10-Q 1 h10511e10vq.txt HCC INSURANCE HOLDINGS, INC. - 9/30/2003 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the Quarter Ended September 30, 2003. [ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 from _______ to __________ Commission file number 001-13790 ---------------------------------------------------- HCC Insurance Holdings, Inc. ------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) Delaware 76-0336636 ------------------------------------------------------------------------------- (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) 13403 Northwest Freeway, Houston, Texas 77040-6094 ------------------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) (713) 690-7300 ------------------------------------------------------------------------------- (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12B-2 of the Act). Yes [X] No [ ] Indicate the number of shares outstanding of each of the issuer's classes of common stock as of the latest practicable date. On October 31, 2003, there were 63.8 million shares of common stock, $1.00 par value issued and outstanding. 1 HCC INSURANCE HOLDINGS, INC. INDEX
PAGE NO. -------- Part I. FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets September 30, 2003 and December 31, 2002 ..................................................3 Condensed Consolidated Statements of Earnings For the nine months and three months ended September 30, 2003 and 2002 ....................4 Condensed Consolidated Statements of Changes in Shareholders' Equity For the nine months ended September 30, 2003...............................................5 Condensed Consolidated Statements of Cash Flows For the nine months and three months ended September 30, 2003 and 2002 ....................6 Notes to Condensed Consolidated Financial Statements............................................7 Item 2. Management's Discussion and Analysis...........................................................21 Item 3. Quantitative and Qualitative Disclosures About Market Risk.....................................30 Item 4. Controls and Procedures........................................................................30 Part II. OTHER INFORMATION Item 1. Legal Proceedings..............................................................................31 Item 6. Exhibits and Reports on Form 8-K...............................................................31 Signatures.......................................................................................................32
This report on Form 10-Q contains certain "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934, which are intended to be covered by the safe harbors created by those laws. We have based these forward-looking statements on our current expectations and projections about future events. These forward-looking statements include information about possible or assumed future results of our operations. All statements, other than statements of historical facts, included or incorporated by reference in this report that address activities, events or developments that we expect or anticipate may occur in the future, including such things as future capital expenditures, business strategy, competitive strengths, goals, growth of our business and operations, plans and references to future successes may be considered forward-looking statements. Also, when we use words such as "anticipate," "believe," "estimate," "expect," "intend," "plan," "probably" or similar expressions, we are making forward-looking statements. Many risks and uncertainties may impact the matters addressed in these forward-looking statements. Many possible events or factors could affect our future financial results and performance. These could cause our results or performance to differ materially from those we express in our forward-looking statements. Although we believe that the assumptions underlying our forward-looking statements are reasonable, any of these assumptions, and therefore also the forward-looking statements based on these assumptions, could themselves prove to be inaccurate. In light of the significant uncertainties inherent in the forward-looking statements which are included in this report, our inclusion of this information is not a representation by us or any other person that our objectives and plans will be achieved. Our forward-looking statements speak only as of the date made and we will not update these forward-looking statements unless the securities laws require us to do so. In light of these risks, uncertainties and assumptions, any forward-looking events discussed in this report may not occur. 2 HCC Insurance Holdings, Inc. and Subsidiaries Condensed Consolidated Balance Sheets (unaudited, in thousands, except per share data)
September 30, 2003 December 31, 2002 ------------------ ----------------- ASSETS Investments: Fixed income securities, at market (cost: 2003 - $1,034,445; 2002 - $807,772) $ 1,069,660 $ 841,548 Marketable equity securities, at market (cost: 2003 - $15,118; 2002 - $15,815) 15,023 15,609 Short-term investments, at cost, which approximates market 430,379 307,215 Other investments, at estimated fair value (cost: 2003 - $2,181; 2002 - $3,264) 2,181 3,264 ---------------- --------------- Total investments 1,517,243 1,167,636 Cash 25,004 40,306 Restricted cash 211,530 189,396 Premium, claims and other receivables 954,599 753,527 Reinsurance recoverables 906,642 798,934 Ceded unearned premium 255,401 164,224 Ceded life and annuity benefits 77,901 78,951 Deferred policy acquisition costs 115,729 68,846 Goodwill 344,497 335,288 Other assets 211,339 107,043 ---------------- --------------- TOTAL ASSETS $ 4,619,885 $ 3,704,151 ================ =============== LIABILITIES Loss and loss adjustment expense payable $ 1,406,843 $ 1,155,290 Life and annuity policy benefits 77,901 78,951 Reinsurance balances payable 251,975 166,659 Unearned premium 558,701 331,050 Deferred ceding commissions 74,424 49,963 Premium and claims payable 867,472 749,523 Notes payable 310,505 230,027 Accounts payable and accrued liabilities 65,582 59,781 ---------------- --------------- Total liabilities 3,613,403 2,821,244 SHAREHOLDERS' EQUITY Common stock, $1.00 par value; 250.0 million shares authorized; (shares issued and outstanding: 2003 - 63,805; 2002 - 62,358) 63,805 62,358 Additional paid-in capital 444,012 416,406 Retained earnings 473,678 383,378 Accumulated other comprehensive income 24,987 20,765 ---------------- --------------- Total shareholders' equity 1,006,482 882,907 ---------------- --------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 4,619,885 $ 3,704,151 ================ ===============
See Notes to Condensed Consolidated Financial Statements. 3 HCC Insurance Holdings, Inc. and Subsidiaries Condensed Consolidated Statements of Earnings (unaudited, in thousands, except per share data)
For the nine months ended For the three months ended September 30, September 30, 2003 2002 2003 2002 --------------- --------------- --------------- --------------- REVENUE Net earned premium $ 535,354 $ 362,399 $ 189,440 $ 136,294 Management fees 78,975 57,052 29,434 18,057 Commission income 42,797 31,631 14,445 10,403 Net investment income 34,867 27,781 11,997 9,797 Net realized investment gain (loss) 352 1,159 168 (10) Other operating income 8,275 3,271 3,136 1,131 --------------- --------------- --------------- --------------- Total revenue 700,620 483,293 248,620 175,672 EXPENSE Loss and loss adjustment expense 339,065 221,246 118,953 85,163 Operating expense: Policy acquisition costs, net 64,521 44,467 23,063 18,933 Compensation expense 84,181 58,744 29,113 19,203 Other operating expense 45,159 36,583 15,547 12,591 --------------- --------------- --------------- --------------- Total operating expense 193,861 139,794 67,723 50,727 Interest expense 5,497 6,892 1,901 2,051 --------------- --------------- --------------- --------------- Total expense 538,423 367,932 188,577 137,941 --------------- --------------- --------------- --------------- Earnings before income tax provision 162,197 115,361 60,043 37,731 Income tax provision 58,909 41,028 21,692 13,462 --------------- --------------- --------------- --------------- Net earnings $ 103,288 $ 74,333 $ 38,351 $ 24,269 =============== =============== =============== =============== BASIC EARNINGS PER SHARE DATA: Earnings per share $ 1.64 $ 1.20 $ 0.60 $ 0.39 =============== =============== =============== =============== Weighted average shares outstanding 63,078 62,170 63,717 62,335 =============== =============== =============== =============== DILUTED EARNINGS PER SHARE DATA: Earnings per share $ 1.61 $ 1.18 $ 0.59 $ 0.39 =============== =============== =============== =============== Weighted average shares outstanding 64,106 62,841 64,885 62,871 =============== =============== =============== =============== Cash dividends declared, per share $ 0.205 $ 0.19 $ 0.075 $ 0.065 =============== =============== =============== ===============
See Notes to Condensed Consolidated Financial Statements. 4 HCC Insurance Holdings, Inc. and Subsidiaries Condensed Consolidated Statements of Changes in Shareholders' Equity For the nine months ended September 30, 2003 (unaudited, in thousands, except per share data, continued)
Accumulated Additional other Total Common paid-in Retained comprehensive shareholders' stock capital earnings income equity --------- --------- ---------- --------- ------------- BALANCE AS OF DECEMBER 31, 2002 $ 62,358 $ 416,406 $ 383,378 $ 20,765 $ 882,907 Net earnings -- -- 103,288 -- 103,288 Other comprehensive income -- -- -- 4,222 4,222 ---------- Comprehensive income 107,510 1,081 shares of common stock issued for exercise of options, including tax benefit of $3,305 1,081 19,700 -- -- 20,781 Issuance of 52 shares of contractually issuable common stock 52 (52) -- -- -- Issuance of 314 shares for acquisition of subsidiaries 314 7,958 -- -- 8,272 Cash dividends declared, $0.205 per share -- -- (12,988) -- (12,988) --------- --------- --------- --------- ---------- BALANCE AS OF SEPTEMBER 30, 2003 $ 63,805 $ 444,012 $ 473,678 $ 24,987 $1,006,482 ========= ========= ========= ========= ==========
See Notes to Condensed Consolidated Financial Statements. 5 HCC Insurance Holdings, Inc. and Subsidiaries Condensed Consolidated Statements of Cash Flows (unaudited, in thousands, except per share data)
For the nine months ended For the three months ended September 30, September 30, 2003 2002 2003 2002 ------------ ------------ ------------ ------------ Cash flows from operating activities: Net earnings $ 103,288 $ 74,333 $ 38,351 $ 24,269 Adjustments to reconcile net earnings to net cash provided by operating activities: Change in premium, claims and other receivables (177,880) (52,440) (7,934) (14,989) Change in reinsurance recoverables (107,708) 52,969 (43,624) 22,933 Change in ceded unearned premium (91,177) (63,893) (25,364) (24,583) Change in loss and loss adjustment expense payable 251,553 (46,305) 101,720 (11,141) Change in reinsurance balances payable 85,316 58,412 21,051 19,953 Change in unearned premium 227,651 100,800 60,931 32,421 Change in premium and claims payable, net of restricted cash 67,849 (16,865) 2,496 24,513 Depreciation and amortization expense 8,485 7,933 2,921 2,555 Other, net (41,487) 7,884 (23,930) 215 ------------ ------------ ------------ ------------ Cash provided by operating activities 325,890 122,828 126,618 76,146 Cash flows from investing activities: Sales of fixed income securities 131,884 197,466 8,703 43,302 Maturity or call of fixed income securities 112,248 32,951 43,162 13,260 Sales of equity securities 1,165 3,417 -- -- Other proceeds 16,846 -- -- -- Change in short-term investments (114,801) 55,867 (25,238) 14,365 Cost of securities acquired (520,491) (412,521) (112,616) (125,421) Payments for purchase of subsidiaries, net of cash received (16,680) -- (12,601) -- Purchases of property and equipment (20,260) (3,948) (17,125) (1,110) ------------ ------------ ------------ ------------ Cash used by investing activities (410,089) (126,768) (115,715) (55,604) Cash flows from financing activities: Issuance of notes payable, net of costs 134,845 40,000 -- -- Sale of common stock 17,476 10,038 5,507 777 Payments on notes payable (68,723) (15,409) (1,101) (2,140) Dividends paid and other, net (14,701) (12,831) (6,564) (3,887) ------------ ------------ ------------ ------------ Cash provided (used) by financing activities 68,897 21,798 (2,158) (5,250) ------------ ------------ ------------ ------------ Net change in cash (15,302) 17,858 8,745 15,292 Cash at beginning of period 40,306 16,891 16,259 19,457 ------------ ------------ ------------ ------------ CASH AT END OF PERIOD $ 25,004 $ 34,749 $ 25,004 $ 34,749 ============ ============ ============ ============
See Notes to Condensed Consolidated Financial Statements 6 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (unaudited, in thousands, except per share data) (1) GENERAL INFORMATION HCC Insurance Holdings, Inc. and its subsidiaries ("we," "us" and "our") provide specialized property and casualty and accident and health insurance coverages, underwriting agency and intermediary services to commercial customers and individuals. Our lines of business include group life, accident and health; aviation; our London market account (which includes energy, marine, property and some accident and health); diversified financial products (which includes directors and officers liability, errors and omissions, employment practices liability and surety); and other specialty lines of insurance. We operate primarily in the United States, the United Kingdom, Bermuda and Spain, although some of our operations have a broader international scope. We market our products both directly to customers and through a network of independent and affiliated agents and brokers. Basis of Presentation The unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and include all adjustments which are, in our opinion, necessary for a fair presentation of the results of the interim periods. All adjustments made to the interim periods are of a normal recurring nature. The condensed consolidated financial statements include the accounts of HCC Insurance Holdings, Inc. and those of our wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated. The condensed consolidated financial statements for periods reported should be read in conjunction with the annual audited consolidated financial statements and related notes. The condensed consolidated balance sheet as of December 31, 2002, was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. During the fourth quarter of 2002, we completed three acquisitions. The results of operations of these entities are included in our condensed consolidated financial statements beginning on the effective date of each transaction. Thus, our condensed consolidated statements of earnings and cash flows for the nine and three months ended September 30, 2002 do not contain any activity generated by these three entities. We are still in the process of completing the purchase price allocation for one of these acquisitions as we are still gathering some of the information needed to make the required calculations. Any subsequent net adjustment will result in a change to recorded goodwill. During the first quarter of 2003, we adopted prospectively Financial Accounting Standards Board Interpretation ("FIN") No. 46 entitled "Consolidation of Variable Interest Entities". We now consolidate an investment in a partnership that owns an office building leased to unaffiliated third parties, whereas previously we used the equity method of accounting to account for this investment. The partnership is not material to our financial position, results of operations or cash flows. Income Tax For the nine months and three months ended September 30, 2003 and 2002, the income tax provision has been calculated based on an estimated effective tax rate for each of the fiscal years. The difference between our effective tax rate and the Federal statutory rate is primarily the result of state income taxes and tax exempt municipal bond interest. 7 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (unaudited, in thousands, except per share data, continued) (1) GENERAL INFORMATION, CONTINUED Stock Options We account for stock options granted to employees using the intrinsic value method of APB Opinion No. 25 entitled "Accounting for Stock Issued to Employees". All options have been granted at fixed exercise prices at the market price of our common stock at the grant date. Because of that, no stock-based employee compensation cost is reflected in our reported net earnings. Options vest over a period of up to seven years and expire four to ten years after grant date. The following table illustrates the effects on net earnings and earnings per share if we had used the fair value method of SFAS No. 123 entitled "Accounting for Stock-Based Compensation".
For the nine months ended For the three months ended September 30, September 30, 2003 2002 2003 2002 ----------- ----------- ----------- ----------- Reported net earnings $ 103,288 $ 74,333 $ 38,351 $ 24,269 Stock-based compensation using fair value method, net of income tax (5,525) (3,882) (1,654) (1,599) ----------- ----------- ----------- ----------- Pro forma net earnings $ 97,763 $ 70,451 $ 36,697 $ 22,670 =========== =========== =========== ========== Reported basic earnings per share $ 1.64 $ 1.20 $ 0.60 $ 0.39 Fair value stock-based compensation (0.09) (0.07) (0.02) (0.03) ----------- ----------- ----------- ---------- Pro forma basic earnings per share $ 1.55 $ 1.13 $ 0.58 $ 0.36 =========== =========== =========== ========== Reported diluted earnings per share $ 1.61 $ 1.18 $ 0.59 $ 0.39 Fair value stock-based compensation (0.08) (0.06) (0.02) (0.03) ----------- ----------- ----------- ---------- Pro forma diluted earnings per share $ 1.53 $ 1.12 $ 0.57 $ 0.36 =========== =========== =========== ==========
Reclassifications Certain amounts in our 2002 condensed consolidated financial statements have been reclassified to conform to the 2003 presentation. Such reclassifications had no effect on our net earnings, shareholders' equity or cash flows. 8 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (unaudited, in thousands, except per share data, continued) (2) ACQUISITION On July 1, 2003, we completed the acquisition of the CUL Group of companies, which included Covenant Underwriters Ltd., an underwriting agency, and Continental Underwriters Ltd., an intermediary. The companies were acquired to diversify into a new specialty line of business. This business combination has been recorded using the purchase method of accounting. The results of operations of these companies have been included in our consolidated financial statements beginning on the effective date of the transaction. We are still in the process of completing the purchase price allocation for this acquisition, as we are still gathering some of the information needed to make the required calculations. The consideration paid and the inclusion of the acquired company's financial information in our consolidated financial statements is not material to our financial position or results of operations. (3) REINSURANCE In the normal course of business our insurance companies cede a portion of their premium to non-affiliated domestic and foreign reinsurers through treaty and facultative reinsurance agreements. Although the ceding of reinsurance does not discharge the primary insurer from liability to its policyholder, our insurance companies participate in such agreements for the purpose of limiting their loss exposure, protecting them against catastrophic loss and diversifying their business. The following table represents the effect of such reinsurance transactions on premium and loss and loss adjustment expense:
Loss and Loss Written Earned Adjustment Premium Premium Expense --------------- --------------- --------------- For the nine months ended September 30, 2003: Direct business $ 1,010,186 $ 846,450 $ 505,110 Reinsurance assumed 289,581 230,988 267,609 Reinsurance ceded (633,640) (542,084) (433,654) --------------- --------------- --------------- NET AMOUNTS $ 666,127 $ 535,354 $ 339,065 =============== =============== =============== For the nine months ended September 30, 2002: Direct business $ 674,258 $ 586,386 $ 389,359 Reinsurance assumed 177,826 162,304 71,321 Reinsurance ceded (449,856) (386,291) (239,434) --------------- --------------- --------------- NET AMOUNTS $ 402,228 $ 362,399 $ 221,246 =============== =============== ===============
9 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (unaudited, in thousands, except per share data, continued) (3) REINSURANCE, CONTINUED
Loss and Loss Written Earned Adjustment Premium Premium Expense --------------- --------------- --------------- For the three months ended September 30, 2003: Direct business $ 355,576 $ 308,195 $ 169,198 Reinsurance assumed 87,464 77,155 98,949 Reinsurance ceded (220,505) (195,910) (149,194) --------------- --------------- --------------- NET AMOUNTS $ 222,535 $ 189,440 $ 118,953 =============== =============== =============== For the three months ended September 30, 2002: Direct business $ 237,478 $ 208,300 $ 128,201 Reinsurance assumed 60,986 57,308 42,055 Reinsurance ceded (153,898) (129,314) (85,093) --------------- --------------- --------------- NET AMOUNTS $ 144,566 $ 136,294 $ 85,163 =============== =============== ===============
The table below represents the composition of reinsurance recoverables in our condensed consolidated balance sheets:
September 30, 2003 December 31, 2002 ------------------ ----------------- Reinsurance recoverable on paid losses $ 94,800 $ 108,104 Reinsurance recoverable on outstanding losses 466,033 437,162 Reinsurance recoverable on incurred but not reported losses 357,719 260,810 Reserve for uncollectible reinsurance (11,910) (7,142) ---------------- ---------------- TOTAL REINSURANCE RECOVERABLES $ 906,642 $ 798,934 ================ ================
10 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (unaudited, in thousands, except per share data, continued) (3) REINSURANCE, CONTINUED Our insurance companies require their reinsurers not authorized by the respective states of domicile of our insurance companies to collateralize the reinsurance obligations due to us. The table below shows amounts held by us as collateral plus other credits available for potential offset.
September 30, 2003 December 31, 2002 ------------------ ----------------- Payables to reinsurers $ 355,579 $ 235,727 Letters of credit 170,371 141,490 Cash deposits 11,233 9,384 ------------------ ----------------- TOTAL CREDITS $ 537,183 $ 386,601 ================== =================
The tables below present the calculation of net reserves, net unearned premium and net deferred policy acquisition costs:
September 30, 2003 December 31, 2002 ------------------ ----------------- Loss and loss adjustment expense payable $ 1,406,843 $ 1,155,290 Reinsurance recoverable on outstanding losses (466,033) (437,162) Reinsurance recoverable on incurred but not reported losses (357,719) (260,810) ------------------ ----------------- NET RESERVES $ 583,091 $ 457,318 ================== ================== Unearned premium $ 558,701 $ 331,050 Ceded unearned premium (255,401) (164,224) ------------------ ------------------ NET UNEARNED PREMIUM $ 303,300 $ 166,826 ================== ================== Deferred policy acquisition costs $ 115,729 $ 68,846 Deferred ceding commissions (74,424) (49,963) ------------------ ------------------ NET DEFERRED POLICY ACQUISITION COSTS $ 41,305 $ 18,883 ================== ==================
We have a reserve of $11.9 million as of September 30, 2003 for potential collectibility issues and associated expenses related to reinsurance recoverables. The adverse economic environment in the worldwide insurance industry, the decline in the market value of investments in equity securities and the terrorist attacks on September 11, 2001 have placed great pressure on certain reinsurers and the results of their operations. Ultimately, these conditions could affect reinsurers' solvency. Historically, there have been insolvencies following a period of competitive pricing in the industry. We limit our exposure by holding funds, letters of credit or other security such that net balances due are significantly less than the gross balances shown in our condensed consolidated balance sheets. While we believe that the reserve is adequate based on currently available information, conditions may change or additional information might be obtained which may result in a future change in the reserve. We periodically review our financial exposure to the reinsurance market and the level of our reserve and continue to take actions in an attempt to mitigate our exposure to possible loss. 11 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (unaudited, in thousands, except per share data, continued) (3) REINSURANCE, CONTINUED A number of reinsurers have delayed or suspended the payment of amounts recoverable under certain reinsurance contracts to which we are a party. Such delays have affected, although not materially to date, the investment income of our insurance companies, but not to any extent their liquidity. In some instances, the reinsurers have withheld payment without reference to a substantive basis for the delay or suspension. In other cases, the reinsurers have claimed they are not liable for payment to us of all or part of the amounts due under the applicable reinsurance agreement. We believe these claims are substantially without merit and expect to collect the full amounts recoverable. We are currently in negotiations with most of these parties, but if such negotiations do not result in a satisfactory resolution of the matters in question, we may seek or be involved in a judicial or arbitral determination of these matters. In some cases, the final resolution of such disputes through arbitration or litigation may extend over several years. In this regard, as of September 30, 2003, our insurance companies had initiated one litigation proceeding against reinsurers. As of such date, our insurance companies had an aggregate amount of $6.1 million which had not been paid to us under the agreements and we estimate that there could be up to an additional $7.7 million of incurred losses and loss expenses and other balances which could become due under the subject agreements. (4) SEGMENT AND GEOGRAPHIC INFORMATION The performance of each segment is evaluated based upon net earnings and is calculated after tax and after all corporate expense allocations, purchase price allocations and intercompany eliminations have been charged or credited to the individual segments. The following tables show information by business segment and geographic location. Geographic location is determined by physical location of our offices and does not represent the location of insureds or reinsureds from whom the business was generated. 12 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (unaudited, in thousands, except per share data, continued) (4) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED
Insurance Underwriting Other Company Agency Intermediary Operations Corporate Total --------------------------------------------------------------------------------------- For the nine months ended September 30, 2003: Revenue: Domestic $ 412,063 $ 71,257 $ 17,141 $ 7,576 $ 898 $ 508,935 Foreign 155,248 9,703 26,734 -- -- 191,685 Inter-segment -- 35,854 2,572 -- -- 38,426 --------------------------------------------------------------------------------------- TOTAL SEGMENT REVENUE $ 567,311 $ 116,814 $ 46,447 $ 7,576 $ 898 739,046 ======================================================================= Inter-segment revenue (38,426) --------- CONSOLIDATED TOTAL REVENUE $ 700,620 ========= Net earnings: Domestic $ 48,942 $ 29,873 $ 3,754 $ 3,710 $ 49 $ 86,328 Foreign 12,166 3,079 6,263 -- -- 21,508 --------------------------------------------------------------------------------------- TOTAL SEGMENT NET EARNINGS $ 61,108 $ 32,952 $ 10,017 $ 3,710 $ 49 107,836 ======================================================================= Inter-segment eliminations (4,548) --------- CONSOLIDATED NET EARNINGS $ 103,288 ========= Other items: Net investment income $ 30,831 $ 2,135 $ 965 $ 33 $ 903 $ 34,867 Depreciation and amortization 2,468 2,983 1,307 380 1,347 8,485 Interest expense (benefit) 47 4,989 2,449 581 (2,569) 5,497 Capital expenditures 2,211 715 1,498 -- 15,836 20,260 Income tax provision 29,750 22,030 5,353 1,554 1,287 59,974 Inter-segment eliminations (1,065) --------- CONSOLIDATED INCOME TAX PROVISION $ 58,909 =========
13 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (unaudited, in thousands, except per share data, continued) (4) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED
Insurance Underwriting Other Company Agency Intermediary Operations Corporate Total --------------------------------------------------------------------------------------- For the nine months ended September 30, 2002: Revenue: Domestic $ 324,746 $ 58,918 $ 18,535 $ 1,335 $ 774 $ 404,308 Foreign 64,648 510 13,827 -- -- 78,985 Inter-segment -- 20,457 746 -- -- 21,203 --------------------------------------------------------------------------------------- TOTAL SEGMENT REVENUE $ 389,394 $ 79,885 $ 33,108 $ 1,335 $ 774 504,496 ======================================================================= Inter-segment revenue (21,203) --------- CONSOLIDATED TOTAL REVENUE $ 483,293 ========= Net earnings: Domestic $ 42,873 $ 17,270 $ 4,658 $ 750 $ 1,309 $ 66,860 Foreign 5,137 300 2,406 -- -- 7,843 --------------------------------------------------------------------------------------- TOTAL SEGMENT NET EARNINGS $ 48,010 $ 17,570 $ 7,064 $ 750 $ 1,309 74,703 ======================================================================= Inter-segment eliminations (370) --------- CONSOLIDATED NET EARNINGS $ 74,333 ========= Other items: Net investment income $ 24,713 $ 2,144 $ 731 $ 34 $ 159 $ 27,781 Depreciation and amortization 2,241 4,585 256 77 774 7,933 Interest expense (benefit) 127 5,748 1,931 -- (914) 6,892 Capital expenditures 1,510 1,155 1,041 -- 242 3,948 Income tax provision 23,375 11,682 5,165 364 631 41,217 Inter-segment eliminations (189) --------- CONSOLIDATED INCOME TAX PROVISION $ 41,028 =========
14 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (unaudited, in thousands, except per share data, continued) (4) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED
Insurance Underwriting Other Company Agency Intermediary Operations Corporate Total --------------------------------------------------------------------------------------- For the three months ended September 30, 2003: Revenue: Domestic $ 145,287 $ 26,423 $ 5,170 $ 2,922 $ 112 $ 179,914 Foreign 55,213 3,929 9,564 -- -- 68,706 Inter-segment -- 12,174 1,100 -- -- 13,274 ---------------------------------------------------------------------------------------- TOTAL SEGMENT REVENUE $ 200,500 $ 42,526 $ 15,834 $ 2,922 $ 112 261,894 ======================================================================= Inter-segment revenue (13,274) ---------- CONSOLIDATED TOTAL REVENUE $ 248,620 ========== Net earnings (loss): Domestic $ 16,982 $ 10,783 $ 737 $ 1,777 $ (429) $ 29,850 Foreign 4,965 1,178 3,224 -- -- 9,367 ---------------------------------------------------------------------------------------- TOTAL SEGMENT NET EARNINGS (LOSS) $ 21,947 $ 11,961 $ 3,961 $ 1,777 $ (429) 39,217 ======================================================================= Inter-segment eliminations (866) ---------- CONSOLIDATED NET EARNINGS $ 38,351 ========== Other items: Net investment income $ 10,605 $ 893 $ 374 $ 25 $ 100 $ 11,997 Depreciation and amortization 851 1,520 230 53 267 2,921 Interest expense (benefit) 22 1,578 659 194 (552) 1,901 Capital expenditures 980 47 610 -- 15,488 17,125 Income tax provision 10,549 8,900 1,693 686 202 22,030 Inter-segment eliminations (338) ---------- CONSOLIDATED INCOME TAX PROVISION $ 21,692 ==========
15 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (unaudited, in thousands, except per share data, continued) (4) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED
Insurance Underwriting Other Company Agency Intermediary Operations Corporate Total --------------------------------------------------------------------------------------- For the three months ended September 30, 2002: Revenue: Domestic $ 114,667 $ 19,001 $ 6,033 $ 730 $ (16) $ 140,415 Foreign 30,700 (81) 4,638 -- -- 35,257 Inter-segment -- 7,579 391 -- -- 7,970 --------------------------------------------------------------------------------------- TOTAL SEGMENT REVENUE $ 145,367 $ 26,499 $ 11,062 $ 730 $ (16) 183,642 ======================================================================= Inter-segment revenue (7,970) --------- CONSOLIDATED TOTAL REVENUE $ 175,672 ========= Net earnings: Domestic $ 12,634 $ 5,871 $ 1,774 $ 455 $ 13 $ 20,747 Foreign 2,397 43 1,138 -- -- 3,578 --------------------------------------------------------------------------------------- TOTAL SEGMENT NET EARNINGS $ 15,031 $ 5,914 $ 2,912 $ 455 $ 13 24,325 ======================================================================= Inter-segment eliminations (56) --------- CONSOLIDATED NET EARNINGS $ 24,269 ========= Other items: Net investment income $ 8,739 $ 814 $ 267 $ 7 $ (30) $ 9,797 Depreciation and amortization 723 1,474 86 11 261 2,555 Interest expense (benefit) 54 1,868 643 -- (514) 2,051 Capital expenditures 503 355 346 -- (94) 1,110 Income tax provision (benefit) 7,361 4,377 1,584 312 (161) 13,473 Inter-segment eliminations (11) --------- CONSOLIDATED INCOME TAX PROVISION $ 13,462 =========
16 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (unaudited, in thousands, except per share data, continued) (4) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED The following tables present revenue by line of business within each operating segment for the periods indicated:
For the nine months ended For the three months ended September 30, September 30, 2003 2002 2003 2002 ----------- ------------- ------------- ------------- Insurance company: Group life, accident and health $ 220,253 $ 170,155 $ 72,744 $ 64,350 Diversified financial products 80,399 14,030 35,581 6,753 London market account 101,733 62,305 35,276 29,784 Aviation 72,779 76,599 24,542 25,845 Other specialty lines of business 35,833 13,347 16,752 4,365 ----------- ------------- ------------- ------------- 510,997 336,436 184,895 131,097 Discontinued lines of business 24,357 25,963 4,545 5,197 ----------- ------------- ------------- ------------- TOTAL NET EARNED PREMIUM $ 535,354 $ 362,399 $ 189,440 $ 136,294 =========== ============= ============= ============= Underwriting agency: Group life, accident and health $ 27,565 $ 36,347 $ 8,889 $ 11,321 Property and casualty 51,410 20,705 20,545 6,736 ----------- ------------- ------------- ------------- TOTAL MANAGEMENT FEES $ 78,975 $ 57,052 $ 29,434 $ 18,057 =========== ============= ============= ============= Intermediary: Group life, accident and health $ 23,353 $ 24,373 $ 6,723 $ 7,893 Property and casualty 19,444 7,258 7,722 2,510 ----------- ------------- ------------- ------------- TOTAL COMMISSION INCOME $ 42,797 $ 31,631 $ 14,445 $ 10,403 =========== ============= ============= =============
17 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (unaudited, in thousands, except per share data, continued) (5) EARNINGS PER SHARE Basic earnings per share is based on the weighted average number of common shares outstanding during the period divided into net earnings. Diluted earnings per share is based on the weighted average number of common shares outstanding plus the potential common shares outstanding during the period divided into net earnings. Outstanding common stock options, when dilutive, are considered to be potential common shares for the purpose of the diluted calculation. The treasury stock method is used to calculate potential common shares due to options. Contingent shares to be issued are included in the earnings per share computation when the underlying conditions for issuance have been met. The following table provides a reconciliation of the denominators used in the earnings per share calculations:
For the nine months ended For the three months ended September 30, September 30, 2003 2002 2003 2002 ---------- ---------- ---------- ---------- Net earnings $ 103,288 $ 74,333 $ 38,351 $ 24,269 ========== ========== ========== ========== Reconciliation of shares outstanding: Shares of common stock outstanding at period end 63,805 62,294 63,805 62,294 Effect of common shares issued during the period (727) (176) (88) (11) Common shares contractually issuable in the future -- 52 -- 52 ---------- ---------- ---------- ---------- Weighted average common shares outstanding 63,078 62,170 63,717 62,335 Additional dilutive effect of outstanding options (as determined by the application of the treasury stock method) 1,028 671 1,168 536 ---------- ---------- ---------- ---------- Weighted average shares and potential common shares outstanding 64,106 62,841 64,885 62,871 ========== ========== ========== ========== Anti-dilutive shares not included in computation 352 415 -- 1,216 ========== ========== ========== ==========
18 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (unaudited, in thousands, except per share data, continued) (6) NOTES PAYABLE The table below shows the composition of our notes payable as shown in our condensed consolidated balance sheets.
September 30, 2003 December 31, 2002 ------------------ ----------------- 1.3% Convertible notes $ 125,000 $ -- 2% Convertible notes 172,451 172,451 $200 million revolving loan facility -- 53,000 Other debt 13,054 4,576 --------------- -------------- TOTAL NOTES PAYABLE $ 310,505 $ 230,027 =============== ==============
In a public offering on March 25, 2003, we sold an aggregate $125.0 million principal amount of 1.3% convertible notes due in 2023. Each one thousand dollar principal amount of notes is convertible into 29.4377 shares of our common stock, which represents an initial conversion price of $33.97 per share. The initial conversion price is subject to change under certain conditions. Interest is to be paid by us on April 1 and October 1 each year, commencing October 1, 2003. Holders may surrender notes for conversion into shares of our common stock if, as of the last day of the preceding calendar quarter, the closing sale price of our common stock for at least 20 consecutive trading days during the period of 30 consecutive trading days ending on the last trading day of that quarter is more than 130% ($44.16 per share) of the conversion price per share of our common stock. We can redeem the notes for cash at any time on or after April 4, 2009. Holders of the notes may require us to repurchase the notes on April 1, 2009, 2014 and 2019 at a price equal to the principal amount of the notes plus accrued and unpaid interest. If the holders require us to repurchase these notes, we may choose to pay the purchase price in cash, in shares of our common stock, or in a combination thereof. We paid $3.2 million in underwriting discounts and expenses in connection with this offering. The underwriting discounts and expenses are being amortized from the issue date until April 1, 2009. We used $66.0 million of the proceeds from this offering to pay down existing indebtedness under our bank facility, while the remainder was used to assist in financing acquisitions and strategic investments and for general corporate purposes. 19 HCC Insurance Holdings, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (unaudited, in thousands, except per share data, continued) (7) SUPPLEMENTAL INFORMATION
For the nine months ended For the three months ended September 30, September 30, 2003 2002 2003 2002 ------------- ------------- ------------- ------------- Interest paid $ 5,744 $ 4,568 $ 3,023 $ 2,151 Income tax paid 54,000 23,045 21,898 10,025 Comprehensive income 107,510 90,921 35,724 35,789 Ceding commissions netted with policy acquisition costs 151,572 102,822 53,495 36,658
(8) COMMITMENTS AND CONTINGENCIES In addition to the matters discussed in Note (3) Reinsurance, we are party to numerous lawsuits and other proceedings that arise in the normal course of our business. Many of such lawsuits and other proceedings involve claims under policies that we underwrite as an insurer or reinsurer, the liabilities for which, we believe, have been adequately included in our loss reserves. Also, from time to time, we are a party to lawsuits and other proceedings which relate to disputes over contractual relationships with third parties, or which involve alleged errors and omissions on the part of our subsidiaries. In addition, we are presently engaged in litigation initiated by the appointed liquidator of a former reinsurer concerning payments made to us prior to the date of the appointment of the liquidator. The disputed payments were made by the now insolvent reinsurer in connection with a commutation agreement. Our understanding is that such litigation is one of a number of similar actions brought by the liquidator. We intend to vigorously contest the action. We do not believe the resolution of any of these matters, some of which include allegations of damages of material amounts, will have a material adverse effect on our financial condition, results of operations or cash flows. 20 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS During the past year we completed four acquisitions. The results of operations of these entities are included in our condensed consolidated financial statements beginning on the effective date of each acquisition. Thus, our condensed consolidated statements of earnings and cash flows do not contain any activity generated by these entities for periods prior to their acquisition. Results of Operations Nine months ended September 30, 2003 versus nine months ended September 30, 2002 Total revenue increased 45% to $700.6 million for the first nine months of 2003 from $483.3 million for the same period in 2002. The revenue increase resulted from premium rate increases, acquisitions and increased business in all segments. Subsidiaries acquired during the past year accounted for $73.4 million in revenue during the first nine months of 2003. Net investment income increased 26% to $34.9 million for the first nine months of 2003 from $27.8 million for the same period in 2002. This increase was due to the higher level of invested assets resulting primarily from cash flow generated by operating activities and from the insurance company we acquired in December, 2002. Cash flow from operating activities was $325.9 million for the first nine months of 2003 compared to $122.8 million for the same period in 2002, continuing a trend of increasing operating cash flow that began in 2002. The majority of the increase in cash flow from operations results from increased earnings and net premium flow, less paid losses and loss adjustment costs, into our insurance companies. We expect the positive cash flow provided by operating activities to continue, most of which will increase invested assets and thus the related investment income. If market interest rates were to rise, the growth in investment income would be accelerated as our current portfolio has a relatively short average duration and would be available to be invested on a longer term basis to take advantage of higher rates. For the first nine months of 2003 our annualized, weighted average, tax equivalent yield was 4.0% compared to 4.5% for the same period in 2002. Compensation expense increased to $84.2 million during the first nine months of 2003 from $58.7 million for the same period in 2002. Subsidiaries acquired during the past year accounted for $19.6 million of the increase. Most of the remaining increase is due to larger bonus and incentive compensation accruals, based on increased earnings. Other operating expense increased to $45.2 million during the first nine months of 2003 compared to $36.6 million in 2002. Again most of the increase, $9.8 million, is due to subsidiaries acquired during the past year. Currency gains amounted to $1.7 million during the first nine months of 2003 compared to gains of $0.5 million during the same period in 2002. During 2003 there was a one-time currency gain of $1.3 million from the settlement of an advance of funds to an unaffiliated entity. During the first nine months of 2003 our insurance company subsidiaries incurred unusually high special assessments of $6.0 million from certain states and state agencies compared to $1.8 million during the same period in 2002. Assessments of this magnitude are not expected in the future. Interest expense was $5.5 million for the first nine months of 2003 compared to $6.9 million for the same period in 2002. Included in the 2002 amount is $2.9 million representing the amortization of underwriting discounts and expenses, which were fully amortized in 2002, related to the issuance of our 2% convertible notes compared to $0.3 million in 2003 related to our 1.3% convertible notes, which were issued in March 2003. Partially offsetting the decrease in amortization is the $0.6 million in interest expense on mortgage debt from a real estate partnership we are now consolidating with our adoption of Financial Accounting Standards Board Interpretation ("FIN") No. 46 during 2003 and an additional $0.8 million interest expense from our 1.3% convertible notes. 21 Income tax expense was $58.9 million for the first nine months of 2003 compared to $41.0 million for the same period in 2002. Our effective tax rate was 36.3% in the 2003 period compared to 35.6% in 2002. The increased rate results from tax-exempt interest income being a lower percentage of consolidated pre-tax earnings as well as immaterial adjustments made to refine our various tax accrual amounts. Net earnings increased 39% to $103.3 million, or $1.61 per diluted share, for the first nine months of 2003 from $74.3 million, or $1.18 per diluted share, for the same period in 2002. The increase in net earnings resulted from continuing good margins on increasing revenue and the effect of acquisitions consummated during the past year. As of September 30, 2003, total assets exceeded $4.6 billion, shareholders' equity exceeded $1.0 billion for the first time and book value per share was $15.77, up 11% from $14.15 as of December 31, 2002. SEGMENTS Insurance Companies The following tables provide information by line of business (amounts in thousands):
Gross Net Net Net written Written Earned Loss premium Premium Premium Ratio ------------ ------------ ------------ ---------- For the nine months ended September 30, 2003: Group life, accident and health $ 426,162 $ 233,589 $ 220,253 63.8% Diversified financial products 400,190 134,417 80,399 47.3 London market account 189,062 135,941 101,733 52.9 Aviation 165,280 75,765 72,779 63.6 Other specialty lines of business 87,393 72,641 35,833 83.1 ------------ ------------ ------------ ---------- 1,268,087 652,353 510,997 60.4 Discontinued lines of business 31,680 13,774 24,357 125.6 ------------ ------------ ------------ ---------- TOTALS $ 1,299,767 $ 666,127 $ 535,354 63.3% ============ ============ ============ ========== Expense Ratio 25.5 --------- Combined Ratio 88.8% ========= For the nine months ended September 30, 2002: Group life, accident and health $ 378,563 $ 176,519 $ 170,155 61.5% Diversified financial products 113,830 28,730 14,030 42.8 London market account 162,399 91,954 62,305 44.1 Aviation 153,908 75,741 76,599 51.5 Other specialty lines of business $ 16,454 $ 13,253 $ 13,347 111.8 ------------ ------------ ------------ ---------- 825,154 386,197 336,436 57.2 Discontinued lines of business 26,930 16,031 25,963 111.0 ------------ ------------ ------------ ---------- TOTALS $ 852,084 $ 402,228 $ 362,399 61.1% ============ ============ ============ ========== Expense Ratio 26.2 --------- Combined Ratio 87.3% =========
22 Gross written premium increased 53% to $1.3 billion for the first nine months of 2003 from $852.1 million for the same period in 2002. All of the lines of business showed some increase as a result of higher premium rates as well as organic growth. The largest growth was in the diversified financial products line of business, which our insurance companies began writing in 2002. Net written premium for the first nine months of 2003 increased 66% to $666.1 million and net earned premium increased 48% to $535.4 million for the same reasons plus an increase in retentions in selected areas. The increase in premium is expected to continue into 2004. The table below shows the composition of net incurred loss and loss adjustment expense for the nine months ended September 30, 2003 and 2002 (amounts in thousands):
2003 2002 ---------------------------- ----------------------------- Amount Loss Ratio Amount Loss Ratio ------------- ----------- ------------ ---------- Deficiency / (redundancy) $ 10,447 1.9% $ (4,137) (1.1)% All other incurred loss and loss adjustment expense 328,618 61.4 225,383 62.2 ------------- ----------- ------------ ----------- Net incurred loss and loss adjustment expense $ 339,065 63.3% $ 221,246 61.1% ============= =========== ============ ===========
The net loss ratio in the diversified financial products line of business increased in 2003 as a result of a change in the mix of business to components with a somewhat higher loss ratio. The London market account's net loss ratio was negatively affected in 2003 due to an increase in reserves in the accident and health category, some of which was adverse development from prior accident years. The net loss ratio in the aviation line of business increased due to unusually good loss experience in 2002 compared to a more expected loss ratio in 2003. Loss experience in the other specialty lines improved in 2003 compared to the prior year as experience approached its expected level. The loss ratio in the discontinued lines of business increased in the first nine months of 2003 following reserve additions resulting from our ongoing review of outstanding claims. For the nine months ended September 30, the gross loss ratio was 71.7% in 2003 compared to 61.5% in 2002. During the first nine months of 2003, we increased our gross losses by $76.1 million on certain assumed accident and health reinsurance contracts reported in the discontinued line of business due to our processing of additional information received and our continuing evaluation of reserves related to this business. Also during the 2003 period, we incurred a $30.0 million gross loss on a large warehouse fire and reduced gross losses on another discontinued program by $14.3 million based on revised current information. During the first nine months of 2002, we reduced our gross losses from the September 11 terrorist attacks by $21.5 million and our gross loss from Total Oil Company loss by $14.0 million to its ultimate settlement amount. As all these losses were substantially reinsured, there was no material effect on our net losses. The table below shows the composition of gross incurred loss and loss adjustment expense for the nine months ended September 30, 2003 and 2002 (amounts in thousands): 23
2003 2002 ----------------------------- ------------------------------ Amount Loss Ratio Amount Loss Ratio ------------- ----------- ------------ ------------ September 11 terrorist attacks $ -- --% $ (21,500) (2.9)% Total Oil Company loss -- -- (14,000) (1.9) Accident and health adjustment 76,115 7.0 -- -- Discontinued program adjustment (14,332) (1.3) -- -- Large warehouse fire 30,000 2.8 -- -- All other incurred loss and loss adjustment expense 680,936 63.2 496,180 66.3 ------------- ----------- ------------ ------------- Gross incurred loss and loss adjustment expense $ 772,719 71.7% $ 460,680 61.5% ============= =========== ============= =============
Policy acquisition costs, which are net of commissions on reinsurance ceded, increased to $64.5 million during the first nine months of 2003, from $44.5 million in the same period in 2002. This increase is in proportion to the increase in net earned premium. Net earnings of our insurance companies increased to $61.1 million in the first nine months of 2003 from $48.0 million for the same period in 2002 due to increased premium volume from rate increases, organic growth and continuing profitable underwriting results somewhat offset by unusually high special assessments from certain states and state agencies during the first nine months of 2003. Underwriting Agencies Management fees increased 38% to $79.0 million for the first nine months of 2003 compared to $57.1 million for the same period in 2002. This increase resulted from both acquisitions made during the past year and our existing underwriting agencies, which are seeing growth in several areas. Net earnings in this segment increased to $33.0 million in the first nine months of 2003 from $17.6 million in 2002 for the same reasons. We expect growth to continue into 2004. Intermediaries Commission income increased 35% to $42.8 million for the first nine months of 2003 compared to $31.6 million for the same period in 2002. The growth resulted principally from acquisitions made during the past year. Net earnings of our intermediaries increased to $10.0 million for the first nine months of 2003 compared to $7.1 million for the same period of 2002 for the same reasons. We expect growth to continue into 2004. Other Operations The other operations segment saw an increase in revenue and segment net income due to income from our strategic investment in Argonaut Group, Inc. made in March 2003 and gains in our strategic investment and trading accounts. Also, segment revenue increased as a result of the initial consolidation of a real estate partnership to comply with FIN No. 46. Period to period comparisons may vary substantially depending on strategic investments, trading activities or dispositions in any given period. 24 Corporate The decrease in segment earnings between periods resulted from the difference in intersegment income tax adjustments and the adjustment of certain accruals to their ultimate liability, which positively affected the 2002 period. There was also an increase in compensation expense during 2003, offsetting reduced net interest expense and currency conversion gains. Quarter ended September 30, 2003 versus quarter ended September 30, 2002 Total revenue increased 42% to $248.6 million for the third quarter of 2003 from $175.7 million for the same period in 2002. The revenue increase resulted from premium rate increases and increased business in all segments. Subsidiaries acquired during the past year accounted for $28.0 million in revenue during the third quarter of 2003. Net investment income increased 22% to $12.0 million for the third quarter of 2003 from $9.8 million for the same period in 2002. This increase was due to the higher level of invested assets resulting primarily from cash flow generated by operating activities and from the insurance company we acquired in December, 2002. Cash flow from operating activities was $126.6 million for the third quarter of 2003 compared to $76.1 million for the same period in 2002, continuing a trend of increasing operating cash flow that began in 2002. The majority of the increase in cash flow from operations results from increased earnings and net premium flow, less paid losses and loss adjustment costs, into our insurance companies. We expect the positive cash flow provided by operating activities to continue, most of which will increase invested assets and thus the related investment income. If market interest rates were to rise, the growth in investment income would be accelerated as our current portfolio has a relatively short average duration and would be available to be invested on a longer term basis to take advantage of higher rates. For the third quarter of 2003 our annualized, weighted average, tax equivalent yield was 3.8% compared to 4.6% for the same period in 2002. Compensation expense increased to $29.1 million during the third quarter of 2003 from $19.2 million for the same period in 2002. Subsidiaries acquired during the past year accounted for $7.8 million of the increase. Other operating expense increased to $15.5 million during the third quarter of 2003 compared to $12.6 million in 2002. The increase is due principally to subsidiaries acquired during the past year. Interest expense was $1.9 million for the third quarter of 2003 compared to $2.1 million for the same period in 2002. Included in the 2002 amount is $0.7 million representing the amortization of underwriting discounts and expenses, which were fully amortized in 2002, related to the issuance of our 2% convertible notes compared to $0.1 million in 2003 related to our 1.3% convertible notes, which were issued in March 2003. Partially offsetting the decrease in amortization is the $0.2 million in interest expense on mortgage debt from a real estate partnership we are now consolidating with our adoption of FIN No. 46 during 2003 and an additional $0.4 million interest expense from our 1.3% convertible notes. Income tax expense was $21.7 million for the third quarter of 2003 compared to $13.5 million for the same period in 2002. Our effective tax rate was 36.1% in the 2003 quarter compared to 35.7% in 2002. The increased rate results primarily from tax-exempt interest income being a lower percentage of consolidated pre-tax earnings. Net earnings increased 58% to $38.4 million, or $0.59 per diluted share, for the third quarter of 2003 from $24.3 million, or $0.39 per diluted share, for the same period in 2002. The increase in net earnings resulted from continuing good margins on increasing revenue and the effect of acquisitions consummated during the past year. As of September 30, 2003, total assets exceeded $4.6 billion, shareholders' equity exceeded $1.0 billion for the first time and book value per share was $15.77, up from $15.21 as of June 30, 2003. 25 SEGMENTS Insurance Companies The following tables provide information by line of business (amounts in thousands):
Gross Net Net Net written Written Earned Loss premium Premium Premium Ratio ------------ ------------- ------------ ----------- For the three months ended September 30, 2003: Group life, accident and health $ 142,680 $ 76,236 $ 72,744 64.1% Diversified financial products 149,764 52,203 35,581 46.7 London market account 48,910 33,387 35,276 53.0 Aviation 56,320 24,561 24,542 63.6 Other specialty lines of business 41,337 33,935 16,752 93.8 ------------ ------------ ------------ ----------- 439,011 220,322 184,895 61.3 Discontinued lines of business 4,029 2,213 4,545 125.4 ------------ ------------ ------------ ----------- TOTALS $ 443,040 $ 222,535 $ 189,440 62.8% ============ ============ ============ Expense Ratio 25.8 ----------- Combined Ratio 88.6% =========== FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2002: Group life, accident and health $ 132,904 $ 69,491 $ 64,350 59.5% Diversified financial products 55,461 13,597 6,753 56.3 London market account 46,346 30,015 29,784 42.4 Aviation 49,804 23,687 25,845 48.5 Other specialty lines of business 6,570 4,288 4,365 106.1 ------------ ------------ ------------ ----------- 291,085 141,078 131,097 54.8 Discontinued lines of business 7,379 3,488 5,197 255.3 ------------ ------------ ------------ ----------- TOTALS $ 298,464 $ 144,566 $ 136,294 62.5% ============ ============ ============ Expense Ratio 27.1 ----------- Combined Ratio 89.6% ===========
Gross written premium increased 48% to $443.0 million for the third quarter of 2003 from $298.5 million for the same period in 2002. All of the lines of business showed some increase as a result of higher premium rates as well as organic growth. The largest growth was in the diversified financial products line of business, which our insurance companies began writing in 2002. Net written premium for the third quarter of 2003 increased 54% to $222.5 million and net earned premium increased 39% to $189.4 million for the same reasons plus an increase in retentions in selected areas. The increase in premium is expected to continue into 2004. 26 The table below shows the composition of net incurred loss and loss adjustment expense for the three months ended September 30, 2003 and 2002 (amounts in thousands):
2003 2002 ------------------------------- ----------------------------- Amount Loss Ratio Amount Loss Ratio ------------- ------------- ------------- ------------- Deficiency / (redundancy) $ 617 0.3% $ (2,207) (1.6)% All other incurred loss and loss adjustment expense 118,336 62.5 87,370 64.1 ------------- ------------- ------------- ------------- Net incurred loss and loss adjustment expense $ 118,953 62.8% $ 85,163 62.5% ============= ============= ============= =============
The net loss ratio in the diversified financial products line of business decreased in 2003 as a result of a change in the mix of business. The London market account's net loss ratio was negatively affected in 2003 due to an increase in reserves in the accident and health category, some of which was adverse development from prior accident years. The net loss ratio in the aviation line of business increased due to unusually good loss experience in 2002 compared to a more expected loss ratio in 2003. Loss experience in the other specialty lines improved in 2003 compared to the prior year, as experience approached its expected level. The loss ratio in the discontinued lines of business remains high following reserve additions resulting from our ongoing review of outstanding claims. For the third quarter, the gross loss ratio was 69.6% in 2003 compared to 64.1% in 2002. During the third quarter of 2003, we incurred a $30.0 million gross loss on a large warehouse fire and reduced gross losses on a discontinued program by $14.3 million based on revised current information. During the third quarter of 2002, we reduced our gross losses from the Total Oil Company loss by $14.0 million to its ultimate settlement amount. As all these losses were substantially reinsured, there was no material effect on our net losses. The table below shows the composition of gross incurred loss and loss adjustment expense for the three months ended September 30, 2003 and 2002 (amounts in thousands):
2003 2002 ------------------------------- ----------------------------- Amount Loss Ratio Amount Loss Ratio ------------- ------------- ------------- ------------- Total Oil Company loss $ -- --% $ (14,000) (5.3)% Discontinued program adjustment (14,332) (3.7) -- -- Large warehouse fire 30,000 7.8 -- -- All other incurred loss and loss adjustment expense 252,479 65.5 184,256 69.4 ------------- ------------- ------------- ------------- Gross incurred loss and loss adjustment expense $ 268,147 69.6% $ 170,256 64.1% ============= ============= ============= =============
Policy acquisition costs, which are net of commissions on reinsurance ceded, increased to $23.1 million during the third quarter of 2003, from $18.9 million in the same period in 2002. This increase is in proportion to the increase in net earned premium. Net earnings of our insurance companies increased to $21.9 million in the third quarter of 2003 from $15.0 million for the same period in 2002 due to increased premium volume from rate increases, organic growth and continuing profitable underwriting results. 27 Underwriting Agencies Management fees increased 63% to $29.4 million for the third quarter of 2003 compared to $18.1 million for the same period in 2002. This increase resulted from both acquisitions made during the past year and our existing underwriting agencies, which are seeing growth in several areas. Net earnings in this segment increased to $12.0 million in the third quarter of 2003 from $5.9 million in 2002 for the same reasons. We expect growth to continue into 2004. Intermediaries Commission income increased 39% to $14.4 million for the third quarter of 2003 compared to $10.4 million for the same period in 2002. The growth resulted principally from acquisitions made during the past year. Net earnings of our intermediaries increased to $4.0 million for the third quarter of 2003 compared to $2.9 million for the same period of 2002 for the same reasons. We expect growth to continue in 2004. Other Operations The other operations segment saw an increase in revenue and segment net income due to income from our strategic investment in Argonaut Group, Inc. made in March 2003 and gains in our strategic investment and trading accounts. Also, segment revenue increased as a result of the initial consolidation of a real estate partnership to comply with FIN No. 46. Period to period comparisons may vary substantially depending on strategic investments, trading activities or dispositions in any given period. Corporate The decrease in segment earnings between periods resulted from differences in compensation and income tax expense. Liquidity and Capital Resources We receive substantial cash from premiums, reinsurance recoverables, management fees and commission income and, to a lesser extent, investment income and proceeds from sales and redemptions of investments and other assets. Our principal cash outflows are for the payment of claims and loss adjustment expenses, payment of premiums to reinsurers, purchase of investments, debt service, policy acquisition costs, operating expenses, income and other taxes and dividends. Variations in operating cash flows can occur due to timing differences in either the payment of claims and the collection of related recoverables or the collection of receivables and the payment of related payable amounts. We maintain a substantial level of cash and liquid short-term investments which are used to meet anticipated payment obligations. Our consolidated cash and investment portfolio increased $334.3 million, or 28% , during the first nine months of 2003 and totaled $1.5 billion as of September 30, 2003, of which $455.4 million was cash and short-term investments. The increase in investments resulted from the positive operating cash flows. In a public offering on March 25, 2003, we sold an aggregate $125.0 million principal amount of 1.3% convertible notes due in 2023. Each one thousand dollar principal amount of notes is convertible into 29.4377 shares of our common stock, which represents an initial conversion price of $33.97 per share. The initial conversion price is subject to change under certain conditions. Interest is to be paid by us on April 1 and October 1 each year, commencing October 1, 2003. Holders may surrender notes for conversion into shares of our common stock if, as of the last day of the preceding calendar quarter, the closing sale price of our common stock for at least 20 28 consecutive trading days during the period of 30 consecutive trading days ending on the last trading day of that quarter is more than 130% ($44.16 per share) of the conversion price per share of our common stock. We can redeem the notes for cash at any time on or after April 4, 2009. Holders of the notes may require us to repurchase the notes on April 1, 2009, 2014 and 2019 at a price equal to the principal amount of the notes plus accrued and unpaid interest. If the holders require us to repurchase these notes, we may choose to pay the purchase price in cash, in shares of our common stock, or in a combination thereof. We paid $3.2 million in underwriting discounts and expenses in connection with this offering. The underwriting discounts and expenses are being amortized from the issue date until April 1, 2009. We used $66.0 million of the proceeds from this offering to pay down existing indebtedness under our bank facility, while the remainder was used to assist in financing acquisitions and strategic investments and for general corporate purposes. Reinsurance recoverables increased during the first nine months of 2003 due principally to the increase in reinsurance recoverables on incurred but not reported losses. A significant portion of this increase comes from the diversified financial products line of business, new in 2002, which is more heavily reinsured than our other lines of business. The increase in gross losses on certain assumed contracts in the discontinued line of business also contributed to the increase. The increase in reinsurance recoverable on outstanding losses results principally from a $30.0 million loss incurred in the third quarter of 2003 which was substantially reinsured. We have a reserve of $11.9 million as of September 30, 2003 for potential collectibility issues and associated expenses related to reinsurance recoverables. The adverse economic environment in the worldwide insurance industry, the decline in the market value of investments in equity securities and the terrorist attacks on September 11, 2001 have placed great pressure on certain reinsurers and the results of their operations. Ultimately, these conditions could affect reinsurers' solvency. Historically, there have been insolvencies following a period of competitive pricing in the industry. We limit our exposure by holding funds, letters of credit or other security such that net balances due are significantly less than the gross balances shown in our condensed consolidated balance sheets. While we believe that the reserve is adequate based on currently available information, conditions may change or additional information might be obtained which may result in a future change in the reserve. We periodically review our financial exposure to the reinsurance market and the level of our reserve and continue to take actions in an attempt to mitigate our exposure to possible loss. A number of reinsurers have delayed or suspended the payment of amounts recoverable under certain reinsurance contracts to which we are a party. Such delays have affected, although not materially to date, the investment income of our insurance companies, but not to any extent their liquidity. In some instances, the reinsurers have withheld payment without reference to a substantive basis for the delay or suspension. In other cases, the reinsurers have claimed they are not liable for payment to us of all or part of the amounts due under the applicable reinsurance agreement. We believe these claims are substantially without merit and expect to collect the full amounts recoverable. We are currently in negotiations with most of these parties, but if such negotiations do not result in a satisfactory resolution of the matters in question, we may seek or be involved in a judicial or arbitral determination of these matters. In some cases, the final resolution of such disputes through arbitration or litigation may extend over several years. In this regard, as of September 30, 2003, our insurance companies had initiated one litigation proceeding against reinsurers. As of such date, our insurance companies had an aggregate amount of $6.1 million which had not been paid to us under the agreements and we estimate that there could be up to an additional $7.7 million of incurred losses and loss expenses and other balances which could become due under the subject agreements. We believe that our operating cash flows, short-term investments, bank facility and shelf registration on file with the United States Securities and Exchange Commission will provide sufficient sources of liquidity to meet our operating needs for the foreseeable future. 29 Critical Accounting Policies We have made no changes in our methods of application of our critical accounting policies from the information provided in our Annual Report on Form 10-K for the year ended December 31, 2002. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK There have been no material changes in market risk from the information provided in Item 7A. "Quantitative and Qualitative Disclosures About Market Risk" in our Annual Report on Form 10-K for the year ended December 31, 2002. ITEM 4. CONTROLS AND PROCEDURES a. Evaluation of disclosure controls and procedures. Within the 90 days prior to the date of this report, we carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. This evaluation was performed under the supervision of, and with the participation of, our management, including the Chief Executive Officer and Chief Financial Officer. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to HCC Insurance Holdings, Inc. and its subsidiaries required to be included in our periodic SEC filings. b. Changes in internal controls. There have been no changes in our internal controls or in other factors which could materially affect internal controls over financial reporting subsequent to the date we carried out our evaluation. 30 PART II - OTHER INFORMATION Item 1. Legal Proceedings In addition to the matters discussed in Note (3) Reinsurance, we are party to numerous lawsuits and other proceedings that arise in the normal course of our business. Many of such lawsuits and other proceedings involve claims under policies that we underwrite as an insurer or reinsurer, the liabilities for which, we believe, have been adequately included in our loss reserves. Also, from time to time, we are a party to lawsuits and other proceedings which relate to disputes over contractual relationships with third parties, or which involve alleged errors and omissions on the part of our subsidiaries. In addition, we are presently engaged in litigation initiated by the appointed liquidator of a former reinsurer concerning payments made to us prior to the date of the appointment of the liquidator. The disputed payments were made by the now insolvent reinsurer in connection with a commutation agreement. Our understanding is that such litigation is one of a number of similar actions brought by the liquidator. We intend to vigorously contest the action. We do not believe the resolution of any of these matters, some of which include allegations of damages of material amounts, will have a material adverse effect on our financial condition, results of operations or cash flows. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits 31.1 Certification by Chief Executive Officer. 31.2 Certification by Chief Financial Officer. 32.1 Certification with respect to quarterly report. (b) Reports on Form 8-K During the third quarter we did not file any reports on Form 8-K. On August 7, 2003, we furnished a report on Form 8-K including our announcement of financial results for the second quarter of 2003. 31 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. HCC Insurance Holdings, Inc. ---------------------------------------------- (Registrant) November 14, 2003 /s/ Stephen L. Way ----------------- ---------------------------------------------- (Date) Stephen L. Way, Chairman of the Board Chief Executive Officer and President November 14, 2003 /s/ Edward H. Ellis, Jr. ----------------- ---------------------------------------------- (Date) Edward H. Ellis, Jr., Executive Vice President and Chief Financial Officer 32 INDEX TO EXHIBITS EXHIBIT NUMBER DESCRIPTION -------------- ----------- 31.1 Certification by Chief Executive Officer. 31.2 Certification by Chief Financial Officer. 32.1 Certification with respect to quarterly report.