-term Investments Cash consists of cash in banks, generally in operating accounts. We classify certificates of deposit, corporate demand notes receivable, commercial paper and money market funds as short-term investments. Short-term investments are classified as investments in our consolidated balance sheets as they relate principally to our investment activities. As of December 31, 2002 and 2001 we included $175.7 million and $189.2 million, respectively, of certain fiduciary funds in short-term investments. These are funds held by underwriting agencies or intermediaries for the benefit of insurance or reinsurance clients. We earn the interest on these funds. We generally maintain our cash deposits in major banks and invest our short-term investments in institutional money-market funds and in investment grade commercial paper and repurchase agreements. F-10 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) These securities typically mature within ninety days and, therefore, bear minimal risk. We have not experienced any losses on our cash deposits or our short-term investments. Restricted Cash and Cash Investments Our agencies withhold premium funds for the payment of claims. These funds are shown as restricted cash and cash investments in our consolidated balance sheets. The corresponding liability is included within premium and claims payable in our consolidated balance sheets. These amounts are considered fiduciary funds and interest earned on these funds accrues to the benefit of the insurance companies for whom the agencies write business. Therefore, we do not include these amounts as cash in our consolidated statements of cash flows. Foreign Currency The functional currency of some of our foreign subsidiaries and branches is the U.S. dollar. Assets and liabilities recorded in foreign currencies are translated into U.S. dollars at exchange rates in effect at the balance sheet date. Transactions in foreign currencies are translated at the rates of exchange in effect on the date the transaction occurs. Transaction gains and losses are recorded in earnings and included in other operating expenses. Our foreign currency transactions are principally denominated in British pound sterling and the Euro. For the years ended December 31, 2002, 2001 and 2000, the gain (loss) from currency conversion was $1.2 million, $0.3 million and $(0.3) million, respectively. A foreign branch of one subsidiary has a functional currency of Canadian dollars. Recent acquisitions have added subsidiaries with functional currencies of the Euro and British pound sterling. The cumulative translation adjustment, representing the effect of translating these subsidiaries' assets and liabilities into U.S. dollars, is included in the foreign currency translation adjustment within accumulated other comprehensive income. We periodically enter into foreign exchange forward contracts as a hedge against future cash flows payable in foreign currencies. To the extent the foreign exchange forward contracts qualify for cash flow hedge accounting treatment, the gain or loss due to changes in fair value is not recognized in our statement of earnings 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 cash flow hedge accounting treatment, the gain or loss due to changes in fair value is recognized in our consolidated statements of earnings, but is generally offset by changes in value of the underlying exposure. Income Tax We file a consolidated Federal income tax return and include the foreign subsidiaries' income to the extent required by law. Deferred income tax is accounted for using the liability method, which reflects the tax impact of temporary differences between the bases of assets and liabilities for financial reporting purposes and such bases as measured by tax laws and regulations. Due to our history of earnings, expectations for future earnings, and taxable income in carry back years, we expect to be able to fully realize the benefit of any net deferred tax asset. Earnings Per Share Basic earnings per share is based on the weighted average number of common shares outstanding during the year 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 year divided into net earnings. Outstanding common stock options, when dilutive, are considered to be potential common stock for F-11 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) the purpose of the diluted calculation. The treasury stock method is used to calculate potential common stock outstanding 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. 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 income and earnings per share (and related assumptions) if we had used the fair value method of SFAS No. 123 entitled "Accounting for Stock-Based Compensation" for the three years ended December 31, 2002:
2002 2001 2000 -------- ------- ------- Reported net earnings.................................. $105,828 $30,197 $55,468 Stock-based compensation using the fair value method, net of income tax.................................... (6,159) (4,426) (4,689) -------- ------- ------- Pro forma net earnings................................. $ 99,669 $25,771 $50,779 ======== ======= ======= Reported basic earnings per share...................... $ 1.70 $ 0.52 $ 1.09 Fair value stock-based compensation.................... (0.10) (0.08) (0.09) -------- ------- ------- Pro forma basic earnings per share..................... $ 1.60 $ 0.44 $ 1.00 ======== ======= ======= Reported diluted earnings per share.................... $ 1.68 $ 0.51 $ 1.07 Fair value stock-based compensation.................... (0.10) (0.08) (0.09) -------- ------- ------- Pro forma diluted earnings per share................... $ 1.58 $ 0.43 $ 0.98 ======== ======= =======
For the purposes of the above presentation, we estimate the fair value of each option grant on the grant date using the Black-Scholes single option pricing model. The table below average fair value of options granted for the three years ended December 31, 2002 and the related assumptions used in the model:
2002 2001 2000 -------- -------- -------- Fair value of options granted........................ $ 7.05 $ 7.66 $ 4.51 Risk free interest rate.............................. 3.5% 4.4% 6.4% Expected volatility factor........................... .3 .3 .3 Dividend yield....................................... 1.14% 0.91% 0.89% Expected option life................................. 5 years 5 years 4 years
Guarantee Fund and Other Assessments Certain of our insurance companies are subject to guarantee fund and other assessments in states where we are licensed. In some cases, the states allow for recoveries of assessments as premium tax offsets, but only over a period of years. We generally accrue the liability when an insolvency or other event occurs that indicates a liability exists and the premium on which the assessment will be based has been written. We recognize an asset for the premium tax offset based on in-force policies. During the years ended December 31, 2002, 2001 and 2000, we incurred a net expense for guarantee fund and other assessments of $4.7 million, $4.5 million, and $1.0 million, respectively. As of December 31, 2002 and 2001, accrued guarantee fund and F-12 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) other assessments were $3.3 million and $2.2 million, respectively, and recognized future premium tax offsets were $0.9 million and $0.8 million, respectively. Effects of Recent Accounting Pronouncements SFAS No. 146 entitled "Accounting for Costs Associated with Exit or Disposal Activities" was issued in July, 2002 and will become effective for us on January 1, 2003. SFAS No. 146 will spread out the reporting of expenses related to restructurings and is a change to existing guidance. The commitment to a plan to exit an activity or dispose of long-lived assets will no longer be enough to record a one-time charge for most anticipated costs. Instead, companies will record exit or disposal costs when they are incurred and can be measured at fair value and the liability will be subsequently adjusted for changes in estimated cash flow. We do not expect the adoption of SFAS No. 146 to have a material effect on our financial position, results of operations or cash flows. Financial Accounting Standards Board Interpretation ("FIN") No. 45 entitled "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others . . ." was issued on November 25, 2002. The provision for initial recognition and measurement are effective on a prospective basis for guarantees that are issued or modified after December 31, 2002 and disclosure requirements were effective for periods ending after December 15, 2002. We have complied with the disclosure requirements in these financial statements and do not believe that the recognition and measurement provisions will have a material effect on our financial position, result of operations or cash flows. FIN No. 46 entitled "Consolidation of Variable Interest Entities", which is an interpretation of Accounting Research Bulletin No. 51 entitled "Consolidated Financial Statements" addresses consolidation by business enterprises of variable interest entities which have certain characteristics. FIN No. 46 requires consolidation of a qualifying variable interest entity when a party has a controlling financial interest regardless of whether or not the party has a majority voting interest. FIN No. 46 is immediately effective for qualifying variable interest entities created after January 31, 2003 and applicable to such entities created prior to February 1, 2003 by the end of our third fiscal quarter in 2003. We are currently studying FIN No. 46 for applicability to us. At the present time we believe FIN No. 46 will only be applicable to one entity in which we have an investment. We invested in a partnership, which owns a building which is rented to unaffiliated parties, as a long term investment. The partnership is not material to our financial position, results of operations or cash flows. We have a maximum exposure to loss of $14.1 million with respect to this entity as a result of our investment and our guarantee of the partnership's debt. Emerging Issues Task Force ("EITF") Issue No. 00-21 entitled "Revenue Arrangements with Multiple Deliverables" is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003 or alternatively can be applied retroactively. EITF Issue No. 00-21 addressed how to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. EITF Issue No. 00-21 also addresses how arrangement consideration should be measured and allocated to the separate units of accounting in the arrangement. We do not believe that this EITF Issue No. 00-21 will have a material effect on our financial position, results of operations or cash flows as the issues in EITF Issue No. 00-21 have been previously addressed when we adopted Securities and Exchange Commissions' Staff Accounting Bulletin 101. Unusual Loss Events During 2001, we experienced three significant gross losses. The first loss was the September 11 terrorist attack which produced the largest loss to our insurance company operations in our history. We recorded gross and net loss reserves of $141.0 million and $35.0 million, respectively. The other two losses were the Petrobras (Brazilian offshore energy production platform) and Total (chemical factory near Toulouse, France) incidents, which produced gross losses of $55.0 million and $49.0 million, respectively. Because these two F-13 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) losses were substantially reinsured, the net losses were not material to our results of operations. The Petrobras loss was paid during 2001 and the Total loss was paid during 2002. All reinsurance recoverables related to both losses have been collected. Other Information During 2001, we recorded a charge totaling $37.3 million related to lines of business that we decided to cease writing, mainly our primary workers' compensation line of business. The composition of this charge is $18.8 million for loss and loss adjustment expense, $2.2 million for net policy acquisition costs and $16.3 million for other operating expense. Included in other operating expense is $15.0 million related to the impairment of goodwill. The fair value of this line of business was calculated based upon the present value of future expected cash flows. Reclassifications Certain amounts in the 2001 and 2000 consolidated financial statements have been reclassified to conform with the 2002 presentation. Such reclassifications had no effect on our shareholders' equity, net earnings or cash flows. (2) GOODWILL AND INTANGIBLE ASSETS SFAS No. 142 entitled "Goodwill and Other Intangible Assets" was issued in June, 2001, and became effective for us on January 1, 2002. SFAS No. 142 requires goodwill to be tested for impairment at a level referred to as a reporting unit. 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 also requires the discontinuance of the amortization of goodwill effective January 1, 2002 and that goodwill recognized for acquisitions which were consummated after July 1, 2001 not be amortized. During 2002 we determined our reporting units and completed our initial and first annual goodwill impairment testing and determined we did not have to record an impairment charge. F-14 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) The tables below reconcile net earnings and earnings per share we reported for the three years ended December 31, 2002 to adjusted amounts that we would have reported had we adopted SFAS No. 142 on January 1, 2000 instead of January 1, 2002:
2002 2001 2000 -------- ------- ------- Net earnings: Reported net earnings................................ $105,828 $30,197 $55,468 Add back goodwill amortization....................... -- 11,924 12,606 Add back license amortization........................ -- 555 317 Less tax benefit from goodwill amortization.......... -- (1,092) (1,089) -------- ------- ------- ADJUSTED NET EARNINGS............................. $105,828 $41,584 $67,302 ======== ======= ======= Basic earnings per share: Reported basic earnings per share.................... $ 1.70 $ 0.52 $ 1.09 Add back amortization, net of tax effect............. -- 0.19 0.24 -------- ------- ------- ADJUSTED BASIC EARNINGS PER SHARE................. $ 1.70 $ 0.71 $ 1.33 ======== ======= ======= Diluted earnings per share: Reported diluted earnings per share.................. $ 1.68 $ 0.51 $ 1.07 Add back amortization, net of tax effect............. -- 0.19 0.23 -------- ------- ------- ADJUSTED BASIC EARNINGS PER SHARE................. $ 1.68 $ 0.70 $ 1.30 ======== ======= =======
The following tables show the balances of our intangible assets, which are included in other assets on our consolidated balance sheets:
2002 2001 ------- ------- Intangible assets not subject to amortization -- insurance company and other licenses................................ $ 6,792 $ 6,792 ======= ======= Intangible assets subject to amortization: Gross amounts recorded.................................... $12,080 $10,231 Less accumulated amortization............................. (4,074) (722) ------- ------- NET INTANGIBLE ASSETS SUBJECT TO AMORTIZATION.......... $ 8,006 $ 9,509 ======= =======
Amortization of intangible assets which are subject to amortization under SFAS No. 142 amounted to $3.4 million, $0.5 million and $0.1 million for the years ended December 31, 2002, 2001 and 2000 respectively. Substantially all of our intangible assets subject to amortization were acquired in our acquisitions in 2001 and 2002. Estimated amortization expense for 2003 and future years is as follows: 2003........................................................ $2,658 2004........................................................ 1,841 2005........................................................ 1,336 2006........................................................ 730 2007........................................................ 638 Thereafter.................................................. 803 ------ TOTAL ESTIMATED AMORTIZATION...................... $8,006 ======
F-15 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) (3) ACQUISITIONS During 2001 and 2002, we completed several acquisitions. The acquired companies are well known in their respective lines of business, having excellent reputations and workforces with significant expertise. They were generally acquired to diversify into new specialty lines of business or grow existing lines of business. These business combinations have been recorded using the purchase method of accounting. The results of operations of these businesses have been included in our consolidated financial statements beginning on the effective date of each transaction. The following table provides some additional information on these transactions (our initial cash consideration includes our out of pocket expenses):
GOODWILL DEDUCTIBLE FOR INITIAL CASH GOODWILL INCOME TAX EFFECTIVE DATE CONSIDERATION RECOGNIZED PURPOSES ----------------- ------------- ------------- -------------- Professional Indemnity Agency, Inc. October 22, 2001 $63.0 million $53.6 million No ASU International, LLC October 30, 2001 29.2 million 23.7 million Yes HCC Global Financial Products, LLC (formerly MAG Global Financial Products) October 1, 2002 6.9 million -- Yes Dickson Manchester & Company Limited December 24, 2002 17.0 million 10.8 million No HCC Europe (formerly St. Paul Espana) December 31, 2002 18.9 million 10.8 million No
The initial consideration given for Professional Indemnity Agency, Inc. also included 0.3 million shares of our common stock. The value of our common stock given as consideration was determined based on closing market price on the day the acquisition was completed. In addition, we will pay up to a maximum of $20.4 million with respect to one of the acquisitions made during 2001 if certain earnings targets are reached through December 31, 2004. The purchase agreements for two of the 2002 acquisitions have clauses requiring additional consideration based on pre-tax earnings through September 30, 2007 for one and December 31, 2005 for the other. Any contingent consideration paid will be recorded as an increase to goodwill. We are still in the process of completing the purchase price allocations for the 2002 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 and, additionally, in the case of the acquisition of HCC Europe, we have not yet completed the final determination of the purchase price, which will be based upon an agreed-upon final closing date balance sheet as per the stock purchase agreement. F-16 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) The following table summarizes the combined estimated fair values of assets acquired and liabilities assumed at the respective dates of acquisition:
2002 2001 -------- -------- Total investments........................................... $131,280 $ 47,650 Premium and other receivables............................... 46,232 30,506 Reinsurance recoverables.................................... 3,676 -- Other policy related assets................................. 5,808 -- Goodwill and intangible assets.............................. 23,816 83,957 All other assets............................................ 6,937 33,710 -------- -------- Total assets acquired............................. 217,749 195,823 Loss and loss adjustment expense payable.................... 82,289 -- Premium and claims payable.................................. 39,816 44,883 Other policy related liabilities............................ 37,419 -- Notes payable............................................... 3,530 12,735 All other liabilities....................................... 11,813 37,724 -------- -------- Total liabilities................................. 174,867 95,342 -------- -------- Net assets acquired............................... $ 42,882 $100,481 ======== ========
Currently identified intangible assets from the 2002 acquisitions consisted of employment and non-compete agreements with an assigned value of $1.9 million with a five year average amortization period. We are still in the process of completing the purchase price allocations for the 2002 acquisitions, as we are still gathering some of the information needed to make the required calculation. It is probable that additional identified intangible assets will be recorded during completion of this process. The following unaudited pro forma summary presents information as if the purchase acquisitions had occurred at the beginning of 2002 and 2001, after giving effect to certain adjustments, including amortization of goodwill (for 2001 pro forma only) and intangible assets, increased interest expense from debt issued to fund the acquisitions and income taxes. The pro forma summary is for information purposes only, does not necessarily reflect the actual results that would have occurred, nor is it necessarily indicative of future results of the combined companies. During 2001, Professional Indemnity Agency, Inc. paid approximately $33.0 million in bonuses to employees and related employment taxes immediately prior to the completion of the acquisition. During 2002, HCC Europe reported a net underwriting loss of approximately $16.7 million due to increases in their loss reserves.
UNAUDITED PROFORMA INFORMATION 2002 2001 - ------------------------------ -------- -------- Revenue..................................................... $731,468 $591,908 Net earnings................................................ 102,960 13,318 Basic earnings per share.................................... 1.65 0.23 Diluted earnings per share.................................. 1.64 0.22
F-17 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) (4) INVESTMENTS Substantially all of our fixed income securities are investment grade; 96% are rated "A" or better. The cost or amortized cost, gross unrealized gain or loss and estimated market value of investments in fixed income and marketable equity securities, all of which are classified as available for sale, are as follows:
COST OR GROSS GROSS ESTIMATED AMORTIZED UNREALIZED UNREALIZED MARKET COST GAIN LOSS VALUE --------- ---------- ---------- --------- December 31, 2002: Marketable equity securities............... $ 15,815 $ 7 $ (213) $ 15,609 US Treasury securities..................... 93,620 2,935 (9) 96,546 Obligations of states, municipalities and political subdivisions................... 246,364 13,205 (101) 259,468 Corporate fixed income securities.......... 232,216 12,739 (679) 244,276 Asset-backed and mortgage-backed securities............................... 144,427 5,907 (461) 149,873 Foreign government securities.............. 91,145 240 -- 91,385 -------- ------- ------- -------- TOTAL SECURITIES................. $823,587 $35,033 $(1,463) $857,157 ======== ======= ======= ======== December 31, 2001: Marketable equity securities............... $ 16,431 $ 176 $ (38) $ 16,569 US Treasury securities..................... 70,235 1,242 (109) 71,368 Obligations of states, municipalities and political subdivisions................... 200,790 5,513 (645) 205,658 Corporate fixed income securities.......... 140,702 4,999 (416) 145,285 Asset-backed and mortgage-backed securities............................... 97,684 1,504 (560) 98,628 Foreign government securities.............. 4,263 226 -- 4,489 -------- ------- ------- -------- TOTAL SECURITIES................. $530,105 $13,660 $(1,768) $541,997 ======== ======= ======= ========
The amortized cost and estimated market value of fixed income securities at December 31, 2002, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. The weighted average life of our asset-backed and mortgage-backed securities is five years.
ESTIMATED AMORTIZED MARKET COST VALUE --------- --------- Due in 1 year or less....................................... $ 65,851 $ 66,673 Due after 1 year through 5 years............................ 315,474 326,561 Due after 5 years through 10 years.......................... 128,883 135,984 Due after 10 years through 15 years......................... 76,966 82,488 Due after 15 years.......................................... 76,171 79,969 -------- -------- Securities with fixed maturities.......................... 663,345 691,675 Asset-backed and mortgage-backed securities................. 144,427 149,873 -------- -------- TOTAL FIXED INCOME SECURITIES........................ $807,772 $841,548 ======== ========
F-18 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) As of December 31, 2002, our insurance companies had deposited fixed income securities with an amortized cost of approximately $32.0 million (market: $34.0 million) to meet the deposit requirements of various insurance departments. All investments in fixed income securities and other investments were income producing for the twelve months preceding December 31, 2002, except for one fixed income security valued at $0.5 million. The sources of net investment income for the three years ended December 31, 2002, are detailed below:
2002 2001 2000 ------- ------- ------- Fixed income securities................................. $31,773 $27,234 $22,074 Short-term investments.................................. 6,801 12,789 18,085 Marketable equity securities............................ 210 294 59 Other investments....................................... 12 4 4 ------- ------- ------- Total investment income.......................... 38,796 40,321 40,222 Investment expense...................................... (1,027) (683) (386) ------- ------- ------- NET INVESTMENT INCOME............................ $37,769 $39,638 $39,836 ======= ======= =======
Realized pre-tax gain (loss) on the sale or write down of investments is as follows:
GAIN LOSS NET ------ ------- ------- For the year ended December 31, 2002: Fixed income securities.................................. $3,027 $(1,621) $ 1,406 Marketable equity securities............................. 207 (312) (105) Other investments........................................ 335 (1,183) (848) ------ ------- ------- REALIZED GAIN (LOSS)........................... $3,569 $(3,116) $ 453 ====== ======= ======= For the year ended December 31, 2001: Fixed income securities.................................. $3,099 $(1,452) $ 1,647 Marketable equity securities............................. 1,224 (1,848) (624) Other investments........................................ 145 (775) (630) ------ ------- ------- REALIZED GAIN (LOSS)........................... $4,468 $(4,075) $ 393 ====== ======= ======= For the year ended December 31, 2000: Fixed income securities.................................. $1,173 $ (970) $ 203 Marketable equity securities............................. 567 (6,195) (5,628) Other investments........................................ 104 -- 104 ------ ------- ------- REALIZED GAIN (LOSS)........................... $1,844 $(7,165) $(5,321) ====== ======= =======
F-19 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) Unrealized pre-tax net gains (losses) on investments for three years ended December 31, 2002 are as follows:
2002 2001 2000 ------- ------ ------- Fixed income securities.................................. $22,022 $ 731 $11,916 Marketable equity securities............................. (344) 2,752 (91) Other investments........................................ 442 (442) -- ------- ------ ------- NET UNREALIZED INVESTMENT GAIN (LOSS).......... $22,120 $3,041 $11,825 ======= ====== =======
(5) NOTES PAYABLE Notes payable as of December 31, 2002 and 2001 are shown in the table below. The estimated fair value of our 2% convertible notes ($185.2 million and $185.9 million at December 31, 2002 and 2001, respectively) is based on its trading market value. For the remainder of our notes payable, the estimated fair value is based on current rates offered to us for debt with similar terms and conditions and approximates the carrying value at both balance sheet dates.
2002 2001 -------- -------- 2% Convertible notes........................................ $172,451 $172,500 Revolving loan facility..................................... 53,000 -- Other debt.................................................. 4,576 9,428 -------- -------- TOTAL NOTES PAYABLE............................... $230,027 $181,928 ======== ========
In a public offering on August 23, 2001, we issued an aggregate $172.5 million principal amount of 2% Convertible Notes due in 2021. Each $1 thousand principal amount of notes is convertible into 31.25 shares of our common stock, which represents an initial conversion price of $32.00 per share. The initial conversion price is subject to change under certain conditions. Interest is to be paid by us on March 1 and September 1 each year. Holders may surrender notes for conversion into shares of our common stock in any calendar quarter if, as of the last day of the preceding calendar quarter, the closing sale price of our common stock for at least 20 trading days in the period of 30 consecutive trading days ending on the last trading day of the quarter is more than 120% ($38.40 per share) of the conversion price per share of our common stock on the last trading day of the quarter. We can redeem the notes for cash at any time on or after September 1, 2006. Holders of the notes may require us to repurchase the notes on September 1, 2004, 2006, 2008, 2011 and 2016. If the holders exercise this option, we may choose to pay the purchase price in cash, in shares of our common stock, or a combination thereof. On September 1, 2002, the first repurchase date of the notes, $49 thousand of the notes were tendered to us and we repurchased them with cash. We paid $4.4 million in underwriting discounts and expenses in connection with the offering, which were being amortized from the issue date until September 1, 2002. We used the proceeds from this offering to repay our remaining indebtedness under our bank facility, assist in financing the recent acquisitions, make a $60.0 million capital contribution to our insurance companies and for general corporate purposes. 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 on June 6, 2001. Interest expense for 2001 includes a charge of $0.6 million 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 17, 2004. The facility is collateralized in part by the pledge of our insurance companies' stock and guarantees entered into by our underwriting agencies and intermediaries. The facility agreement contains certain restrictive covenants, which we believe are typical for F-20 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) similar financing arrangements. As of December 31, 2002 the weighted average interest rate on the outstanding balance was 3.2%. At December 31, 2002, certain of our subsidiaries maintained revolving lines of credit with a bank in the combined maximum amount of $26.8 million available through December 17, 2004. Advances under the lines of credit are limited to amounts required to fund draws, if any, on letters of credit issued by the bank on behalf of the subsidiaries and short-term direct cash advances. The lines of credit are collateralized by securities having an aggregate market value of up to $33.5 million, the actual amount of collateral at any one time being 125% of the aggregate amount outstanding. Interest on the lines is payable at the bank's prime rate of interest (4.25% at December 31, 2002) for draws on the letters of credit and prime less 1% on short-term cash advances. As of December 31, 2002, letters of credit totaling $12.1 million had been issued to insurance companies by the bank on behalf of our subsidiaries, with total securities of $15.2 million collateralizing the lines. (6) INCOME TAX As of December 31, 2002 and 2001, we had current income taxes receivable of $3.9 million and $15.5 million, respectively, included in other assets in the consolidated balance sheets. The components of the income tax provision for the three years ended December 31, 2002 are as follows:
2002 2001 2000 ------- ------- ------- Current................................................. $48,111 $35,055 $26,948 Deferred................................................ 9,240 (4,869) 8,919 ------- ------- ------- TOTAL INCOME TAX PROVISION.................... $57,351 $30,186 $35,867 ======= ======= =======
F-21 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) The net deferred tax liability and asset are included in accounts payable and accrued liabilities and other assets, respectively, in our consolidated balance sheets. The composition of deferred tax assets and liabilities as of December 31, 2002 and 2001, is as follows:
2002 2001 -------- ------- Federal tax net operating loss carryforwards................ $ 5,370 $10,117 State tax net operating loss carryforwards.................. 5,671 5,464 Excess of financial unearned premium over tax............... 9,746 6,555 Effect of loss reserve discounting and salvage and subrogation accrual for tax............................... 10,544 9,897 Excess of financial accrued expenses over tax............... 1,960 4,918 Allowance for bad debts, not deductible for tax............. 3,346 2,788 Foreign branch net operating loss carryforwards............. 2,169 2,568 Valuation allowance......................................... (11,547) (10,435) -------- ------- Total assets...................................... 27,259 31,872 Unrealized gain on increase in value of securities available for sale (shareholders' equity)........................... 12,170 3,717 Deferred policy acquisition costs, net of ceding commissions, deductible for tax........................... 4,653 2,256 Amortizable goodwill for tax................................ 11,061 5,256 Property and equipment depreciation and other items......... 9,850 4,165 -------- ------- Total liabilities................................. 37,734 15,394 -------- ------- NET DEFERRED TAX ASSET (LIABILITY)................ $(10,475) $16,478 ======== =======
Changes in the valuation allowance account applicable to deferred tax assets result primarily from the acquisition and expiration of net operating losses and other tax attributes related to acquired subsidiaries. The changes for the three years ended December 31, 2002 are as follows:
2002 2001 2000 ------- ------- ------- Balance, beginning of year.............................. $10,435 $ 9,666 $12,091 Change during year...................................... 1,112 769 (2,425) ------- ------- ------- BALANCE, END OF YEAR.......................... $11,547 $10,435 $ 9,666 ======= ======= =======
As of December 31, 2002, we have Federal tax net operating loss carryforwards of approximately $14.7 million that will expire in varying amounts through the year 2021. Future use of these carryforwards is subject to statutory limitations due to prior changes of ownership. There are valuation allowances in the amount of $4.3 million recorded with respect to these loss carryforwards that would reduce goodwill if the carryforwards are realized. In addition, we have approximately $6.8 million of Federal tax loss carryforwards, principally from our foreign insurance companies that can be used only against future taxable income of those entities. There are valuation allowances in the amount of $0.3 million recorded with respect to these loss carryforwards that would be credited to income if the carryforwards are realized. Based upon our history of taxable income in our domestic insurance and other operations and our projections of future taxable income in our domestic and foreign insurance operations, we believe it is more likely than not that the deferred tax assets related to our loss carryforwards, for which there are no valuation allowances, will be realized. We have various state tax net operating loss carryforwards for which we have established valuation allowances of approximately $5.6 million covering all of the related tax benefit. F-22 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) The following table summarizes the differences between our effective tax rate for financial statement purposes and the Federal statutory rate for the three years ended December 31, 2002:
2002 2001 2000 ------- ------- ------- Statutory tax rate...................................... 35.0% 35.0% 35.0% Federal tax at statutory rate........................... $57,113 $21,134 $31,967 Nontaxable municipal bond interest and dividends received deduction.................................... (3,391) (3,314) (3,545) Other non deductible expenses........................... 442 512 620 Non deductible goodwill amortization.................... -- 7,781 2,497 State income taxes...................................... 2,414 3,259 4,202 Foreign income taxes.................................... 2,921 2,915 1,537 Foreign tax credit...................................... (2,597) (2,968) (1,826) Other, net.............................................. 449 867 415 ------- ------- ------- INCOME TAX PROVISION.......................... $57,351 $30,186 $35,867 ======= ======= ======= EFFECTIVE TAX RATE............................ 35.1% 50.0% 39.3% ======= ======= =======
(7) SEGMENT AND GEOGRAPHIC DATA We have classified our activities into four operating business segments based upon services provided: 1) insurance company operations, 2) underwriting agency operations, 3) intermediary operations, and 4) other operations. See Note 1 for a description of the services provided by and the principal subsidiaries included in our insurance company, underwriting agency and intermediary segments. Our other operations segment performed various insurance related services and contains insurance related investments made from time to time. During 2001, we sold the last of our service operations, which will result in a decrease in other operating income in future years until additional investments, which are contemplated, are made. Corporate includes general corporate operations, and those minor operations not included in an operating segment. Inter-segment revenue consists primarily of management fees of our underwriting agency segment, commission income of our intermediary segment and service revenue of our other operations charged to our insurance company segment on business retained by our insurance companies. Inter-segment pricing (either flat rate fees or as a percentage premium) approximates what is charged to unrelated parties for similar services. The performance of each of our segments is evaluated by our management based upon net earnings. Net earnings is calculated after tax and after all corporate expense allocations, amortization of goodwill, interest expense on debt incurred at the purchase date and intercompany eliminations have been charged or credited to our 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. Effective January 1, 2001 and 2002, we consolidated the operations of three and one of our underwriting agencies, respectively, into the operations of our insurance companies. Policies incepting on or after the effective dates, along with associated expenses, will be reported in our insurance company segment. The administration of all policies incepting before the effective dates, which are now in run off, along with associated expenses, will continue to be reported in our underwriting agency segment. This consolidation will affect the comparability of segment information between periods. SFAS No. 142, which we adopted effective January 1, 2002, required the discontinuance of the amortization of goodwill and indefinite lived intangible assets on a prospective basis. This will affect the F-23 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) comparability of certain segment information between periods. Pro forma segment information is shown in the tables for the years ended December 31, 2001 and 2000, as if we had adopted SFAS No. 142 as of January 1, 2000.
INSURANCE UNDERWRITING OTHER COMPANY AGENCY INTERMEDIARY OPERATIONS CORPORATE TOTAL --------- ------------ ------------ ---------- --------- -------- For the year ended December 31, 2002: Revenue: Domestic.......................... $449,391 $ 75,653 $24,104 $4,874 $ 616 $554,638 Foreign........................... 91,796 4,487 18,461 -- -- 114,744 Inter-segment..................... -- 31,906 992 -- -- 32,898 -------- -------- ------- ------ ------ -------- Total segment revenue........ $541,187 $112,046 $43,557 $4,874 $ 616 702,280 ======== ======== ======= ====== ====== Inter-segment revenue............... (32,898) -------- CONSOLIDATED TOTAL REVENUE... $669,382 ======== Net earnings: Domestic.......................... $ 62,190 $ 23,180 $ 5,183 $3,052 $2,922 $ 96,527 Foreign........................... 6,040 2,076 2,390 -- -- 10,506 -------- -------- ------- ------ ------ -------- Total segment net earnings... $ 68,230 $ 25,256 $ 7,573 $3,052 $2,922 107,033 ======== ======== ======= ====== ====== Inter-segment eliminations.......... (1,205) -------- CONSOLIDATED NET EARNINGS.... $105,828 ======== Other items: Net investment income............. $ 33,587 $ 2,954 $ 993 $ 41 $ 194 $ 37,769 Depreciation and amortization..... 3,153 6,190 350 82 1,033 10,808 Interest expense (benefit)........ (113) 7,767 2,575 -- (1,928) 8,301 Capital expenditures.............. 2,803 1,208 1,491 -- 280 5,782 Income tax provision.............. 33,074 15,499 6,550 1,566 1,368 58,057 Inter-segment eliminations........ (706) -------- Consolidated income tax provision.................... $ 57,351 ========
For 2002, earnings before income taxes was $144.3 million for our domestic subsidiaries and $18.8 million for our foreign subsidiaries and branches. F-24 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA)
INSURANCE UNDERWRITING OTHER COMPANY AGENCY INTERMEDIARY OPERATIONS CORPORATE TOTAL --------- ------------ ------------ ---------- --------- -------- For the year ended December 31, 2001: Revenue: Domestic.......................... $330,724 $64,848 $23,518 $14,885 $1,426 $435,401 Foreign........................... 45,098 2,312 22,650 -- -- 70,060 Inter-segment..................... -- 22,619 491 1,967 -- 25,077 -------- ------- ------- ------- ------ -------- Total segment revenue..... $375,822 $89,779 $46,659 $16,852 $1,426 530,538 ======== ======= ======= ======= ====== Inter-segment revenue............... (25,077) -------- CONSOLIDATED TOTAL REVENUE................. $505,461 ======== Net earnings (loss): Domestic.......................... $ 1,020 $16,075 $ 4,382 $ 7,149 $ (979) $ 27,647 Foreign........................... (3,923) 1,137 4,280 -- -- 1,494 -------- ------- ------- ------- ------ -------- Total segment net earnings (loss).................. $ (2,903) $17,212 $ 8,662 $ 7,149 $ (979) 29,141 ======== ======= ======= ======= ====== Inter-segment eliminations........ 1,056 -------- CONSOLIDATED NET EARNINGS................ $ 30,197 ======== SFAS No. 142 pro forma adjustments: Net effect of goodwill and intangible asset amortization................... $ 2,142 $ 5,892 $ 3,353 $ -- $ -- $ 11,387 -------- ------- ------- ------- ------ -------- Pro forma segment net earnings (loss)......................... $ (761) $23,104 $12,015 $ 7,149 $ (979) 40,528 ======== ======= ======= ======= ====== Inter-segment eliminations........ 1,056 -------- PRO FORMA CONSOLIDATED NET EARNINGS................ $ 41,584 ======== Other items: Net investment income............. $ 30,766 $ 5,202 $ 2,771 $ 85 $ 814 $ 39,638 Depreciation, amortization and impairments.................... 20,685 9,783 3,723 256 479 34,926 Interest expense.................. 37 5,198 3,534 15 100 8,884 Capital expenditures.............. 3,049 1,048 1,627 107 6,452 12,283 Income tax provision.............. 2,432 15,604 3,054 3,692 4,756 29,538 Inter-segment eliminations........ 648 -------- Consolidated income tax provision.................... $ 30,186 ========
During 2001, our insurance company segment recorded two large unusual items: 1) a $22.8 million (net of income tax) loss due to the terrorist attack on September 11 and 2) a $29.4 million charge (net of income tax) related to lines of business we decided to cease writing. Included in the latter amount, was a $15.0 million charge for the impairment of goodwill, which was not deductible for income tax purposes. Also during 2001, earnings (loss) before income taxes was $60.4 million for our domestic subsidiaries and $(0.1) million for our foreign subsidiaries and branches. F-25 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA)
INSURANCE UNDERWRITING OTHER COMPANY AGENCY INTERMEDIARY OPERATIONS CORPORATE TOTAL --------- ------------ ------------ ---------- --------- -------- For the year ended December 31, 2000: Revenue: Domestic.......................... $276,240 $ 99,808 $31,525 $23,826 $ 1,035 $432,434 Foreign........................... 15,054 4,446 21,669 -- -- 41,169 Inter-segment..................... -- 16,404 345 1,468 -- 18,217 -------- -------- ------- ------- ------- -------- Total segment revenue..... $291,294 $120,658 $53,539 $25,294 $ 1,035 491,820 ======== ======== ======= ======= ======= Inter-segment revenue............... (18,217) -------- CONSOLIDATED TOTAL REVENUE................. $473,603 ======== Net earnings (loss): Domestic.......................... $ 27,289 $ 20,771 $ 9,846 $ 5,960 $(4,710) $ 59,156 Foreign........................... (3,094) 672 1,366 -- -- (1,056) -------- -------- ------- ------- ------- -------- Total segment net earnings (loss).................. $ 24,195 $ 21,443 $11,212 $ 5,960 $(4,710) 58,100 ======== ======== ======= ======= ======= Inter-segment eliminations........ (619) Cumulative effect of accounting change......................... (2,013) -------- CONSOLIDATED NET EARNINGS................ $ 55,468 ======== SFAS No. 142 pro forma adjustments: Net effect of goodwill and intangible asset amortization................... $ 597 $ 7,687 $ 3,522 $ 28 $ -- $ 11,834 -------- -------- ------- ------- ------- -------- Pro forma segment net earnings (loss)......................... $ 24,792 $ 29,130 $14,734 $ 5,988 $(4,710) 69,934 ======== ======== ======= ======= ======= Inter-segment eliminations........ (619) Cumulative effect of accounting change......................... (2,013) -------- PRO FORMA CONSOLIDATED NET EARNINGS................ $ 67,302 ======== Other items: Net investment income............. $ 27,948 $ 7,547 $ 3,335 $ 476 $ 530 $ 39,836 Depreciation and amortization..... 3,662 11,926 3,567 385 368 19,908 Interest expense.................. 103 9,222 4,846 2 6,174 20,347 Capital expenditures.............. 3,124 4,651 1,082 219 1,074 10,150 Income tax provision (benefit).... 8,308 20,900 6,402 3,578 (1,604) 37,584 Inter-segment eliminations........ (382) Cumulative effect of accounting change......................... (1,335) -------- Consolidated income tax provision.................... $ 35,867 ========
For 2000, earnings (loss) before income taxes was $92.7 million for our domestic subsidiaries and $(1.4) million for our foreign subsidiaries and branches. F-26 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) The following tables present revenue by line of business within each of our operating segments for the three years ended December 31, 2002:
2002 2001 2000 -------- -------- -------- Insurance company: Group life, accident and health.................... $240,070 $143,851 $109,077 Aviation........................................... 100,960 91,377 73,695 London market account.............................. 89,260 43,360 16,234 Global financial products.......................... 23,102 4 -- Other specialty lines.............................. 22,337 15,120 14,552 -------- -------- -------- 475,729 293,712 213,558 Discontinued lines................................. 29,792 49,075 54,089 -------- -------- -------- TOTAL NET EARNED PREMIUM........................ $505,521 $342,787 $267,647 ======== ======== ======== Underwriting agency: Life, accident and health.......................... $ 44,615 $ 47,857 $ 70,536 Property and casualty.............................. 32,467 13,938 25,522 -------- -------- -------- TOTAL MANAGEMENT FEES........................... $ 77,082 $ 61,795 $ 96,058 ======== ======== ======== Intermediary: Life, accident and health.......................... $ 32,045 $ 33,739 $ 36,795 Property and casualty.............................. 9,527 9,673 13,091 -------- -------- -------- TOTAL COMMISSION INCOME......................... $ 41,572 $ 43,412 $ 49,886 ======== ======== ========
Assets by business segment and geographic location are shown in the following tables:
INSURANCE UNDERWRITING OTHER COMPANY AGENCY INTERMEDIARY OPERATIONS CORPORATE TOTAL ---------- ------------ ------------ ---------- --------- ---------- December 31, 2002: Domestic...................... $2,068,095 $651,786 $ 47,946 $5,925 $46,477 $2,820,229 Foreign....................... 445,692 61,078 377,152 -- -- 883,922 ---------- -------- -------- ------ ------- ---------- Total assets................ $2,513,787 $712,864 $425,098 $5,925 $46,477 $3,704,151 ========== ======== ======== ====== ======= ========== December 31, 2001: Domestic...................... $1,696,823 $742,739 $ 75,162 $5,790 $32,875 $2,553,389 Foreign....................... 290,597 36,936 338,198 -- -- 665,731 ---------- -------- -------- ------ ------- ---------- Total assets................ $1,987,420 $779,675 $413,360 $5,790 $32,875 $3,219,120 ========== ======== ======== ====== ======= ==========
The changes in the carrying amount of goodwill for the year end December 31, 2002 are as follows:
INSURANCE UNDERWRITING COMPANY AGENCY INTERMEDIARY TOTAL --------- ------------ ------------ -------- Goodwill as of December 31, 2001........ $130,504 $107,598 $77,216 $315,318 Additions and other adjustments......... 13,700 5,985 285 19,970 -------- -------- ------- -------- Goodwill as of December 31, 2002........ $144,204 $113,583 $77,501 $335,288 ======== ======== ======= ========
F-27 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) We are still in the process of completing the purchase price allocations for the 2002 acquisitions (see Note 2). Any subsequent net adjustment will result in a change to recorded goodwill. (8) 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 net premium and loss and loss adjustment expense:
LOSS AND LOSS WRITTEN EARNED ADJUSTMENT PREMIUM PREMIUM EXPENSE --------- --------- ------------- For the year ended December 31, 2002: Direct business.......................................... $ 904,737 $ 801,851 $ 504,815 Reinsurance assumed...................................... 254,512 229,287 99,437 Reinsurance ceded........................................ (613,338) (525,617) (297,761) --------- --------- --------- NET AMOUNTS....................................... $ 545,911 $ 505,521 $ 306,491 ========= ========= ========= For the year ended December 31, 2001: Direct business.......................................... $ 783,124 $ 789,893 $ 612,455 Reinsurance assumed...................................... 226,951 218,234 451,390 Reinsurance ceded........................................ (637,117) (665,340) (796,455) --------- --------- --------- NET AMOUNTS....................................... $ 372,958 $ 342,787 $ 267,390 ========= ========= ========= For the year ended December 31, 2000: Direct business.......................................... $ 676,730 $ 663,458 $ 493,647 Reinsurance assumed...................................... 290,727 311,137 279,999 Reinsurance ceded........................................ (683,669) (706,948) (575,176) --------- --------- --------- NET AMOUNTS....................................... $ 283,788 $ 267,647 $ 198,470 ========= ========= =========
Ceding commissions netted with policy acquisition costs in the consolidated statements of earnings are $142.0 million, $185.2 million, and $214.7 million for the years ended December 31, 2002, 2001, and 2000, respectively. The table below represents the composition of reinsurance recoverables in our consolidated balance sheets:
2002 2001 -------- -------- Reinsurance recoverable on paid losses...................... $108,104 $ 86,653 Reinsurance recoverable on outstanding losses............... 304,220 414,428 Reinsurance recoverable on incurred but not reported losses.................................................... 393,752 403,223 Reserve for uncollectible reinsurance....................... (7,142) (5,176) -------- -------- TOTAL REINSURANCE RECOVERABLES....................... $798,934 $899,128 ======== ========
F-28 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) Our insurance companies require reinsurers not authorized by their respective states of domicile to collateralize their reinsurance obligations to us. The table below shows amounts held by us as collateral plus other credits available for potential offset as of December 31, 2002 and 2001:
2002 2001 -------- -------- Payables to reinsurers...................................... $235,727 $199,581 Letters of credit........................................... 141,490 145,796 Cash deposits............................................... 9,384 14,851 -------- -------- TOTAL CREDITS........................................ $386,601 $360,228 ======== ========
The tables below present the calculation of net reserves, net unearned premium and net deferred policy acquisition costs as of December 31, 2002 and 2001:
2002 2001 ---------- ---------- Loss and loss adjustment expense payable.................... $1,155,290 $1,130,748 Reinsurance recoverable on outstanding losses............... (304,220) (414,428) Reinsurance recoverable on incurred but not reported losses.................................................... (393,752) (403,223) ---------- ---------- NET RESERVES......................................... $ 457,318 $ 313,097 ========== ========== Unearned premium............................................ $ 331,050 $ 179,530 Ceded unearned premium...................................... (164,224) (71,140) ---------- ---------- NET UNEARNED PREMIUM................................. $ 166,826 $ 108,390 ========== ========== Deferred policy acquisition costs........................... $ 68,846 $ 32,071 Deferred ceding commissions................................. (49,963) (16,681) ---------- ---------- NET DEFERRED POLICY ACQUISITION COSTS................ $ 18,883 $ 15,390 ========== ==========
In order to reduce our exposure to reinsurance credit risk, we evaluate the financial condition of our reinsurers and place our reinsurance with a diverse group of companies and syndicates, which we believe to be financially sound. The following table shows reinsurance balances relating to our reinsurers with a net recoverable balance greater than $15.0 million as of December 31, 2002 and 2001. The total recoverables F-29 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) column includes paid loss recoverable, outstanding loss recoverable, incurred but not reported loss recoverable and ceded unearned premium.
LETTERS OF CREDIT, TOTAL CASH DEPOSITS AND REINSURER RATING LOCATION RECOVERABLES OTHER PAYABLES NET - --------- ------ -------------- ------------ ------------------ ------- December 31, 2002: Lloyd's Syndicate Number 1101......... NR United Kingdom $40,450 $ 258 $40,192 Lloyd's Syndicate Number 2488......... A- United Kingdom 31,640 1,998 29,642 Lloyd's Syndicate Number 1206......... C+ United Kingdom 29,540 40 29,500 Odyssey American Reinsurance Corp..... A Connecticut 25,087 843 24,244 American Fidelity Assurance Company... A+ Oklahoma 23,305 -- 23,305 American Re-Insurance Company......... A+ Delaware 19,797 229 19,568 Lloyd's Syndicate Number 0957......... NR United Kingdom 19,403 22 19,381 Lloyd's Syndicate Number 0033......... A- United Kingdom 19,277 62 19,215 Lloyd's Syndicate Number 0055......... NR United Kingdom 17,009 65 16,944 Canada Life Assurance Company......... A+ Canada 16,900 96 16,804 Lloyd's Syndicate Number 0510......... A- United Kingdom 16,250 562 15,688 Transatlantic Reinsurance Company..... A++ New York 17,288 1,771 15,517 Lloyd's Syndicate Number 0990......... NR United Kingdom 15,329 58 15,271 December 31, 2001: Lloyd's Syndicate Number 1101......... NR United Kingdom $40,913 $1,532 $39,381 Canada Life Assurance Company......... A+ Canada 28,956 -- 28,956 Lloyd's Syndicate Number 1206......... C+ United Kingdom 27,251 351 26,900 AXA Corporate Solutions Reinsurance Co. ................................ A+ Delaware 26,582 680 25,902 Lloyd's Syndicate Number 2488......... A- United Kingdom 25,813 1,187 24,626 American Re-Insurance Company......... A++ Delaware 24,674 1,697 22,977 SCOR Reinsurance Company.............. A New York 21,883 -- 21,883 American Fidelity Assurance Company... A+ Oklahoma 19,881 12 19,869 Transatlantic Reinsurance Company..... A++ New York 20,543 849 19,694 Federal Insurance Company............. A++ Indiana 26,902 8,971 17,931 Lloyd's Syndicate Number 0957......... NR United Kingdom 17,653 -- 17,653 Lloyd's Syndicate Number 0510......... A- United Kingdom 17,647 1,500 16,147 Lloyd's Syndicate Number 0055......... NR United Kingdom 16,168 305 15,863
Ratings for companies are published by A.M. Best Company, Inc. Ratings for individual syndicates are published by Moody's Investors Services, Inc. "NR" indicates that the indicated Lloyd's syndicate has not been rated. Lloyd's of London is an insurance and reinsurance marketplace composed of many independent underwriting syndicates financially supported by a central trust fund. HCC Life Insurance Company previously sold its entire block of individual life insurance and annuity business to Life Reassurance Corporation of America (rated A++ by A.M. Best Company, Inc.) in the form of an indemnity reinsurance contract. Ceded life and annuity benefits amounted to $79.0 million and $83.0 million as of December 31, 2002 and 2001, respectively. F-30 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) We have a reserve of $7.1 million as of December 31, 2002 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 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. 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. 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 consolidated balance sheets. 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 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 December 31, 2002, our insurance companies had initiated two litigation proceedings against reinsurers. As of such date, our insurance companies had an aggregate amount of $5.8 million which had not been paid to us under the agreements and we estimate that there could be up to an additional $10.7 million of incurred losses and loss expenses and other balances due under the subject agreements. (9) COMMITMENTS AND CONTINGENCIES Litigation In addition to the matters discussed in Note (8), 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 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 believe the resolution of any such lawsuits will not have a material adverse effect on our financial condition, results of operations or cash flows. We have received substantial assessments from a state health insurance association, which was established by the state to provide health insurance to "high-risk" or otherwise uninsured individuals within that state. The expenses of the association are currently funded principally through assessments on insurers. With the current assessment, the association changed the calculation method for the amount of the assessment, which resulted in a significant increase in the amount of our assessment ($5.2 million). We and other insurers are presently contesting the change in the assessment methodology. We believe we will receive relief from the current assessment and that any amount we may ultimately have to pay will not be material to F-31 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) our financial position and result of operations, after taking into consideration credits we would receive against other taxes in the state. Foreign Currency Forward Contracts On a limited basis, we enter into foreign currency forward contracts as a hedge against foreign currency fluctuations. Rattner Mackenzie Limited has revenue streams in U.S. dollars and Canadian dollars but incurs expenses in British pound sterling. To mitigate the foreign exchange risk, from time to time we have entered into foreign currency forward contracts expiring at staggered times. As of December 31, 2002, we had no foreign currency forward contracts outstanding. The foreign currency forward contracts are used to convert currency at a known rate in an amount which either approximates or is less than monthly expenses. Thus, the effect of these transactions is to limit the foreign currency exchange risk of the recurring monthly expenses. We utilize these foreign currency forward contracts strictly as a cash flow hedge against existing exposure to foreign currency fluctuations rather than as a form of speculative or trading investment. Catastrophe Exposure We write business in areas exposed to catastrophic losses and have significant exposures to this type of loss in California, the Atlantic Coast of the United States, certain United States Gulf Coast states, particularly Florida and Texas, the Caribbean and Mexico. We assess our overall exposures to a single catastrophic event and apply procedures that we believe are more conservative than are typically used by the industry to ascertain our probable maximum loss from any single event. We maintain reinsurance protection which we believe is sufficient to cover any foreseeable event. Leases We lease administrative office facilities under long-term non-cancelable operating lease agreements expiring at various dates through the year 2010. In addition to rent, the agreements generally require the payment of utilities, real estate taxes, insurance and repairs. We recognize rent expense on a straight-line basis over the terms of these leases. In addition, we lease computer equipment and automobiles under operating leases expiring at various dates through the year 2007. Rent expense under operating leases amounted to $8.4 million, $7.1 million, and $7.3 million, for the years ended December 31, 2002, 2001, and 2000, respectively. At December 31, 2002, future minimum annual rental payments required under long-term, non-cancelable operating leases, excluding certain expenses payable by us, are as follows:
FOR THE YEARS ENDED DECEMBER 31, AMOUNT DUE - -------------------------------- ---------- 2003...................................................... $ 8,687 2004...................................................... 6,956 2005...................................................... 6,194 2006...................................................... 4,227 2007...................................................... 2,605 Thereafter................................................ 1,322 ------- TOTAL FUTURE MINIMUM ANNUAL RENTAL PAYMENTS DUE............. $29,991 =======
F-32 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) Loan Guarantee We guaranteed the mortgage debt of a partnership in which we are a limited partner. The total amount of the loan is $11.1 million as of December 31, 2002. We invested in the partnership, which owns a building which is rented to unaffiliated parties, as a long-term investment. Indemnification We have sold businesses in the past. In connection with these sales, we have provided indemnifications to the buyers, which we believe are typical for transactions of this nature, based upon the type of business sold. Certain of these indemnifications have no limit. It is not possible to estimate the maximum potential amount under these indemnifications as our performance under the indemnifications and our ultimate liability are based upon the occurrence of future events which may or may not occur. We currently have a liability in the amount of $6.2 million recorded for performance under one such indemnification. This indemnification was given by a company we acquired, prior to its acquisition, in connection with a sale of one of its subsidiaries. Terrorist Exposure Subsequent to the terrorist attack on September 11, 2001, where possible, we canceled all terrorist coverage under the terms of existing in-force policies, primarily in the property and energy book of the London market account line of business. Our reinsurance protections in these books have been renewed without coverage for acts of terrorism. We thus only have exposure on policies that contained such coverage and are still in force. This exposure is diminishing as these policies expire and with respect to some risks, would be covered by the provisions of the Federal Terrorism Risk Insurance Act of 2002. Under the Terrorism Risk Insurance Act of 2002, we are required to offer terrorism coverage to our commercial policyholders in certain lines of business written in the United States, for which we may, when warranted, charge an additional premium. The policyholders may or may not accept such coverage. This law also established a deductible that each insurer would have to meet before U.S. Federal reimbursement would occur. For 2003, our deductible is approximately $11.2 million based on 7% of 2002 subject premium as defined under the applicable regulations. Thereafter, the Federal government would provide reimbursement for 90% of our insured, covered insured losses up to the maximum amount set out in the Act. (10) RELATED PARTY TRANSACTIONS Certain of our Directors are officers, directors or owners of business entities with which we transact business. Balances with these business entities and other related parties included in our consolidated balance sheets are as follows:
2002 2001 ------- ------ Other investments........................................... $ 3,264 $4,317 Premiums, claims and other receivables...................... 1,189 776 Other assets................................................ 18,252 2,807
F-33 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) Transactions with these business entities and other related parties included in our consolidated statements of earnings are as follows:
2002 2001 2000 ----- ----- ------- Management fees............................................ $ 91 $ 58 $ -- Investment income.......................................... -- -- 112 Net realized investment gain (loss)........................ (601) 53 (5,067) Other operating income (loss).............................. 668 (508) 89 Other operating expense.................................... -- -- 112 Interest expense........................................... 154 217 74
Additionally, we had $10.1 million and $15.7 million payable at December 31, 2002 and 2001, respectively, to former owners of businesses we have acquired who are now officers of certain of our subsidiaries. Such payables represent payments due under the terms of the acquisition agreements. We also have entered into an agreement with an entity owned by an officer and Director, pursuant to which we rent equipment for providing transportation services to our employees, our Directors and our clients. We provide our own employees to operate the equipment and pay all expenses related to their operation. For the years ended December 31, 2002, 2001 and 2000, we paid rentals of $1.2 million, $1.0 million, and $0.6 million, respectively, to this entity. (11) SHAREHOLDERS' EQUITY 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 $152.4 million after deducting underwriting discounts, commissions and offering expenses and were used to pay down our bank facility. Property and casualty insurance companies domiciled in the State of Texas are limited in the payment of dividends to their shareholders in any twelve-month period, without the prior written consent of the Commissioner of Insurance, to the greater of statutory net income for the prior calendar year or 10% of their statutory policyholders' surplus as of the prior year end. During 2003, Houston Casualty Company's ordinary dividend capacity will be approximately $40.0 million and U.S. Specialty Insurance Company's ordinary dividend capacity will be approximately $11.0 million. Avemco Insurance Company is limited by the State of Maryland in the amount of dividends which it may pay in any twelve-month period, without prior regulatory approval, to the lesser of its statutory net investment income excluding realized capital gains for the prior calendar year or 10% of its statutory policyholders' surplus as of the prior year end. During 2003, Avemco Insurance Company's ordinary dividend capacity will be zero as a result of a special approved dividend paid in 2002. HCC Life Insurance Company is limited by the laws of the State of Indiana in the amount of dividends it may pay in any twelve-month period, without prior regulatory approval, to the greater of its statutory net gain from operations for the prior calendar year or 10% of its statutory capital and surplus as of the prior year end. Dividends may only be paid out of statutory unassigned surplus funds. During 2003, HCC Life Insurance Company's ordinary dividend capacity will be approximately $6.0 million. F-34 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) The components of accumulated other comprehensive income (loss) are as follows:
ACCUMULATED UNREALIZED UNREALIZED OTHER FOREIGN HEDGE INVESTMENT COMPREHENSIVE CURRENCY GAIN GAIN INCOME TRANSLATION (LOSS) (LOSS) (LOSS) ----------- ----------- ----------- ------------- Balance December 31, 1999............... $(483) $ -- $(2,209) $ (2,692) Net change for year..................... (172) -- 7,577 7,405 ----- ---- ------- -------- Balance December 31, 2000............... (655) -- 5,368 4,713 Net change for year..................... (279) 24 2,042 1,787 ----- ---- ------- -------- Balance December 31, 2001............... (934) 24 7,410 6,500 Net change for year..................... 50 (24) 14,239 14,265 ----- ---- ------- -------- Balance December 31, 2002............... $(884) $ -- $21,649 $ 20,765 ===== ==== ======= ========
(12) STOCK OPTIONS During 2001, we replaced all previous option plans with our 2001 Flexible Incentive Plan for purposes of new option grants, which is administered by the Compensation Committee of the Board of Directors. Each option may be used to purchase one share of our common stock. Options cannot be repriced under the plan. As of December 31, 2002, 7.3 million shares of our common stock were reserved for the exercise of options, of which 6.4 million shares were reserved for options previously granted and 0.9 million shares were reserved for future issuances of options. The following table provides an analysis of stock option activity during the three years ended December 31, 2002:
2002 2001 2000 -------------------- -------------------- -------------------- AVERAGE AVERAGE AVERAGE NUMBER EXERCISE NUMBER EXERCISE NUMBER EXERCISE OF SHARES PRICE OF SHARES PRICE OF SHARES PRICE --------- -------- --------- -------- --------- -------- Outstanding, beginning of year........................ 3,305 $17.39 5,494 $15.54 5,470 $16.08 Granted at market value....... 4,116 22.45 797 24.54 1,745 13.59 Forfeitures and expirations... (219) 19.84 (251) 17.73 (434) 18.32 Exercised..................... (831) 14.01 (2,735) 15.68 (1,287) 14.34 ----- ------ ------ ------ ------ ------ OUTSTANDING, END OF YEAR...... 6,371 $20.99 3,305 $17.39 5,494 $15.54 ===== ====== ====== ====== ====== ====== EXERCISABLE, END OF YEAR...... 1,437 $17.81 1,100 $16.70 2,717 $16.59 ===== ====== ====== ====== ====== ======
Options outstanding and exercisable as of December 31, 2002 are shown on the following schedule:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE --------------------------------------- -------------------- AVERAGE AVERAGE AVERAGE RANGE OF NUMBER OF REMAINING EXERCISE NUMBER OF EXERCISE EXERCISE PRICES SHARES CONTRACTUAL LIFE PRICE SHARES PRICE - --------------- --------- ---------------- -------- --------- -------- Under $20.50.................... 2,793 4.3 years $17.30 1,003 $15.17 $20.50-$22.50................... 1,616 5.8 years 21.96 208 21.26 $22.51-$27.00................... 1,596 6.0 years 24.82 154 25.42 Over $27.00..................... 366 4.8 years 28.19 72 28.19 ----- --------- ------ ----- ------ TOTAL OPTIONS................. 6,371 5.2 years $20.99 1,437 $17.81 ===== ========= ====== ===== ======
F-35 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) (13) EARNINGS PER SHARE The following table provides reconciliation of the denominators used in the earnings per share calculations for the three years ended December 31, 2002:
2002 2001 2000 -------- ------- ------- NET EARNINGS........................................... $105,828 $30,197 $55,468 ======== ======= ======= Reconciliation of number of shares outstanding: Shares of common stock outstanding at year end......... 62,358 61,438 51,342 Changes in common stock due to issuance................ (185) (3,272) (908) Contingent shares to be issued......................... -- -- 39 Common stock contractually issuable in the future...... 52 155 269 -------- ------- ------- Weighted average common stock outstanding............ 62,225 58,321 50,742 Additional dilutive effect of outstanding options (as determined by the application of the treasury stock method).............................................. 711 1,298 877 -------- ------- ------- WEIGHTED AVERAGE COMMON STOCK AND POTENTIAL COMMON STOCK OUTSTANDING................................. 62,936 59,619 51,619 ======== ======= ======= Anti-dilutive shares not included in computation....... 1,105 187 1,500 ======== ======= =======
(14) STATUTORY INFORMATION Our insurance companies file financial statements prepared in accordance with statutory accounting practices prescribed or permitted by domestic or foreign insurance regulatory authorities. The differences between statutory financial statements and financial statements prepared in accordance with generally accepted accounting principles vary between domestic and foreign jurisdictions. The principal differences are that for statutory financial statements deferred policy acquisition costs are not recognized, only some of the deferred income tax assets are recorded, bonds are generally carried at amortized cost, certain assets are non-admitted and charged directly to surplus, a liability for a provision for reinsurance is recorded and charged directly to surplus, and outstanding losses and unearned premium are presented net of reinsurance. In addition, under statutory accounting rules, life insurance companies recognize two investment related liabilities, the asset valuation reserve and interest maintenance reserve. Statutory policyholders' surplus, and net income for the three years ended December 31, 2002, after intercompany eliminations, of our insurance companies included in those companies' respective filings with regulatory authorities are as follows:
2002 2001 2000 -------- -------- -------- Statutory policyholders' surplus..................... $523,807 $401,393 $326,249 Statutory net income................................. 68,462 16,555 13,749
Our statutory policyholders' surplus has been adversely affected by statutory adjustments for reinsurance recoverables which, although required statutorily, have no effect on net earnings or shareholders' equity in accordance with generally accepted accounting principles. Our statutory net income for 2001 has been reduced by $22.8 million (net of income tax) from the September 11 terrorist attack and $8.1 million (net of income tax) from charges related to lines of business we decided to cease writing. The National Association of Insurance Commissioners adopted Statements of Statutory Accounting Principles in March, 1998, which became effective on January 1, 2001, through their adoption by the individual states. The cumulative effect of codification was to increase statutory policyholders' surplus of our insurance companies by approximately $8.9 million. Our use of statutory accounting practices prescribed by F-36 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) state regulatory authorities caused a $1.5 million increase in our insurance companies' aggregate statutory policyholders' surplus as of December 31, 2002 compared to amounts that would have been recorded under the codification rules of The National Association of Insurance Commissioners. The statutory surplus of each of our insurance companies is significantly in excess of regulatory risk-based capital requirements. (15) LIABILITY FOR UNPAID LOSS AND LOSS ADJUSTMENT EXPENSE The following table provides a reconciliation of the liability of loss and loss adjustment expense for the three years ended December 31, 2002:
2002 2001 2000 ---------- ---------- -------- Reserves for loss and loss adjustment expense at beginning of the year........................... $1,130,748 $ 944,117 $871,104 Less reinsurance recoverables..................... 817,651 694,245 597,498 ---------- ---------- -------- Net reserves at beginning of the year............. 313,097 249,872 273,606 Net reserve adjustments from acquisition and disposition of subsidiaries..................... 79,558 285 514 Incurred loss and loss adjustment expense: Provision for loss and loss adjustment expense for claims occurring in the current year..... 313,270 278,103 208,055 Increase (decrease) in estimated loss and loss adjustment expense for claims occurring in prior years.................................. (6,779) (10,713) (9,585) ---------- ---------- -------- Incurred loss and loss adjustment expense, net of reinsurance..................................... 306,491 267,390 198,470 ---------- ---------- -------- Loss and loss adjustment expense payments for claims occurring during: Current year.................................... 115,809 102,206 76,725 Prior years..................................... 126,019 102,244 145,993 ---------- ---------- -------- Loss and loss adjustment expense payments, net of reinsurance..................................... 241,828 204,450 222,718 ---------- ---------- -------- Net reserves at end of the year................... 457,318 313,097 249,872 Plus reinsurance recoverables..................... 697,972 817,651 694,245 ---------- ---------- -------- RESERVES FOR LOSS AND LOSS ADJUSTMENT EXPENSE AT END OF THE YEAR......................... $1,155,290 $1,130,748 $944,117 ========== ========== ========
During 2002, we had net loss and loss adjustment expense redundancy of $6.8 million relating to prior year losses compared to redundancies of $10.7 million in 2001 and $9.6 million in 2000. The 2002 redundancy resulted from a deficiency of $7.7 million due to a third quarter charge related to certain business included in discontinued lines, offset by a net redundancy of $14.5 million from all other sources. Deficiencies and redundancies in the reserves occur as we continually review our loss reserves with our actuaries, increasing or reducing loss reserves as a result of such reviews and as losses are finally settled and claims exposures are reduced. We believe we have provided for all material net incurred losses. We have no material exposure to environmental pollution losses, because Houston Casualty Company only began writing business in 1981 and its policies normally contain pollution exclusion clauses which limit F-37 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) pollution coverage to "sudden and accidental" losses only, thus excluding intentional (dumping) and seepage claims. Policies issued by HCC Life Insurance Company, Avemco Insurance Company and U.S. Specialty Insurance Company, because of the types of risks covered, are not considered to have significant environmental exposures. Therefore, we do not expect to experience any material loss development for environmental pollution claims. Likewise, we have no material exposure to asbestos claims. (16) SUPPLEMENTAL INFORMATION Supplemental cash flow information for the three years ended December 31, 2002, is summarized below:
2002 2001 2000 ------- ------- ------- Interest paid........................................... $ 4,900 $ 7,980 $17,418 Income tax paid......................................... 22,642 28,411 11,859 Dividends declared but not paid at year end............. 4,061 3,848 3,557
The unrealized gain or loss on securities available for sale, deferred taxes related thereto, and the issuance of our common stock for the purchase of subsidiaries are non-cash transactions which have been included as direct increases or decreases in our shareholders' equity. The cumulative effect of accounting change due to our adoption of Staff Accounting Bulletin No. 101 during 2000 was a non-cash charge to our earnings. (17) QUARTERLY FINANCIAL DATA (UNAUDITED)
FOURTH QUARTER THIRD QUARTER SECOND QUARTER FIRST QUARTER ------------------- ------------------- ------------------- ------------------- 2002 2001 2002 2001 2002 2001 2002 2001 -------- -------- -------- -------- -------- -------- -------- -------- Total revenue......................... $186,089 $132,192 $175,672 $137,621 $155,912 $120,556 $151,709 $115,092 ======== ======== ======== ======== ======== ======== ======== ======== Net earnings (loss)................... $ 31,495 $ 23,837 $ 24,269 $(29,076) $ 26,782 $ 20,258 $ 23,282 $ 15,178 ======== ======== ======== ======== ======== ======== ======== ======== Basic earnings (loss) per share data: Earnings (loss) per share............. $ 0.50 $ 0.39 $ 0.39 $ (0.49) $ 0.43 $ 0.34 $ 0.38 $ 0.28 ======== ======== ======== ======== ======== ======== ======== ======== Weighted average shares outstanding... 62,387 61,021 62,335 59,399 62,236 58,998 61,936 53,720 ======== ======== ======== ======== ======== ======== ======== ======== Diluted earnings (loss) per share data: Earnings (loss) per share............. $ 0.50 $ 0.38 $ 0.39 $ (0.49) $ 0.43 $ 0.34 $ 0.37 $ 0.28 ======== ======== ======== ======== ======== ======== ======== ======== Weighted average shares outstanding... 63,109 62,051 62,871 59,399 62,889 60,470 62,713 55,070 ======== ======== ======== ======== ======== ======== ======== ========
During the third quarter of 2001, we recorded two large unusual items: 1) a $22.8 million (net of income tax) loss due to the terrorist attack on September 11; and 2) a $29.6 million charge (net of income tax) related to lines of business we decided to cease writing. Included in the latter amount was a $15.0 million charge for the impairment of goodwill, which was not deductible for income tax purposes. During the third quarter of 2002, we recorded a $5.0 million (net of income tax) charge to strengthen reserves related to certain business included in discontinued lines. The sum of the quarters earnings (loss) per share may not equal the annual amounts due to rounding. (18) SUBSEQUENT EVENTS On March 25, 2003, we sold an aggregate of $125.0 million principal amount of 1.3% Convertible Notes due in 2023 in a public offering. Each $1 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. 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 F-38 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) 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. Holders of the notes may require us to repurchase the notes on April 1, 2009, 2014 and 2019. If the holders exercise this option, we may choose to pay the purchase price in cash, in shares of our common stock, or in a combination thereof. We plan to use the proceeds from this offering to pay down existing indebtedness under our bank facility, assist in financing future acquisitions and strategic investments and for general corporate purposes. F-39 REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors and Shareholders HCC Insurance Holdings, Inc.: Our report on the consolidated financial statements of HCC Insurance Holdings, Inc., which included an emphasis paragraph related to a change in method of revenue recognition for certain contracts, effective January 1, 2000, and a change in method of accounting for goodwill, effective January 1, 2002, is included on page F-1 of this Form 10-K. In connection with our audits of such financial statements, we have also audited the financial statement schedules listed in Item 15 of this Form 10-K. These financial statement schedules are the responsibility of the Company's management. In our opinion, these financial statement schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. /s/ PricewaterhouseCoopers LLP Houston, Texas March 21, 2003 S-1 SCHEDULE 1 HCC INSURANCE HOLDINGS, INC. SUMMARY OF INVESTMENTS OTHER THAN INVESTMENTS IN RELATED PARTIES (IN THOUSANDS)
DECEMBER 31, 2002 - ------------------------------------------------------------------------------------------------ COLUMN A COLUMN B COLUMN C COLUMN D - ------------------------------------------------------------------------------------------------ AMOUNT AT WHICH SHOWN IN THE TYPE OF INVESTMENT COST VALUE BALANCE SHEET - ------------------ ---------- -------- --------------- Fixed maturities: Bonds -- United States government and government agencies and authorities.......................... $ 93,620 $ 96,546 $ 96,546 Bonds -- states, municipalities and political subdivisions...................................... 46,750 49,230 49,230 Bonds -- special revenue............................. 199,614 210,238 210,238 Bonds -- corporate................................... 232,216 244,276 244,276 Asset-backed and mortgage-backed securities.......... 144,427 149,873 149,873 Bonds -- foreign government.......................... 91,145 91,385 91,385 ---------- -------- ---------- Total fixed maturities.......................... 807,772 $841,548 $ 841,548 ---------- -------- ---------- Equity securities: Common stocks -- banks, trusts and insurance companies......................................... 10,475 $ 10,482 $ 10,482 Common stocks -- industrial, miscellaneous and all other............................................. 212 121 121 Non-redeemable preferred stocks...................... 5,128 5,006 5,006 ---------- -------- ---------- Total equity securities......................... 15,815 $ 15,609 $ 15,609 ---------- ======== ---------- Short-term investments................................. 307,215 307,215 Other investments...................................... 3,264 3,264 ---------- ---------- TOTAL INVESTMENTS............................... $1,134,066 $1,167,636 ========== ==========
S-2 SCHEDULE 2 HCC INSURANCE HOLDINGS, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT BALANCE SHEETS (IN THOUSANDS)
DECEMBER 31, --------------------- 2002 2001 ---------- -------- ASSETS Cash........................................................ $ 56 $ 8,719 Short-term investments...................................... 4,837 1,497 Investment in subsidiaries.................................. 915,213 734,067 Receivable from subsidiaries................................ 14,133 12,754 Intercompany loans to subsidiaries for acquisitions......... 190,187 190,167 Other assets................................................ 1,581 5,732 ---------- -------- TOTAL ASSETS...................................... $1,126,007 $952,936 ========== ======== LIABILITIES AND SHAREHOLDERS' EQUITY Notes payable............................................... $ 225,629 $173,198 Note payable to related party............................... 825 2,667 Deferred Federal income tax................................. 7,129 1,652 Accounts payable and accrued liabilities.................... 9,517 11,966 ---------- -------- Total liabilities................................. 243,100 189,483 Total shareholders' equity........................ 882,907 763,453 ---------- -------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY........ $1,126,007 $952,936 ========== ========
See Notes to Condensed Financial Information. S-3 SCHEDULE 2 HCC INSURANCE HOLDINGS, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF EARNINGS (IN THOUSANDS)
FOR THE YEARS ENDED DECEMBER 31, ---------------------------------- 2002 2001 2000 ---------- --------- --------- Equity in earnings of subsidiaries.......................... $108,833 $37,439 $62,416 Interest income from subsidiaries........................... 7,277 5,019 9,160 Interest income............................................. 171 764 343 Other income................................................ 10 13 146 -------- ------- ------- Total revenue..................................... 116,291 43,235 72,065 Interest expense............................................ 7,880 8,737 20,249 Other operating expense..................................... 2,290 1,600 1,582 -------- ------- ------- Total expense..................................... 10,170 10,337 21,831 -------- ------- ------- Earnings before income tax benefit................ 106,121 32,898 50,234 Income tax expense (benefit)................................ 293 2,701 (5,234) -------- ------- ------- NET EARNINGS...................................... $105,828 $30,197 $55,468 ======== ======= =======
See Notes to Condensed Financial Information. S-4 SCHEDULE 2 HCC INSURANCE HOLDINGS, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF COMPREHENSIVE INCOME (IN THOUSANDS)
FOR THE YEARS ENDED DECEMBER 31, ---------------------------------- 2002 2001 2000 ---------- --------- --------- Net earnings................................................ $105,828 $30,197 $55,468 Other comprehensive income, net of tax: Foreign currency translation adjustment..................... 50 (279) (172) Gains (losses) in fair value of subsidiaries' foreign currency forward contracts recorded as a hedge, net of income tax charge (benefit) of $(13) in 2002 and $13 in 2001...................................................... (24) 24 -- Investment gains (losses): Consolidated subsidiaries' investment gains during the year, net of deferred tax charge of, $8,040 in 2002; $1,137 in 2001; and $2,386 in 2000..................... 14,533 2,297 4,118 Less consolidated subsidiaries' reclassification adjustments for (gains) losses included in net earnings, net of deferred tax (charge) benefit of $(159) in 2002; $(138) in 2001; and $1,862 in 2000 (294) (255) 3,459 -------- ------- ------- Other comprehensive income.................................. 14,265 1,787 7,405 -------- ------- ------- COMPREHENSIVE INCOME.............................. $120,093 $31,984 $62,873 ======== ======= =======
See Notes to Condensed Financial Information. S-5 SCHEDULE 2 HCC INSURANCE HOLDINGS, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF CASH FLOWS (IN THOUSANDS)
FOR THE YEARS ENDED DECEMBER 31, --------------------------------- 2002 2001 2000 --------- ---------- -------- Cash flows from operating activities: Net earnings.............................................. $105,828 $ 30,197 $55,468 Adjustment to reconcile net earnings to net cash provided by operating activities: Undistributed net income of subsidiaries.................. (74,864) (20,184) (40,818) Amortization and depreciation............................. 3,279 2,586 527 Increase in accrued interest receivable added to intercompany loan balances............................. (7,277) (835) (5,160) Change in accounts payable and accrued liabilities........ (2,663) 1,181 (5,286) Tax benefit from exercise of stock options................ 4,030 12,312 3,627 Other, net................................................ 2,088 2,000 (1,107) -------- --------- ------- Cash provided by operating activities.................. 30,421 27,257 7,251 Cash flows from investing activities: Cash contributions to subsidiaries........................ (69,007) (84,151) (1,130) Purchase of subsidiaries.................................. (24,593) (96,405) (10,345) Change in short-term investments.......................... (3,340) 1,991 (3,093) Change in receivable from subsidiaries.................... (1,379) (11,317) 4,710 Intercompany loans to subsidiaries for acquisitions....... (16,806) (1,275) (16,509) Payments on intercompany loans to subsidiaries............ 31,964 34,674 42,838 -------- --------- ------- Cash provided (used) by investing activities........... (83,161) (156,483) 16,471 Cash flows from financing activities: Proceeds from note payable, net of costs.................. 76,000 175,401 26,470 Payments on notes payable................................. (27,467) (216,523) (57,042) Sale of common stock...................................... 11,207 192,831 17,235 Dividends paid............................................ (15,663) (13,822) (10,350) -------- --------- ------- Cash provided (used) by financing activities........... 44,077 137,887 (23,687) -------- --------- ------- Net change in cash..................................... (8,663) 8,661 35 Cash as of beginning of year........................... 8,719 58 23 -------- --------- ------- CASH AS OF END OF YEAR................................. $ 56 $ 8,719 $ 58 ======== ========= =======
See Notes to Condensed Financial Information. S-6 HCC INSURANCE HOLDINGS, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT NOTES TO CONDENSED FINANCIAL INFORMATION (1) The accompanying condensed financial information should be read in conjunction with the consolidated financial statements and the related notes thereto of HCC Insurance Holdings, Inc. and Subsidiaries. Investments in subsidiaries are accounted for using the equity method. Certain amounts in the 2001 and 2000 condensed financial information have been reclassified to conform with the 2002 presentation. Such reclassifications had no effect on our shareholders' equity, net earnings or cash flows. (2) Intercompany loans to subsidiaries are demand notes issued primarily to fund the cash portion of acquisitions. They bear interest at a rate set by management, which approximates the interest rate charged to us for similar debt. As of December 31, 2002, the interest rate on intercompany loans was 5.0%. S-7 SCHEDULE 3 HCC INSURANCE HOLDINGS, INC. SUPPLEMENTARY INSURANCE INFORMATION (IN THOUSANDS)
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN F COLUMN G COLUMN H - ------------------------ ----------------- ----------------- ------------ -------- -------------- ----------------- (1) (1) (2) DECEMBER 31, FOR THE YEARS ENDED DECEMBER 31, ---------------------------------------------------- --------------------------------------------- FUTURE POLICY BENEFITS, CLAIMS, BENEFITS, LOSSES, LOSSES AND DEFERRED POLICY CLAIMS AND LOSS UNEARNED PREMIUM NET INVESTMENT SETTLEMENT SEGMENTS ACQUISITION COSTS EXPENSES PREMIUMS REVENUE INCOME EXPENSES - ------------------------ ----------------- ----------------- ------------ -------- -------------- ----------------- 2002 - ------------------------ Insurance Company....... $18,883 $1,234,241 $331,050 $505,521 $33,587 $306,491 Underwriting Agency..... 2,954 Intermediary............ 993 Other Operations........ 41 Corporate............... 194 ------- ---------- -------- -------- ------- -------- Total................... $18,883 $1,234,241 $331,050 $505,521 $37,769 $306,491 ======= ========== ======== ======== ======= ======== 2001 - ------------------------ Insurance Company....... $15,390 $1,213,761 $179,530 $342,787 $30,766 $267,390 Underwriting Agency..... 5,202 Intermediary............ 2,771 Other Operations........ 85 Corporate............... 814 ------- ---------- -------- -------- ------- -------- Total................... $15,390 $1,213,761 $179,530 $342,787 $39,638 $267,390 ======= ========== ======== ======== ======= ======== 2000 - ------------------------ Insurance Company....... $ 9,095 $1,030,877 $190,550 $267,647 $27,948 $198,470 Underwriting Agency..... 7,547 Intermediary............ 3,335 Other Operations........ 476 Corporate............... 530 ------- ---------- -------- -------- ------- -------- Total................... $ 9,095 $1,030,877 $190,550 $267,647 $39,836 $198,470 ======= ========== ======== ======== ======= ======== COLUMN A COLUMN I COLUMN J COLUMN K - ------------------------ ----------------- --------- -------- (3) FOR THE YEARS ENDED DECEMBER 31, ---------------------------------------- AMORTIZATION OF OTHER DEFERRED POLICY OPERATING PREMIUM SEGMENTS ACQUISITION COSTS EXPENSES WRITTEN - ------------------------ ----------------- --------- -------- 2002 - ------------------------ Insurance Company....... $63,274 $ 40,008 $545,911 Underwriting Agency..... 63,448 Intermediary............ 26,857 Other Operations........ 256 Corporate............... (2,432) ------- -------- -------- Total................... $63,274 $128,137 $545,911 ======= ======== ======== 2001 - ------------------------ Insurance Company....... $27,923 $ 53,250 $372,958 Underwriting Agency..... 51,766 Intermediary............ 31,409 Other Operations........ 5,995 Corporate............... (1,539) ------- -------- -------- Total................... $27,923 $140,881 $372,958 ======= ======== ======== 2000 - ------------------------ Insurance Company....... $23,743 $ 19,849 $283,788 Underwriting Agency..... 69,092 Intermediary............ 31,078 Other Operations........ 15,755 Corporate............... 586 ------- -------- -------- Total................... $23,743 $136,360 $283,788 ======= ======== ========
- --------------- (1) Columns C and D are shown ignoring the effects of reinsurance. (2) Net investment income was allocated to the subsidiary, and therefore the segment, on which the related investment asset was recorded. (3) Other operating expenses is after all corporate expense allocations and amortization of goodwill have been charged or credited to the individual segments. Note: Column E is omitted because we have no other policy claims and benefits payable. S-8 SCHEDULE 4 HCC INSURANCE HOLDINGS, INC. REINSURANCE (DOLLARS IN THOUSANDS)
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F - ----------------------------------------------------------------------------------------------------------------- PERCENT OF DIRECT CEDED TO OTHER ASSUMED FROM AMOUNT AMOUNT COMPANIES OTHER COMPANIES NET AMOUNT ASSUMED TO NET ---------- -------------- --------------- ---------- -------------- For the year ended December 31, 2002: Life insurance in force............. $1,021,600 $529,874 $ -- $491,726 --% ========== ======== ======== ======== === Earned premium: Property and liability insurance.... $ 293,614 $222,906 $133,736 $204,444 65% Accident and health insurance....... 508,237 302,711 95,551 301,077 32% ---------- -------- -------- -------- Total.......................... $ 801,851 $525,617 $229,287 $505,521 45% ========== ======== ======== ======== === For the year ended December 31, 2001: Life insurance in force............. $ 597,886 $597,310 $ -- $ 576 --% ========== ======== ======== ======== === Earned premium: Property and liability insurance.... $ 284,488 $229,791 $ 95,342 $150,039 64% Accident and health insurance....... 505,405 435,549 122,892 192,748 64% ---------- -------- -------- -------- Total.......................... $ 789,893 $665,340 $218,234 $342,787 64% ========== ======== ======== ======== === For the year ended December 31, 2000: Life insurance in force............. $ 633,988 $633,851 $ -- $ 137 --% ========== ======== ======== ======== === Earned premium: Property and liability insurance.... $ 290,928 $285,020 $ 92,253 $ 98,161 94% Accident and health insurance....... 372,530 421,928 218,884 169,486 129% ---------- -------- -------- -------- Total.......................... $ 663,458 $706,948 $311,137 $267,647 116% ========== ======== ======== ======== ===
S-9 SCHEDULE 5 HCC INSURANCE HOLDINGS, INC. VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS)
2002 2001 2000 ------- ------- ------- Reserve for uncollectible reinsurance: Balance as of beginning of year........................... $ 5,176 $ 4,057 $ 5,541 Total provision charged to expense........................ 5,530 1,119 465 Total amounts written off................................. (3,564) -- (1,949) ------- ------- ------- BALANCE AS OF END OF YEAR.............................. $ 7,142 $ 5,176 $ 4,057 ======= ======= ======= Allowance for doubtful accounts: Balance as of beginning of year........................... $ 2,779 $ 3,325 $ 1,729 Acquisitions of subsidiaries.............................. 455 453 -- Total provision charged to expense........................ 487 2,366 2,815 Total amounts written off................................. (1,442) (3,365) (1,219) ------- ------- ------- BALANCE AS OF END OF YEAR.............................. $ 2,279 $ 2,779 $ 3,325 ======= ======= =======
S-10 INDEX TO EXHIBITS (Items denoted by a letter are incorporated by reference to other documents previously filed with the Securities and Exchange Commission as set forth at the end of this index. Items not denoted by a letter are being filed herewith.)
EXHIBIT NUMBER - ------- (A)3.1 -- Bylaws of HCC Insurance Holdings, Inc., as amended. (B)3.2 -- Restated Certificate of Incorporation and Amendment of Certificate of Incorporation of HCC Insurance Holdings, Inc., filed with the Delaware Secretary of State on July 23, 1996 and May 21, 1998, respectively. (A)4.1 -- Specimen of Common Stock Certificate, $1.00 par value, of HCC Insurance Holdings, Inc. (C)10.1 -- Share Purchase Agreement dated January 29, 1999, among HCC Insurance Holdings, Inc. and Gerald Axel, Barry J. Cook, Gary J. Lockett, Christopher F.B. Mays, Mark E. Rattner, Marshall Rattner, Inc., John Smith and Keith W. Steed. (D)10.2 -- Agreement and Plan of Merger dated as of October 11, 1999 among HCC Insurance Holdings, Inc., Merger Sub of Delaware, Inc. and The Centris Group, Inc. (E)10.3 -- Agreement and Plan of Merger dated as of January 19, 2001 among HCC Insurance Holdings, Inc., HCC Employee Benefits, Inc. and James Scott Schanen, Lisa Rae Schanen, Conor Schanen qsst, Austin Schanen qsst, Kevin Tolbert and Schanen Consulting Corporation. (F)10.4 -- Loan Agreement ($300,000,000 Revolving Loan Facility) dated as of December 17, 1999 among HCC Insurance Holdings, Inc.; Wells Fargo Bank (Texas), National Association; Bank of America, N.A.; Bank of New York; Bank One, N.A.; First Union National Bank; and Dresdner Bank AG, New York and Grand Cayman Branches. (G)10.5 -- Amendment to Loan Agreement dated as of August 11, 2000 among HCC Insurance Holdings, Inc.; Wells Fargo Bank (Texas), National Association; First Union National Bank; Bank of America, N.A.; The Bank of New York; Bank One, N.A.; and Dresdner Bank AG, New York and Grand Cayman Branches. (G)10.6 -- Second Amendment to Loan Agreement dated as of June 6, 2001 among HCC Insurance Holdings, Inc.; Wells Fargo Bank (Texas), National Association; First Union National Bank; Bank of America, N.A.; and The Bank of New York. 10.7 -- Third Amendment to Loan Agreement dated as of March 21, 2003 among HCC Insurance Holdings, Inc.; Wells Fargo Bank (Texas), National Association; First Union National Bank; Bank of America, N.A.; and The Bank of New York. (H)10.8 -- HCC Insurance Holdings, Inc. 1994 Nonemployee Director Stock Option Plan. (I)10.9 -- HCC Insurance Holdings, Inc. 1992 Incentive Stock Option Plan, as amended and restated. (I)10.10 -- HCC Insurance Holdings, Inc. 1995 Flexible Incentive Plan, as amended and restated. (I)10.11 -- HCC Insurance Holdings, Inc. 1997 Flexible Incentive Plan, as amended and restated. (I)10.12 -- HCC Insurance Holdings, Inc. 1996 Nonemployee Director Stock Option Plan, as amended and restated. (J)10.13 -- HCC Insurance Holdings, Inc. 2001 Flexible Incentive Plan, as amended and restated. 10.14 -- Form of Incentive Stock Option Agreement under the HCC Insurance Holdings, Inc. 2001 Flexible Incentive Plan. 10.15 -- Employment Agreement effective as of January 1, 2003, between HCC Insurance Holdings, Inc. and Stephen L. Way. 10.16 -- Employment Agreement effective as of January 10, 2002, between HCC Insurance Holdings, Inc. and Craig J. Kelbel. 10.17 -- Employment Agreement effective as of June 3, 2002, between HCC Insurance Holdings, Inc. and Michael J. Schell. (G)10.18 -- Employment Agreement effective as of January 1, 2002, between HCC Insurance Holdings, Inc. and Edward H. Ellis, Jr.
EXHIBIT NUMBER - ------- 10.19 -- Employment Agreement effective as of January 1, 2003 between HCC Insurance Holdings, Inc. and Christopher L. Martin. 12 -- Statement Regarding Computation of Ratios. 21 -- Subsidiaries of HCC Insurance Holdings, Inc. 23 -- Consent of Independent Accountants -- PricewaterhouseCoopers LLP dated March 27, 2003. 24 -- Powers of Attorney. 99.1 -- Certification with respect to annual report. 99.2 -- Certification by Chief Executive Officer. 99.3 -- Certification by Chief Financial Officer.
- --------------- (A) Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s Registration Statement on Form S-1 (Registration No. 33-48737) filed October 27, 1992. (B) Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s Registration Statement on Form S-8 (Registration No. 333-61687) filed August 17, 1998. (C) Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s Form 10-Q for the fiscal quarter ended March 31, 1999. (D) Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s Schedule 14D-1 Tender Offer Statement in respect to shares of The Centris Group, Inc. filed October 18, 1999. (E) Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s Form 10-K for the fiscal year ended December 31, 2000. (F) Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s Form 8-K filed December 20, 1999. (G) Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s Form 10-K for the fiscal year ended December 31, 2001. (H) Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s Registration Statement on Form S-8 (Registration No. 33-94472) filed July 11, 1995. (I) Incorporated by reference to Exhibits to HCC Insurance Holdings, Inc.'s Form 10-K for the fiscal year ended December 31, 1999. (J) Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s Definitive Proxy Statement for the May 22, 2002 Annual Meeting of Shareholders filed April 26, 2002. EX-10.7 3 h03402exv10w7.txt 3RD AMENDMENT TO LOAN AGREEMENT EXHIBIT 10.7 THIRD AMENDMENT TO LOAN AGREEMENT THIS THIRD AMENDMENT TO LOAN AGREEMENT (this "Amendment") is made and entered into as of March 21, 2003 by and among HCC INSURANCE HOLDINGS, INC., a Delaware corporation (the "Borrower"); each of the Lenders which is a party to the Loan Agreement (as defined below) (individually, a "Lender" and, collectively, the "Lenders"), WELLS FARGO BANK TEXAS, NATIONAL ASSOCIATION, Administrative Agent for the Lenders and Lead Arranger (in such capacity, together with its successors in such capacity, the "Agent"), FIRST UNION NATIONAL BANK, as Syndication Agent, BANK OF AMERICA, N.A., as Documentation Agent, and THE BANK OF NEW YORK, as Senior Managing Agent. RECITALS A. The Borrower, the Lenders and the Agent executed and delivered that certain Loan Agreement dated as of December 17, 1999. Said Loan Agreement, as heretofore amended, is herein called the "Loan Agreement". Any capitalized term used in this Amendment and not otherwise defined shall have the meaning ascribed to it in the Loan Agreement. B. The Borrower, the Lenders and the Agent desire to amend the Loan Agreement in certain respects. NOW, THEREFORE, in consideration of the premises and the mutual agreements, representations and warranties herein set forth, and further good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the Borrower, the Lenders and the Agent do hereby agree as follows: SECTION 1. Amendments to Loan Agreement. Effective as of the date hereof, Section 8.1(vii) of the Loan Agreement is hereby amended to read in its entirety as follows: (vii) (x) unsecured Indebtedness of Borrower incurred through public debt offerings which is outstanding as of March 21, 2003 (approximately $172,000,000); (y) additional unsecured Indebtedness of Borrower in an aggregate amount not to exceed, in the aggregate at any one time outstanding, $28,000,000 (to be increased on a dollar-for-dollar basis by any repayment of the Indebtedness described in the preceding clause (x) so long as at least $100,000,000 of the availability for borrowings under clauses (x) and (y) of this provision shall used for (or reserved for use for) public debt offerings by Borrower); and (z) additional unsecured Indebtedness of Borrower incurred through public debt offerings so long as such additional Indebtedness shall not exceed, in the aggregate at any one time outstanding, $230,000,000; provided that such additional Indebtedness shall have with no structured principal amortization and shall have a stated maturity later than the Revolving Loan Maturity Date as of the date such additional Indebtedness is incurred; and SECTION 2. Amendment Fee. No part of this Amendment shall become effective until the Borrower shall have delivered to the Agent payment to each Lender executing this Amendment on or prior to March 21, 2003 of a fee of $5,000. SECTION 3. Ratification. Except as expressly amended by this Amendment, the Loan Agreement and the other Loan Documents shall remain in full force and effect. None of the rights, title and interests existing and to exist under the Loan Agreement are hereby released, diminished or impaired, and the Borrower hereby reaffirms all covenants, representations and warranties in the Loan Agreement (except such representations and warranties which are, by their express terms, limited to a prior date). SECTION 4. Expenses. The Borrower shall pay to the Agent all reasonable fees and expenses of its respective legal counsel (pursuant to Section 11.3 of the Loan Agreement) incurred in connection with the execution of this Amendment. SECTION 5. Certifications. The Borrower hereby certifies that (a) no material adverse change in the assets, liabilities, financial condition, business or affairs of the Borrower has occurred since December 31, 2002 and (b) no uncured Default or uncured Event of Default has occurred and is continuing or will occur as a result of this Amendment. SECTION 6. Miscellaneous. This Amendment (a) shall be binding upon and inure to the benefit of the Borrower, the Lenders and the Agent and their respective successors, assigns, receivers and trustees; (b) may be modified or amended only by a writing signed by the required parties; (c) shall be governed by and construed in accordance with the laws of the State of Texas and the United States of America; (d) may be executed in several counterparts by the parties hereto on separate counterparts, and each counterpart, when so executed and delivered, shall constitute an original agreement, and all such separate counterparts shall constitute but one and the same agreement and (e) together with the other Loan Documents, embodies the entire agreement and understanding between the parties with respect to the subject matter hereof and supersedes all prior agreements, consents and understandings relating to such subject matter. The headings herein shall be accorded no significance in interpreting this Amendment. NOTICE PURSUANT TO TEX. BUS. & COMM. CODESS.26.02 THE LOAN AGREEMENT, AS AMENDED BY THIS AMENDMENT, AND ALL OTHER LOAN DOCUMENTS EXECUTED BY ANY OF THE PARTIES PRIOR HERETO OR SUBSTANTIALLY CONCURRENTLY HEREWITH CONSTITUTE A WRITTEN LOAN AGREEMENT WHICH REPRESENTS THE FINAL AGREEMENT BETWEEN THE PARTIES AND MAY NOT BE CONTRADICTED BY EVIDENCE OF PRIOR, CONTEMPORANEOUS OR SUBSEQUENT ORAL AGREEMENTS OF THE PARTIES. THERE ARE NO UNWRITTEN ORAL AGREEMENTS BETWEEN THE PARTIES. IN WITNESS WHEREOF, the Borrower, the Lenders and the Agent have caused this Amendment to be signed by their respective duly authorized officers, effective as of the date first above written. HCC INSURANCE HOLDINGS, INC., a Delaware corporation By: /s/ Edward H. Ellis, Jr. ----------------------------------------------- Name: Edward H. Ellis, Jr. --------------------------------------------- Title: Executive Vice President and CFO -------------------------------------------- WELLS FARGO BANK TEXAS, NATIONAL ASSOCIATION, as Administrative Agent and Lead Arranger and as a Lender By: /s/ Jonathan C. Homeyer ----------------------------------------------- Name: Jonathan C. Homeyer --------------------------------------------- Title: Regional V.P. -------------------------------------------- BANK OF AMERICA, N.A., as Documentation Agent and as a Lender By: /s/ Leslie Nannan ----------------------------------------------- Name: Leslie Nannan --------------------------------------------- Title: Vice President -------------------------------------------- THE BANK OF NEW YORK, as Senior Managing Agent and as a Lender By: /s/ Lizanne T. Eberle ----------------------------------------------- Name: Lizanne T. Eberle --------------------------------------------- Title: Vice President -------------------------------------------- CITICORP USA By: /s/ David A. Dodge ----------------------------------------------- Name: David A. Dodge --------------------------------------------- Title: Managing Director -------------------------------------------- SOUTHWEST BANK OF TEXAS, N.A. By: /s/ Kenneth C. Gealter ----------------------------------------------- Name: Kenneth C. Gealter --------------------------------------------- Title: Vice President -------------------------------------------- The undersigned hereby join in this Amendment to evidence their consent to execution by Borrower of this Amendment, to confirm that each Loan Document now or previously executed by the undersigned applies and shall continue to apply to the Loan Agreement, as amended hereby, to acknowledge that without such consent and confirmation, Lenders would not execute this Amendment and to join in the notice pursuant to Tex. Bus. & Comm. Codess.26.02 set forth above. AVEMCO CORPORATION, a Delaware corporation, LDG REINSURANCE CORPORATION, a Massachusetts corporation, HCC EMPLOYER SERVICES, INC., an Alabama corporation, HCC EMPLOYEE BENEFITS, INC., a Delaware corporation, HCC AVIATION INSURANCE GROUP, INC., a Texas corporation, HCC BENEFITS CORPORATION, a Delaware corporation, HCC RISK MANAGEMENT, CORPORATION, a Texas corporation, HCC INTERMEDIATE HOLDINGS, INC., a Delaware corporation, ASU INTERNATIONAL, INC., a Massachusetts corporation, MARSHALL RATTNER, INC., a New York corporation, HCC EMPLOYER SERVICES, INC., an Illinois corporation, HCC-ASU ACQUISITION SUB, INC., a Massachusetts corporation, HCC ACQUISITION SUB, INC., a New York corporation By: /s/ Edward H. Ellis, Jr. ----------------------------------------------- Name: Edward H. Ellis, Jr. --------------------------------------------- Title: Executive Vice President -------------------------------------------- EX-10.14 4 h03402exv10w14.txt FORM OF INCENTIVE STOCK OPTION AGREEMENT EXHIBIT 10.14 INCENTIVE STOCK OPTION AGREEMENT UNDER THE HCC INSURANCE HOLDINGS, INC. 2001 FLEXIBLE INCENTIVE PLAN This STOCK OPTION AGREEMENT (the "Agreement") is made and entered into effective as of the date of grant as set forth on the signature page below by and between HCC INSURANCE HOLDINGS, INC., a Delaware corporation (the "Company"), and the undersigned employee (the "Employee"). W I T N E S S E T H : WHEREAS, the Board of Directors of the Company, with the approval and authorization of the shareholders thereof, has resolved that the interests of the Company will be advanced by encouraging and enabling certain of its employees, directors and consultants and certain employees of its Subsidiaries (as such term is defined in the Plan) to acquire proprietary shares in the Company, thus providing them with a more direct concern in the welfare of the Company and the Subsidiaries and assuring a closer identification of their interests with those of the Company and the Subsidiaries; and WHEREAS, the Board of Directors believes that the acquisition of such an interest in the Company will stimulate the endeavors of such employees, directors and consultants on behalf of the Company and the Subsidiaries and strengthen their desire to remain with the Company and the Subsidiaries; and WHEREAS, the Employee above referenced is one of such individuals. NOW, THEREFORE, in consideration of the premises and the mutual covenants herein contained and other good and valuable consideration, the parties hereto agree as follows: 1. Option to Purchase. The Company hereby grants to the Employee as a matter of separate inducement and agreement in connection with such Employee's employment by the Company or the Subsidiaries, and not in lieu of any salary or other compensation for such Employee's services, the right and option to purchase, at the time and on the terms and conditions hereinafter set forth, that number of shares of the presently authorized Common Stock of the Company at the per-share purchase price set forth on the signature page of this Agreement. 2. The Plan. The option provided for in this Agreement is granted pursuant to the HCC Insurance Holdings, Inc. 2001 Flexible Incentive Plan (the "Plan") as of the date of grant specified on the signature page of this Agreement (the "Date of Grant"). The terms and provisions of such Plan are incorporated herein by reference and, except to the extent expressly provided by the Plan, in the event of any conflict between the terms and provisions of this Agreement and those of the Plan, the terms and provisions of the Plan, including without limitation, those with respect to the powers of the administrative committee appointed thereunder (hereinafter referred to as the "Committee"), shall prevail and be controlling. All capitalized terms not otherwise defined herein shall have the meaning set forth in the Plan. 3. Term of Option. This option shall continue until 11:59 p.m. Houston time on the date of expiration specified on the signature page of this Agreement (the "Date of Expiration"), except and to the extent that such term may be reduced as provided in Paragraphs 6 and 11 hereof; provided, however, that if any termination date provided for herein shall fall on a Saturday, Sunday, or legal holiday, then such termination date shall be deemed to be the first normal business day of the Company, at its office specified in Paragraph 18 hereof, before such Saturday, Sunday, or legal holiday. 4. Vesting. Except as otherwise provided herein, this option shall be exercisable on or prior to the Date of Expiration, and only to the extent of shares that have vested in accordance with the vesting schedule set forth on the signature page of this Agreement. The Employee's right to exercise the option granted hereunder accrues only in accordance with the preceding sentence and terminates as set forth herein. This option shall be exercisable during the lifetime of the Employee only by the Employee. In no event may the Employee or any person exercising this option pursuant to Paragraph 6(d) hereof exercise this option (before or after any adjustment or substitution pursuant to Paragraph 10, 11, or 12 hereof) for a fraction of a share. 5. Manner of Exercise. (a) Subject to the terms hereof, the option granted hereby may be exercised by delivering to the Treasurer of the Company or his designee at any time prior to the Date of Expiration a written notice specifying the number of vested shares the Employee then desires to purchase. (b) The Employee shall deliver to the Treasurer of the Company or his designee a cashier's check payable in United States currency (unless a personal check shall be acceptable to such officer) to the order of the Company for an amount equal to the purchase price for such number of shares; or, certificates for Common Stock of the Company (provided such Common Stock has been held by the Employee for such period of time, if any, as is required by the Committee), valued at the Fair Market Value of such Common Stock on the date of exercise of this option or a combination of both, as payment of all or any portion of the option price for such number of shares. The check or, if applicable, the certificates, shall be accompanied by such other instruments or agreements duly signed by the Employee as in the opinion of counsel for the Company may be necessary or advisable in order that the issuance of such number of shares comply with applicable rules and regulations under the Securities Act of 1933, as amended (the "Act"), any appropriate state securities laws, or any requirement of any national securities exchange on which such stock may be traded. As soon as practicable after any such exercise of the option in whole or in part by the Employee, the Company will deliver to the Employee a certificate for the number of shares with respect to which the option shall have been so exercised, issued in the Employee's name. Such stock certificate shall carry such restrictive legend, and such written instructions shall be given to the Company's transfer agent, as the Company may deem necessary or advisable for 2 any purpose, including, without limitation, compliance with the requirements of the Act or any state securities laws. 6. Termination of Employment. (a) In the event the employment of the Employee is terminated for any reason other than death, Disability, voluntary termination by the Employee, or for cause (as determined by the Committee in its sole and absolute discretion), then the Employee shall have the right at any time within sixty (60) days after the termination of such employment or, if shorter, during the unexpired term of this option, to exercise this option for the full number of shares not previously exercised or any portion thereof, except as to the issuance of fractional shares, but only to the extent this option was otherwise exercisable in accordance with Paragraph 4 hereof on the date of such cessation of employment. (b) In the event the employment of the Employee is terminated for cause (which determination shall be made in the sole and absolute discretion of the Committee), the Employee shall have the right at any time within ten (10) days after the termination of such employment or, if shorter, during the unexpired term of this option, to exercise this option for the full number of shares not previously exercised or any portion thereof, except as to the issuance of fractional shares, but only to the extent this option was otherwise exercisable in accordance with Paragraph 4 hereof as of the date of such termination of employment for cause. (c) In the event the employment of the Employee is terminated voluntarily by the Employee, the Employee shall have the right at any time within thirty (30) days after the termination of such employment or, if shorter, during the unexpired term of this option, to exercise this option for the full number of shares not previously exercised or any portion thereof, except as to the issuance of fractional shares, but only to the extent this option was otherwise exercisable in accordance with Paragraph 4 hereof as of the date of such termination of employment for cause. (d) In the event the employment of the Employee is terminated by reason of Disability, then the Employee shall have the right to exercise this option for the full number of shares not previously exercised or any portion thereof, except as to the issuance of fractional shares, to the full extent of this option at any time within one year from the date of such termination or within the unexpired term of this option, whichever is shorter. (e) In the event of the death of the Employee while in the employ of the Company or the Subsidiaries, this option may be exercised for the full number of shares not previously exercised, or any portion thereof, except as to the issuance of fractional shares, to the full extent of this option at any time within one year from the date of death of the Employee or within the unexpired term of this option, whichever is shorter, by the person or persons to whom the Employee's rights under this option shall pass by the Employee's will or by the laws of descent and distribution, whichever is applicable. 3 7. Shares Issued. Shares to be issued on the exercise of this option may, at the election of the Company, be either authorized and unissued shares, or shares previously issued and reacquired by the Company. 8. Delivery of Certificates. The Company shall not be required to issue or deliver any certificates for shares purchased upon the exercise of this option prior to: (i) the obtaining of any approval from any governmental agency which the Company shall, in its sole discretion, determine to be necessary or advisable; (ii) the completion of any registration or other qualification of such shares under any state or federal law or ruling or regulation of any governmental body which the Company shall, in its sole discretion, determine to be necessary or advisable; and (iii) the determination by the Committee that the Employee has tendered to the Company any federal, state or local tax owed by Employee as a result of exercising this option when the Company has a legal liability to satisfy such tax. In addition, if shares reserved for issuance upon the exercise of this option shall not then be registered under the Act, the Company may, upon Employee's exercise of this option, require Employee or his permitted transferee to represent in writing that the shares being acquired are for investment and not with a view to distribution, and may mark the certificate for the shares with a legend restricting transfer and may issue stop transfer orders relating to such certificate to the Company's transfer agent. 9. Taxes. In connection with the exercise of the option by the Employee and, as a condition to the Company's obligation to deliver shares upon exercise of the option, the Employee shall make arrangements satisfactory to the Committee to insure that the amount of the federal withholding tax, if any, required to be withheld with respect to delivery of the shares is made available by the Employee for timely payment of the tax by the Company to the United States Government. 10. Certain Adjustments. In the event that, prior to the delivery of all of the shares in respect to which this option is granted, there shall be any change in the outstanding Common Stock of the Company, through recapitalization, reclassification, stock dividend, stock split, amendment to the Company's Certificate of Incorporation or reverse stock split, an appropriate and proportionate adjustment shall be made in the number and/or kind of securities allocated to the option hereby granted, without change in the aggregate purchase price applicable to the unexercised portion of the option, but with a corresponding adjustment in the number and price for each share covered by the option. Such adjustments shall be made by the Committee, whose determination in the matter shall be conclusive and binding on the Company, the Employee and the Employee's legal representative. 11. Reorganization. (a) In the event that, prior to the delivery of all the shares in respect of which this option is granted, a Reorganization of the Company shall occur, as defined in Section 2.3 of the Plan: (i) If provision be made in writing in connection with the Reorganization for the assumption and continuance of the option hereby granted, or the substitution for such option of a new option covering the shares of the 4 successor employer corporation, with appropriate adjustment as to the number and kind of shares and prices, the option hereby granted, or the new option substituted therefor, as the case may be, shall continue in the manner and under the terms provided. (ii) In the event provision is not made in connection with a Reorganization for the continuance and assumption of the option granted under the Plan or for the substitution of an option covering the shares of the successor employer corporation, then the Employee shall be entitled, prior to the effective date of any such reorganization and notwithstanding the provisions of Paragraph 4 hereof (except as to the issuance of fractional shares), to purchase the full number of shares not previously exercised under such option, without regard to the determination as to the periods and installments of exercisability made pursuant to the Plan if (and only if) such option has not at that time expired or been terminated. (b) All adjustments under this Section shall be made by the Committee, whose determination as to what adjustments shall be made and the extent thereof, shall be final, binding and conclusive on the Company, the Employee and the Employee's legal representatives. 12. Merger or Consolidation. In the event that, prior to the delivery of all of the shares in respect to which this option is granted, there shall be a merger or consolidation of the Company in which the Company is the surviving corporation and, if as a result thereof, outstanding shares of Common Stock of the Company are changed, converted or exchanged, then there shall be substituted for each share of stock subject to the option granted hereby the number, kind or amount of shares of stock or other securities or cash, property, rights or obligations into which the outstanding shares of Common Stock of the Company shall be so changed, converted or exchanged as a result of such merger or consolidation. In the case of any such substitution or adjustment as provided in this paragraph, the option price referred to in this Agreement for the shares covered hereby shall be the option price for the shares or other securities or cash, property, rights or obligations which shall have been substituted for the shares covered hereby or to which such shares shall have been adjusted. Any adjustment or substitutions pursuant to this paragraph shall be made by the Committee, whose determination in the matter shall be conclusive and binding on the Company, the Employee and his legal representatives. 13. Forfeiture of Option Gain. The purpose of the Plan is to attract, retain and reward employees; to increase stock ownership and identification with the Company's interests; and to provide incentive for remaining with and enhancing the value of the Company and its Subsidiaries over the long-term. The Employee hereby acknowledges that in the course of employment with the Company, the Employee has been and will continue to be provided access to certain confidential and proprietary information and knowledge relating to the operation, products, and services of the Company and the Subsidiaries and has been and will continue to be trained and instructed in the unique business methods of the Company and the Subsidiaries. The Employee further acknowledges that in the course of employment with the Company, the 5 Employee has been and will continue to be entrusted with customer lists, financial information, and other confidential information regarding the Company's and the Subsidiaries' financial performance, shareholders, business plans, product development, product and system configurations, and other business methods and functions considered proprietary by the Company. As consideration for the above described training and access to confidential information and for the grant of this option, the Employee hereby agrees that if at any time within the term of the Option the Employee engages in any activity in competition with any activity of the Company (or its Subsidiaries), or inimical, contrary or harmful to the interests of the Company (or its Subsidiaries), including, but not limited to: (a) conduct related to the Employee's employment for which either criminal or civil penalties may be sought against the Employee; (b) violation of the policies of the Company, including, without limitation, the Company's insider trading policy; (c) disclosing or misusing any confidential information or material concerning the Company; (d) participating in a hostile takeover attempt; (e) making any statement (orally or in writing) about the Company and/or any Subsidiary or any service or product of the Company and/or the Subsidiaries which statement is false and may reasonably be expected to be detrimental to the Company and/or the Subsidiaries; then this option shall terminate effective as of the date on which the Employee engages in such activity, unless terminated sooner by operation of another term or condition of this Agreement or the Plan. 14. No Shareholder Rights. Neither the Employee nor his legal representative shall be or have any of the rights or privileges of a shareholder of the Company in respect to any of the shares issuable upon the exercise of this option unless and until certificates representing such shares shall have been issued and delivered to the Employee. 15. No Employment Obligation. Neither the granting of this option, the exercise of any part hereof, nor any provision of this Agreement shall constitute or be evidence of any understanding, express or implied, on the part of the Company to employ the Employee for any specified period. 16. Non-Transferability. This option shall, by its terms, be nontransferable by the Employee other than by will or the laws of descent and distribution. During the Employee's lifetime, the option shall be exercisable only by the Employee or by the Employee's duly appointed guardian or personal representative. 17. Construction. The Committee shall have authority to make reasonable constructions of this option and to correct any defect or supply any omission or reconcile any 6 inconsistency in this option, and to prescribe reasonable rules and regulations relating to the administration of this option and other similar options granted under the Plan. 18. Notices. Any notice relating to this Agreement shall be in writing and delivered in person or by registered mail to the Company at the Company's principal office, 13403 Northwest Freeway, Houston, Texas 77040-6094, or to such other address as may be hereafter specified by the Company, to the attention of its Treasurer. All notices to the Employee or other person or persons then entitled to exercise the option shall be delivered to the Employee or such other person or persons at the Employee's address specified on the signature page of this Agreement. 19. Confidentiality. The Employee agrees that, as partial consideration for the granting of this option, the Employee will keep confidential all information and knowledge which the Employee has relating to the manner and amount of the Employee's participation in the Plan; provided, however, that such information may be given in confidence to the Employee's spouse or to a financial institution to the extent that such information is necessary in order to secure a loan. 20. Effect of Payment. Any payment or any issuance or transfer of shares of the Common Stock to the Employee or the Employee's legal representative, heir, legatee or distributee, in accordance with the provisions hereof, shall, to the extent thereof, be in full satisfaction of all claims of such person hereunder. The Committee may require the Employee, legal representative, heir, legatee or distributee, as a condition precedent to such payment, to execute a release and receipt therefor in such form as it shall determine. 21. Incentive Stock Option. This option is intended to qualify as an "incentive stock option" within the meaning of Section 422 of the Code, and shall be so construed; provided, however, that nothing in this Agreement shall be interpreted as a representation, guarantee, or other understanding on the part of the Company that this option is or will be determined to be an "incentive stock option" within the meaning of that or any other section of the Code. 22. Miscellaneous. If any provision of this Agreement is held to be illegal, invalid, or unenforceable under any applicable laws, the legality, validity, and enforceability of the remaining provisions of this Agreement shall not be affected thereby, and in lieu of such illegal, invalid, or unenforceable provision, there shall be added automatically as a part of this Agreement a provision as similar in terms to such illegal, invalid, or unenforceable provision as may be possible and be legal, valid and enforceable. This Agreement constitutes the entire agreement of the parties with respect to the subject matter hereof and no provision hereof may be amended, modified or waived except by a written agreement signed by the parties. This Agreement may be executed in any number of counterparts, all of which shall be considered one and the same instrument. This Agreement shall be governed by and construed in accordance with the laws of the State of Texas, without regard to the conflicts of laws principles thereof, to the maximum extent practicable calls for performance and shall be performable at the offices of the Company in Houston, Harris County, Texas and venue for any dispute arising hereunder shall lie exclusively in the state and/or federal courts of Harris County, Texas and the Southern District of Texas, Houston Division, respectively. 7 23. Expiration of Agreement. IF THIS AGREEMENT IS NOT SIGNED AND RETURNED TO OUR OFFICES WITHIN 30 DAYS OF THE DATE OF EMPLOYEE'S RECEIPT OF THIS AGREEMENT, THIS AGREEMENT AND THE OPTION PROVIDED FOR HEREIN IS NULL AND VOID. 8 EX-10.15 5 h03402exv10w15.txt EMPLOYMENT AGREEMENT - STEPHEN L. WAY Exhibit 10.15 EMPLOYMENT AGREEMENT This EMPLOYMENT AGREEMENT ("Agreement") is entered into effective as of the 1st day of January, 2003 (the "Effective Date"), between HCC INSURANCE HOLDINGS, INC. ("HCC" or "Company") and STEPHEN L. WAY ("Executive"), sometimes collectively referred to herein as the "Parties." R E C I T A L S: WHEREAS, Executive is to be employed as Chief Executive Officer ("CEO") and Executive Chairman of the Board of HCC; WHEREAS, it is the desire of the Board of Directors of HCC (the "Board") to (i) directly engage Executive as an officer of HCC and its subsidiaries; and (ii) directly engage, if elected, the services of Executive as a director of HCC and its subsidiaries; WHEREAS, Executive is desirous of committing himself to serve HCC on the terms herein provided; and WHEREAS, Executive and HCC have previously entered into an Employment Agreement effective as of January 1, 2000 (the "2000 Contract") which is to be cancelled, terminated and of no further force or effect, as of the Effective Date. NOW, THEREFORE, in consideration of the foregoing and of the respective covenants and agreements set forth below, the Parties agree as follows: 1. TERMINATION OF 2000 CONTRACT AND TERM. Effective as of the Effective Date, the 2000 Contract shall be cancelled, terminated and of no further force or effect. The Company hereby agrees to employ Executive as its Chief Executive Officer and Executive Chairman of the Board, and Executive hereby agrees to accept such employment, on the terms and conditions set forth herein, for the period commencing on the Effective Date and expiring as of 11:59 p.m. on December 31, 2007 (unless sooner terminated or unless renewed as hereinafter set forth). Unless Executive or the Company has given written notice of termination at least 120 days before the end of any calendar year, at the end of each year of the term and any extension thereof, this Agreement shall be extended automatically and without any further action on the part of any party for an additional one year so that unless so terminated, Executive shall always have a five-year term remaining on this Agreement. As used herein the "Term" shall mean the initial five-year term and any subsequent renewal or renewals thereof. In addition, at Executive's sole election, at any time during the Term, Executive shall have the right to terminate his position as CEO, but continue as Executive Chairman of the Board, provided, in such event the Term of this Agreement shall continue for a period of five (5) years from the date Executive no longer serves as CEO, with no right to further renewals. 2. DUTIES. (A) DUTIES AS EMPLOYEE OF THE COMPANY. Executive shall, subject to the supervision of the Board of Directors, have general management and control of HCC in the ordinary course of its business with all such powers with respect to such management and control as may be reasonably incident to such responsibilities. During normal business hours, Executive shall devote substantially all of his time and attention to diligently attending to the business of the Company. During the Term, and except as shall exist prior to the date of this Agreement, Executive shall not directly or indirectly render any services of a business, commercial, or professional nature to any other person, firm, corporation, or organization, whether for compensation or otherwise, without the prior consent of the Board of Directors of HCC. However, Executive shall have the right to engage in such activities as may be appropriate in order to manage his personal investments so long as such activities do not interfere or conflict with the performance of his duties to the Company hereunder. The conduct of such activity shall not be deemed to materially interfere or conflict with Executive's performance of his duties until Executive has been notified in writing thereof and given a reasonable period in which to cure same. (B) OTHER DUTIES. At all times during the Term, the Company shall use its best efforts to cause Executive to be elected a director and to serve as Executive Chairman of the Board of HCC. Any such failure to use its best efforts prior to a Change of Control shall be a material breach of this Agreement for purposes of Section (4)(a)(iv). Executive agrees to serve as a director and member of HCC and of any of its subsidiaries and in one or more executive offices of any of HCC's subsidiaries, provided Executive is indemnified for serving in any and all such capacities in a manner acceptable to the Company and Executive. Executive agrees that while a full time employee he shall not be entitled to receive any compensation for serving as a director of HCC, or in any capacities of HCC's subsidiaries other than the compensation to be paid to Executive by the Company pursuant to this Agreement. If Executive is not a full time employee, he shall be compensated as an outside director. 3. COMPENSATION AND RELATED MATTERS. (A) BASE SALARY AND DEFERRED COMPENSATION (1) Executive shall receive a base salary (the "Base Salary") paid by the Company at the annual rate of $800,000, during the period beginning on the Effective Date and for each year of the Term, payable not less frequently than in substantially equal monthly installments (or such other more frequent times as executives of HCC normally are paid). (2) In addition to the Base Salary, Executive shall receive deferred compensation (the "Deferred Compensation") of $400,000 for each calendar year or portion thereof of the Term. Such Deferred Compensation shall be credited to Executive on December 31st of each calendar year, or portion thereof, during the Term and shall earn interest at the rate of the prime lending rate announced by the Bank of America, N.A. from time-to-time, plus one (1) percent. The Deferred Compensation shall be paid to Executive in one lump sum payment at the time Executive terminates his employment with HCC. 2 (3) If Executive elects to terminate his position as CEO but remain as Executive Chairman of the Board, the Base Salary set forth in (i) above shall be reduced from $8000,000 to $500,000 per annum (and all other terms of this Agreement shall continue to apply). (B) BONUS PAYMENTS. During the Term, Executive shall be entitled to receive, in addition to the Base Salary, an annual cash bonus payment in amounts to be determined at the sole discretion of the Compensation Committee. (C) EXPENSES. During the Term of this Agreement and the Consulting Period, defined hereunder, Executive shall be entitled to receive prompt reimbursement for all reasonable expenses incurred by him (in accordance with the policies and procedures established by the Board for the Companys senior executive officers) in performing services hereunder, provided that Executive properly accounts therefor in accordance with Company policy. (D) OTHER BENEFITS. Executive shall be entitled to participate in or receive benefits under any compensation employee benefit plan or other arrangement made available by the Company now or in the future to its senior executive officers and key management employees, subject to and on a basis consistent with the terms, conditions, and overall administration of such plan or arrangement. Nothing paid to Executive under any plan or arrangement presently in effect or made available in the future shall be deemed to be in lieu of the Base Salary or Defined Compensation payable to Executive pursuant to subsection (a) of this Section. The Company shall not make any changes in any employee benefit plans or other arrangements in effect on the date hereof or subsequently in effect in which Executive currently or in the future participates (including, without limitation, each pension and retirement plan, supplemental pension and retirement plan, savings and profit sharing plan, stock or unit ownership plan, stock or unit purchase plan, stock or unit option plan, life insurance plan, medical insurance plan, disability plan, dental plan, health and accident plan, or any other similar plan or arrangement) that would adversely affect Executive's rights or benefits thereunder, unless such change occurs pursuant to a program applicable to substantially all executives of the Company and does not result in a proportionately greater reduction in the rights of or benefits to Executive as compared with any other executive of the Company. (E) VACATIONS. Executive shall be entitled to forty (40) paid vacation days per year during the Term, or such additional number as may be determined by the Board from time to time. There shall be indefinite carryovers of unused vacation from year to year. For purposes of this Section, weekends shall not count as vacation days, and Executive shall also be entitled to all paid holidays given by the Company to its senior executive officers. (F) PERQUISITES. Executive shall be entitled to receive the perquisites and fringe benefits applicable to a senior executive officer of HCC in accordance with any practice established by the Compensation Committee. Notwithstanding, and in addition to, any perquisites to which Executive is entitled pursuant to the preceding sentence, Executive shall: (i) have the use of two company vehicles similar to those Executive has been provided prior to the date of this Agreement and the Company shall pay all expenses related to Executive's use of such automobiles, including gasoline, insurance, and maintenance. At the beginning of each calendar year of the Term, HCC 3 shall replace the older vehicle (or if both are the same age--one of such vehicles) with a new vehicle. Executive shall receive ownership to both such vehicles upon termination of Executive's employment; (ii) be allowed to travel with his spouse on business utilizing First Class passage under the Company's corporate account, as Executive determines; (iii) receive reimbursement of annual country club dues for Executives membership in Lochinvar Country Club, Shadow Hawk County Club plus one additional country club to be determined by Executive. In addition, Executive shall have the right to change membership in any such club and to obtain membership to any other club (at Company's sole cost) so long as Company is not required to hold membership in, or pay dues for, more than three (3) such country clubs at any one time. Following termination of this Agreement, Executive shall be bonused such ownership; (iv) receive all existing life insurance plus an additional term or life policy in an amount equal to $5,000,000. Upon Executive's termination, all such life insurance shall be converted to ordinary life insurance to be owned by Executive or Executive's designee; (v) be entitled to utilize an office at the Companys executive offices or, at Executives election, to be reimbursed for the utilization of an office at Executives home; (vi) be entitled to utilize the services of Company employees at an estimated aggregate annual cost of $400,000 (which shall be added to Executives taxable income) during the Term and the Consulting Period; (vii) have the right to utilize during the Term and the Consulting Period at no cost to Executive, the use of the Company's airplanes (subject to being taxed on the basis of a first class ticket for transportation for personal use) and the pilots and engineers employed by the Company pursuant to the contractual arrangement in existence as of the Effective Date hereof; and (viii) be entitled to be reimbursed for all methods of communications used by Executive (including, without limitation, the installation cost and use of software, telephone, facsimile machines, etc., other similar equipment, and all upgrades thereof) in Executives house, aircraft and boat which shall continue through the Term and the Consulting Period. In addition to all other benefits provided for in this Agreement, Executive shall be entitled to receive medical insurance as currently provided under the Company's group program, as such may be changed from time to time in the future, and Executive shall be entitled to continue to be covered by such group program, or, if not permitted under the terms of the group program, then the Company shall provide Executive with a medical insurance policy providing substantially similar benefits as to the group program for the period ending on the later of: (i) the date of Executive's death; (ii) if Executive is married on the date of his death, the date of the death of Executive's spouse; or (iii) as to each minor dependent of Executive, the later of the date that each such dependent reaches the age of twenty-five or completes college (as defined in the Company's group program). Executive shall be entitled to receive the medical benefits defined herein at no cost to the Executive. The Company shall pay for Executive's preparation of estate planning and wealth preservation documents during the course of Executive's employment with the Company. Such estate planning and wealth preservation documents may be changed from time to time, at the Company's cost and expense, pursuant to Executive's changing circumstances. During Executive's employment he has been instrumental in designing and utilizing the Company's Logo, Executive shall, during the Term of this Agreement be entitled to utilize such Logo in such manner as Executive may determine and, in the event of a Change of Control, as defined below, such Logo shall belong exclusively to Executive. 4 (G) PRORATION. Any payments or benefits payable to Executive hereunder in respect of any calendar year during which Executive is employed by the Company for less than the entire year, unless otherwise provided in the applicable plan or arrangement or herein, shall be prorated in accordance with the number of days in such calendar year during which he is so employed. Notwithstanding the foregoing, any payments pursuant to Sections 4(c) or 4(d) of this Agreement shall not be subject to proration. 4. TERMINATION. (A) DEFINITIONS. (1) "CAUSE" shall mean: (i) Material dishonesty which is not the result of an inadvertent or innocent mistake of Executive with respect to the Company or any of its subsidiaries; (ii) Willful misfeasance or nonfeasance of duty by Executive intended to injure or having the effect of injuring in some material fashion the reputation, business, or business relationships of the Company or any of its subsidiaries or any of their respective officers, directors, or employees; (iii) Material violation by Executive of any material term of this Agreement; or (iv) Conviction of Executive of any felony, any crime involving moral turpitude or any crime other than a vehicular offense which could reflect in some material fashion unfavorably upon the Company or any of its subsidiaries. Executive may not be terminated for Cause unless and until there has been delivered to Executive written notice from the Board supplying the particulars of Executive's acts or omissions that the Board believes constitute Cause, a reasonable period of time (not less than 30 days) has been given to Executive after such notice to either cure the same or to meet with the Board, with his attorney if so desired by Executive, and following which the Board by action of not less than two-thirds of its members furnishes to Executive a written resolution specifying in detail its findings that Executive has been terminated for Cause as of the date set forth in the notice to Executive. (2) A "CHANGE OF CONTROL" shall be deemed to have occurred if: (i) Any "person" or "group" (within the meaning of Sections 13(d) and 14(d)(2) of the Securities Exchange Act of 1934) other than a trustee or other fiduciary holding securities under an employee benefit plan of the Company becomes the "beneficial owner" (as defined in Rule 13d-3 under the Securities Exchange Act of 1934), directly or indirectly, of 50% or more of the Company's then outstanding voting common stock; or 5 (ii) At any time during the period of three (3) consecutive years (not including any period prior to the date hereof), individuals who at the beginning of such period constituted the Board (and any new director whose election by the Board or whose nomination for election by the Company's shareholders were approved by a vote of at least two-thirds of the directors then still in office who either were directors at the beginning of such period or whose election or nomination for election was previously so approved) cease for any reason to constitute a majority thereof; or (iii) The shareholders of the Company approve a merger or consolidation of the Company with any other corporation, other than a merger or consolidation (a) in which a majority of the directors of the surviving entity were directors of the Company prior to such consolidation or merger, and (b) which would result in the voting securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being changed into voting securities of the surviving entity) more than 50% of the combined voting power of the voting securities of the surviving entity outstanding immediately after such merger or consolidation; or (iv) The shareholders approve a plan of complete liquidation of the Company or an agreement for the sale or disposition by the Company of all or substantially all of the Company's assets. (3) A "DISABILITY" shall mean the absence of Executive from Executive's duties with the Company on a full-time basis for 180 consecutive days, or 180 days in a 365-day period, as a result of incapacity due to mental or physical illness which results in the Executive being unable to perform the essential functions of his position, with or without reasonable accommodation. (4) A "GOOD REASON" shall mean any of the following (without Executive's express written consent): (i) A material alteration in the nature or status of Executive's title, duties or responsibilities, or the assignment of duties or responsibilities inconsistent with Executive's status, title, duties and responsibilities; (ii) A failure by the Company to continue in effect any employee benefit plan in which Executive was participating, or the taking of any action by the Company that would adversely affect Executive's participation in, or materially reduce Executive's benefits under, any such employee benefit plan, unless such failure or such taking of any action adversely affects the senior members of corporate management of the Company generally to the same extent; (iii) A relocation of the Company's principal executive offices, or Executive's relocation to any place other than the principal executive offices, 6 exceeding a distance of fifty (50) miles from the Company's current executive office located in Houston, Texas, except for reasonably required travel by Executive on the Company's business; (iv) Any material breach by the Company of any provision of this Agreement; or (v) Any failure by the Company to obtain the assumption and performance of this Agreement by any successor (by merger, consolidation, or otherwise) or assign of the Company. However, Good Reason shall exist with respect to an above specified matter only if such matter is not corrected by the Company within thirty (30) days of its receipt of written notice of such matter from Executive, and in no event shall a termination by Executive occurring more than ninety (90) days following the date of the event described above be a termination for Good Reason due to such event. (5) "TERMINATION DATE" shall mean the date Executive terminated for any reason pursuant to this Agreement. (B) TERMINATION WITHOUT CAUSE, OR TERMINATION FOR GOOD REASON: BENEFITS. In the event there is a termination by the Company without Cause, or if Executive terminates for Good Reason, or if there is a Change of Control (a "Termination Event"), this Agreement shall terminate except as provided in Section 6, and Executive shall be entitled to the following severance benefits: (1) Base Salary and Deferred Compensation (as defined in Section 3(a)), at the rate and payable at Executive's option (or the option of Executive's estate) within sixty (60) days in a lump sum payment or such longer period of time as Executive shall determine. (2) To the extent not theretofore paid or provided, or otherwise set forth herein, the Company shall timely pay or provide to Executive any other amounts or benefits required to be paid or provided or which Executive is eligible to receive under any plan, program, policy or practice, or contract or agreement of the Company and its affiliated companies for the period of time equal to the remainder of the Term, at its sole expense, and shall continue to provide (through its own plan and/or individual policies) Executive (and Executive's dependents) with health benefits no less favorable than the group health plan benefits provided during such period to any senior executive officer of the Company or any affiliated company (to the extent any such coverage or benefits are taxable to Executive by reason of being provided under a self-insured health plan of the Company or an affiliate, the Company shall make Executive "whole" for the same on an after-tax basis), provided, however, such coverage shall be secondary to any group health plan coverage Executive (or his dependents) receive from another employer, (such other amounts and benefits shall be hereinafter referred to as the "Other Benefits"); 7 (3) If Executive receives any payments whether or not pursuant to this Agreement which are subject to an excise tax imposed under Section 4999 of the Internal Revenue Code of 1986, as amended, or any similar tax imposed under federal, state, or local law (collectively, "Excise Taxes"), the Company shall pay to Executive (on or before the date on which the Company is required to withhold such Excise Taxes), 1) an additional amount equal to all Excise Taxes then due and payable, and 2) the amount necessary to defray Executive's increased (federal, state, and local) tax liability arising due to payment of the amount specified in this Subsection (4) which shall include any costs and expenses, including penalties and interest incurred by Executive in connection with any audit, proceedings, etc. related to the payment of such Excise Taxes or this payment. For purposes of calculating the amount payable to Executive under this Section, the federal and state income tax rates used shall be the highest marginal federal and state rates applicable to ordinary income in Executive's state of residence, taking into account any federal income tax deductions or credits available to Executive for state income taxes. The Company shall cause its independent auditors to calculate such amount and provide Executive a copy of such calculation at least ten (10) days prior to the date specified above for payment of such amount. It is the intent of the Parties that this Subsection (4) shall place Executive in the same net after-tax position Executive would have been in had no payment been subject to an Excise Tax and, notwithstanding anything to the contrary, it shall be construed to effectuate said result; (4) All accrued compensation and unreimbursed expenses through the Termination Date. Such amounts shall be paid to Executive in a lump sum in cash within thirty (30) days after the Termination Date; and (5) Executive shall be free to accept other employment during such period, and there shall be no offset of any employment compensation earned by Executive in such other employment during such period against payments due Executive under this Section 4, and there shall be no offset in any compensation received from such other employment against the Base Salary set forth above. (6) In addition to all amounts otherwise paid to Executive pursuant to this Agreement, all amounts that Executive would otherwise have received during the Consulting Period, including, without limitation, all perquisites, as set forth in subsection 3(f). (C) TERMINATION IN EVENT OF DEATH: BENEFITS. If Executive's employment is terminated by reason of Executive's death during the Term of this Agreement, this Agreement shall terminate except as provided in Section 6 without further obligation to Executive's legal representatives under this Agreement, other than for payment of all compensation and unreimbursed expenses, as Executive would have been entitled to during the remaining portion of the Term and the Consulting Period, the timely payment or provision of Other Benefits through the date of death, and, if such death occurs on or after October 1 of any year, such cash or stock bonus as Executive would otherwise have been awarded in such year if Executives death had not occurred. Such amounts shall be paid to Executive's estate or beneficiary, as applicable, in a lump sum in cash within ninety (90) days after the date of death. 8 (D) TERMINATION IN EVENT OF DISABILITY: BENEFITS. If Executive's employment is terminated by reason of Executive's Disability during the Term, except as provided for in Section 6, this Agreement shall terminate and Executive shall receive payment of all compensation for the Term plus the Consulting Period, and if such Disability occurs on or after October 1 of any year, Executive shall be entitled to the same cash or stock bonus in such year that Executive would have been awarded if such Disability had not occurred. Executive's compensation shall not be reduced by any long-term disability coverage Executive actually receives. (E) VOLUNTARY TERMINATION BY EXECUTIVE AND TERMINATION FOR CAUSE: BENEFITS. Executive may terminate his employment with the Company without Good Reason by giving written notice of his intent and stating an effective Termination Date at least ninety (90) days after the date of such notice; provided, however, that the Company may accelerate such effective date by paying Executive through the proposed Termination Date and also vesting awards that would have vested but for this acceleration of the proposed Termination Date. Upon such a termination by Executive, except as provided in Section 6, or upon termination for Cause by the Company, this Agreement shall terminate, and the Company shall pay to Executive all accrued compensation, unreimbursed expenses and the Other Benefits through the Termination Date. Such amounts shall be paid to Executive in a lump sum in cash within thirty (30) days after the date of termination. (F) DIRECTOR POSITIONS. Upon termination of employment, for any reason Executive shall remain on any and all Board positions held with the Company and/or any of its subsidiaries and affiliates. At such time, Executive shall be paid as an outside director. 5. NON-COMPETITION, NON-SOLICITATION, AND CONFIDENTIALITY. At the inception of this employment relationship, and continuing on an ongoing basis, the Company agrees to give Executive access to Confidential Information (including, without limitation, Confidential Information, as defined below, of the Company's Affiliates) which the Executive has not had access to or knowledge of before the execution of this Agreement. At the time this Agreement is made, the Company agrees to provide Executive with initial and ongoing Specialized Training, which Executive has not had access to or knowledge of before the execution of this Agreement. "Specialized Training" includes the training the Company provides to its employees that is unique to its business and enhances Executive's ability to perform Executive's job duties effectively. Specialized Training includes, without limitation, orientation training; sales methods/techniques training; operation methods training; and computer and systems training. In consideration of all of the foregoing, Executive agrees as follows: (A) NON-COMPETITION DURING EMPLOYMENT. Executive agrees that, in consideration for the Company's promise to provide Executive with Confidential Information and Specialized Training, during the Term he will not compete with the Company by engaging in the conception, design, development, production, marketing, or servicing of any product or service that is substantially similar to the products or services which the Company provides, and that he will not work for, in any capacity, assist, or become affiliated with as an owner, partner, etc., either directly or indirectly, any individual or business which offers or performs services, or offers or provides products substantially similar to the services and products provided by Company. 9 (B) CONFLICTS OF INTEREST. Executive agrees that during the Term, he will not engage, either directly or indirectly, in any activity (a "Conflict of Interest") which might adversely affect the Company or its affiliates, including ownership of a material interest in any supplier, contractor, distributor, subcontractor, customer or other entity with which the Company does business or accepting any material payment, service, loan, gift, trip, entertainment, or other favor from a supplier, contractor, distributor, subcontractor, customer or other entity with which the Company does business, and that Executive will promptly inform the Chairman of the Company as to each offer received by Executive to engage in any such activity. Executive further agrees to disclose to the Company any other facts of which Executive becomes aware which might in Executives good faith judgment reasonably be expected to involve or give rise to a Conflict of Interest or potential Conflict of Interest. (C) NON-COMPETITION AFTER TERMINATION. Executive agrees that Executive shall not, at any time during the period of two (2) years after the termination of the Term for any reason, within any of the markets in which the Company has sold products or services or formulated a plan to sell products or services into a market during the last twelve (12) months of Executive's employ; engage in or contribute Executive's knowledge to any work which is competitive with or similar to a product, process, apparatus, service, or development on which Executive worked or with respect to which Executive had access to Confidential Information while employed by the Company; provided, however, this subsection (c) shall not operate to prevent Executive from engaging in retail insurance or re-insurance activities during such two-year period to the extent such activities do not compete or permit any other person or entity to compete with any business the Company or any of its subsidiaries or affiliated companies were engaged in at the time of such termination. Following the expiration of said two (2) year period, Executive shall continue to be obligated under the Confidential Information Section of this Agreement not to use or to disclose Confidential Information of the Company so long as it shall not be publicly available. It is understood that the geographical area set forth in this covenant is divisible so that if this clause is invalid or unenforceable in an included geographic area, that area is severable and the clause remains in effect for the remaining included geographic areas in which the clause is valid. (d) NON-SOLICITATION OF CUSTOMERS. Executive further agrees that for a period of two (2) years after the termination of the Term, he will not solicit or accept any business from any customer or client or prospective customer or client with whom Executive dealt or solicited while employed by Company during the last twelve (12) months of his employment. (e) NON-SOLICITATION OF EMPLOYEES. Executive agrees that for the duration of the Term, and for a period of two (2) years after the termination of the Term except for Frank J. Bramanti, L. Edward Tuffley, Byron Way and Rosemary Gilarade, and Executive's personal service employees, he will not either directly or indirectly, on his own behalf or on behalf of others, solicit, attempt to hire, or hire any person employed by Company to work for Executive or for another entity, firm, corporation, or individual. (f) CONFIDENTIAL INFORMATION. Executive further agrees that he will not, except as the Company may otherwise consent or direct in writing, reveal or disclose, sell, use, lecture upon, 10 publish or otherwise disclose to any third party any Confidential Information or proprietary information of the Company, or authorize anyone else to do these things at any time either during or subsequent to his employment with the Company. This Section shall continue in full force and effect after termination of Executive's employment and after the termination of this Agreement. Executive's obligations under this Section with respect to any specific Confidential Information and proprietary information shall cease when that specific portion of the Confidential Information and proprietary information becomes publicly known, in its entirety and without combining portions of such information obtained separately. It is understood that such Confidential Information and proprietary information of the Company include matters that Executive conceives or develops, as well as matters Executive learns from other employees of Company. Confidential Information is defined to include information: (1) disclosed to or known by the Executive as a consequence of or through his employment with the Company; (2) not generally known outside the Company; and (3) which relates to any aspect of the Company or its business, finances, operation plans, budgets, research, or strategic development. "Confidential Information" includes, but is not limited to the Company's trade secrets, proprietary information, financial documents, long range plans, customer lists, employer compensation, marketing strategy, data bases, costing data, computer software developed by the Company, investments made by the Company, and any information provided to the Company by a third party under restrictions against disclosure or use by the Company or others. (g) RETURN OF DOCUMENTS, EQUIPMENT, ETC. All writings, records, and other documents and things comprising, containing, describing, discussing, explaining, or evidencing any Confidential Information, and all equipment, components, parts, tools, and the like in Executive's custody or possession that have been obtained or prepared in the course of Executive's employment with the Company shall be the exclusive property of the Company, shall not be copied and/or removed from the premises of the Company, except in pursuit of the business of the Company, and shall be delivered to the Company, without Executive retaining any copies, upon notification of the termination of Executive's employment or at any other time requested by the Company. The Company shall have the right to retain, access, and inspect all property of Executive of any kind in the office, work area, and on the premises of the Company upon termination of Executive's employment and at any time during employment by the Company to ensure compliance with the terms of this Agreement. (h) REAFFIRM OBLIGATIONS. Upon termination of his employment with the Company, Executive, if requested by Company, shall reaffirm in writing Executive's recognition of the importance of maintaining the confidentiality of the Company's Confidential Information and proprietary information, and reaffirm any other obligations set forth in this Agreement. (i) PRIOR DISCLOSURE. Executive represents and warrants that he has not used or disclosed any Confidential Information he may have obtained from Company prior to signing this Agreement, in any way inconsistent with the provisions of this Agreement. (j) CONFIDENTIAL INFORMATION OF PRIOR COMPANIES. Executive will not disclose or use during the period of his employment with the Company any proprietary or Confidential Information or Copyright Works which Executive may have acquired because of employment with 11 an employer other than the Company or acquired from any other third party, whether such information is in Executive's memory or embodied in a writing or other physical form. (k) BREACH. Executive agrees that any breach of Sections 5(a), (c), (d), (e) or (f) above cannot be remedied solely by money damages, and that in addition to any other remedies Company may have, Company is entitled to obtain injunctive relief against Executive. Nothing herein, however, shall be construed as limiting Company's right to pursue any other available remedy at law or in equity, including recovery of damages and termination of this Agreement and/or any payments that may be due pursuant to this Agreement. (l) RIGHT TO ENTER AGREEMENT. Executive represents and covenants to Company that he has full power and authority to enter into this Agreement and that the execution of this Agreement will not breach or constitute a default of any other agreement or contract to which he is a party or by which he is bound. (m) EXTENSION OF POST-EMPLOYMENT RESTRICTIONS. In the event Executive breaches Sections 5(b), (d), or (e) above, the restrictive time periods contained in those provisions will be extended by the period of time Executive was in violation of such provisions. (n) ENFORCEABILITY. The agreements contained in Section 5 are independent of the other agreements contained herein. Accordingly, failure of the Company to comply with any of its obligations outside of this Section do not excuse Executive from complying with the agreements contained herein. (o) SURVIVABILITY. The agreements contained in Sections 5 shall survive the termination of this Agreement for any reason. 6. CONSULTING AGREEMENT. Effective upon Executives termination of employment for any reason other than Executives termination by the Company for Cause, HCC hereby retains Executive as a consultant (an independent contractor and not as an employee) for a period of five (5) years (the "Consulting Period"). During the Consulting Period, Executive shall have the sole option to cease acting as Executive Chairman of the Board and shall thereafter serve as Non-Executive Chairman of the Board. Termination of the Term shall not effect the Parties' rights and obligations under this Section 6, subject to the following: Executive agrees to provide, if requested, 1,000 hours of service (the "Consulting Services") per year, as required by the Company. Prior to a Change of Control, the Company shall use its best effort to cause Executive to continue as a Director and Chairman of the Board during the term of the Consulting Period. HCC shall pay Executive $450,000 per year of the Consulting Period, payable quarterly, in advance. Executive may elect to delay payment for services, but not the services themselves. During such Consulting Period, Executive shall receive, to the extent permitted by law and the terms of any existing plan, all of the Company's benefits as if Executive was a full time employee. In addition, the terms of this Section 6 shall remain in full force and effect whether or not Executive dies or suffers a Disability pursuant to the terms hereof during the Consulting Period. Further, if at any time during the Term of this Agreement Executive shall elect, at his sole option, to cease being a full time employee, then and in that event, Executive shall become a consultant pursuant to the terms of this Section. During the Consulting 12 Period, Executive shall have the right to the same benefits for the same purposes and to the same extent as were in effect during the term of this Agreement, provided, however, if Executive ceases to be the Executive Chairman, Executive shall no longer receive Deferred Compensation.. The Consulting Services to be provided shall be commensurate with Executive's training, background, experience and prior duties with the Company. Executive shall receive such stock options or cash bonuses as the Compensation Committee, in its sole discretion shall determine. Executive agrees to make himself reasonably available to provide such Consulting Services during the Consulting Period; provided, however, the Company agrees that it shall provide reasonable advance notice to Executive of its expected consulting needs and any request for Consulting Services hereunder shall not unreasonably interfere with Executive's other business activities and personal affairs as determined in good faith by Executive. In addition, Executive shall not be required to perform any requested Consulting Services which, in Executive's good faith opinion, would cause Executive to breach any fiduciary duty or contractual obligation Executive may have to another employer. Further, during the Consulting Period, Executive shall not be subject to any non-competition provisions except for the two-year period provided for in Section 5(c). Unless waived by Executive, Executive shall not be required to perform Consulting Services for more than four (4) days during any week or for more than eight (8) hours during any day. Executives travel time shall constitute hours of Consulting Services for purposes of this Section 6. The Parties contemplate that, when appropriate, the Consulting Services shall be performed at Executive's office or residence and at the Company's executive offices in Houston, Texas and may be performed at such other locations only as they may mutually agree upon. Executive shall be properly reimbursed for all travel and other expenses reasonably incurred by Executive in rendering the Consulting Services. 7. ASSIGNMENT. This Agreement cannot be assigned by Executive. The Company may assign this Agreement only to a successor (whether direct or indirect, by purchase, merger, consolidation or otherwise) to all or substantially all of the business and assets of the Company provided such successor expressly agrees in writing reasonably satisfactory to Executive to assume and perform this Agreement in the same manner and to the same extent that the Company would be required to perform it if no such succession and assignment had taken place. Failure of the Company to obtain such written agreement prior to the effectiveness of any such succession shall be a material breach of this Agreement. 8. BINDING AGREEMENT. Executive understands that his obligations under this Agreement are binding upon Executive's heirs, successors, personal representatives, and legal representatives. 9. NOTICES. All notices pursuant to this Agreement shall be in writing and sent certified mail, return receipt requested, addressed as set forth below, or by delivering the same in person to such party, or by transmission by facsimile to the number set forth below (which shall not constitute notice). Notice deposited in the United States Mail, mailed in the manner described herein above, shall be effective upon deposit. Notice given in any other manner shall be effective only if and when received: If to Executive: Stephen L. Way 10 East Bend Lane 13 Houston, Texas 77007 Fax: (713) 864-2822 If to Company: HCC Insurance Holdings, Inc. 13403 Northwest Freeway Houston, Texas 77040 Fax: (713) 462-2401 Attention: General Counsel with a copy (which shall Arthur S. Berner, Esq. not constitute notice) to: Haynes and Boone, LLP 1000 Louisiana Street, Suite 4300 Houston, Texas 77002-5012 Fax: (713) 236-5652 10. WAIVER. No waiver by either party to this Agreement of any right to enforce any term or condition of this Agreement, or of any breach hereof, shall be deemed a waiver of such right in the future or of any other right or remedy available under this Agreement. 11. SEVERABILITY. If any provision of this Agreement is determined to be void, invalid, unenforceable, or against public policy, such provisions shall be deemed severable from the Agreement, and the remaining provisions of the Agreement will remain unaffected and in full force and effect. 12. ARBITRATION. In the event any dispute arises out of Executive's employment with or by the Company, or separation/termination therefrom, whether as an employee or as a consultant which cannot be resolved by the Parties to this Agreement, such dispute shall be submitted to final and binding arbitration. The arbitration shall be conducted in accordance with the National Rules for the resolution of Employment Disputes of the American Arbitration Association ("AAA"). If the Parties cannot agree on an arbitrator, a list of seven (7) arbitrators will be requested from AAA, and the arbitrator will be selected using alternate strikes with Executive striking first. The cost of the arbitration will be shared equally by Executive and Company; provided, however, the Company shall promptly reimburse Executive for all costs and expenses incurred in connection with any dispute in an amount up to, but not exceeding twenty percent (20%) of Executives Base Salary (or, if the dispute arises during the Consulting Period, Executive's Base Salary as in effect immediately prior to the beginning of the Consulting Period) unless such termination was for Cause in which event Executive shall not be entitled to reimbursement unless and until it is determined he was terminated other than for Cause. Arbitration of such disputes is mandatory and in lieu of any and all civil causes of action and lawsuits either party may have against the other arising out of Executive's employment with Company, or separation therefrom. Such arbitration shall be held in Houston, Texas. 13. ENTIRE AGREEMENT. The terms and provisions contained herein shall constitute the entire agreement between the parties with respect to Executive's employment with Company during the time period covered by this Agreement. This Agreement replaces and supersedes any and all 14 existing Agreements entered into between Executive and the Company relating generally to the same subject matter, if any, and shall be binding upon Executive's heirs, executors, administrators, or other legal representatives or assigns. 14. MODIFICATION OF AGREEMENT. This Agreement may not be changed or modified or released or discharged or abandoned or otherwise terminated, in whole or in part, except by an instrument in writing signed by the Executive and an officer or other authorized executive of Company. 15. EFFECTIVE DATE. It is understood by Executive that this Agreement shall be effective when signed by both Company and Executive. 16. GOVERNING LAW. This Agreement shall be governed by and construed in accordance with the laws of the State of Texas. 17. JURISDICTION AND VENUE. With respect to any litigation regarding this Agreement, Executive agrees to venue in the state or federal courts in Harris County, Texas, and agrees to waive and does hereby waive any defenses and/or arguments based upon improper venue and/or lack of personal jurisdiction. By entering into this Agreement, Executive agrees to personal jurisdiction in the state and federal courts in Harris County, Texas. [REMAINDER OF THIS PAGE LEFT INTENTIONALLY BLANK] 15 IN WITNESS WHEREOF, the Parties have executed this Agreement in multiple copies, effective as of the date first written above. EXECUTIVE COMPANY HCC INSURANCE HOLDINGS, INC. /s/ Stephen L. Way By: /s/ Walter J. Lack - --------------------------------- --------------------------------- STEPHEN L. WAY WALTER J. LACK, Chairman of the Compensation Committee Date: March 26, 2003 Date: March 26, 2003 ----------------------------- ------------------------------ [SIGNATURE PAGE OF WAY EMPLOYMENT AGREEMENT] EX-10.16 6 h03402exv10w16.txt EMPLOYMENT AGREEMENT - CRAIG J. KELBEL EXHIBIT 10.16 EMPLOYMENT AGREEMENT This EMPLOYMENT AGREEMENT ("Agreement") is entered into effective as of the 10th day of January, 2002 (the "Effective Date"), between HCC INSURANCE HOLDINGS, INC. ("HCC" or the "Company"), and CRAIG J. KELBEL ("Executive"), sometimes collectively referred to herein as the "Parties." R E C I T A L S: WHEREAS, Executive is to be employed as an Executive Vice President; WHEREAS, it is the desire of the Board of Directors of HCC (the "Board") to directly engage Executive as an officer of HCC and its Subsidiaries; WHEREAS, Executive is desirous of committing himself to serve HCC on the terms herein provided; and WHEREAS, Executive has previously entered into an Employment Agreement dated as of the 4th day of June, 1999 (the "1999 Agreement"), which such agreement, having been made with HCC Benefits Corporation is to be terminated hereby; NOW, THEREFORE, in consideration of the foregoing and of the respective covenants and agreements set forth below, the Parties agree as follows: 1. TERM. Effective as of the Effective Date, the 1999 Agreement is terminated in its entirety and the Company hereby agrees to employ Executive as an Executive Vice President, and Executive hereby agrees to accept such employment, on the terms and conditions set forth herein, for the period commencing on the Effective Date and expiring as of 11:59 p.m. on December 31, 2005 (the "Basic Term") (unless sooner terminated as hereinafter set forth). 2. DUTIES. (a) DUTIES AS EMPLOYEE OF THE COMPANY. Executive shall, subject to the supervision of the President of the Company, act as an Executive Vice President of HCC in the ordinary course of its business with all such powers with respect to such management and control as may be reasonably incident to such responsibilities. During normal business hours, Executive shall devote his full time and attention to diligently attending to the business of the Company during the Basic Term. During the Basic Term, Executive shall not directly or indirectly render any services of a business, commercial, or professional nature to any other person, firm, corporation, or organization, whether for compensation or otherwise, without the prior written consent of the President of HCC. However, Executive shall have the right to engage in such activities as may be appropriate in order to manage his personal investments so long as such activities do not materially interfere or conflict with the performance of his duties to the Company hereunder. The conduct of such activity shall not be deemed to materially interfere or conflict with Executive's performance of his duties until Executive has been notified in writing thereof and given a reasonable period in which to cure the same. (b) OTHER DUTIES. If elected, Executive agrees to serve as a member of such managerial Committees of HCC and of any of its Subsidiaries and in one or more executive offices of any of HCC's Subsidiaries, provided Executive is indemnified for serving in any and all such capacities in a manner acceptable to the Company and Executive. If elected, Executive agrees that he shall not be entitled to receive any compensation for serving as a director of HCC, or in any capacities of HCC's Subsidiaries other than the compensation to be paid to Executive by the Company pursuant to this Agreement. 3. COMPENSATION AND RELATED MATTERS. (a) BASE SALARY. Executive shall receive a base salary paid by the Company as follows: $425,000 for 2002; $450,000 for 2003; $475,000 for 2004; and $500,000 for 2005 to be paid in substantially equal monthly installments. For purposes of this Agreement, "Base Salary" shall mean the Executive's initial base salary and, as increased, the increased base salary. (b) BONUS PAYMENTS. Pursuant to the 1999 Agreement, Executive was to receive payments of $100,000 in each of 2002 and 2003. Executive will be paid $200,000 on January 2, 2002 in full settlement of such payments. In addition, Executive shall be entitled to receive a bonus in the amount of $10,000 for each Subsidiary (defined below) which achieves on an annual basis pre-tax net earnings equal to the approved budget for such Subsidiary. In addition, Executive shall be entitled to an additional bonus of $50,000 if the total on an annual basis for all of such Subsidiaries' pre-tax net earnings exceeds, in the aggregate, the budget for such Subsidiaries. For purposes of this Agreement, Subsidiary shall mean HCC Employee Benefits; Rattner McKenzie Ltd.; HCC Benefits; PIA, ASU and LDG Re (run off only). (c) OPTIONS. Executive shall receive options to acquire 100,000 shares of HCC Common Stock. Such options shall become vested in four equal installments of 25,000 shares commencing January 1, 2003, and on each January 1 thereafter. The option shall terminate on December 31, 2007. The option grant price shall be determined in accordance with the Company's Stock Option Plan on the date of grant which shall be no later than January 30, 2002. (d) EXPENSES. During the Basic Term, Executive shall be entitled to receive prompt reimbursement for all reasonable expenses incurred by him (in accordance with the policies and procedures established by the Board for the Company's senior executive officers) in performing services hereunder, provided that Executive properly accounts therefor in accordance with Company policy. (e) OTHER BENEFITS. Executive shall be entitled to participate in or receive benefits under any compensation, employee benefit plan, or other arrangement made generally available by the Company now or in the future to its senior executive officers, subject to and on a basis consistent with the terms, conditions, and overall administration of such plan or arrangement. Nothing paid to Executive under any plan or arrangement presently in effect or made available in the future shall be deemed to be in lieu of the Base Salary payable to Executive pursuant to Paragraph (a) of this 2 Section. The Company shall not make any changes in any employee benefit plans or other arrangements in effect on the date hereof or subsequently in effect in which Executive currently or in the future participates (including, without limitation, each pension and retirement plan, supplemental pension and retirement plan, savings and profit sharing plan, stock or unit ownership plan, stock or unit purchase plan, stock or unit option plan, life insurance plan, medical insurance plan, disability plan, dental plan, health and accident plan, or any other similar plan or arrangement) that would adversely affect Executive's rights or benefits thereunder, unless such change occurs pursuant to a program applicable generally to executives of the Company and does not result in a proportionately greater reduction in the rights of or benefits to Executive as compared with any other executive of the Company. Executive shall be entitled to be reimbursed for temporary housing through February 15, 2002, in connection with Executive's relocation to Houston, Texas. (f) VACATIONS. Executive shall be entitled to twenty (20) paid vacation days per year during the Basic Term. There shall be no carryover of unused vacation from year to year. For purposes of this Paragraph, weekends shall not count as vacation days, and Executive shall also be entitled to all paid holidays given by the Company to its senior executive officers. (g) PERQUISITES. Executive shall be entitled to receive the perquisites and fringe benefits provided generally to an executive officer of HCC in accordance with any practice established by the Board. Notwithstanding, and in addition to any perquisites to which Executive is entitled pursuant to the preceding sentence, Executive shall: (1) have a $1,000 per month automobile allowance to be utilized by Executive to pay expenses related to Executive's use of his automobile, including gasoline, insurance, and maintenance; (2) be reimbursed for all dues at the Lochinvar Country Club; and (3) be entitled to travel on first-class if traveling domestically and business class if traveling internationally, and shall be required to use upgraded tickets if available. (h) PRORATION. Any payments or benefits payable to Executive hereunder in respect of any calendar year during which Executive is employed by the Company for less than the entire year, unless otherwise provided in the applicable plan or arrangement, shall be prorated in accordance with the number of days in such calendar year during which he is so employed. Notwithstanding the foregoing, any payments pursuant to Paragraph 4(c) or 4(d) this Agreement shall not be subject to proration. (i) CONSULTING. Effective January 1, 2006, unless this Agreement has been renewed, Executive shall become a consultant to the Company for the period (the "Consulting Period") beginning on such date and ending on December 31, of such year equal to the number of full years Executive was a full-time employee of the Company commencing January 1, 2002. So, as an example, if Executive worked until December 31, 2005 (or four full years), the Consulting Period would be four years. Executive shall receive an annual consulting fee of $50,000 and be required to perform 250 hours of consulting services (the "Consulting Services"). The Consulting Services to be provided shall be commensurate with Executive's training, background, experience and prior duties with the Company. Executive agrees to make himself reasonably available to provide such Consulting Services during the Consulting Period; provided, however, the Company agrees that it shall provide reasonable advance notice to Executive of its expected consulting needs and any request for Consulting Services hereunder shall not unreasonably interfere with Executive's other business activities and personal affairs, as determined in good faith by Executive. In addition, 3 Executive shall not be required to perform any requested Consulting Services which, in Executive's good faith opinion, would cause Executive to breach any fiduciary duty or contractual obligation Executive may have to another employer. Executive's travel time shall constitute hours of Consulting Services for purposes of this Paragraph. The Parties contemplate that, when appropriate, the Consulting Services shall be performed at Executive's office, residence or at the Company's executive offices in Houston, Texas and may be performed at such other locations only as they may mutually agree upon. Executive shall be promptly reimbursed for all travel and other expenses reasonably incurred by Executive in rendering the Consulting Services. Other than the consulting fee, Executive shall be entitled to no further benefits from the Company. Executive shall not be entitled to consult if he is no longer employed by the Company at the time the Consulting Period is to begin, unless Executive has been terminated without Cause. In the event Executive dies or becomes disabled during the Consulting Period, Executive or his legal representative shall continue to receive the annual consulting fee for the remainder of the Consulting Period. The Company's obligation to retain Executive as a Consultant shall immediately terminate if Executive violates the non-competition, non-solicitation or confidentiality provisions of this Agreement, or if after such non-competition period, Executive competes during the Consulting Period 4. TERMINATION. (a) DEFINITIONS. (1) "CAUSE" shall mean: (i) Material dishonesty which is not the result of an inadvertent or innocent mistake of Executive with respect to the Company or any of its Subsidiaries; (ii) Willful misfeasance or nonfeasance of duty by Executive intended to injure or having the effect of injuring in some material fashion the reputation, business, or business relationships of the Company or any of its Subsidiaries or any of their respective officers, directors, or employees; (iii) Material violation by Executive of any material term of this Agreement; (iv) Conviction of Executive of any felony, any crime involving moral turpitude or any crime other than a vehicular offense which could reflect in some material fashion unfavorably upon the Company or any of its Subsidiaries. Executive may not be terminated for Cause unless and until there has been delivered to Executive written notice from the Board supplying the particulars of his acts or omissions that the Board believes constitute Cause, a reasonable period of time (not less than 30 days) has been given to Executive after such notice to either cure the same or to meet with the Board with his attorney if so desired by Executive, and following which the Board furnishes to Executive a written resolution specifying in detail its findings that Executive has been terminated for Cause as of the date set forth in the notice to Executive. 4 (2) A "CHANGE OF CONTROL" shall be deemed to have occurred if: (i) Any "person" or "group" (within the meaning of Sections 13(d) and 14(d)(2) of the Securities Exchange Act of 1934) other than a trustee or other fiduciary holding securities under an employee benefit plan of the Company becomes the "beneficial owner" (as defined in Rule 13d-3 under the Securities Exchange Act of 1934), directly or indirectly, of 50% or more of the Company's then outstanding voting common stock; or (ii) The shareholders of the Company approve a merger or consolidation of the Company with any other corporation, other than a merger or consolidation (a) in which a majority of the directors of the surviving entity were directors of the Company prior to such consolidation or merger, or (b) which would result in the voting securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being changed into voting securities of the surviving entity) more than 50% of the combined voting power of the voting securities of the surviving entity outstanding immediately after such merger or consolidation; or (iii) The shareholders approve a plan of complete liquidation of the Company or an agreement for the sale or disposition by the Company of all or substantially all of the Company's assets. (3) A "DISABILITY" shall mean the absence of Executive from Executive's duties with the Company on a full-time basis for 180 consecutive days, or 180 days in a 365-day period, as a result of incapacity due to mental or physical illness which results in the Executive being unable to perform the essential functions of his position, with or without reasonable accommodation. (4) A "GOOD REASON" shall mean any of the following (without Executive's express written consent): (i) Within six (6) months following a Change of Control, there is a material alteration in the nature or status of Executive's duties or responsibilities, or the assignment of duties or responsibilities inconsistent with, Executive's status, duties or responsibilities (a "Material Alteration"); (ii) A failure by the Company to continue in effect any employee benefit plan in which Executive was participating, or the taking of any action by the Company that would adversely affect Executive's participation in, or materially reduce Executive's benefits under, any such employee benefit plan, unless such failure or such taking of any action adversely affects the management of the Company generally; (iii) Executive's relocation to any place, other than the executive offices as a result of the Company relocating its executive offices, exceeding a distance of fifty (50) miles from the Company's current executive office located in Houston, Texas, except for reasonably required travel by Executive on the Company's business; 5 (iv) Any material breach by the Company of any material provision of this Agreement; or (v) Any failure by the Company to obtain the assumption and performance of this Agreement by any successor (by merger, consolidation, or otherwise) or assign of the Company. However, Good Reason shall exist with respect to an above specified matter only if (i) such matter relates to subparagraphs (ii), (iii), (iv) or (v) hereof, and it is not corrected by the Company within thirty (30) days after the Company's receipt of written notice of such matter from Executive or (ii) if there is a Material Alteration and it relates to subparagraph (i) hereof, such matter is not corrected after receipt of written notice by the later of thirty (30)days following receipt of the written notice, or six months following the Change of Control; and in no event shall a termination by Executive occurring more than the later of ninety (90) days following the date of the event described above or sixty (60) days after the end of the six months following a Change of Control be a termination for Good Reason due to such event. (5) "TERMINATION DATE" shall mean the date Executive terminates or is terminated for any reason pursuant to this Agreement. (b) TERMINATION WITHOUT CAUSE OR FOR GOOD REASON: BENEFITS. In the event there is a termination by the Company without Cause, or if Executive terminates for Good Reason (a "Termination Event"), this Agreement shall terminate and Executive shall be entitled to the following severance benefits: (1) For the remainder of the Basic Term after the Termination Date, Base Salary (as defined in Paragraph 3(a)), at the rate in effect immediately prior to the Termination Event, payable in a lump sum, appropriately discounted to take into consideration the lump sum early payment; (2) If there is a Termination Event, any stock options ("Stock Awards") which Executive has received under this Agreement or otherwise shall vest immediately and all such Stock Awards shall be exercisable for thirty (30) days from the date of such Termination Event or the remainder of their term, whichever is less; (3) To the extent not theretofore paid or provided, the Company shall timely pay or provide to Executive any other amounts or benefits required to be paid or provided or which Executive is eligible to receive under any plan, program, policy or practice, or contract or agreement of the Company and its affiliated companies for the period of time equal to the lesser of six months following Executive's Termination or the date Executive begins new employment. The Company, at its sole expense, shall continue to provide (through its own plan and/or individual policies) Executive (and Executive's dependents) with health benefits no less favorable than the group health plan benefits provided generally during such period to the senior executive officers of the Company or any 6 affiliated company (to the extent any such coverage or benefits are taxable to Executive by reason of being provided under a self-insured health plan of the Company or an affiliate, the Company shall make Executive "whole" for the same on an after-tax basis), provided, however, such coverage shall be secondary to any group health plan coverage Executive (or his dependents) receive from another employer, (such other amounts and benefits shall be hereinafter referred to as the "Other Benefits"); (4) All accrued compensation and unreimbursed expenses through the Termination Date. Such amounts shall be paid to Executive in a lump sum in cash within thirty (30) days after the Termination Date; and (5) Executive shall be free to accept other employment during such period, and there shall be no offset of any employment compensation earned by Executive in such other employment during such period against payments due Executive under this Paragraph (4), and there shall be no offset in any compensation received from such other employment against the Base Salary set forth above. (c) TERMINATION IN EVENT OF DEATH: BENEFITS. If Executive's employment is terminated by reason of Executive's death during the Basic Term, this Agreement shall terminate without further obligation to Executive's legal representatives under this Agreement, other than for payment of all accrued compensation, unreimbursed expenses, the timely payment or provision of Other Benefits through the date of death. Such amounts shall be paid to Executive's estate or beneficiary, as applicable, in a lump sum in cash within ninety (90) days after the date of death. In addition, Executive's legal representatives shall receive, at the same time as if Executive were still an employee, Executive's Base Salary for the lesser of one (1) year or the date this Agreement would otherwise have terminated. With respect to the provision of Other Benefits, the term Other Benefits as used in this Paragraph 4(c) shall include, without limitation, and Executive's estate and/or beneficiaries shall be entitled to receive, benefits at least equal to the most favorable benefits provided by the Company to the estates and beneficiaries of other executive level employees of the Company under such plans, programs, practices, and policies relating to death benefits, if any, as in effect with respect to other executives and their beneficiaries at any time during the 120-day period immediately preceding the date of death. Additionally, all Stock Awards shall be vested immediately and shall be exercisable for the later of one year after the date of such vesting or the remaining term of such option. (d) TERMINATION IN EVENT OF DISABILITY: BENEFITS. If Executive's employment is terminated by reason of Executive's Disability during the Basic Term, this Agreement shall terminate but the Company shall continue to pay the Base Salary for a period of three (3) months and thereafter shall make such additional payment for the Term so that the after tax effect of Executive's compensation is the same as before the Disability. Executive shall, not be entitled to any subsequent cash or stock bonuses. In addition, all outstanding Stock Awards shall vest immediately upon such termination due to Disability and shall be exercisable for one year after the date of such vesting. Executive's Benefits shall continue to the end of the Basic Term. 7 (e) VOLUNTARY TERMINATION BY EMPLOYEE AND TERMINATION FOR CAUSE: BENEFITS. Executive may terminate his employment with the Company without Good Reason by giving written notice of his intent and stating an effective Termination Date at least ninety (90) days after the date of such notice; provided, however, that the Company may accelerate such effective date by paying Executive through the proposed Termination Date and also vesting awards that would have vested but for this acceleration of the proposed Termination Date. Upon such a termination by Executive or upon termination for Cause by the Company, this Agreement shall terminate and the Company shall pay to Executive all accrued compensation, unreimbursed expenses and the Other Benefits through the Termination Date. Such amounts shall be paid to Executive in a lump sum in cash within thirty (30) days after the date of termination. In addition, all unvested stock options shall terminate and all vested options will terminate fifteen (15) days after the Termination Date. (f) DIRECTOR POSITIONS. Executive agrees that upon termination of employment, for any reason, at the request of the Chairman of the Board, Executive will immediately tender his resignation from any and all Board positions held with the Company and/or any of its Subsidiaries and affiliates. 5. NON-COMPETITION, NON-SOLICITATION, AND CONFIDENTIALITY. Executive recognizes and agrees that the benefit of not being employed at-will, is provided in consideration for, among other things, the agreements contained in this Section, as well as the Stock Awards granted to Executive pursuant to this Agreement. The Company agrees that while employed pursuant to this Agreement, Executive will be provided with confidential information of Company; specialized training on how to perform his duties; and contact with the Company's customers and potential customers. (a) NON-COMPETITION DURING EMPLOYMENT. Executive agrees that during the Basic Term, he will not compete with the Company by engaging in the conception, design, development, production, marketing, or servicing of any product or service that is substantially similar to the products or services which the Company provides, and that he will not work for, in any capacity, assist, or become affiliated with as an owner, partner, etc., either directly or indirectly, any individual or business which offers or performs services, or offers or provides products substantially similar to the services and products provided by Company, provided, Executive shall not be prevented from owning no more than 2% of any Company whose stock is publicly traded. (b) CONFLICTS OF INTEREST. Executive agrees that during the Basic Term, he will not engage, either directly or indirectly, in any activity (a "Conflict of Interest") which might adversely affect the Company or its affiliates, including ownership of a material interest in any supplier, contractor, distributor, subcontractor, customer or other entity with which the Company does business or accepting any material payment, service, loan, gift, trip, entertainment, or other favor from a supplier, contractor, distributor, subcontractor, customer or other entity with which the Company does business, and that Executive will promptly inform the President of the Company as to each offer received by Executive to engage in any such activity. Executive further agrees to disclose to the Company any other facts of which Executive becomes aware which in Executive's good faith judgment could reasonably be expected to involve or give rise to a Conflict of Interest or potential Conflict of Interest. 8 (c) NON-COMPETITION AFTER TERMINATION. Executive agrees that Executive shall not, at any time during the period of two (2) years after the later of termination of the Basic Term for any reason, within any of the markets in which the Company has sold products or services or formulated a plan to sell products or services into a market during the last twelve (12) months of Executive's employ or which the Company enters into within three (3) months thereafter, engage in or contribute Executive's knowledge to any work which is competitive with or similar to a product, process, apparatus, service, or development on which Executive worked or with respect to which Executive had access to Confidential Information while employed by the Company. Following the expiration of said two (2) year period, Executive shall continue to be obligated under the Confidential Information Paragraph of this Agreement not to use or to disclose Confidential Information of the Company so long as it shall not be publicly available. It is understood that the geographical area set forth in this covenant is divisible so that if this clause is invalid or unenforceable in an included geographic area, that area is severable and the clause remains in effect for the remaining included geographic areas in which the clause is valid. (d) CONFIDENTIAL INFORMATION. Executive further agrees that he will not, except as the Company may otherwise consent or direct in writing, reveal or disclose, sell, use, lecture upon, publish or otherwise disclose to any third party any Confidential Information or proprietary information of the Company, or authorize anyone else to do these things at any time either during or subsequent to his employment with the Company. This Section shall continue in full force and effect after termination of Executive's employment and after the termination of this Agreement. Executive's obligations under this Paragraph with respect to any specific Confidential Information and proprietary information shall cease when that specific portion of the Confidential Information and proprietary information becomes publicly known, in its entirety and without combining portions of such information obtained separately. It is understood that such Confidential Information and proprietary information of the Company include matters that Executive conceives or develops, as well as matters Executive learns from other employees of Company. Confidential Information is defined to include information: (1) disclosed to or known by the Executive as a consequence of or through his employment with the Company; (2) not generally known outside the Company; and (3) which relates to any aspect of the Company or its business, finances, operation plans, budgets, research, or strategic development. "Confidential Information" includes, but is not limited to the Company's trade secrets, proprietary information, financial documents, long range plans, customer lists, employer compensation, marketing strategy, data bases, costing data, computer software developed by the Company, investments made by the Company, and any information provided to the Company by a third party under restrictions against disclosure or use by the Company or others. (e) RETURN OF DOCUMENTS, EQUIPMENT, ETC. All writings, records, and other documents and things comprising, containing, describing, discussing, explaining, or evidencing any Confidential Information, and all equipment, components, parts, tools, and the like in Executive's custody or possession that have been obtained or prepared in the course of Executive's employment with the Company shall be the exclusive property of the Company, shall not be copied and/or removed from the premises of the Company, except in pursuit of the business of the Company, and shall be delivered to the Company, without Executive retaining any copies, upon notification of the termination of Executive's employment or at any other time requested by the Company. The 9 Company shall have the right to retain, access, and inspect all property of Executive of any kind in the office, work area, and on the premises of the Company upon termination of Executive's employment and at any time during employment by the Company to ensure compliance with the terms of this Agreement. (f) REAFFIRM OBLIGATIONS. Upon termination of his employment with the Company, Executive, if requested by Company, shall reaffirm in writing Executive's recognition of the importance of maintaining the confidentiality of the Company's Confidential Information and proprietary information, and reaffirm any other obligations set forth in this Agreement. (g) PRIOR DISCLOSURE. Executive represents and warrants that he has not used or disclosed any Confidential Information he may have obtained from Company prior to signing this Agreement, in any way inconsistent with the provisions of this Agreement. (h) CONFIDENTIAL INFORMATION OF PRIOR COMPANIES. Executive will not disclose or use during the period of his employment with the Company any proprietary or Confidential Information or Copyright Works which Executive may have acquired because of employment with an employer other than the Company or acquired from any other third party, whether such information is in Executive's memory or embodied in a writing or other physical form. (i) BREACH. Executive agrees that any breach of Paragraphs 5(a) or (c) above cannot be remedied solely by money damages, and that in addition to any other remedies Company may have, Company is entitled to obtain injunctive relief against Executive. Nothing herein, however, shall be construed as limiting Company's right to pursue any other available remedy at law or in equity, including recovery of damages and termination of this Agreement and/or any payments that may be due pursuant to this Agreement. (j) RIGHT TO ENTER AGREEMENT. Executive represents and covenants to Company that he has full power and authority to enter into this Agreement and that the execution of this Agreement will not breach or constitute a default of any other agreement or contract to which he is a party or by which he is bound. (k) ENFORCEABILITY. The agreements contained in this Section 5 are independent of the other agreements contained herein. Accordingly, failure of the Company to comply with any of its obligations outside of this Paragraph do not excuse Executive from complying with the agreements contained herein. (l) SURVIVABILITY. The agreements contained in Paragraphs 5(c)-(d) shall survive the termination of this Agreement for any reason. 6. ASSIGNMENT. This Agreement cannot be assigned by Executive. The Company may assign this Agreement only to a successor (whether direct or indirect, by purchase, merger, consolidation or otherwise) to all or substantially all of the business and assets of the Company provided such successor expressly agrees in writing reasonably satisfactory to Executive to assume and perform this Agreement in the same manner and to the same extent that the Company would be 10 required to perform it if no such succession and assignment had taken place. Failure of the Company to obtain such written agreement prior to the effectiveness of any such succession shall be a material breach of this Agreement. 7. BINDING AGREEMENT. Executive understands that his obligations under this Agreement are binding upon Executive's heirs, successors, personal representatives, and legal representatives. 8. NOTICES. All notices pursuant to this Agreement shall be in writing and sent certified mail, return receipt requested, addressed as set forth below, or by delivering the same in person to such party, or by transmission by facsimile to the number set forth below (which shall not constitute notice). Notice deposited in the United States Mail, mailed in the manner described hereinabove, shall be effective upon deposit. Notice given in any other manner shall be effective only if and when received: If to Executive: Craig J. Kelbel ----------------------------- ----------------------------- Fax: ------------------------- If to Company: HCC Insurance Holdings, Inc. 13403 Northwest Freeway Houston, Texas 77040 Attn: General Counsel Fax: (713) 744-9648 with a copy (which shall Arthur S. Berner, Esq. not constitute notice) to: Haynes and Boone, LLP 1000 Louisiana Street, Suite 4300 Houston, Texas 77002-5012 Fax: (713) 236-5652 9. WAIVER. No waiver by either party to this Agreement of any right to enforce any term or condition of this Agreement, or of any breach hereof, shall be deemed a waiver of such right in the future or of any other right or remedy available under this Agreement. 10. SEVERABILITY. If any provision of this Agreement is determined to be void, invalid, unenforceable, or against public policy, such provisions shall be deemed severable from the Agreement, and the remaining provisions of the Agreement will remain unaffected and in full force and effect. 11. ENTIRE AGREEMENT. The terms and provisions contained herein shall constitute the entire agreement between the parties with respect to Executive's employment with Company during the time period covered by this Agreement. This Agreement replaces and supersedes any and all 11 existing Agreements entered into between Executive and the Company relating generally to the same subject matter, if any, and shall be binding upon Executive's heirs, executors, administrators, or other legal representatives or assigns. 12. MODIFICATION OF AGREEMENT. This Agreement may not be changed or modified or released or discharged or abandoned or otherwise terminated, in whole or in part, except by an instrument in writing signed by the Executive and an officer or other authorized executive of Company. 13. UNDERSTAND AGREEMENT. Executive represents and warrants that he has read and understood each and every provision of this Agreement, and Executive understands that he has the right to obtain advice from legal counsel of choice, if necessary and desired, in order to interpret any and all provisions of this Agreement, and that Executive has freely and voluntarily entered into this Agreement. 14. GOVERNING LAW. This Agreement shall be governed by and construed in accordance with the laws of the State of Texas. 15. JURISDICTION AND VENUE. With respect to any litigation regarding this Agreement, Executive agrees to venue in the state or federal courts in Harris County, Texas, and agrees to waive and does hereby waive any defenses and/or arguments based upon improper venue and/or lack of personal jurisdiction. By entering into this Agreement, Executive agrees to personal jurisdiction in the state and federal courts in Harris County, Texas. [REMAINDER OF THIS PAGE LEFT INTENTIONALLY BLANK] 12 IN WITNESS WHEREOF, the Parties have executed this Agreement in multiple copies, effective as of the date first written above. EXECUTIVE COMPANY HCC INSURANCE HOLDINGS, INC. /s/ Craig J. Kelbel By: /s/ John N. Molbeck, Jr. - -------------------------------------- ------------------------------- CRAIG J. KELBEL JOHN N. MOLBECK, JR., President Dated: January 28, 2002 Dated: January 21, 2002 -------------------------------- ---------------------------- [SIGNATURE PAGE TO EMPLOYMENT AGREEMENT] 13 EX-10.17 7 h03402exv10w17.txt EMPLOYMENT AGREEMENT - MICHAEL J. SCHELL EXHIBIT 10.17 EMPLOYMENT AGREEMENT This EMPLOYMENT AGREEMENT ("Agreement") is entered into effective as of the 3rd day of June, 2002 (the "Effective Date"), between HCC INSURANCE HOLDINGS, INC. ("HCC" or the "Company"), and MIKE SCHELL ("Executive"), sometimes collectively referred to herein as the "Parties." R E C I T A L S: WHEREAS, Executive is to be employed as Executive Vice President of HCC and President, Chief Executive Officer and a Director of Houston Casualty Company ("HC"); and, as an integral part of its management who participates in the decision-making process relative to short and long-term planning and policy for HCC and HC, Executive will serve on the Company's Executive Management Group and Senior Management Group; and WHEREAS, it is the desire of the Boards of Directors of HCC and HC (the "Boards") to directly engage Executive as an officer of HCC and HC; and WHEREAS, Executive is desirous of committing himself to serve HCC and the Subsidiaries on the terms herein provided. NOW, THEREFORE, in consideration of the foregoing and of the respective covenants and agreements set forth below, the Parties agree as follows: 1. TERM. Effective as of the Effective Date, the Company hereby agrees to employ Executive as Executive Vice President of HCC and President and Chief Executive Officer of HC, and Executive hereby agrees to accept such employment, on the terms and conditions set forth herein, for the period commencing on the Effective Date and expiring as of 11:59 p.m. on June 3rd, 2007 (the "Basic Term") (unless sooner terminated as hereinafter set forth). 2. DUTIES. (a) DUTIES AS EMPLOYEE OF THE COMPANY. Executive shall, subject to the supervision of the President of the Company, or such other person as the Board may direct, act as Executive Vice President of HCC and as President and Chief Executive Officer of HC in the ordinary course of their business with all such powers with respect to such management and control as may be reasonably incident to such responsibilities. During normal business hours, Executive shall devote his full time and attention to diligently attending to the business of the Company and HC during the Basic Term. During the Basic Term, Executive shall not directly or indirectly render any services of a business, commercial, or professional nature to any other person, firm, corporation, or organization, whether for compensation or otherwise, without the prior written consent of the President of HCC. However, Executive shall have the right to engage in such activities as may be appropriate in order to manage his personal investments so long as such activities do not materially interfere or conflict with the performance of his duties to the Company hereunder. The conduct of such activity shall not be deemed to materially interfere or conflict with Executive's performance of his duties until Executive has been notified in writing thereof and given a reasonable period in which to cure the same. (b) OTHER DUTIES. If requested, Executive agrees to serve as President or other senior executive officer of U.S. Specialty Insurance Company ("USSIC"), HCC Life Insurance Company ("HCCL") and Avemco Insurance Company ("AIC") (collectively, HC, USSIC, HCCL and AIC are referred to herein as the "Subsidiaries") and as a member of such management or operating committees of HCC and any of the Subsidiaries, provided Executive is indemnified for serving in any and all such capacities in a manner acceptable to the Company and Executive. If elected, Executive agrees that he shall not be entitled to receive any compensation for serving as a director of HCC or any of the Subsidiaries other than the compensation to be paid to Executive by the Company pursuant to this Agreement. 3. COMPENSATION AND RELATED MATTERS. (a) BASE SALARY. Executive shall receive a base salary paid by the Company as follows: $450,000 for the Basic Term in substantially equal monthly installments. The base salary shall be increased by $25,000 on each anniversary of the Effective Date during the Basic Term. For purposes of this Agreement, "Base Salary" shall mean the Executive's initial base salary or, if increased, then the increased base salary. (b) BONUS PAYMENTS AND OPTIONS. (i) Each calendar year, Executive shall receive a bonus of $12,500 for each of the four Subsidiaries that has pre-tax net income exceeding the approved budget, plus an additional $50,000 if all of the Subsidiaries exceed their approved budgets. Any deficits caused by a Subsidiary failing to meet the pre-tax net income budget are carried forward for the next year, for that specific Subsidiary. (ii) Executive shall receive options to acquire 200,000 shares of HCC Common Stock pursuant to a standard option agreement issued under HCC's stock option plans. Such options shall vest in five (5) equal installments beginning on the first anniversary of the date of grant and will expire on the sixth (6th) anniversary of the date of grant. (c) EXPENSES. During the Basic Term, Executive shall be entitled to receive prompt reimbursement for all reasonable expenses incurred by him (in accordance with the policies and procedures established by the Board for the Company's senior executive officers) in performing services hereunder, provided that Executive properly accounts therefor in accordance with Company policy. (d) OTHER BENEFITS. Executive shall be entitled to participate in or receive benefits under any compensation, employee benefit plan, or other arrangement made generally available by the Company now or in the future to its senior executive officers, subject to and on a basis consistent with the terms, conditions, and overall administration of such plan or arrangement; 2 provided, however, Executive shall receive a term life insurance policy in the amount of $1,000,000 and an AD&D insurance policy under the Company's standard terms, also in the amount of $1,000,000. Nothing paid to Executive under any plan or arrangement presently in effect or made available in the future shall be deemed to be in lieu of the Base Salary payable to Executive pursuant to Paragraph (a) of this Section. The Company shall not make any changes in any employee benefit plans or other arrangements in effect on the date hereof or subsequently in effect in which Executive currently or in the future participates (including, without limitation, each pension and retirement plan, supplemental pension and retirement plan, savings and profit sharing plan, stock or unit ownership plan, stock or unit purchase plan, stock or unit option plan, life insurance plan, medical insurance plan, disability plan, dental plan, health and accident plan, or any other similar plan or arrangement) that would adversely affect Executive's rights or benefits thereunder, unless such change occurs pursuant to a program applicable to executives of the Company and does not result in a proportionately greater reduction in the rights of or benefits to Executive as compared with other executives of the Company. (e) VACATIONS. Executive shall be entitled to twenty (20) paid vacation days per year during the Basic Term. There shall be no carryover of unused vacation from year to year. For purposes of this Paragraph, weekends shall not count as vacation days, and Executive shall also be entitled to all paid holidays given by the Company to its senior executive officers. (f) PERQUISITES. Executive shall be entitled to receive the perquisites and fringe benefits provided generally to an executive officer of HCC in accordance with any practice established by the Board. Notwithstanding, and in addition to, any perquisites to which Executive is entitled pursuant to the preceding sentence, Executive shall: (i) have a car allowance of $1,000 per month; (ii) be allowed to travel on business utilizing first class domestic passage and business class international passage using Company mileage upgrades (and, upon approval of the Chief Executive Officer, shall be entitled to utilize the corporate aircraft); and (iii) receive the right to use one corporate club membership with annual dues to be paid by HCC. (g) PRORATION. Any payments or benefits payable to Executive hereunder in respect of any calendar year during which Executive is employed by the Company for less than the entire year, unless otherwise provided in the applicable plan or arrangement, shall be prorated in accordance with the number of days in such calendar year during which he is so employed. Notwithstanding the foregoing, any payments pursuant to Paragraph 4(c) or 4(d) this Agreement shall not be subject to proration. 4. TERMINATION. (a) DEFINITIONS. (1) "CAUSE" shall mean: (i) Material dishonesty which is not the result of an inadvertent or innocent mistake of Executive with respect to the Company or any of its subsidiaries; 3 (ii) Willful misfeasance or nonfeasance of duty by Executive intended to injure or having the effect of injuring in some material fashion the reputation, business, or business relationships of the Company or any of its subsidiaries or any of their respective officers, directors, or employees; (iii) Material violation by Executive of any material term of this Agreement; (iv) Conviction of Executive of any felony, any crime involving moral turpitude or any crime other than a vehicular offense which could reflect in some material fashion unfavorably upon the Company or any of its subsidiaries. Executive may not be terminated for Cause unless and until there has been delivered to Executive written notice from the Board supplying the particulars of his acts or omissions that the Board believes constitute Cause, a reasonable period of time (not less than 30 days) has been given to Executive after such notice to either cure the same or to meet with the Board with his attorney if so desired by Executive, and following which the Board furnishes to Executive a written resolution specifying in detail its findings that Executive has been terminated for Cause as of the date set forth in the notice to Executive. (2) A "CHANGE OF CONTROL" shall be deemed to have occurred if: (i) Any "person" or "group" (within the meaning of Sections 13(d) and 14(d)(2) of the Securities Exchange Act of 1934) other than a trustee or other fiduciary holding securities under an employee benefit plan of the Company becomes the "beneficial owner" (as defined in Rule 13d-3 under the Securities Exchange Act of 1934), directly or indirectly, of 50% or more of the Company's then outstanding voting common stock; or (ii) The shareholders of the Company approve a merger or consolidation of the Company with any other corporation, other than a merger or consolidation (a) in which a majority of the directors of the surviving entity were directors of the Company prior to such consolidation or merger, or (b) which would result in the voting securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being changed into voting securities of the surviving entity) more than 50% of the combined voting power of the voting securities of the surviving entity outstanding immediately after such merger or consolidation; or (iii) The shareholders approve a plan of complete liquidation of the Company or an agreement for the sale or disposition by the Company of all or substantially all of the Company's assets. (3) A "DISABILITY" shall mean the absence of Executive from Executive's duties with the Company on a full-time basis for 180 consecutive days, or 180 days in a 365-day period, as a result of incapacity due to mental or physical illness which results in the Executive being unable to perform the essential functions of his position, with or without reasonable accommodation. 4 (4) A "GOOD REASON" shall mean any of the following (without Executive's express written consent): (i) Within six (6) months following a Change of Control, there is a material adverse alteration in the Executive's compensation and, in addition, a material alteration in the nature or status of Executive's duties or responsibilities, or the assignment of duties or responsibilities inconsistent with, Executive's status, duties or responsibilities (a "Material Alteration"); (ii) The taking of any action by the Company that would adversely affect Executive's participation in, or materially reduce Executive's benefits under, any such employee benefit plan, unless such failure or such taking of any action adversely affects the management of the Company generally; (iii) Executive's involuntary relocation to any place, other than the executive offices as a result of the Company relocating its executive offices, exceeding a distance of fifty (50) miles from the Company's current executive office located in Houston, Texas, except for reasonably required travel by Executive on the Company's business; (iv) Any material breach by the Company of any material provision of this Agreement; or (v) Any failure by the Company to obtain the assumption and performance of this Agreement by any successor (by merger, consolidation, or otherwise) or assign of the Company. However, Good Reason shall exist with respect to an above specified matter only if (i) such matter relates to subparagraphs (ii), (iii), (iv) or (v) hereof, and it is not corrected by the Company within thirty (30) days after the Company's receipt of written notice of such matter from Executive or (ii) if there is a Material Alteration and it relates to subparagraph (i) hereof, such matter is not corrected after receipt of written notice by the later of thirty (30) days following receipt of the written notice, or six months following the Change of Control; and in no event shall a termination by Executive occurring more than the later of ninety (90) days following the date of the event described above or sixty (60) days after the end of the six months following a Change of Control be a termination for Good Reason due to such event. (5) "TERMINATION DATE" shall mean the date Executive terminates or is terminated for any reason pursuant to this Agreement. (b) TERMINATION WITHOUT CAUSE OR FOR GOOD REASON: BENEFITS. In the event there is a termination by the Company without Cause, or if Executive terminates for Good Reason (a "Termination Event"), this Agreement shall terminate and Executive shall be entitled to the following severance benefits: (1) For the remainder of the Basic Term after the Termination Date, Base Salary (as defined in Paragraph 3(a)), at the rate in effect immediately prior to the Termination 5 Event, payable in a lump sum, appropriately discounted to take into consideration the lump sum early payment; (2) If there is a Termination Event, any stock options ("Stock Awards") which Executive has received under this Agreement or otherwise shall vest immediately, provided, however, all such Stock Awards shall be exercisable for ninety (90) days from the date of such Termination Event or the remainder of their term, whichever is less; (3) To the extent not theretofore paid or provided, the Company shall timely pay or provide to Executive any other amounts or benefits required to be paid or provided or which Executive is eligible to receive under any plan, program, policy or practice, or contract or agreement of the Company and its affiliated companies for the period of time equal to the lesser of six months following Executive's Termination or the date Executive begins new employment. The Company, at its sole expense, shall continue to provide (through its own plan and/or individual policies) Executive (and Executive's dependents) with health benefits no less favorable than the group health plan benefits provided generally during such period to the senior executive officers of the Company or any affiliated company (to the extent any such coverage or benefits are taxable to Executive by reason of being provided under a self-insured health plan of the Company or an affiliate, the Company shall make Executive "whole" for the same on an after-tax basis) (such other amounts and benefits shall be hereinafter referred to as the "Other Benefits"); (4) All accrued compensation and unreimbursed expenses through the Termination Date. Such amounts shall be paid to Executive in a lump sum in cash within thirty (30) days after the Termination Date; and (5) Executive shall be free to accept other employment during such period, and, except as set forth above, there shall be no offset of any employment compensation earned by Executive in such other employment during such period against payments due Executive under this Paragraph (4), and there shall be no offset in any compensation received from such other employment against the Base Salary set forth above. (c) TERMINATION IN EVENT OF DEATH: BENEFITS. If Executive's employment is terminated by reason of Executive's death during the Basic Term, this Agreement shall terminate without further obligation to Executive's legal representatives under this Agreement, other than for payment of all accrued compensation, unreimbursed expenses, the timely payment or provision of Other Benefits through the date of death. Such amounts shall be paid to Executive's estate or beneficiary, as applicable, in a lump sum in cash within ninety (90) days after the date of death. In addition, Executive's legal representatives shall receive, at the same time as if Executive were still an employee, Executive's Base Salary remaining for the Basic Term, less the face amount of any life insurance proceeds from insurance policies provided by the Company. With respect to the provision of Other Benefits, the term Other Benefits as used in this Paragraph 4(c) shall include, without limitation, and Executive's estate and/or beneficiaries shall be entitled to receive, benefits at least equal to the most favorable benefits provided by the Company to the estates and beneficiaries of other executive level employees of the Company under such plans, programs, practices, and policies relating to death benefits, if any, as in effect with respect to other executives and their beneficiaries at any time during the 120-day period immediately preceding the date of death. Additionally, all Stock 6 Awards shall be vested immediately and shall be exercisable for the earlier of one year after the date of such vesting or the remaining term of such option. (d) TERMINATION IN EVENT OF DISABILITY: BENEFITS. If Executive's employment is terminated by reason of Executive's Disability during the Basic Term, this Agreement shall terminate but the Company shall continue to pay the Base Salary for a period of three (3) months and thereafter shall make such additional payment for the Basic Term so that the after tax effect of Executive's compensation is the same as before the Disability. Executive shall not be entitled to any subsequent cash or stock bonuses. In addition, all outstanding Stock Awards shall vest immediately upon such termination due to Disability and shall be exercisable for the earlier of one year after the date of such vesting or the remaining term of such option. Executive's Benefits shall continue to the end of the Basic Term. (e) VOLUNTARY TERMINATION BY EMPLOYEE AND TERMINATION FOR CAUSE: BENEFITS. Executive may terminate his employment with the Company without Good Reason by giving written notice of his intent and stating an effective Termination Date at least ninety (90) days after the date of such notice; provided, however, that the Company may accelerate such effective date by paying Executive through the proposed Termination Date and also vesting awards that would have vested but for this acceleration of the proposed Termination Date. Upon such a termination by Executive or upon termination for Cause by the Company, this Agreement shall terminate and the Company shall pay to Executive all accrued compensation, unreimbursed expenses and the Other Benefits through the Termination Date. Such amounts shall be paid to Executive in a lump sum in cash within thirty (30) days after the date of termination. In addition, all unvested Stock Awards shall terminate and all vested Stock Awards will terminate thirty (30) days after the Termination Date. (f) DIRECTOR POSITIONS. Executive agrees that upon termination of employment, for any reason, at the request of the Chairman of the Board, Executive will immediately tender his resignation from any and all Board positions held with the Company and/or any of its subsidiaries and affiliates. 5. NON-COMPETITION, NON-SOLICITATION, AND CONFIDENTIALITY. Executive recognizes and agrees that the benefit of not being employed at-will, is provided in consideration for, among other things, the agreements contained in this Section, as well as the Stock Awards granted to Executive pursuant to this Agreement. The Company agrees that while employed pursuant to this Agreement, Executive will be provided with confidential information of Company; specialized training on how to perform his duties; and contact with the Company's customers and potential customers. (a) NON-COMPETITION DURING EMPLOYMENT. Executive agrees that during the Basic Term, he will not compete with the Company by engaging in the conception, design, development, production, marketing, or servicing of any product or service that is substantially similar to the products or services which the Company provides, and that he will not work for, in any capacity, assist, or become affiliated with as an owner, partner, etc., either directly or indirectly, any individual or business which offers or performs services, or offers or provides products substantially similar to the services and products provided by Company, provided, Executive shall not be prevented from owning no more than 2% of any Company whose stock is publicly traded. 7 (b) CONFLICTS OF INTEREST. Executive agrees that during the Basic Term, he will not engage, either directly or indirectly, in any activity (a "Conflict of Interest") which might adversely affect the Company or its affiliates, including ownership of a material interest in any supplier, contractor, distributor, subcontractor, customer or other entity with which the Company does business or accepting any material payment, service, loan, gift, trip, entertainment, or other favor from a supplier, contractor, distributor, subcontractor, customer or other entity with which the Company does business, and that Executive will promptly inform the President of the Company as to each offer received by Executive to engage in any such activity. Executive further agrees to disclose to the Company any other facts of which Executive becomes aware which in Executive's good faith judgment could reasonably be expected to involve or give rise to a Conflict of Interest or potential Conflict of Interest. (c) NON-COMPETITION AFTER TERMINATION. Executive agrees that Executive shall not, at any time during the period of one (1) year after termination for any reason, within any of the markets in which the Company has sold products or services or formulated a plan to sell products or services into a market during the last twelve (12) months of Executive's employ or which the Company enters into within three (3) months thereafter, engage in or contribute Executive's knowledge to any work which is competitive with or similar to a product, process, apparatus, service, or development on which Executive worked or with respect to which Executive had access to Confidential Information while employed by the Company. Following the expiration of said one (1) year period, Executive shall continue to be obligated under the Confidential Information Paragraph of this Agreement not to use or to disclose Confidential Information of the Company so long as it shall not be publicly available. It is understood that the geographical area set forth in this covenant is divisible so that if this clause is invalid or unenforceable in an included geographic area, that area is severable and the clause remains in effect for the remaining included geographic areas in which the clause is valid. (d) CONFIDENTIAL INFORMATION. Executive further agrees that he will not, except as the Company may otherwise consent or direct in writing, reveal or disclose, sell, use, lecture upon, publish or otherwise disclose to any third party any Confidential Information or proprietary information of the Company, or authorize anyone else to do these things at any time either during or subsequent to his employment with the Company. This Section shall continue in full force and effect after termination of Executive's employment and after the termination of this Agreement. Executive's obligations under this Paragraph with respect to any specific Confidential Information and proprietary information shall cease when that specific portion of the Confidential Information and proprietary information becomes publicly known, in its entirety and without combining portions of such information obtained separately. It is understood that such Confidential Information and proprietary information of the Company include matters that Executive conceives or develops, as well as matters Executive learns from other employees of Company. Confidential Information is defined to include information: (1) disclosed to or known by the Executive as a consequence of or through his employment with the Company; (2) not generally known outside the Company; and (3) which relates to any aspect of the Company or its business, finances, operation plans, budgets, research, or strategic development. "Confidential Information" includes, but is not limited to the Company's trade secrets, proprietary information, financial documents, long range plans, customer lists, employer compensation, marketing strategy, data bases, costing data, computer software 8 developed by the Company, investments made by the Company, and any information provided to the Company by a third party under restrictions against disclosure or use by the Company or others. (e) NON-SOLICITATION. The Executive agrees that during his period of employment with the Company and for a period of two (2) years after termination of employment (for any reason), the Executive will not, directly or indirectly, solicit, divert, or hire away or attempt to solicit, divert, or hire away any person employed by the Company, its subsidiaries or affiliates, whether or not such person is a full-time or temporary employee of the Company, its subsidiaries or affiliates and will not make known to any person, firm, entity, or corporation the names and addresses of any of the employees of the Company, its subsidiaries or affiliates or any information pertaining to the employees of the Company, its subsidiaries or affiliates. (f) RETURN OF DOCUMENTS, EQUIPMENT, ETC. All writings, records, and other documents and things comprising, containing, describing, discussing, explaining, or evidencing any Confidential Information, and all equipment, components, parts, tools, and the like in Executive's custody or possession that have been obtained or prepared in the course of Executive's employment with the Company shall be the exclusive property of the Company, shall not be copied and/or removed from the premises of the Company, except in pursuit of the business of the Company, and shall be delivered to the Company, without Executive retaining any copies, upon notification of the termination of Executive's employment or at any other time requested by the Company. The Company shall have the right to retain, access, and inspect all property of Executive of any kind in the office, work area, and on the premises of the Company upon termination of Executive's employment and at any time during employment by the Company to ensure compliance with the terms of this Agreement. (g) REAFFIRM OBLIGATIONS. Upon termination of his employment with the Company, Executive, if requested by Company, shall reaffirm in writing Executive's recognition of the importance of maintaining the confidentiality of the Company's Confidential Information and proprietary information, and reaffirm any other obligations set forth in this Agreement. (h) PRIOR DISCLOSURE. Executive represents and warrants that he has not used or disclosed any Confidential Information he may have obtained from Company prior to signing this Agreement, in any way inconsistent with the provisions of this Agreement. (i) CONFIDENTIAL INFORMATION OF PRIOR COMPANIES. Executive will not disclose or use during the period of his employment with the Company any proprietary or Confidential Information or Copyright Works which Executive may have acquired because of employment with an employer other than the Company or acquired from any other third party, whether such information is in Executive's memory or embodied in a writing or other physical form. (j) BREACH. Executive agrees that any breach of Paragraphs 5(a) or (c) above cannot be remedied solely by money damages, and that in addition to any other remedies Company may have, Company is entitled to obtain injunctive relief against Executive. Nothing herein, however, shall be construed as limiting Company's right to pursue any other available remedy at law or in equity, including recovery of damages and termination of this Agreement and/or any payments that may be due pursuant to this Agreement. 9 (k) RIGHT TO ENTER AGREEMENT. Executive represents and covenants to Company that he has full power and authority to enter into this Agreement and that the execution of this Agreement will not breach or constitute a default of any other agreement or contract to which he is a party or by which he is bound. (l) ENFORCEABILITY. The agreements contained in this Section 5 are independent of the other agreements contained herein. Accordingly, failure of the Company to comply with any of its obligations outside of this Paragraph do not excuse Executive from complying with the agreements contained herein. (m) SURVIVABILITY. The agreements contained in Paragraphs 5(c)-(e) shall survive the termination of this Agreement for any reason. 6. ASSIGNMENT. This Agreement cannot be assigned by Executive. The Company may assign this Agreement only to a successor (whether direct or indirect, by purchase, merger, consolidation or otherwise) to all or substantially all of the business and assets of the Company provided such successor expressly agrees in writing reasonably satisfactory to Executive to assume and perform this Agreement in the same manner and to the same extent that the Company would be required to perform it if no such succession and assignment had taken place. Failure of the Company to obtain such written agreement prior to the effectiveness of any such succession shall be a material breach of this Agreement. 7. BINDING AGREEMENT. Executive understands that his obligations under this Agreement are binding upon Executive's heirs, successors, personal representatives, and legal representatives. 8. NOTICES. All notices pursuant to this Agreement shall be in writing and sent certified mail, return receipt requested, addressed as set forth below, or by delivering the same in person to such party, or by transmission by facsimile to the number set forth below (which shall not constitute notice). Notice deposited in the United States Mail, mailed in the manner described hereinabove, shall be effective upon deposit. Notice given in any other manner shall be effective only if and when received: If to Executive: Mike Schell 3 Hampton Court Houston, Texas 77024 Fax: 713-827-0642 If to Company: HCC Insurance Holdings, Inc. 13403 Northwest Freeway Houston, Texas 77040 Attn: General Counsel Fax: (713) 744-9648 10 with a copy (which shall Arthur S. Berner, Esq. not constitute notice) to: Haynes and Boone, LLP 1000 Louisiana Street, Suite 4300 Houston, Texas 77002-5012 Fax: (713) 236-5652 9. WAIVER. No waiver by either party to this Agreement of any right to enforce any term or condition of this Agreement, or of any breach hereof, shall be deemed a waiver of such right in the future or of any other right or remedy available under this Agreement. 10. SEVERABILITY. If any provision of this Agreement is determined to be void, invalid, unenforceable, or against public policy, such provisions shall be deemed severable from the Agreement, and the remaining provisions of the Agreement will remain unaffected and in full force and effect. 11. ENTIRE AGREEMENT. The terms and provisions contained herein shall constitute the entire agreement between the parties with respect to Executive's employment with Company during the time period covered by this Agreement. This Agreement replaces and supersedes any and all existing Agreements entered into between Executive and the Company relating generally to the same subject matter, if any, and shall be binding upon Executive's heirs, executors, administrators, or other legal representatives or assigns. 12. MODIFICATION OF AGREEMENT. This Agreement may not be changed or modified or released or discharged or abandoned or otherwise terminated, in whole or in part, except by an instrument in writing signed by the Executive and an officer or other authorized executive of Company. 13. UNDERSTAND AGREEMENT. Executive represents and warrants that he has read and understood each and every provision of this Agreement, and Executive understands that he has the right to obtain advice from legal counsel of choice, if necessary and desired, in order to interpret any and all provisions of this Agreement, and that Executive has freely and voluntarily entered into this Agreement. 14. GOVERNING LAW. This Agreement shall be governed by and construed in accordance with the laws of the State of Texas. 15. JURISDICTION AND VENUE. With respect to any litigation regarding this Agreement, Executive agrees to venue in the state or federal courts in Harris County, Texas, and agrees to waive and does hereby waive any defenses and/or arguments based upon improper venue and/or lack of personal jurisdiction. By entering into this Agreement, Executive agrees to personal jurisdiction in the state and federal courts in Harris County, Texas. 11 IN WITNESS WHEREOF, the Parties have executed this Agreement in multiple copies, effective as of the date first written above. EXECUTIVE COMPANY HCC INSURANCE HOLDINGS, INC. /s/ Mike Schell By: /s/ Stephen L. Way - ------------------------------------ -------------------------------- Mike Schell STEPHEN L. WAY, Chief Executive Officer and Chairman of the Board Dated: December 25, 2002 Dated: November 18, 2002 ------------------------------ ----------------------------- SIGNATURE PAGE TO EMPLOYMENT AGREEMENT 12 EX-10.19 8 h03402exv10w19.txt EMPLOYMENT AGREEMENT - CHRISTOPHER L. MARTIN EXHIBIT 10.19 EMPLOYMENT AGREEMENT This EMPLOYMENT AGREEMENT ("Agreement") is entered into effective as of the 1st day of January, 2003 (the "Effective Date"), between HCC Insurance Holdings, Inc. and Christopher L. Martin ("Executive"). As used herein, the "Company" shall mean HCC Insurance Holdings, Inc. ("HCC") and any direct or indirect subsidiary of HCC, which may change from time-to-time, for which Executive devotes from time-to-time the substantial portion of his efforts. HCC, Executive and the Company are sometimes collectively referred to herein as the "Parties" and individually as a "Party." R E C I T A L S: WHEREAS, Executive is to be employed as an officer or key employee of the Company; WHEREAS, it is the desire of the Company to engage Executive as an officer or key employee of the Company; WHEREAS, Executive is desirous of being employed by the Company on the terms herein provided; and NOW, THEREFORE, in consideration of the foregoing and of the respective covenants and agreements set forth below, the Parties agree as follows: 1. TERM. Effective as of the Effective Date, Executive's previous employment agreement dated October 1, 2000, as amended, is terminated, and the Company hereby employs Executive, and Executive hereby accepts such employment, on the terms and conditions set forth herein, for the period (the "Basic Term") commencing on the Effective Date and expiring at 11:59 p.m. on December 31, 2005 (unless sooner terminated as hereinafter set forth). 2. DUTIES. (A) DUTIES AS EMPLOYEE OF THE COMPANY. Executive shall, subject to the supervision of Chief Executive Officer of the Company or such other person designated by such Chief Executive Officer, act as an officer or key employee of the Company in the ordinary course of its business with all such powers with respect to such management and control as may be reasonably incident to such responsibilities. During the Basic Term, Executive's duties and title may be changed but the compensation provided for in Section 3 from time-to-time shall not be reduced. During normal business hours, Executive shall devote his/her full time and attention to diligently attending to the business of the Company. During the Basic Term, Executive shall not directly or indirectly render any services of a business, commercial, or professional nature to any other person, firm, corporation, or organization, whether for compensation or otherwise, without the prior written consent of the Chief Executive Officer of the Company. However, Executive shall have the right to engage in such activities as may be appropriate in order to manage his personal investments so long as such activities do not materially interfere or conflict with the performance of his duties to the Company hereunder. The conduct of such activity shall not be deemed to materially interfere or conflict with Executive's performance of his duties until Executive has been notified in writing thereof and given a reasonable period in which to cure the same. (B) OTHER DUTIES. If elected, Executive agrees to serve as a member of such managerial Committees of the Company and of any of its direct or indirect parents or subsidiaries (collectively "Affiliates") and in one or more executive offices of any of the Company's Affiliates, provided Executive is indemnified for serving in any and all such capacities in a manner acceptable to the Company and Executive. If elected, Executive agrees that he shall not be entitled to receive any compensation for serving as a director of HCC, or in any capacities for the Company's Affiliates other than the compensation to be paid to Executive by the Company pursuant to this Agreement. 3. COMPENSATION AND RELATED MATTERS. (A) BASE SALARY. Executive shall receive an initial base salary paid by the Company of $220,000 for the period from the Effective Date to December 31, 2003; $240,000 for the calendar year beginning January 1, 2004; and $265,000 for the calendar year beginning January 1, 2005. For purposes of this Agreement, "Base Salary" shall mean the Executive's initial base salary or, if increased, then the increased base salary. The Base Salary shall be paid in substantially equal monthly installments. (B) BONUS PAYMENTS. Executive shall be eligible to receive, in addition to the Base Salary, an annual cash and/or stock bonus payment in an amount, which may be zero, to be determined at the sole discretion of the Chief Executive Officer of the Company or such other person in accordance with the Company's policies. (C) EXPENSES. During the Basic Term, Executive shall be entitled to receive prompt reimbursement for all reasonable expenses incurred by him (in accordance with the policies and procedures established by the Company) in performing services hereunder, provided that Executive properly accounts therefor in accordance with Company policy. (D) OTHER BENEFITS. Executive shall be entitled to participate in or receive benefits ("Other Benefits") under any compensation, employee benefit plan, or other arrangement made generally available by the Company, subject to and on a basis consistent with the terms, conditions, and overall administration of such plan or arrangement. Nothing paid to Executive under any plan or arrangement presently in effect or made available in the future shall be deemed to be in lieu of the Base Salary payable to Executive pursuant to Paragraph (a) of this Section. (E) VACATIONS. Executive shall be entitled to twenty (20) paid vacation days per year during the Basic Term. There shall be no carryover of unused vacation from year to year. For purposes of this Paragraph, weekends shall not count as vacation days, and Executive shall also be entitled to all paid holidays given by the Company to its senior executive officers. (F) PERQUISITES. Executive shall be entitled to receive the perquisites and fringe benefits provided for on Appendix 1 hereof. 2 (G) PRORATION. Any payments or benefits payable to Executive hereunder in respect of any calendar year during which Executive is employed by the Company for less than the entire year, unless otherwise provided in the applicable plan or arrangement, shall be prorated in accordance with the number of days in such calendar year during which he is so employed. Notwithstanding the foregoing, any payments pursuant to Paragraph 4(c) or 4(d) this Agreement shall not be subject to proration. 4. TERMINATION. (A) DEFINITIONS. (1) "CAUSE" shall mean: (i) Material dishonesty which is not the result of an inadvertent or innocent mistake of Executive with respect to the Company, its parent, or any of its affiliated companies; (ii) Willful misfeasance or nonfeasance of duty by Executive; (iii) Material violation by Executive of any material term of this Agreement; (iv) Conviction of Executive of any crime other than a vehicular offense which could reflect in some material fashion unfavorably upon the Company, its parent, or any of its affiliated companies. Executive may not be terminated for Cause unless and until there has been delivered to Executive written notice from the Chief Executive Officer of the Company (the "CEO") supplying the particulars of his acts or omissions that the Board believes constitute Cause, a reasonable period of time (not less than 30 days) has been given to Executive after such notice to either cure the same or to meet with the CEO with his attorney if so desired by Executive, and following which the CEO reaffirms its previous decision. (2) A "DISABILITY" shall mean the absence of xecutive from Executive's duties with the Company on a full-time basis for 180 consecutive days, or 180 days in a 365-day period, as a result of incapacity due to mental or physical illness which results in the Executive being unable to perform the essential functions of his position, with or without reasonable accommodation. (3) A "GOOD REASON" shall mean any of the following (without Executive's express written consent): (i) The taking of any action by the Company that would adversely affect Executive's participation in, or materially reduce Executive's benefits under, any employee benefit plan, unless such failure or such taking of any action adversely affects persons in the Company generally; 3 (ii) Executive's involuntary relocation to any place, other than the executive offices as a result of the Company relocating its executive offices, exceeding a distance of fifty (50) miles from the place of Executive's normal place of employment on the Effective Date, except for reasonably required travel by Executive on the Company's business; (iii) Any material breach by the Company of any material provision of this Agreement; or (iv) Any failure by the Company to obtain the assumption and performance of this Agreement by any successor (by merger, consolidation, or otherwise) or assign of the Company. However, Good Reason shall exist with respect to an above specified matter only if such matter is not corrected, or begun to be corrected, by the Company within thirty (30) days after the Company's receipt of written notice of such matter from Executive. In no event shall a termination by Executive occurring more than ninety (90) days following the date of the event described be a termination for Good Reason due to such event. (4) "TERMINATION DATE" shall mean the date Executive terminates or is terminated for any reason pursuant to this Agreement. (B) TERMINATION WITHOUT CAUSE OR FOR GOOD REASON: BENEFITS. In the event there is a termination by the Company without Cause, or if Executive terminates for Good Reason (a "Termination Event"), this Agreement shall terminate and Executive shall be entitled to the following severance benefits: (1) For the remainder of the Basic Term after the Termination Date, Base Salary (as defined in Paragraph 3(a)), at the rate in effect immediately prior to the Termination Event, payable within thirty (30) days after the Termination Date in a lump sum, appropriately discounted to take into consideration the lump sum early payment; (2) All accrued compensation and unreimbursed expenses through the Termination Date. Such amounts shall be paid to Executive in a lump sum in cash within thirty (30) days after the Termination Date; and (3) Executive shall be free to accept other employment during such period, and other than as set forth herein, there shall be no offset of any employment compensation earned by Executive in such other employment during such period against payments due Executive under this Paragraph (4), and there shall be no offset in any compensation received from such other employment against the Base Salary set forth above. (C) TERMINATION IN EVENT OF DEATH: BENEFITS. If Executive's employment is terminated by reason of Executive's death during the Basic Term, this Agreement shall terminate without further obligation to Executive's legal representatives under this Agreement, other than for payment of all accrued compensation, unreimbursed expenses, and the timely payment or provision 4 of Other Benefits through the date of death. Such amounts shall be paid to Executive's estate or beneficiary, as applicable, in a lump sum in cash within ninety (90) days after the date of death. (D) TERMINATION IN EVENT OF DISABILITY: BENEFITS. If Executive's employment is terminated by reason of Executive's Disability during the Basic Term, this Agreement shall terminate but the Company shall continue to pay the Base Salary for a period of three (3) months and thereafter shall make such additional payment for the Basic Term so that the after tax effect of Executive's compensation is the same as before the Disability. Executive shall, not be entitled to any subsequent cash or stock bonuses. (E) VOLUNTARY TERMINATION BY EMPLOYEE AND TERMINATION FOR CAUSE: BENEFITS. Executive may terminate his employment with the Company without Good Reason by giving written notice of his intent and stating an effective Termination Date at least ninety (90) days after the date of such notice; provided, however, that the Company may accelerate such effective date by paying Executive through the proposed Termination Date (but not to exceed ninety (90) days). Upon such a termination by Executive or upon termination for Cause by the Company, this Agreement shall terminate and the Company shall pay to Executive all accrued compensation, unreimbursed expenses and Other Benefits through the Termination Date. Such amounts shall be paid to Executive in a lump sum in cash within sixty (60) days after the date of termination. (F) DIRECTOR POSITIONS. Executive agrees that upon termination of employment, for any reason, at the request of the Chairman of the Board, Executive will immediately tender his resignation from any and all Board positions held with the Company and/or any of its Affiliates. 5. NON-COMPETITION, NON-SOLICITATION, AND CONFIDENTIALITY. At the inception of this employment relationship, and continuing on an ongoing basis, the Company agrees to give Executive access to Confidential Information (including, without limitation, Confidential Information, as defined below, of the Company's Affiliates) which the Executive has not had access to or knowledge of before the execution of this Agreement. At the time this Agreement is made, the Company agrees to provide Executive with initial and ongoing Specialized Training, which Executive has not had access to or knowledge of before the execution of this Agreement. "Specialized Training" includes the training the Company provides to its employees that is unique to its business and enhances Executive's ability to perform Executive's job duties effectively. Specialized Training includes, without limitation, orientation training; sales methods/techniques training; operation methods training; and computer and systems training. (A) NON-COMPETITION DURING EMPLOYMENT. Executive agrees that, in consideration for the Company's promise to provide Executive with Confidential Information and Specialized Training, during the Basic Term, he will not compete with the Company by engaging in the conception, design, development, production, marketing, or servicing of any product or service that is substantially similar to the products or services which the Company provides, and that he will not work for, in any capacity, assist, or become affiliated with as an owner, partner, etc., either directly or indirectly, any individual or business which offers or performs services, or offers or provides products substantially similar to the services and products provided by Company, provided, Executive shall not be prevented from owning no more than 2% of any company whose stock is publicly traded. 5 (B) CONFLICTS OF INTEREST. Executive agrees that during the Basic Term, he will not engage, either directly or indirectly, in any activity (a "Conflict of Interest") which might adversely affect the Company or its affiliates, including ownership of a material interest in any supplier, contractor, distributor, subcontractor, customer or other entity with which the Company does business or accepting any material payment, service, loan, gift, trip, entertainment, or other favor from a supplier, contractor, distributor, subcontractor, customer or other entity with which the Company does business, and that Executive will promptly inform the Chief Executive Officer of the Company as to each offer received by Executive to engage in any such activity. Executive further agrees to disclose to the Company any other facts of which Executive becomes aware which in Executive's good faith judgment could reasonably be expected to involve or give rise to a Conflict of Interest or potential Conflict of Interest. (C) NON-COMPETITION AFTER TERMINATION. Executive agrees that in order to protect the Company's Confidential Information, it is necessary to enter into the following restrictive covenant, which is ancillary to the enforceable promises between the Company and Executive otherwise contained in this Agreement. Executive agrees that Executive shall not, at any time during the period of one (1) years after termination for any reason, within any of the markets in which the Company has sold products or services or formulated a plan to sell products or services into a market during the last twelve (12) months of Executive's employ or which the Company enters into within three (3) months thereafter, engage in or contribute Executive's knowledge to any work which is competitive with or similar to a product, process, apparatus, service, or development on which Executive worked or with respect to which Executive had access to Confidential Information or Specialized Training while employed by the Company. Following the expiration of said one (1) year period, Executive shall continue to be obligated under the Confidential Information paragraph of this Agreement not to use or to disclose Confidential Information of the Company so long as it shall not be publicly available. It is understood that the geographical area set forth in this covenant is divisible so that if this clause is invalid or unenforceable in an included geographic area, that area is severable and the clause remains in effect for the remaining included geographic areas in which the clause is valid. (D) CONFIDENTIAL INFORMATION. Executive agrees that he will not, except as the Company may otherwise consent or direct in writing, reveal or disclose, sell, use, lecture upon, publish or otherwise disclose to any third party any Confidential Information or proprietary information of the Company, or authorize anyone else to do these things at any time either during or subsequent to his employment with the Company. This paragraph shall continue in full force and effect after termination of Executive's employment and after the termination of this Agreement. Executive's obligations under this Paragraph with respect to any specific Confidential Information and proprietary information shall cease when that specific portion of the Confidential Information and proprietary information becomes publicly known, in its entirety and without combining portions of such information obtained separately. It is understood that such Confidential Information and proprietary information of the Company include matters that Executive conceives or develops, as well as matters Executive learns from other employees of the Company. "Confidential Information" is defined to include information: (1) disclosed to or known by the Executive as a consequence of or through his employment with the Company; (2) not generally known outside the Company; and (3) which relates to any aspect of the Company or its business, finances, operation plans, budgets, research, or strategic development. "Confidential Information" includes, but is not limited to the 6 Company's trade secrets, proprietary information, financial documents, long range plans, customer lists, employer compensation, marketing strategy, data bases, costing data, computer software developed by the Company, investments made by the Company, and any information provided to the Company by a third party under restrictions against disclosure or use by the Company or others. (E) NON-SOLICITATION. To protect the Company's Confidential Information, and in the event of Executive's termination of employment for any reason whatsoever, whether by Executive or the Company, it is necessary to enter into the following restrictive covenant, which is ancillary to the enforceable promises between the Company and Executive otherwise contained in this Agreement. Executive covenants and agrees that for a period of two (2) years after termination of employment (for any reason), Executive will not, directly or indirectly, either individually or as a principal, partner, agent, consultant, contractor, employee or as a director or officer of any corporation or association, or in any other manner or capacity whatsoever, except on behalf of the Company, solicit business, or attempt to solicit business, and products or services competitive with products or services sold by the Company, from the Company's clients or customers, or those individuals or entities with whom the Company did business during Executive's employment, including, without limitation, the Company's perspective or potential customers or clients. Executive agrees that during Executive's employment and for a period of two (2) years from the date of any termination of Executive's employment for any reason, Executive will not, either directly or indirectly, or by acting in concert with others, solicit or influence any Company employee to leave the Company's employment. (F) RETURN OF DOCUMENTS, EQUIPMENT, ETC. All writings, records, and other documents and things comprising, containing, describing, discussing, explaining, or evidencing any Confidential Information, and all equipment, components, parts, tools, and the like in Executive's custody or possession that have been obtained or prepared in the course of Executive's employment with the Company shall be the exclusive property of the Company, shall not be copied and/or removed from the premises of the Company, except in pursuit of the business of the Company, and shall be delivered to the Company, without Executive retaining any copies, upon notification of the termination of Executive's employment or at any other time requested by the Company. The Company shall have the right to retain, access, and inspect all property of Executive of any kind in the office, work area, and on the premises of the Company upon termination of Executive's employment and at any time during employment by the Company to ensure compliance with the terms of this Agreement. (G) REAFFIRM OBLIGATIONS. Upon termination of Executive's employment with the Company, Executive, if requested by Company, shall reaffirm in writing Executive's recognition of the importance of maintaining the confidentiality of the Company's Confidential Information and proprietary information, and reaffirm any other obligations set forth in this Agreement. (H) PRIOR DISCLOSURE. Executive represents and warrants that Executive has not used or disclosed any Confidential Information he may have obtained from the Company prior to signing this Agreement, in any way inconsistent with the provisions of this Agreement. (I) NO PREVIOUS RESTRICTIVE AGREEMENTS. Executive represents that, except as disclosed in writing to the Company, Executive is not bound by the terms of any agreement with any 7 previous employer or other party to refrain from using or disclosing any trade secret or confidential or proprietary information in the course of Executive's employment by the Company or to refrain from competing, directly or indirectly, with the business of such previous employer or any other party. Executive further represents that Executive's performance of all the terms of this Agreement and Executive's work duties for the Company does not and will not breach any agreement to keep in confidence proprietary information, knowledge or data acquired by Executive in confidence or in trust prior to Executive's employment with the Company, and Executive will not disclose to the Company or induce the Company to use any confidential or proprietary information or material belonging to any previous employer or other party. (J) BREACH. Executive agrees that any breach of Paragraphs 5(a) through (f) above cannot be remedied solely by money damages, and that in addition to any other remedies Company may have, Company is entitled to obtain injunctive relief against Executive. Nothing herein, however, shall be construed as limiting the Company's right to pursue any other available remedy at law or in equity, including recovery of damages and termination of this Agreement and/or any payments that may be due pursuant to this Agreement. (K) RIGHT TO ENTER AGREEMENT. Executive represents and covenants to the Company that he has full power and authority to enter into this Agreement and that the execution of this Agreement will not breach or constitute a default of any other agreement or contract to which he is a party or by which he is bound. (L) ENFORCEABILITY. The agreements contained in this Section 5 are independent of the other agreements contained herein. Accordingly, failure of the Company to comply with any of its obligations outside of this Section do not excuse Executive from complying with the agreements contained herein. (M) SURVIVABILITY. The agreements contained in this Section 5 shall survive the termination of this Agreement for any reason. (N) REFORMATION. If a court concludes that any time period or the geographic area specified in Section 5(c) or 5(e) of this Agreement are unenforceable, then the time period will be reduced by the number of months, or the geographic area will be reduced by the elimination of the overbroad portion, or both, so that the restrictions may be enforced in the geographic area and for the time to the fullest extent permitted by law. 6. ASSIGNMENT. This Agreement cannot be assigned by Executive. The Company may assign this Agreement only to a successor (whether direct or indirect, by purchase, merger, consolidation or otherwise) to all or substantially all of the business and assets of the Company provided such successor expressly agrees in writing reasonably satisfactory to Executive to assume and perform this Agreement in the same manner and to the same extent that the Company would be required to perform it if no such succession and assignment had taken place. Failure of the Company to obtain such written agreement prior to the effectiveness of any such succession shall be a material breach of this Agreement. 8 7. BINDING AGREEMENT. Executive understands that his obligations under this Agreement are binding upon Executive's heirs, successors, personal representatives, and legal representatives. 8. NOTICES. All notices pursuant to this Agreement shall be in writing and sent certified mail, return receipt requested, addressed as set forth below, or by delivering the same in person to such party, or by transmission by facsimile to the number set forth below (which shall not constitute notice). Notice deposited in the United States Mail, mailed in the manner described hereinabove, shall be effective upon deposit. Notice given in any other manner shall be effective only if and when received: If to Executive: Christopher L. Martin 5901 Fordham Houston, Texas 77005 Fax: 713 661 7922 If to Company: HCC Insurance Holdings, Inc. 13403 Northwest Freeway Houston, Texas 77040 Attn: General Counsel Fax: (713) 744-9648 with a copy (which shall Arthur S. Berner, Esq. not constitute notice) to: Haynes and Boone, LLP 1000 Louisiana Street, Suite 4300 Houston, Texas 77002-5012 Fax: (713) 236-5652 9. WAIVER. No waiver by either party to this Agreement of any right to enforce any term or condition of this Agreement, or of any breach hereof, shall be deemed a waiver of such right in the future or of any other right or remedy available under this Agreement. 10. SEVERABILITY. If any provision of this Agreement is determined to be void, invalid, unenforceable, or against public policy, such provisions shall be deemed severable from the Agreement, and the remaining provisions of the Agreement will remain unaffected and in full force and effect. 11. ENTIRE AGREEMENT. The terms and provisions contained herein shall constitute the entire agreement between the parties with respect to Executive's employment with Company during the time period covered by this Agreement. This Agreement replaces and supersedes any and all existing Agreements entered into between Executive and the Company relating generally to the same subject matter, if any, and shall be binding upon Executive's heirs, executors, administrators, or other legal representatives or assigns. 9 12. MODIFICATION OF AGREEMENT. This Agreement may not be changed or modified or released or discharged or abandoned or otherwise terminated, in whole or in part, except by an instrument in writing signed by the Executive and an officer or other authorized executive of Company. 13. UNDERSTAND AGREEMENT. Executive represents and warrants that he has read and understood each and every provision of this Agreement, and Executive understands that he has the right to obtain advice from legal counsel of his choice, if necessary and desired, in order to interpret any and all provisions of this Agreement, and that Executive has freely and voluntarily entered into this Agreement. 14. GOVERNING LAW. This Agreement shall be governed by and construed in accordance with the laws of the State of Texas. 15. JURISDICTION AND VENUE. With respect to any litigation regarding this Agreement, Executive agrees to venue in the state or federal courts in Harris County, Texas, and agrees to waive and does hereby waive any defenses and/or arguments based upon improper venue and/or lack of personal jurisdiction. By entering into this Agreement, Executive agrees to personal jurisdiction in the state and federal courts in Harris County, Texas. 16. TOLLING. If Executive violates any of the restrictions contained in Section 5(c) or 5(e), the restrictive period will be suspended and will not run in favor of Executive from the time of the commencement of any violation until the time when the Executive cures the violation to the Company's satisfaction. REMAINDER OF THIS PAGE LEFT INTENTIONALLY BLANK 10 IN WITNESS WHEREOF, the Parties have executed this Agreement in multiple copies, effective as of the date first written above. EXECUTIVE COMPANY HCC INSURANCE HOLDINGS, INC. /s/ Christopher L. Martin By:/s/ Stephen L. Way - ---------------------------- --------------------------- CHRISTOPHER L. MARTIN STEPHEN L. WAY, Chief Executive Officer Dated: March 26, 2003 Dated: March 26, 2003 ---------------------- -------------------------- SIGNATURE PAGE TO EMPLOYMENT AGREEMENT 11 APPENDIX 1 1. Executive shall be employed as an Executive Vice President General Councel of the Company. 2. Dues paid at The Houstonian. 3. Car allowance of $750 per month. EX-12 9 h03402exv12.txt STATEMENT RE COMPUTATION OF RATIOS . . . HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES STATEMENT OF RATIOS
FOR THE YEARS ENDED DECEMBER 31, (DOLLARS IN THOUSANDS) ADJUSTED 2002 2001 2000 1999 (2) 1999 1998 Gross premium to surplus ratio: Gross written premium $1,163,397 $1,014,833 $ 972,154 $ 576,184 $ 500,962 Policyholders' surplus 523,807 401,393 326,249 315,474 369,401 Premium to surplus ratio (1) 222.1% 252.8% 298.0% 182.6% 135.6% (Gross premium to surplus ratio = gross written premium divided by policyholders' surplus) Net premium to surplus ratio: Net written premium $ 545,475 $ 371,409 $ 283,947 $ 150,261 $ 123,315 Policyholders' surplus 523,807 401,393 326,249 315,474 369,401 Premium to surplus ratio (1) 104.1% 92.5% 87.0% 47.6% 33.4% (Net premium to surplus ratio = net written premium divided by policyholders' surplus) Loss ratio: Incurred loss and loss adjustment expense $ 313,744 $ 266,537 $ 190,272 $ 119,093 $ 160,908 $ 95,435 Net earned premium 506,371 341,779 267,481 146,850 150,304 142,108 Loss ratio (1) 62.0% 78.0% 71.1% 81.1% 107.1% 67.2% (Loss ratio = incurred loss and loss adjustment expense divided by net earned premium) Expense ratio: Underwriting expense $ 130,578 $ 88,461 $ 76,548 $ 33,427 $ 34,220 $ 19,417 Net written premium 545,475 371,409 283,947 145,200 150,261 123,315 Expense ratio (1) 23.9% 23.8% 27.0% 23.0% 22.8% 15.7% (Expense ratio = underwriting expense divided by net written premium) Combined ratio (1) 85.9% 101.8% 98.1% 104.1% 129.9% 82.9% (Combined ratio = loss ratio plus expense ratio)
(1) Calculated for our insurance companies on the basis of statutory accounting principles. (2) Excluding the effects of the provision for reinsurance in 1999 HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES STATEMENT OF RATIOS (continued)
FOR THE YEARS ENDED DECEMBER 31, (DOLLARS IN THOUSANDS) ADJUSTED 2002 2001 2000 1999 (2) 1999 1998 Loss ratio: Incurred loss and loss adjustment expense $306,491 $267,390 $198,470 $109,650 $109,650 $ 91,302 Net earned premium 505,521 342,787 267,647 141,362 141,362 143,100 Loss ratio (3) 60.6% 78.0% 74.2% 77.6% 77.6% 63.8% (Loss ratio = incurred loss and loss adjustment expense divided by net earned premium) Expense ratio: Underwriting expense $128,528 $ 88,192 $ 56,223 $ 29,661 $ 73,123 $ 30,700 Net earned premium 505,521 342,787 267,647 141,362 141,362 143,100 Expense ratio (3) 25.4% 25.7% 21.0% 21.0% 51.7% 21.5% (Expense ratio = underwriting expense divided by net earned premium) Combined ratio (3) 86.0% 103.7% 95.2% 98.6% 129.3% 85.3% (Combined ratio = loss ratio plus expense ratio)
(2) Excluding the effects of the provision for reinsurance in 1999. (3) Calculated for our insurance companies on the basis of generally accepted accounting principles. EX-21 10 h03402exv21.txt SUBSIDIARIES . . . HCC INSURANCE HOLDINGS, INC. SUBSIDIARIES
STATE OR COUNTRY NAME OF INCORPORATION ---- ---------------- 1. ASU International, Inc. Massachusetts 2. ASU International Limited (UK) United Kingdom 3. Avemco Corporation Delaware 4. Avemco Insurance Company Maryland 5. Avemco Services, Inc. Maryland 6. Aviation & Marine Premium Acceptance Corporation Texas 7. Centris Insurance Company Indiana 8. Centris Underwriting Agencies, Inc. Indiana 9. Dickson Manchester & Company, Limited (UK) United Kingdom 10. Dickson Manchester Underwriting, Limited (UK) United Kingdom 11. Eagles Aerobatic Flight Team, Inc. Wisconsin 12. Eastern Aviation & Marine Underwriters, Inc. Maryland 13. Euro Sports Underwriters Limited (UK) United Kingdom 14. HCC Acquisitions (U.K.) Limited United Kingdom 15. HCC Acquisition Sub, Inc. New York 16. HCC Administrators, Inc. Illinois 17. HCC Aviation Insurance Group, Inc. Texas 18. HCC Aviation, Ltd. Texas 19. HCC Benefits Corporation Delaware 20. HCC Employee Benefits, Inc. Delaware 21. HCC Employer Services, Inc. (AL) Alabama 22. HCC Employer Services, Inc. (IL) Illinois 23. HCC Intermediate Holdings, Inc. Delaware 24. HCC Life Insurance Company Indiana 25. HCC Reinsurance Company Limited (Bermuda) Bermuda 26. HCC Risk Management Corporation Texas 27. HCC Risk Management, Inc. Indiana 28. HCC Service Company, Ltd. Texas 29. HCC Service Delaware, LLC Delaware 30. HCC Specialty Insurance Company Oklahoma 31. HCC Specialty Insurance Holdings Ltd. United Kingdom 32. HCC Strategic Investments, LLC Delaware 33. HCC Underwriters, a Texas Corporation Texas 34. HCCS Corporation Delaware 35. Houston Casualty Company Texas 36. Houston Casualty Company Europe, Seguros y Reaseguros, S.A. (Spain) Spain 37. Intellicare, Inc. Alabama 38. Interra, Inc. Indiana 39. Interra Reinsurance Group, Inc. Indiana 40. LDG Insurance Agency Incorporated Massachusetts 41. LDG Re (London) Ltd. United Kingdom 42. LDG Re Worldwide Limited Delaware 43. LDG Re Worldwide Limited (UK) United Kingdom 44. LDG Reinsurance Corporation Massachusetts 45. Loss Management, Inc. Delaware 46. Loss Management Services, Inc. Maryland 47. MAG Acquisition Sub, Inc. Delaware 48. HCC Global Financial Products, LLC Delaware
49. HCC Global Financial Products of Alabama, LLC Alabama 50. HCC Global Financial Products of Georgia, LLC Georgia 51. HCC Global Financial Products, S.L. Spain 52. HCC Global Financial Products of Texas, LLC Texas 53. Manchester Dickson Holdings, Limited (UK) United Kingdom 54. Marshall Adjusting Corp. New York 55. Marshall Rattner, Inc. New York 56. Merger Sub, Inc. Texas 57. National Insurance Underwriters Arkansas 58. PEPYS Holdings Limited United Kingdom 59. PEPYS Management Services Limited United Kingdom 60. Premier Risk Services Limited United Kingdom 61. Professional Indemnity Agency, Inc. New Jersey 62. Professional Indemnity Agency, Inc. of New York New York 63. Rattner Mackenzie Insurance Services (Guernsey) Ltd. Guernsey 64. Rattner Mackenzie Ltd. (Bermuda) Bermuda 65. Rattner Mackenzie Limited (UK) United Kingdom 66. Rattner Mackenzie Limited (RML) (Exempted) Co. Jordan 67. Rattner Mackenzie (North America), Inc. New York 68. SBS Insurance Holdings, a Texas Corporation Texas 69. Select Benefits, Inc. Indiana 70. Signal Aviation Insurance Services, Inc. Nevada 71. Specialty Reinsurance Intermediaries, Inc. Massachusetts 72. Specialty Insurance Underwriters, Inc. Missouri 73. HCC Specialty Insurance Holdings Ltd. United Kingdom 74. The Centris Group, Inc. Delaware 75. The Schanen Consulting Group, LLC Georgia 76. The Wheatley Group, Ltd. New York 77. TMD Rattner, L.L.C. New York 78. TTR, L.L.C. New York 79. USBenefits Insurance Services, Inc. California 80. US Holdings, Inc. Delaware 81. U.S. Specialty Insurance Company Texas 82. VASA Brougher, Inc. Indiana 83. VASA Insurance Group, Inc. Indiana 84. VASA North America, Inc. Indiana
EX-23 11 h03402exv23.txt CONSENT OF PRICEWATERHOUSECOOPERS LLP CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the registration statements on Form S-8 (Nos. 333-89905 and 333-99551) and Form S-3 (Nos. 333-58350 and 333-76122) of HCC Insurance Holdings, Inc. of our reports dated March 21, 2003, relating to the financial statements and financial statement schedules, which appear in HCC Insurance Holdings, Inc.'s Annual Report on Form 10-K for the year ended December 31, 2002. /s/ PricewaterhouseCoopers LLP Houston, Texas March 27, 2003 EX-24 12 h03402exv24.txt POWERS OF ATTORNEY POWER OF ATTORNEY Know all men by these presents, that the undersigned constitutes and appoints Stephen L. Way and Edward H. Ellis, Jr., and each of them, his true and lawful attorney-in-fact and agent, with full power of substitution and re-substitution, for him and in his name, place and stead, in any and all capacities, to sign this Annual Report on Form 10-K and any and all amendments thereto, and to file same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto such attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that such attorneys-in-fact and agents or any of the, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. /s/ FRANK J. BRAMANTI ------------------------ Frank J. Bramanti Date: March 20, 2003 POWER OF ATTORNEY Know all men by these presents, that the undersigned constitutes and appoints Stephen L. Way and Edward H. Ellis, Jr., and each of them, his true and lawful attorney-in-fact and agent, with full power of substitution and re-substitution, for him and in his name, place and stead, in any and all capacities, to sign this Annual Report on Form 10-K and any and all amendments thereto, and to file same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto such attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that such attorneys-in-fact and agents or any of the, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. /s/ PATRICK B. COLLINS ------------------------ Patrick B. Collins Date: March 20, 2003 POWER OF ATTORNEY Know all men by these presents, that the undersigned constitutes and appoints Stephen L. Way and Edward H. Ellis, Jr., and each of them, his true and lawful attorney-in-fact and agent, with full power of substitution and re-substitution, for him and in his name, place and stead, in any and all capacities, to sign this Annual Report on Form 10-K and any and all amendments thereto, and to file same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto such attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that such attorneys-in-fact and agents or any of the, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. /s/ JAMES R. CRANE ------------------------ James R. Crane Date: March 20, 2003 POWER OF ATTORNEY Know all men by these presents, that the undersigned constitutes and appoints Stephen L. Way and Edward H. Ellis, Jr., and each of them, his true and lawful attorney-in-fact and agent, with full power of substitution and re-substitution, for him and in his name, place and stead, in any and all capacities, to sign this Annual Report on Form 10-K and any and all amendments thereto, and to file same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto such attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that such attorneys-in-fact and agents or any of the, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. /s/ J. ROBERT DICKERSON ------------------------ J. Robert Dickerson Date: March 20, 2003 POWER OF ATTORNEY Know all men by these presents, that the undersigned constitutes and appoints Stephen L. Way and Edward H. Ellis, Jr., and each of them, his true and lawful attorney-in-fact and agent, with full power of substitution and re-substitution, for him and in his name, place and stead, in any and all capacities, to sign this Annual Report on Form 10-K and any and all amendments thereto, and to file same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto such attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that such attorneys-in-fact and agents or any of the, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. /s/ JAMES C. FLAGG, PHD. ------------------------ James C. Flagg, PhD. Date: March 20, 2003 POWER OF ATTORNEY Know all men by these presents, that the undersigned constitutes and appoints Stephen L. Way and Edward H. Ellis, Jr., and each of them, his true and lawful attorney-in-fact and agent, with full power of substitution and re-substitution, for him and in his name, place and stead, in any and all capacities, to sign this Annual Report on Form 10-K and any and all amendments thereto, and to file same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto such attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that such attorneys-in-fact and agents or any of the, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. /s/ EDWIN H. FRANK, III ----------------------- Edwin H. Frank, III Date: March 20, 2003 POWER OF ATTORNEY Know all men by these presents, that the undersigned constitutes and appoints Stephen L. Way and Edward H. Ellis, Jr., and each of them, his true and lawful attorney-in-fact and agent, with full power of substitution and re-substitution, for him and in his name, place and stead, in any and all capacities, to sign this Annual Report on Form 10-K and any and all amendments thereto, and to file same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto such attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that such attorneys-in-fact and agents or any of the, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. /s/ ALLAN W. FULKERSON ------------------------ Allan W. Fulkerson Date: March 20, 2003 POWER OF ATTORNEY Know all men by these presents, that the undersigned constitutes and appoints Stephen L. Way and Edward H. Ellis, Jr., and each of them, his true and lawful attorney-in-fact and agent, with full power of substitution and re-substitution, for him and in his name, place and stead, in any and all capacities, to sign this Annual Report on Form 10-K and any and all amendments thereto, and to file same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto such attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that such attorneys-in-fact and agents or any of the, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. /s/ WALTER J. LACK ------------------------ Walter J. Lack Date: March 20, 2003 POWER OF ATTORNEY Know all men by these presents, that the undersigned constitutes and appoints Stephen L. Way and Edward H. Ellis, Jr., and each of them, his true and lawful attorney-in-fact and agent, with full power of substitution and re-substitution, for him and in his name, place and stead, in any and all capacities, to sign this Annual Report on Form 10-K and any and all amendments thereto, and to file same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto such attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that such attorneys-in-fact and agents or any of the, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. /s/ MICHAEL A. F. ROBERTS -------------------------- Michael A. F. Roberts Date: March 20, 2003 EX-99.1 13 h03402exv99w1.txt CERTIFICATION RE ANNUAL REPORT CERTIFICATION WITH RESPECT TO ANNUAL REPORT OF HCC INSURANCE HOLDINGS, INC. The undersigned, being the chief executive officer and chief financial officer of HCC Insurance Holdings, Inc. (the "Company"), in compliance with the White-Collar Crime Penalty Enhancement Act of 2002, 18 U.S.C. Section 1350, do hereby certify to the best of their knowledge with respect to the Annual Report of the Company on Form 10-K, as filed with the Securities and Exchange Commission for the year ended December 31, 2002, (the "Report"): 1. that the Report fully complies with all requirements of section 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended; and 2. that the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. March 27, 2003 /s/ Stephen L. Way - ---------------------- --------------------------------------------------------- (Date) Stephen L. Way, Chairman of the Board, Chief Executive Officer and President March 27, 2003 /s/ Edward H. Ellis, Jr. - ---------------------- --------------------------------------------------------- (Date) Edward H. Ellis, Jr., Executive Vice President and Chief Financial Officer
EX-99.2 14 h03402exv99w2.txt CERTIFICATION OF CEO PURSUANT TO SECTION 906 EXHIBIT 99.2 CERTIFICATION BY CHIEF EXECUTIVE OFFICER I, Stephen L. Way, certify that: 1. I have reviewed this annual report on Form 10-K of HCC Insurance Holdings, Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a. designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b. evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c. presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a. all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. /s/ STEPHEN L. WAY -------------------------------------- Stephen L. Way, Chairman of the Board, Chief Executive Officer and President March 27, 2003 - ------------------ (Date) A signed original of this written statement required by Section 906 has been provided to HCC Insurance Holdings, Inc. and will be retained by HCC Insurance Holdings, Inc. and furnished by the Securities and Exchange Commission or its staff upon request. EX-99.3 15 h03402exv99w3.txt CERTIFICATION OF CFO PURSUANT TO SECTION 906 EXHIBIT 99.3 CERTIFICATION BY CHIEF FINANCIAL OFFICER I, Edward H. Ellis, Jr., certify that: 1. I have reviewed this annual report on Form 10-K of HCC Insurance Holdings, Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a. designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b. evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c. presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a. all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. /s/ EDWARD H. ELLIS, JR. -------------------------------------- Edward H. Ellis, Jr. Executive Vice President and Chief Financial Officer March 27, 2003 - ------------------ (Date) A signed original of this written statement required by Section 906 has been provided to HCC Insurance Holdings, Inc. and will be retained by HCC Insurance Holdings, Inc. and furnished by the Securities and Exchange Commission or its staff upon request. -----END PRIVACY-ENHANCED MESSAGE-----