10-Q

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

þ   Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the Quarter Ended September 30, 2006.

o   Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 from ___to ___

Commission file number   001-13790

HCC Insurance Holdings, Inc.
(Exact name of registrant as specified in its charter)
Delaware	76-0336636
(State or other jurisdiction of incorporation or organization)	(IRS Employer Identification No.)
13403 Northwest Freeway, Houston, Texas	77040-6094
(Address of principal executive offices)	(Zip Code)
(713) 690-7300
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.

Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer þ Accelerated filer o Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No þ

Indicate the number of shares outstanding of each of the registrant’s classes of common stock as of the latest practicable date.

On November 30, 2006, there were approximately 111.7 million shares of common stock, $1.00 par value issued and outstanding.

1

HCC INSURANCE HOLDINGS, INC.
TABLE OF CONTENTS

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

2

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

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

This report on Form 10-Q contains certain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are intended to be covered by the safe harbors created by those laws. We have based these forward-looking statements on our current expectations and projections about future events. These forward-looking statements include information about possible or assumed future results of our operations. All statements, other than statements of historical facts, included or incorporated by reference in this report that address activities, events or developments that we expect or anticipate may occur in the future, including such things as growth of our business and operations, business strategy, competitive strengths, acquisitions, capital expenditures, goals, plans and references to future successes may be considered forward-looking statements. Also, when we use words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “plan,” “probably” or similar expressions, we are making forward-looking statements.

Many risks and uncertainties may impact the matters addressed in these forward-looking statements, which could affect our future financial results and performance, including, among other things:

• the effects of catastrophic losses;

• the cyclical nature of the insurance business;

• inherent uncertainties in the loss estimation process, which can adversely impact the adequacy of loss reserves;

• the effects of emerging claim and coverage issues;

• the effects of extensive governmental regulation of the insurance industry;

• potential credit risk with brokers;

• our increased retention of risk, which could expose us to greater potential losses;

• the adequacy of reinsurance protection;

• the ability or willingness of reinsurers to pay balances due us;

• the occurrence of terrorist activities;

• our ability to maintain our competitive position;

• changes in our assigned financial strength ratings;

• our ability to raise capital in the future;

• attraction and retention of qualified employees;

• fluctuations in the fixed income securities market, which may reduce the value of our investment assets;

• our ability to successfully expand our business through the acquisition of insurance-related companies;

• our ability to receive dividends from our insurance company subsidiaries in needed amounts;

• fluctuations in foreign exchange rates;

• failures of our information technology systems, which could adversely affect our business;

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• developments in the SEC’s informal inquiry related to our past practices in connection with grants of stock options;

• potential issues related to the effects of Sections 409A and 162(m) of the Internal Revenue Code and any expenses associated therewith;

• changes to improve our internal controls related to the process of granting, documenting and accounting for stock option awards;

• additional expenses and taxes associated with our stock option investigation and related matters;

• potential litigation that could result from our stock option investigation;

• the ability of our Executive Officers to define and implement a strategic business plan; and

• our ability to cure all defaults or events of default under our outstanding loan agreements.

These events or factors could cause our results or performance to differ materially from those we express in our forward-looking statements. Although we believe that the assumptions underlying our forward-looking statements are reasonable, any of these assumptions, and, therefore, also the forward-looking statements based on these assumptions, could themselves prove to be inaccurate. In light of the significant uncertainties inherent in the forward-looking statements which are included in this report, our inclusion of this information is not a representation by us or any other person that our objectives and plans will be achieved.

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

4

HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

(unaudited, in thousands except per share data)

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

See Notes to Condensed Consolidated Financial Statements.

5

HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Statements of Earnings

(unaudited, in thousands except per share data)

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

See Notes to Condensed Consolidated Financial Statements.

6

HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Statement of Changes in Shareholders’ Equity

Nine months ended September 30, 2006

(unaudited, in thousands except per share data)

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

See Notes to Condensed Consolidated Financial Statements.

7

HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(unaudited, in thousands)

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

See Notes to Condensed Consolidated Financial Statements.

8

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

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

9

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

Also during the third quarter of 2005, we reached agreements with various reinsurers to commute certain reinsurance recoverables related to our discontinued accident and health line of business. The reinsurers paid us $119.6 million of cash, which was less than the related recoverables, in consideration for discounting the recoverables and reassuming the associated loss reserves. We recorded a pre-tax loss of $26.0 million, which was included in loss and loss adjustment expense in our insurance company segment. Net earnings were reduced $16.9 million, or $0.16 per diluted share.

Income Tax

For the nine months ended September 30, 2006 and 2005, the income tax provision was calculated based on an estimated effective tax rate for each fiscal year. Our effective tax rate differs from the United States Federal statutory rate primarily due to tax-exempt municipal bond interest, state income taxes and a special $2.1 million U.S. repatriation tax benefit in 2005.

Recent Accounting Change

The Financial Accounting Standards Board (FASB) has issued FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes. Effective January 1, 2007, FIN 48 clarifies the accounting for uncertain income tax positions. We are currently reviewing the requirements of FIN 48 to determine the effect it will have on our consolidated financial statements.

The FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”), which clarified the definition of fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurement. SFAS 157 does not require any new fair value measurements and eliminates inconsistencies in guidance found in various prior accounting pronouncements. SFAS 157 will be effective for us on January 1, 2008. We are currently assessing whether the adoption of SFAS 157 will have an impact on our consolidated financial statements.

The Securities and Exchange Commission has issued Staff Accounting Bulletin (SAB) No.108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. SAB 108 establishes a standard approach for quantifying the materiality of errors to current and prior period financial statements. SAB 108’s guidelines must be applied in the fourth quarter, and adjustments, if any, will be recorded either by restating prior year financial statements or recording a cumulative effect adjustment as of January 1, 2006. We believe the requirements of SAB 108 will have no effect on our consolidated financial statements.

10

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

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

• The dates on documentation such as e-mails, regulatory form filings, acquisition agreements and other correspondence;

• The date that the relevant stock option grant was entered into Equity Edge, our stock option tracking and accounting system;

• Requirements of Accounting Principles Board (APB) No. 25, Accounting for Stock Issued to Employees, and related interpretations; and

• Guidance from the Office of Chief Accountant of the Securities and Exchange Commission (SEC) contained in a letter dated September 19, 2006.

11

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 The Special Committee concluded that mis-priced option grants, the effect of which, together with certain other adjustments, resulted in a cumulative net decrease in shareholders’ equity at December 31, 2005 of $3.3 million, affected all levels of employees. The Special Committee found that Stephen L. Way, Chief Executive Officer, retroactively priced options, that he should have known he was granting options in a manner that conflicted with our stock option plans and public statements, and that this constituted a failure to align the stock option granting process with our stock option plans and public statements. Although finding his actions were inconsistent with the duties and obligations of a chief executive officer of a publicly-traded company, the Special Committee also found that Mr. Way’s motivation appeared to be the attraction and retention of talent and to provide employees with the best option price. The Special Committee also concluded that Christopher L. Martin, Executive Vice President and General Counsel, was aware that options were being retroactively priced in a manner inconsistent with applicable plan terms and the procedures memoranda that he had prepared, that granting in-the-money options had accounting implications, and that he did not properly document our Compensation Committee’s informal delegation of authority to Mr. Way. The Special Committee also found that there was no evidence that Mr. Way or Mr. Martin intended to falsify the consolidated financial statements.

Before the Board of Directors reviewed the results of the investigation, the Chairman of the Compensation Committee tendered his resignation from the Board of Directors on November 8, 2006. After reviewing the results of the investigation, the Board of Directors determined that it would be appropriate to accept the resignations of Mr. Way and Mr. Martin, which both tendered on November 17, 2006. Mr. Way will remain a director of HCC and serve as the non-executive Chairman of the Board of Directors and has entered into a consulting agreement with us to assist in the transition of leadership and to provide strategic guidance. We have entered into agreements with Mr. Way and Mr. Martin which, among other things, require them to disgorge an amount equal to the difference between the actual measurement date prices determined by HCC and the prices at which these individuals exercised mis-priced options since 1997.

As a result of the determinations of the Special Committee and because the resulting cumulative charge would be material to the second quarter and full year 2006 consolidated net earnings, we concluded that we needed to amend our 2005 Annual Report filed with the SEC on Form 10-K and our first quarter 2006 quarterly report filed with the SEC on Form 10-Q, to restate our consolidated financial statements and disclosures. However, the impact of the restatement in any of the restated periods is not material. The amended Forms 10-K/A and 10-Q/A have been filed with the SEC. We made the restatement in accordance with generally accepted accounting principles to record the following:

• Non-cash compensation expense for the difference between the stock price on the stated grant date and the actual measurement date and for the fluctuations in stock price in certain instances where variable accounting should have been applied.

• Other adjustments that were not recorded in the originally filed financial statements due to their immateriality. These minor adjustments primarily relate to fee and commission income, loss and loss adjustment expense, policy acquisition costs and other operating expense. In addition, balance sheet reclassifications have been recorded to appropriately present certain reinsurance recoverables and payables.

• Related tax effects associated with the recognition of non-cash compensation expense and other adjustments as well as additional taxes that may be due and payable.

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

12

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

We were unable to timely file our quarterly reports on Form 10-Q for the quarters ended June 30, 2006 and September 30, 2006, primarily due to not knowing the financial impact of the Special Committee’s investigation. We have also restated the June 30, 2005 and September 30, 2005 financial statements included in our quarterly reports on Form 10-Q for the respective 2006 quarters.

Based on the determinations of the Special Committee and our voluntary internal review, we identified a number of occasions during the period 1997 through 2005 and into 2006 on which we used an incorrect measurement date for financial accounting and reporting purposes for options granted. In accordance with Accounting Principles Board (APB) No. 25, Accounting for Stock Issued to Employees, and its related interpretations, we should have recorded compensation expense related to these options for the excess of the market price of our stock on the actual measurement date over the exercise price of the option. For periods commencing January 1, 2006, compensation expense is being recognized in accordance with Statement of Financial Accounting Standards (SFAS) No. 123(R) (revised), Share-Based Payment. However, we determined an incremental amount related to the mis-priced options must be recorded.

The types of errors identified were as follows:

• We determined that many block grants to employees during the period 1997 through 2005 were subject to a retroactive look-back period. In all such cases, the price of our stock at the end of the look-back period, which was generally 30 days or less, was higher than the price of our stock on the stated grant date.

• In addition to being subject to the retroactive pricing discussed above, we determined that the strike price of block grants in 1999, 2002 and 2005 was determined prior to the final determination of the identity of the employee and/or the number of options to be granted. Further, proper approval, in most cases, had not been given until after the grant date. In all such cases, the price of our stock at the time when all required determinations were final and proper approval had been obtained was higher than the price of our stock on the stated grant date. The time lag between the stated grant date and the finalization of the awards was typically 30-45 days, except in the case of the 2002 grant which was finalized several months subsequent to the stated grant date.

• For the period from 1997 to 2005 and into 2006, we determined that there was a regular practice of granting options to newly hired employees and existing employees being promoted after the end of a 30-45 day period following the hire or promotion date. This practice included the use of the 30-45 day period as a look-back period during which the date with the lowest price during that period was selected as the stated grant date.

• In several instances, grants to senior executives were determined at a date subsequent to the stated grant date. In most cases, this resulted from extended negotiations of employment agreements and, in some cases, administrative delays. In virtually all cases, the price of our stock at the time the grants were made and properly approved was higher than the price of our stock on the stated grant date.

• In a few cases, options were granted and then repriced downward. As a result, variable accounting should have been applied to these options.

• We lacked timely or adequate documentation to support the stated grant date in the case of certain of the above errors.

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

13

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

In connection with the investigation, we determined that a number of executive officers received in-the-money options. If such options are ultimately determined to be in-the-money grants for tax purposes, pursuant to Section 162(m) of the Internal Revenue Code and, if in the year of exercise the officers’ compensation, including proceeds from options exercised, exceeded $1.0 million, we would not be entitled to a tax deduction for any amount in excess of such $1.0 million for officers covered by Section 162(m). We estimate the tax effect of the deduction was $4.6 million, substantially all of which was recorded as a reduction to shareholders’ equity.

There were immaterial adjustments that were not made in the originally filed consolidated financial statements. We have taken the opportunity presented by this restatement to record these adjustments, which amounted to a net $2.4 million increase in earnings from continuing operations before income tax expense, for the years 2001 through 2005.

The increase (decrease) on net earnings of each type of adjustment was as follows (in thousands):

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

The restatement adjustments reduced previously reported diluted net earnings per share by $0.03 and $0.00 for the nine and three months ended September 30, 2005, respectively.

Enacted October 22, 2004, Section 409A of the Internal Revenue Code significantly changed the rules for nonqualified deferred compensation plans. Section 409A imposes certain restrictions and taxes on stock awards that constitute deferred compensation. Section 409A relates specifically to the personal tax liabilities of our employees that have received discounted options. We are currently reviewing the implications of Section 409A on grants awarded with intrinsic value that vested after December 31, 2004 and modifications made to existing grants after October 3, 2004 along with potential remedial actions.

As of December 15, 2006, we have paid direct costs of approximately $6.0 million, of which $2.5 million was incurred through September 30, 2006, for costs associated with the Special Committee’s investigation and additional related professional services and consulting fees associated with the restatement effort.

14

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

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

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

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

15

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

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

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

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

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

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

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

16

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

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

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

17

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

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

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

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

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

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

18

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

Exercise of options during the first nine months of 2006 and 2005 resulted in cash receipts of $11.7 million and $32.7 million, respectively. We generally recognize a tax benefit when our employees exercise options. SFAS 123(R) requires that we report the tax benefit related to the excess of the tax deductible amount over the recognized compensation expense as financing cash flow, rather than as operating cash flow under APB 25. We recorded a $3.3 million benefit as financing cash flow in the first nine months of 2006 and $3.4 million as operating cash flow in the first nine months of 2005.

Prior to the adoption of SFAS 123(R), we accounted for stock-based compensation using the intrinsic value method prescribed in APB Opinion No. 25 and related interpretations. Under APB Opinion No. 25, compensation cost was measured as of the date the number of shares and exercise price became fixed. The terms of an award were generally fixed on the date of grant, requiring the stock option to be accounted for as a fixed award. For fixed awards, compensation expense was measured as the excess, if any, of the quoted market price of our stock at the date of grant over the exercise price of the option granted. Compensation expense for fixed awards, if any, was recognized ratably over the vesting period using the straight-line single option method.

If the number of shares or exercise price was not fixed upon the date of grant, the award was accounted for as a variable award until the number of shares or the exercise price became fixed, or until the award was exercised, canceled, or expired unexercised. For variable awards, intrinsic value was remeasured each period and was equal to the fair market value of our stock as of the end of the reporting period less the grant exercise price. As a result, the amount of compensation expense or benefit to be recognized each period fluctuated based on changes in our closing price from the end of the previous reporting period to the end of the current reporting period. In cases when our closing stock price did not exceed the recipient’s exercise price, no compensation expense resulted. Compensation expense for variable awards, if any, was recognized in accordance with FIN No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plan, An Interpretation of APB Opinions No. 15 and 25.

19

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

We accounted for modifications to stock options under APB No. 25, as subsequently interpreted by FIN No. 44. Modifications included, but were not limited to, acceleration of vesting, extension of the exercise period following termination of employment and/or continued vesting while not providing substantive services. Compensation expense for modified awards was recorded in the period of modification for the intrinsic value of the vested portion of the award, including vesting that occurred while not providing substantive services, after the date of modification. The intrinsic value of the award was the difference between the fair market value of our common stock on the date of modification and the recipient’s exercise price.

Stock options issued to non-employees were accounted for in accordance with the provisions of SFAS No. 123 and EITF No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. Compensation expense for stock options issued to non-employees was valued using the Black-Scholes model and was amortized over the vesting period in accordance with FIN No. 28.

Prior to adoption of SFAS 123(R), we were required to disclose the effect on net earnings and earnings per share if we had used the fair value method of SFAS No. 123, Accounting for Stock-Based Compensation, to value stock options. The effect on our consolidated financial results in 2005 if we had valued our options using the fair value method under SFAS 123 and the assumptions listed above is as follows:

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

20

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

(4)

REINSURANCE

In the normal course of business, our insurance companies cede a portion of their premium to domestic and foreign reinsurers through treaty and facultative reinsurance agreements. Although ceding for reinsurance purposes does not discharge the primary insurer from liability to its policyholder, our insurance companies participate in such agreements in order to limit their loss exposure, protect them against catastrophic loss and diversify their business. The following table presents the effect of such reinsurance transactions on our premium and loss and loss adjustment expense.

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

21

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

Ceding commissions netted with policy acquisition costs in the condensed consolidated statements of earnings were $35.1 million in the first nine months of 2006 and $80.6 million in the first nine months of 2005.

The table below shows the components of reinsurance recoverables in our condensed consolidated balance sheets.

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

Our reserve for uncollectible reinsurance covers potential collectibility issues, including disputed amounts and associated expenses. While we believe the reserve is adequate based on information currently available, conditions may change or additional information might be obtained which may require us to change the reserve in the future. We periodically review our financial exposure to the reinsurance market and the level of our reserve and continue to take actions in an attempt to mitigate our exposure to possible loss.

We limit the liquidity exposure related to our reinsurance recoverables by holding funds, letters of credit or other security, such that net balances due are significantly less than the gross balances shown in our condensed consolidated balance sheets. Additionally, our U.S. domiciled insurance companies require their reinsurers not authorized by the respective states of domicile of our insurance companies to collateralize their reinsurance obligations due to us. The table below shows the amounts of letters of credit and cash deposits held by us as collateral, plus other credits available for potential offset.

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

22

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

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

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

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

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

23

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

(6)

SEGMENT AND GEOGRAPHIC INFORMATION

The performance of each segment is evaluated by our management based on net earnings. Net earnings is calculated after tax and after all corporate expense allocations, interest expense on debt incurred at the purchase date, and intercompany eliminations have been charged or credited to our individual segments. All stock-based compensation is included in the corporate segment since it is not included in management’s evaluation of the other 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 April 1, 2006 and January 1, 2005, we consolidated two underwriting agencies into two insurance companies and all operations after those dates have been reported in our insurance company segment.

	Insurance				Other
	Company		Agency		Operations		Corporate			Total
Nine months ended September 30, 2006
Revenue:
Domestic	$	1,077,065	$	49,256	$	57,792	$	4,413		$	1,188,526
Foreign		260,526		27,135		—		—			287,661
Inter-segment		19		54,473		—		—			54,492
Total segment revenue	$	1,337,610	$	130,864	$	57,792	$	4,413			1,530,679
Inter-segment eliminations											(54,492	)
Consolidated total revenue										$	1,476,187
Net earnings (loss):
Domestic	$	159,617	$	21,858	$	37,336	$	(13,909	)	$	204,902
Foreign		48,625		6,939		—		—			55,564
Total segment net earnings (loss)	$	208,242	$	28,797	$	37,336	$	(13,909	)		260,466
Inter-segment eliminations											1,077
Consolidated net earnings										$	261,543
Other items:
Net investment income	$	98,492	$	6,916	$	1,839	$	1,712		$	108,959
Depreciation and amortization		3,425		6,792		381		1,644			12,242
Interest expense (benefit)		838		8,875		423		(2,224	)		7,912
Capital expenditures		2,837		1,629		498		4,681			9,645
Income tax expense (benefit)		97,240		20,607		18,459		(6,629	)		129,677
Inter-segment eliminations											642
Consolidated income tax expense										$	130,319

24

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

	Insurance					Other
	Company			Agency		Operations		Corporate			Total
Nine months ended September 30, 2005 (As restated)
Revenue:
Domestic	$	891,726		$	46,532	$	22,067	$	1,974		$	962,299
Foreign		203,278			29,516		—		—			232,794
Inter-segment		153			65,789		—		—			65,942
Total segment revenue	$	1,095,157		$	141,837	$	22,067	$	1,974			1,261,035
Inter-segment eliminations												(65,942	)
Consolidated total revenue											$	1,195,093
Net earnings:
Domestic	$	75,805		$	20,592	$	13,716	$	(198	)	$	109,915
Foreign		9,466			4,245		—		—			13,711
Total segment net earnings	$	85,271	(1)	$	24,837	$	13,716	$	(198	)		123,626
Inter-segment eliminations												1,823
Earnings from discontinued operations, net of income taxes												707
Consolidated net earnings											$	126,156
Other items:
Net investment income	$	63,222		$	4,820	$	767	$	1,230		$	70,039
Depreciation and amortization		3,500			5,603		343		1,617			11,063
Interest expense (benefit)		313			6,859		564		(1,888	)		5,848
Capital expenditures		1,520			2,745		249		2,038			6,552
Income tax expense		33,681			17,950		6,524		9			58,164
Inter-segment eliminations												927
Consolidated income tax expense on continuing operations											$	59,091

(1) Includes $48.3 million after-tax loss due to the 2005 hurricanes and $16.9 million after-tax loss due to commutations.

25

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

	Insurance				Other
	Company		Agency		Operations			Corporate			Total
Three months ended September 30, 2006
Revenue:
Domestic	$	373,463	$	19,581	$	18,898		$	1,899		$	413,841
Foreign		95,527		7,329		—			—			102,856
Inter-segment		6		17,304		—			—			17,310
Total segment revenue	$	468,996	$	44,214	$	18,898		$	1,899			534,007
Inter-segment eliminations												(17,310	)
Consolidated total revenue											$	516,697
Net earnings (loss):
Domestic	$	54,922	$	8,485	$	12,221		$	(7,865	)	$	67,763
Foreign		23,827		695		—			—			24,522
Total segment net earnings (loss)	$	78,749	$	9,180	$	12,221		$	(7,865	)		92,285
Inter-segment eliminations												972
Consolidated net earnings											$	93,257
Other items:
Net investment income (loss)	$	33,111	$	2,340	$	(39	)	$	793		$	36,205
Depreciation and amortization		1,154		2,755		127			562			4,598
Interest expense		118		3,007		159			191			3,475
Capital expenditures		1,658		440		3			1,414			3,515
Income tax expense (benefit)		36,783		6,530		6,000			(3,338	)		45,975
Inter-segment eliminations												480
Consolidated income tax expense											$	46,455

26

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

	Insurance					Other
	Company			Agency		Operations		Corporate			Total
Three months ended September 30, 2005 (As restated)
Revenue:
Domestic	$	312,271		$	16,668	$	15,682	$	769		$	345,390
Foreign		58,253			8,388		—		—			66,641
Inter-segment		12			21,065		—		—			21,077
Total segment revenue	$	370,536		$	46,121	$	15,682	$	769			433,108
Inter-segment eliminations												(21,077	)
Consolidated total revenue											$	412,031
Net earnings (loss):
Domestic	$	2,276		$	4,049	$	9,821	$	3,056		$	19,202
Foreign		(13,162	)		659		—		—			(12,503	)
Total segment net earnings (loss)	$	(10,886	)(1)	$	4,708	$	9,821	$	3,056			6,699
Inter-segment eliminations												6
Earnings from discontinued operations, net of income taxes												707
Consolidated net earnings											$	7,412
Other items:
Net investment income	$	22,607		$	1,924	$	79	$	388		$	24,998
Depreciation and amortization		1,164			1,708		128		703			3,703
Interest expense (benefit)		47			2,514		186		(677	)		2,070
Capital expenditures		757			1,211		172		1,119			3,259
Income tax expense (benefit)		(9,875	)		3,937		5,174		1,477			713
Inter-segment eliminations												(139	)
Consolidated income tax expense on continuing operations											$	574

(1) Includes $48.3 million after-tax loss due to the 2005 hurricanes and $16.9 million after-tax loss due to commutations.

27

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

The following tables present selected revenue items by line of business.

	Nine months ended					Three months ended
	September 30,					September 30,
	2006			2005		2006		2005
				(As restated)
Diversified financial products	$	538,063		$	371,414	$	189,744	$	143,084
Group life, accident and health		385,257			380,681		129,234		125,079
Aviation		112,661			101,817		40,430		35,008
London market account		80,455			66,402		31,590		8,784
Other specialty lines		88,569			69,574		30,033		25,023
Discontinued lines		(64	)		6,013		19		1,080
Net earned premium	$	1,204,941		$	995,901	$	421,050	$	338,058
Property and casualty	$	86,016		$	85,684	$	32,565	$	26,813
Accident and health		18,393			15,315		6,297		5,260
Fee and commission income	$	104,409		$	100,999	$	38,862	$	32,073

(6)	SUPPLEMENTAL INFORMATION
	Supplemental information was as follows.

	Nine months ended				Three months ended
	September 30,				September 30,
	2006		2005		2006		2005
			(As restated)				(As restated)
Cash received from commutations	$	12,750	$	154,078	$	12,750	$	119,621
Income taxes paid		125,228		63,138		50,354		13,579
Interest paid		7,044		5,756		3,556		3,140
Comprehensive income (loss)		276,109		108,161		132,891		(5,185	)

28

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

(7)	COMMITMENTS AND CONTINGENCIES
	Litigation
	We are party to lawsuits, arbitrations and other proceedings that arise in the normal course of our business. Many of such lawsuits, arbitrations 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, arbitrations and other proceedings that relate to disputes over contractual relationships with third parties, or that involve alleged errors and omissions on the part of our subsidiaries. We have provided accruals for these items to the extent we deem the losses probable and reasonably estimable.
	We have been engaged in litigation initiated by the appointed liquidator of a former reinsurer concerning payments made to us prior to the date of appointment of the liquidator. The disputed payments, totaling $10.3 million, were made by the now insolvent reinsurer in connection with a commutation agreement. We reached an agreement in principle with the liquidator to resolve this matter and are in the process of finalizing the agreements. The expected resolution will not have a material effect on our consolidated financial position, results of operations or cash flows.
	In April 2006, we were named as a defendant in a complaint related to insurance marketing and producer compensation practices. The lawsuit was filed in Federal District Court in Georgia by a number of corporate plaintiffs against approximately 100 insurance entity defendants. The suit has been transferred to the multi-district litigation proceeding pending in the United States District Court for the District of New Jersey for coordinated or consolidated pre-trial proceedings with suits previously transferred that appear to the court to involve common questions of fact. The complaint alleges violations of Federal antitrust law, the Racketeering Influence and Corrupt Organization Act and various state anti-fraud laws. The lawsuit seeks unspecified damages. We are vigorously contesting this action.
	Although the ultimate outcome of the matters mentioned above cannot be determined at this time, based on present information, the availability of insurance coverage and advice received from our outside legal counsel, we believe the resolution of these matters will not have a material adverse effect on our consolidated financial position, results of operations or cash flows.

29

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

	Indemnifications
	In conjunction with the sales of business assets and subsidiaries, we have provided indemnifications to the buyers. Certain indemnifications cover typical representations and warranties related to our responsibilities to perform under the sales contracts. We cannot quantify the maximum potential exposure covered by all of our indemnifications because the indemnifications cover a variety of matters, operations and scenarios. Certain of these indemnifications have no time limit. For those with a time limit, the longest such indemnification expires on December 31, 2009.
	We accrue a loss related to our indemnifications when a valid claim is made by a buyer and we believe we have potential exposure. We currently have several claims under indemnifications that cover certain net losses incurred in periods prior to our sale of certain subsidiaries. As of September 30, 2006, we have recorded a liability of $13.9 million and have provided $5.2 million of letters of credit to cover our obligations or anticipated payments under these indemnifications.
	Stock Option Investigation Matters
	Based on the Special Committee’s voluntary independent investigation of our past practices related to granting stock options, we determined that the price on the actual measurement date for a number of our stock option grants during the period 1997 through 2005 and into 2006 did not correspond to the price on the stated grant date and that certain option grants were retroactively repriced. The investigation was conducted with the help of a law firm that was not previously involved with our stock option plans and procedures. The SEC has commenced an informal inquiry. In connection with its inquiry, we received a document request from the SEC. We intend to fully cooperate with the informal inquiry. We are unable to predict the outcome of or the future costs related to the informal inquiry.
(8)	SUBSEQUENT EVENTS
	On October 30, 2006, we received a registered letter from U.S. Bank, as trustee for the holders of our 2.00% Convertible Notes due 2021, 1.30% Convertible Notes due 2023 and 2.00% Convertible Exchange Notes due 2021, stating that U.S. Bank, as trustee, had not received our consolidated financial statements for the quarter ended June 30, 2006. If we do not file our Quarterly Report on Form 10-Q for the quarter ended June 30, 2006 with the SEC and deliver the report to the trustee within sixty days from the date notice was received from the trustee, such failure to file and deliver will be considered an “Event of Default” under the indenture governing the notes. If an “Event of Default” were to occur under the indentures for any series of the notes, the trustee or holders of at least 25% of the aggregate principal of such series then outstanding could declare all the unpaid principal on such series of notes then outstanding to be immediately due and payable. Likewise, we have not timely delivered our Form 10-Q’s for the quarters ended June 30 and September 30, 2006 as required by the terms of our Revolving Loan Facility agreement. The banks that are a party to the agreement waived certain “Defaults” or “Events of Default” until January 31, 2007. In addition, our restatement of our prior year financial statements might be considered an “Event of Default” which has been waived until January 31, 2007. Our failure to comply with the covenants in the indentures for our convertible notes and our Revolving Loan Facility loan agreement in the future could have a material adverse effect on our stock price, business and financial condition if we would not have available funds at that time to repay any defaulted debt. A default and acceleration under the indentures for our convertible notes and loan agreement may also trigger cross-acceleration under our other debt instruments.
	In December 2006, our existing Revolving Loan Facility was increased by $100.0 million to $300.0 million. Pursuant to the terms of the agreement, the Company can borrow up to $25 million in addition to what is currently borrowed for working capital purposes. However, the full unfunded amount of the facility would be available to pay any potential convertible note conversion or put.

30

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

On August 3, 2006, we reached an agreement to acquire the assets of the Health Products Division (the Division) of Allianz Life Insurance Company of North America for cash consideration of $140.0 million and to assume the Division’s outstanding loss reserves. The Division’s operations include medical stop loss insurance for self-insured corporations and groups; excess insurance for HMOs; provider excess insurance for integrated delivery systems; excess medical reinsurance to small and regional insurance carriers; and Life Trac, a network for providing organ and bone marrow transplants. The Division currently writes more than $300.0 million in annual gross premium. We plan to integrate the Division’s operations into HCC Life Insurance Company, within our insurance company segment. Internal funds were utilized to make the acquisition, which was consummated on October 2, 2006.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following Management’s Discussion and Analysis should be read in conjunction with the Condensed Consolidated Financial Statements and the related Notes thereto.

RESTATEMENT OF FINANCIAL STATEMENTS

In light of published reports concerning the pricing of stock options and the timing of stock option grants at numerous other companies, in the second quarter of 2006 we undertook a voluntary internal review of our past practices related to grants of stock options. The voluntary review by our management concluded that the actual accounting measurement dates for certain past stock option grants differed from the originally stated grant dates, which were also utilized as the measurement dates for such awards. In August 2006, our Board of Directors formed a Special Committee of independent directors to commence an investigation of our past stock option granting practices for the period 1995 through 2005. The Special Committee was composed of the members of the Audit Committee of the Board of Directors. The Special Committee retained the law firm of Skadden, Arps, Slate, Meagher & Flom, LLP as its independent legal counsel and LECG as forensic accountants to aid in the investigation.

On November 17, 2006, we announced that the Special Committee had made certain determinations as a result of its review of our past stock option granting practices. The Special Committee found that we had used incorrect accounting measurement dates for stock option grants covering a significant number of employees and members of our Board of Directors during the period 1997 through 2005 and that certain option grants were retroactively priced. Additionally, at the direction of the Special Committee, we reviewed our stock option granting practices from 1992, the year of our initial public stock offering, through 1994 and in 2006 and found incorrect measurement dates due to retroactive pricing were used in 2006. In substantially all of these instances, the price on the actual measurement date was higher than the price on the stated grant date; thus recipients of the options could exercise at a strike price lower than the actual measurement date price. To determine the actual measurement dates, the Special Committee utilized the following sources of information:

•     The dates on documentation such as e-mails, regulatory form filings, acquisition agreements and other correspondence;

•     The date that the relevant stock option grant was entered into Equity Edge, our stock option tracking and accounting system;

•     Requirements of Accounting Principles Board (APB) No. 25, Accounting for Stock Issued to Employees, and related interpretations; and

•     Guidance from the Office of Chief Accountant of the Securities and Exchange Commission (SEC) contained in a letter dated September 19, 2006.

The Special Committee concluded that mis-priced option grants, the effect of which, together with certain other adjustments, resulted in a cumulative net decrease in shareholders’ equity at December 31, 2005 of $3.3 million, affected all levels of employees. The Special Committee found that Stephen L. Way, Chief Executive Officer, retroactively priced options, that he should have known he was granting options in a manner that conflicted with our stock option plans and public statements, and that this constituted a failure to align the stock option granting process with our stock option plans and public statements. Although finding his actions were inconsistent with the duties and obligations of a chief executive officer of a publicly-traded company, the Special Committee also found that Mr. Way’s motivation appeared to be the attraction and retention of talent and to provide employees with the best option price. The Special Committee also concluded that Christopher L. Martin, Executive Vice President and General Counsel, was aware that options were being retroactively priced in a manner inconsistent with applicable plan terms and the procedures memoranda that he had prepared, that granting in-the-money options had accounting implications, and that he did not properly document our Compensation Committee’s informal delegation of authority to Mr. Way. The Special Committee also found that there was no evidence that Mr. Way or Mr. Martin intended to falsify the consolidated financial statements.

32

Before the Board of Directors reviewed the results of the investigation, the Chairman of the Compensation Committee tendered his resignation from the Board of Directors on November 8, 2006. After reviewing the results of the investigation, the Board of Directors determined that it would be appropriate to accept the resignations of Mr. Way and Mr. Martin, which both tendered on November 17, 2006. Mr. Way will remain a director of HCC and serve as the non-executive Chairman of the Board of Directors and has entered into a consulting agreement with us to assist in the transition of leadership and to provide strategic guidance. We have entered into agreements with Mr. Way and Mr. Martin which, among other things, require them to disgorge an amount equal to the difference between the actual measurement date prices determined by HCC and the prices at which these individuals exercised mis-priced options since 1997.

As a result of the determinations of the Special Committee and because the resulting cumulative charge would be material to the second quarter and full year 2006 consolidated net earnings, we concluded that we needed to amend our 2005 Annual Report filed with the SEC on Form 10-K and our first quarter 2006 quarterly report filed with the SEC on Form 10-Q, to restate our consolidated financial statements and disclosures. The amended Forms 10-K/A and 10-Q/A have been filed with the SEC. We made the restatement in accordance with generally accepted accounting principles to record the following:

• Non-cash compensation expense for the difference between the stock price on the stated grant date and the actual measurement date and for the fluctuations in stock price in certain instances where variable accounting should have been applied;

• Other minor adjustments that were not recorded in the originally filed financial statements due to their immateriality; and

• Related tax effects for all items.

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

We were unable to timely file our quarterly reports on Form 10-Q for the quarters ended June 30, 2006 and September 30, 2006, primarily due to not knowing the financial impact of the Special Committee’s investigation. We have also restated the June 30, 2005 and September 30, 2005 financial statements included in our quarterly reports on Form 10-Q for the respective 2006 quarters.

Based on the determinations of the Special Committee and our voluntary internal review, we identified a number of occasions during the period 1997 through 2005 and into 2006 on which we used an incorrect measurement date for financial accounting and reporting purposes for options granted. In accordance with Accounting Principles Board (APB) No. 25, Accounting for Stock Issued to Employees, and its related interpretations, we should have recorded compensation expense related to these options for the excess of the market price of our stock on the actual measurement date over the exercise price of the option. For periods commencing January 1, 2006, compensation expense is being recognized in accordance with Statement of Financial Accounting Standards (SFAS) No. 123(R) (revised), Share-Based Payment. However, we determined an incremental amount related to the mis-priced options must be recorded.

33

The types of errors identified were as follows:

•     We determined that many block grants to employees during the period 1997 through 2005 were subject to a retroactive look-back period. In all such cases, the price of our stock at the end of the look-back period, which was generally 30 days or less, was higher than the price of our stock on the stated grant date.

•     In addition to being subject to the retroactive pricing discussed above, we determined that the strike price of block grants in 1999, 2002 and 2005 was determined prior to the final determination of the identity of the employee and/or the number of options to be granted. Further, proper approval, in most cases, had not been given until after the grant date. In all such cases, the price of our stock at the time when all required determinations were final and proper approval had been obtained was higher than the price of our stock on the stated grant date. The time lag between the stated grant date and the finalization of the awards was typically 30-45 days, except in the case of the 2002 grant which was finalized several months subsequent to the stated grant date.

•     For the period from 1997 to 2005 and into 2006, we determined that there was a regular practice of granting options to newly hired employees and existing employees being promoted after the end of a 30-45 day period following the hire or promotion date. This practice included the use of the 30-45 day period as a look-back period during which the date with the lowest price during that period was selected as the stated grant date.

•     In several instances, grants to senior executives were determined at a date subsequent to the stated grant date. In most cases, this resulted from extended negotiations of employment agreements and, in some cases, administrative delays. In virtually all cases, the price of our stock at the time the grants were made and properly approved was higher than the price of our stock on the stated grant date.

•     In a few cases, options were granted and then repriced downward. As a result, variable accounting should have been applied to these options.

•     We lacked timely or adequate documentation to support the stated grant date in the case of certain of the above errors.

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

In connection with the investigation, we determined that a number of executive officers received in-the-money options. If such options are ultimately determined to be in-the-money grants for tax purposes, pursuant to Section 162(m) of the Internal Revenue Code and, if in the year of exercise the officers’ compensation, including proceeds from options exercised, exceeded $1.0 million, we would not be entitled to a tax deduction for any amount in excess of such $1.0 million for officers covered by Section 162(m). We estimate the tax effect of the deduction was $4.6 million, substantially all of which was recorded as a reduction to shareholders’ equity.

There were immaterial adjustments that were not made in the originally filed consolidated financial statements. We have taken the opportunity presented by this restatement to record these adjustments, which amounted to a net $2.4 million increase in earnings from continuing operations before income tax expense, for the years 2001 through 2005.

34

The increase (decrease) on net earnings of each type of adjustment was as follows (in thousands):

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

The restatement adjustments reduced previously reported diluted net earnings per share by $0.03 and $0.00 for the nine and three months ended September 30, 2005, respectively.

Enacted October 22, 2004, Section 409A of the Internal Revenue Code significantly changed the rules for nonqualified deferred compensation plans. Section 409A imposes certain restrictions and taxes on stock awards that constitute deferred compensation. Section 409A relates specifically to the personal tax liabilities of our employees that have received discounted options. We are currently reviewing the implications of Section 409A on grants awarded with intrinsic value that vested after December 31, 2004 and modifications made to existing grants after October 3, 2004 along with potential remedial actions.

As of December 15, 2006, we have paid direct costs of approximately $6.0 million, of which $2.5 million was incurred through September 30, 2006, for costs associated with the Special Committee’s investigation and additional related professional services and consulting fees associated with the restatement effort. We expect to pay up to several million dollars of additional expense in the next few months associated with the conclusion of the investigation and restatement of our consolidated financial statements.

Overview

We are a specialty insurance group with offices in the United States, the United Kingdom, Spain and Bermuda transacting business in more than 50 countries. Our group consists of insurance companies, underwriting agencies and reinsurance brokers. Our shares are traded on the New York Stock Exchange and had a market capitalization of $3.7 billion at September 30, 2006. We earned $261.5 million or $2.24 per diluted share in the first nine months of 2006 compared to $126.2 million or $1.17 per diluted share in the first nine months of 2005, and $93.3 million or $0.80 per diluted share in the third quarter of 2006 compared to $7.4 million or $0.07 per diluted share in the third quarter of 2005. The 2005 year-to-date and quarterly periods include a $48.3 million ($0.45 per diluted share) after-tax loss due to hurricanes and $16.9 million ($0.16 per diluted share) after-tax loss due to commutations. The 2006 per share amounts include the effect of dilution from a $150.0 million common stock offering in November 2005. Shareholders’ equity increased 33% from a year ago to $2.0 billion at September 30, 2006, principally from a combination of net earnings and the 2005 equity offering.

We underwrite a variety of specialty lines of business identified as diversified financial products; group life, accident and health; aviation; London market account; and other specialty lines of business. Products in each line are marketed by our insurance companies and agencies, either through a network of independent agents and brokers or directly to customers. With the exception of our public company directors’ and officers’ liability business, certain international aviation risks and our London market business, we focus on lower limit, smaller premium business that is less susceptible to price competition, severity of loss or catastrophe risk. Our principal insurance companies are rated “AA (Very Strong)” by Standard & Poor’s Corporation and “A+ (Superior)” by A.M. Best Company, Inc.

We generate our revenue from five primary sources: 1) risk-bearing earned premium produced by our insurance company operations, 2) non-risk-bearing fee and commission income received by our underwriting agency and intermediary operations, 3) ceding commissions in excess of policy acquisition costs earned by our insurance company operations, 4) investment income earned by all of our operations and 5) other operating income. We produced $1.5 billion of revenue in the first nine months of 2006, an increase of 24% over the same period in 2005. Net earned premium increased due to greater retentions, predominantly in our diversified financial products line of business, organic growth in certain lines of business, acquisitions and payment of reinstatement

35

premium in 2005, which reduced net written and net earned premium. Investment income increased due to a 29% growth in total investments and an increase in interest rates. Other operating income increased due to activity in our strategic investments and trading portfolio.

During the past several years, we substantially increased our shareholders’ equity by retaining most of our earnings and issuing additional shares of common stock. With this additional equity, we increased the underwriting capacity of our insurance companies and made strategic acquisitions, adding new lines of business or expanding those with favorable underwriting characteristics.

Our 2006 and 2005 acquisitions are listed below. Net earnings and cash flows from each acquired entity are included in our operations beginning on the effective date of each transaction.

Company	Segment	Effective date acquired
Allianz Life Insurance Company Health Products Division	Insurance company	October 2, 2006
G.B. Kenrick & Associates, Inc.	Agency	July 1, 2006
Novia Underwriters, Inc.	Agency	June 30, 2006
Illium Insurance Group	Agency	December 31, 2005
Perico Ltd.	Agency	December 1, 2005
Perico Life Insurance Company	Insurance company	November 30, 2005
HCC International Insurance Company	Insurance company	July 1, 2005
United States Surety Company	Insurance company	March 1, 2005

The following section discusses our key operating results. The reasons for any significant variations between the quarters ended September 30, 2006 and 2005 are the same as those discussed below for the respective nine month periods, unless otherwise noted. Amounts in the following tables are in thousands, except for earnings per share, percentages, ratios and number of employees.

Results of Operations

Net earnings increased to $261.6 million ($2.24 per diluted share) in the first nine months of 2006 from $126.2 million ($1.17 per diluted share) in the same period of 2005. Net earnings increased to $93.3 million ($0.80 per diluted share) in the third quarter of 2006 from $7.0 million ($0.07 per diluted share) in the third quarter of 2005. The 2005 year-to-date and quarterly periods include a $48.3 million ($0.45 per diluted share) after-tax loss due to hurricanes and $16.9 million ($0.16 per diluted share) after-tax loss due to commutations. Growth in underwriting profits, net investment income and other operating income contributed to the increase in 2006 earnings.

36

The following table sets forth the relationships of certain income statement items as a percent of total revenue.

	Nine months ended						Three months ended
	September 30,						September 30,
	2006			2005			2006			2005
				(As restated)						(As restated)
Net earned premium		81.6	%		83.3	%		81.5	%		82.0	%
Fee and commission income		7.1			8.4			7.5			7.8
Net investment income		7.4			5.9			7.0			6.1
Net realized investment gain (loss)		(0.1	)		0.2			0.1			—
Other operating income		4.0			2.2			3.9			4.1
Total revenue		100.0			100.0			100.0			100.0
Loss and loss adjustment expense, net		46.7			56.9			45.7			71.8
Policy acquisition costs, net		15.7			15.7			15.1			15.9
Other operating expense		10.6			11.5			11.5			10.0
Interest expense		0.5			0.5			0.7			0.5
Earnings from continuing operations before income tax expense		26.5			15.4			27.0			1.8
Income tax expense		8.8			4.9			9.0			0.2
Earnings from continuing operations		17.7	%		10.5	%		18.0	%		1.6	%

Total revenue increased 24% to $1.5 billion in 2006, driven by growth in net earned premium, investment income and other operating income. We expect total revenue to continue to grow in the fourth quarter.

Gross written premium, net written premium and net earned premium are detailed below. Gross written premium increased from organic growth in certain lines of business and from acquisitions. Increased retentions, particularly in our diversified financial products line of business, and the payment of reinstatement premiums in the third quarter of 2005 contributed to the growth in net written and earned premium. In addition, following an increase in our retentions at the renewal of certain reinsurance programs of our aviation line, a transfer of in force business from reinsurers resulted in increased net written premium and net earned premium in 2006. See the Insurance Company Segment section below for further discussion of the changes in premium revenue.

	Nine months ended				Three months ended
	September 30,				September 30,
	2006		2005		2006		2005
Gross written premium	$	1,628,213	$	1,540,002	$	536,101	$	525,447
Net written premium		1,299,114		1,107,443		422,581		371,698
Net earned premium		1,204,941		995,901		421,052		338,058

37

Fee and commission income are shown in the table below. Fee and commission income increased as a result of profit commissions from reinsurers, which were triggered by reserve releases in the second and third quarter of 2006. Partially offsetting this increase was the effect of insurance company subsidiaries ceding less insurance, thereby reducing ceding commissions earned by them and reinsurance commissions earned by our reinsurance intermediaries.

	Nine months ended				Three months ended
	September 30,				September 30,
	2006		2005		2006		2005
			(As restated)
Agency	$	70,712	$	71,680	$	24,781	$	23,533
Insurance companies		33,697		29,319		14,081		8,540
Fee and commission income	$	104,409	$	100,999	$	38,862	$	32,073

The sources of net investment income are detailed below.

	Nine months ended						Three months ended
	September 30,						September 30,
	2006			2005			2006			2005
Fixed income securities	$	81,349		$	56,017		$	29,858		$	19,855
Short-term investments		21,817			13,899			7,792			5,468
Other investments		9,870			2,891			(382	)		482
Total investment income		113,036			72,807			37,268			25,805
Investment expense		(4,077	)		(2,768	)		(1,063	)		(807	)
Net investment income	$	108,959		$	70,039		$	36,205		$	24,998

Net investment income increased 56% in the first nine months of 2006 and 45% in the third quarter of 2006, compared to the prior year periods. The increase was primarily due to higher investment assets, which increased to $3.8 billion at September 30, 2006 compared to $3.0 billion at September 30, 2005, and increasing interest rates. The growth in investment assets resulted from: 1) higher net earnings, 2) higher retentions, 3) commutations of reinsurance recoverables in late 2005, 4) our public offering of common stock in 2005 and 5) the increase in net loss reserves particularly from our diversified financial products line of business, which generally have a longer time period between occurrence and payment of claims. We continue to invest our funds primarily in fixed income securities, with a duration of 4.8 years at September 30, 2006. We expect investment assets and investment income to continue to increase through year-end.

At September 30, 2006, our unrealized gain on fixed income securities was $0.6 million, compared to an unrealized loss of $54.1 million at June 30, 2006 and $8.5 million at December 31, 2005, due to decreases in market interest rates. The change in the unrealized gain or loss, net of the related income tax effect, is recorded in other comprehensive income and fluctuates with changes in market interest rates. Our general policy has been to hold our fixed income securities, which are classified as available for sale, through periods of fluctuating interest rates and to not realize significant gains or losses from their sale. The unrealized gain on our fixed income securities increased to $19.8 million at November 30, 2006.

38

Information about our portfolio of fixed income securities is as follows:

	Nine months ended						Three months ended
	September 30,						September 30,
	2006			2005			2006			2005
Average yield		4.2	%		3.9	%		4.3	%		3.9	%
Average tax equivalent yield		5.2	%		4.8	%		5.1	%		4.8	%
Weighted average maturity	7.0 years			7.6 years
Weighted average duration	4.8 years			4.8 years

The average yield on our short-term investments increased from 2.7% in 2005 to 4.2% in 2006.

Other operating income increased in 2006 compared to the prior year, primarily due to net gains from trading securities and gains from the partial sale of a strategic investment. Period to period comparisons of other operating income may vary substantially depending on market values of trading securities and other financial instruments and on income from strategic investments or dispositions of such investments. The following table details the sources of other operating income.

	Nine months ended				Three months ended
	September 30,				September 30,
	2006		2005		2006		2005
Strategic investments	$	28,057	$	10,085	$	15,308	$	6,872
Trading securities		24,161		9,210		2,307		7,783
Financial instruments		3,265		3,250		1,273		603
Other		3,588		3,571		1,388		1,606
Other operating income	$	59,071	$	26,116	$	20,276	$	16,864

Loss and loss adjustment expense increased 1% (15% excluding losses related to the hurricanes and commutations) and policy acquisition costs increased 23% over the prior year nine-month amounts primarily due to the growth in net earned premium. See the Insurance Company Segment section below for further discussion of the changes in loss and loss adjustment expense and policy acquisition costs.

Other operating expense, which includes compensation expense, increased 14% compared to the 2005 year-to-date period and 44% quarter over quarter. The 2006 amounts increased for stock option expense under Statement of Financial Accounting Standards (SFAS) No. 123(R), a higher provision for reinsurance, higher professional and legal costs, and operating expenses of subsidiaries acquired in the second half of 2005. We had 1,547 employees at September 30, 2006 compared to 1,373 a year earlier, with the increase due to acquisitions. See the Recent Accounting Changes section below for further discussion of our adoption of SFAS 123(R) in 2006. The first nine months of 2005 included expense related to an indemnification claim.

Our effective income tax rate was 33.3% for 2006, compared to 32.0% for 2005. We recorded a special $2.1 million U.S. repatriation tax benefit in 2005.

At September 30, 2006, book value per share was $17.59 up from $15.26, total assets were $7.5 billion up from $7.0 billion, and shareholders’ equity was $2.0 billion up from $1.7 billion, all compared to December 31, 2005.

39

Segments

Insurance Company Segment

Net earnings of our insurance company segment increased to $208.2 million in the first nine months of 2006 compared to $85.3 million in the same period of 2005. The 2005 period included $65.2 million of after-tax losses related to commutations and hurricanes. The growth in segment net earnings was driven by an increase in underwriting income, increased investment income and the operations of acquired subsidiaries. Even though there is some pricing competition in certain of our markets, our margins remain at an acceptable level of profitability due to our underwriting expertise and discipline. We expect net earnings from our insurance companies to continue to grow in the fourth quarter.

Premium

Gross written premium increased 6% to $1.6 billion in the first nine months of 2006 compared to 2005. Net written premium increased 17% to $1.3 billion and net earned premium increased 21% to $1.2 billion for the same period. The increase in gross written premium was due to higher writings in the energy sector of our London market account, diversified financial products and other specialty lines of business, partially offset by the non-renewal of a book of accident and health business that was 100% reinsured. The increases in net written and net earned premium were primarily due to higher retention levels on non-catastrophe business and growth in the energy sector, although our retention percentage on this line was reduced in 2006 to spread the risk. The overall percentage of retained premium increased to 80% in 2006 from 72% in 2005.

Gross written, net written and net earned premium increased 2%, 14% and 25%, respectively, quarter over quarter. We had reduced writings of international directors and officers insurance in 2006. In addition, the 2005 net written and net earned premium were reduced by $20.7 million for premium to reinstate our excess of loss reinsurance protection following the 2005 hurricanes. Net written and net earned premium are expected to continue to grow in the fourth quarter of 2006.

40

The following tables provide premium information by line of business.

	Gross		Net			NWP as			Net
	written		written			% of			earned
	premium		premium			GWP			premium
Nine months ended September 30, 2006
Diversified financial products	$	690,779	$	574,098			83	%	$	538,063
Group life, accident and health		415,215		388,895			94			385,257
Aviation		166,072		128,810			78			112,661
London market account		202,964		111,278			55			80,455
Other specialty lines		152,960		96,056			63			88,569
Discontinued lines		223		(23	)	nm				(64	)
Totals	$	1,628,213	$	1,299,114			80	%	$	1,204,941

Nine months ended September 30, 2005
Diversified financial products	$	665,400	$	480,405		72	%	$	371,414
Group life, accident and health		453,558		381,367		84			380,681
Aviation		159,446		99,879		63			101,817
London market account		124,134		64,938		52			66,402
Other specialty lines		133,766		78,542		59			69,574
Discontinued lines		3,698		2,312	nm				6,013
Totals	$	1,540,002	$	1,107,443		72	%	$	995,901

Three months ended September 30, 2006
Diversified financial products	$	240,046		$	200,333		83	%	$	189,744
Group life, accident and health		142,457			130,007		91			129,234
Aviation		50,976			38,446		75			40,430
London market account		44,799			20,761		46			31,590
Other specialty lines		57,837			32,963		57			30,033
Discontinued lines		(14	)		71	nm				19
Totals	$	536,101		$	422,581		79	%	$	421,050

Three months ended September 30, 2005
Diversified financial products	$	241,781	$	184,931			76	%	$	143,084
Group life, accident and health		147,236		124,358			84			125,079
Aviation		53,090		31,597			60			35,008
London market account		32,366		(370	)	nm				8,784
Other specialty lines		49,991		30,220			60			25,023
Discontinued lines		983		962		nm				1,080
Totals	$	525,447	$	371,698			71	%	$	338,058

nm — Not meaningful comparison

The changes in premium volume and retention levels between years resulted principally from the following factors:

• Diversified financial products — Growth in our surety and credit products was strong from both organic growth and our 2005 acquisitions. The growth in net written and net earned premium was due to increased retentions resulting from a reduction in proportional reinsurance.

• Group life, accident and health — Gross written premium declined primarily because we non-

41

renewed a book of business which was 100% reinsured. Profit margins remain at acceptable levels despite competition from the fully insured market.

• Aviation — The growth in net written and net earned premium was due to the effect of recapture of ceded unearned premium from a transfer of in force business in the second quarter of 2006. In addition, retentions increased from a reduction in proportional reinsurance.

• London market account — Gross written premium increased due to the substantial increase in rates in the energy sector as a result of the 2005 hurricane losses, more than offsetting a reduction in our property sector premium. Net written premium increased for the same reason and will be reflected in increases in our net earned premium later in 2006 and into 2007. In 2006, to increase our capacity and spread our risk in the energy sector, we entered into a new quota share reinsurance agreement. Although the cost of our 2006 excess of loss reinsurance increased, our potential profitability is greater on the increased gross written premium. Our aggregate exposure in Florida and the Gulf of Mexico is lower in 2006 than it was in 2005. Net written premium and net earned premium were reduced in 2005 by additional excess of loss premium to reinstate catastrophe reinsurance coverage, which distorts the retention percentages.

• Other specialty lines — We experienced organic growth in our other specialty lines of business from increased writings in several products. The mix of products affected the retention percentages. Rates in this line have been relatively stable.

Losses and Loss Adjustment Expenses

The net redundancy relating to prior year losses included in our net incurred loss and loss adjustment expense was $6.0 million in the first nine months of 2006, compared to a net deficiency of $27.5 million (including $26.0 million due to commutations) in the first nine months of 2005. We had a net redundancy of $6.8 million in the third quarter of 2006 and a net deficiency of $25.2 million (including $26.0 million due to commutations) in the third quarter of 2005. During the third quarter of 2006, following a review of ultimate loss ratios, we reduced our net loss reserves by $4.8 million, primarily related to aviation and by $1.9 million related to one large 2005 hurricane claim that was settled for an amount less than reserved. During the second quarter of 2005, we reduced our net loss reserves on the 2004 hurricanes by $5.8 million to reflect revised estimates of our remaining liabilities. This reduction was offset by reserve increases in our London market account and group life, accident and health lines of business. Deficiencies and redundancies in reserves occur as a result of our continuing review and as losses are finally settled or claims exposures change. We have no material exposure to environmental or asbestos losses and believe we have provided for all material net incurred losses.

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Our gross loss ratio was 56.7% in the first nine months of 2006 and 79.4% (including 19.9% related to the 2005 hurricanes) in the same period of 2005. The following table provides comparative net loss ratios, by line of business, which reflect better than expected aviation underwriting results in 2006 and the effects of hurricanes and commutations in 2005. The net loss ratios excluding hurricanes and commutations were 59.0% and 60.2% in the nine months and third quarter of 2005, respectively.

	Nine months ended September 30,											Three months ended September 30,
	2006						2005					2006					2005
	Net			Net			Net		Net			Net		Net			Net		Net
	earned			loss			earned		loss			earned		loss			earned		loss
	premium			ratio			premium		ratio			premium		ratio			premium		ratio
									(As restated)
Diversified financial products	$	538,063			49.0	%	$	371,414		48.1	%	$	189,744		46.5	%	$	143,084		48.5	%
Group life, accident and health		385,257			71.3			380,681		73.0			129,234		73.7			125,079		78.9
Aviation		112,661			55.9			101,817		73.3			40,430		55.0			35,008		100.0
London market account		80,455			44.5			66,402		95.1			31,590		42.9			8,784		424.3
Other specialty lines		88,569			58.1			69,574		76.1			30,033		55.2			25,023		111.2
Discontinued lines		(64	)	nm				6,013	nm				19	nm				1,080	nm
Totals	$	1,204,941			57.2	%	$	995,901		68.3	%	$	421,050		56.1	%	$	338,058		87.5	%
Expense ratio					25.7					26.2					24.5					25.3
Combined ratio					82.9	%				94.5	%				80.6	%				112.8	%

nm — Not meaningful comparison

Comments on significant changes in net loss ratios by line of business follow:

• Aviation — Underwriting results have been better than expected in 2006. The 2005 hurricanes increased the loss ratios 8.2% and 24.1% for the nine months and third quarter of 2005, respectively.

• London market account — The 2005 hurricanes increased the loss ratios 54.9% and 393.3% for the nine months and third quarter of 2005, respectively. The London market account line of business can have relatively high quarter-to-quarter volatility due to catastrophe exposure.

• Other specialty lines — The 2005 hurricanes increased the net loss ratios 18.6% and 51.8% for the nine months and third quarter of 2005, respectively.

• Discontinued lines — The 2005 commutation losses primarily affected this line of business.

Policy Acquisition Costs

Policy acquisition costs, which are net of the related portion of commissions on reinsurance ceded, increased to $231.0 million in the first nine months of 2006 from $187.7 million in the first nine months of 2005. Policy acquisition costs as a percentage of net earned premium increased to 19.2% in 2006 from 18.8% in 2005 due to changes in the mix of business. The expense ratio was lower than 2005 due to the higher level of net earned premium in 2006 and the effect of reinstatement premiums in 2005.

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Agency Segment

Revenue from our agency segment decreased to $130.9 million in the first nine months of 2006 from $141.8 million in the first nine months of 2005, primarily due to less business produced in certain lines and the overall effect of ceding less insurance. In addition, we consolidated two underwriting agencies into insurance companies in 2005 and 2006. However, segment net earnings increased in 2006 to $28.8 million from $24.8 million in 2005 due to higher foreign earnings from brokering directors’ and officers’ liability business. While increased retentions result in less fee and commission income to our agency segment, they generate increased insurance company revenue and net earnings.

Other Operations Segment

Revenue and net earnings from our other operations segment increased to $57.8 million and $37.3 million, respectively, in the first nine months of 2006 compared to 2005 primarily due to net gains from trading securities and the partial sale of a strategic investment. Results of this segment may vary substantially period to period depending on our investment in or disposition of strategic investments and activity in our trading portfolio.

Liquidity and Capital Resources

We receive substantial cash from premiums, reinsurance recoverables, commutations, fee and commission income, proceeds from sales and redemptions of investments and investment income. Our principal cash outflows are for the payment of claims and loss adjustment expenses, premium payments to reinsurers, purchases of investments, debt service, policy acquisition costs, operating expenses, taxes and dividends.

Cash provided by operating activities can fluctuate due to timing differences in the collection of premiums and reinsurance recoverables and the payment of losses and premium and reinsurance balances payable, the completion of commutations and activity in our trading portfolio. Our cash provided by operating activities has been strong in recent years due to: 1) our increasing net earnings, 2) growth in net written premium and net loss reserves due to organic growth, acquisitions and increased retentions, 3) commutations of selected reinsurance agreements and 4) expansion of our diversified financial products line of business, where we retain premium longer due to the longer duration of claims liabilities.

44

The components of our net operating cash flows are detailed in the following table.

	Nine months ended						Three months ended
	September 30,						September 30,
	2006			2005			2006			2005
				(As restated)						(As restated)
Net earnings	$	261,543		$	126,156		$	93,257		$	7,412
Change in premium, claims and other receivables, net of reinsurance, other payables and restricted cash		(79,176	)		(67,328	)		(28,950	)		47,397
Change in unearned premium, net		109,051			103,503			4,837			32,106
Change in loss and loss adjustment expense payable, net of reinsurance recoverables		149,937			376,060			36,521			270,187
Change in trading portfolio		(99,193	)		(54,654	)		(14,702	)		(16,600	)
Other, net		17,544			(30,483	)		8,802			(6,085	)
Cash provided by operating activities	$	359,706		$	453,254		$	99,765		$	334,417

Cash provided by operating activities decreased $93.5 million in the first nine months of 2006 and $234.7 million quarter over quarter. Cash received from commutations, included in cash provided by operating activities, totaled $12.8 million in 2006 and $154.1 million in 2005 ($119.6 million in third quarter 2005). Cash flow from operations decreased in 2006 primarily due to payment of 2005 hurricane claims in 2006, the timing of receipt of receivables and payment of related payables, and commutations, partially offset by an increase in net earnings.

Our combined cash and investment portfolio increased by $532.7 million during 2006 to a total of $3.9 billion at September 30, 2006. We maintain a substantial level of cash and liquid short-term investments to meet anticipated payment obligations.

In 2006, we paid $32.3 million, which had been accrued at December 31, 2005, related to earnout consideration based on the terms of prior acquisition agreements. In June and July 2006, we acquired Novia Underwriters, Inc. and G.B. Kenrick and Associates, Inc. for a cash consideration.

Our $200.0 million Revolving Loan Facility allows us to borrow up to the maximum allowed by the facility on a revolving basis until the facility expires on November 30, 2009. We had borrowings of $84.0 million as of September 30, 2006. We have a commitment for a new $300.0 million facility with more favorable terms, which will replace our current facility.

In the second quarter of 2006, we filed a “Universal Shelf” registration statement with the Securities and Exchange Commission, which replaced our previously filed registration statements and provides for the issuance of an aggregate of $1.0 billion of our securities. These securities may be debt securities, equity securities, trust preferred securities, or a combination thereof.

As a result of our common stock trading at specified price levels in the third quarter of 2006, holders may elect to surrender our 1.30% Convertible Notes and 2.00% Convertible Exchange Notes (Notes) in the fourth quarter for cash equal to the principal amount of the Notes ($297.3 million at September 30, 2006) and common stock for the value of the conversion premium. We expect to use operating cash flow and the Revolving Loan Facility to fund any Notes surrendered, which have been minimal to date. Assuming an average price of $33.00 for our stock, we would issue approximately 4.6 million shares of common stock should all Note holders elect conversion. The dilutive effect of these shares is included in the calculation of our diluted earnings per share. Our common stock must meet the specified price levels in each subsequent quarter in order for the Notes to be eligible for conversion in the following quarter.

As a result of our delayed filing of our Form 10-Q for the quarters ended June 30, 2006 and September

45

30, 2006, we are ineligible to register our securities on Form S-3 or use our previously filed shelf registration statement for sale of our securities by us or resale of our securities by others until we have timely filed all periodic reports under the Securities Exchange Act of 1934 for one year. We may use Form S-1 to raise capital and borrow money utilizing public debt or complete acquisitions of other companies, which could increase transaction costs and adversely impact our ability to raise capital and borrow money or complete acquisitions in a timely manner. In addition, the financial strength ratings of our insurance companies and our debt ratings, which A.M. Best placed under review with negative implications and Fitch Ratings and Standard & Poor’s affirmed with a stable outlook, if reduced, might significantly impede our ability to raise capital and borrow money.

On October 30, 2006, we received a registered letter from U.S. Bank, as trustee for the holders of our 2.00% Convertible Notes due 2021, 1.30% Convertible Notes due 2023 and 2.00% Convertible Exchange Notes due 2021, stating that U.S. Bank, as trustee, had not received our consolidated financial statements for the quarter ended June 30, 2006. If we do not file our Quarterly Report on Form 10-Q for the quarter ended June 30, 2006 with the SEC and deliver the report to the trustee within sixty days from the date notice was received from the trustee, such failure to file and deliver will be considered an “Event of Default” under the indenture governing the notes. If an “Event of Default” were to occur under the indentures for any series of the notes, the trustee or holders of at least 25% of the aggregate principal of such series then outstanding could declare all the unpaid principal on such series of notes then outstanding to be immediately due and payable. Likewise, we have not timely delivered our Form 10-Q’s for the quarters ended June 30 and September 30, 2006 as required by the terms of our Revolving Loan Facility agreement. The banks that are a party to the agreement waived certain “Defaults” or “Events of Default” until January 31, 2007. In addition, our restatement of our prior year financial statements might be considered an “Event of Default” which has been waived until January 31, 2007. Our failure to comply with the covenants in the indentures for our convertible notes and our Revolving Loan Facility loan agreement in the future could have a material adverse effect on our stock price, business and financial condition if we would not have available funds at that time to repay any defaulted debt. A default and acceleration under the indentures for our convertible notes and loan agreement may also trigger cross-acceleration under our other debt instruments.

In December 2006, our existing Revolving Loan Facility was increased by $100.0 million to $300.0 million. Pursuant to the terms of the agreement, the Company can borrow up to $25 million in addition to what is currently borrowed for working capital purposes. However, the full unfunded amount of the facility would be available to pay any potential convertible note conversion or put.

Based on the Special Committee’s voluntary independent investigation of our past practices related to granting stock options, we determined that the price on the actual measurement date for a number of our stock option grants during the period 1997 through 2005 and into 2006 did not correspond to the price on the stated grant date and that certain option grants were retroactively repriced. The investigation was conducted with the help of a law firm that was not previously involved with our stock option plans and procedures. The SEC has commenced an informal inquiry. In connection with its inquiry, we received a document request from the SEC. We intend to fully cooperate with the informal inquiry. We are unable to predict the outcome of or the future costs related to the informal investigation.

Our debt to total capital ratio was 16.7% at September 30, 2006 and 15.5% at December 31, 2005.

46

On October 2, 2006, we completed our acquisition of the assets of Allianz Life Insurance Company’s Health Products Division for cash consideration of $140.0 million and assumption of $151.5 million of loss reserves. The transaction was completed using existing capital resources and without incurring any additional debt.

We believe that our operating cash flows, investments, Revolving Loan Facility and other sources of liquidity will provide sufficient sources of liquidity to meet our current operating needs for the foreseeable future.

Recent Accounting Changes

Effective January 1, 2006, we adopted SFAS No. 123(R), Share-Based Payment, using the modified prospective method. In 2006 and thereafter, we will expense the fair value of our unvested stock options granted before January 1, 2006 and all options granted after that date. Prior to adoption, we accounted for our stock options in accordance with Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and did not recognize compensation expense for options granted. Under the modified prospective method of SFAS 123(R), the 2005 and prior period financial statements were not restated when we adopted SFAS 123(R). We made no modifications to our stock option plans in conjunction with the adoption of SFAS 123(R).

In the first nine months of 2006, we expensed $9.5 million ($6.8 million after-tax or $0.06 per diluted share) of stock-based compensation, after the effect of the deferral and amortization of related policy acquisition costs. We expensed $3.4 million ($2.4 million after-tax or $0.02 per diluted share) in the third quarter of 2006. At September 30, 2006, there was approximately $33.0 million of total unrecognized compensation expense related to unvested options that is expected to be recognized over a weighted-average period of three years. In 2006, we expect to recognize $12.9 million of expense, including the amortization of deferred policy acquisition costs, related to stock-based compensation for options currently outstanding. In accordance with the requirements of APB Opinion No. 25, we recorded $2.2 million and $0.8 million of stock-based compensation in the nine and three months ended September 30, 2005, respectively.

The Financial Accounting Standards Board (FASB) has issued FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes. Effective January 1, 2007, FIN 48 clarifies the accounting for uncertain income tax positions. We are currently reviewing the requirements of FIN 48 to determine the effect it will have on our consolidated financial statements.

The FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157), which clarified the definition of fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurement. SFAS 157 does not require any new fair value measurements and eliminates inconsistencies in guidance found in various prior accounting pronouncements. SFAS 157 will be effective for us on January 1, 2008. We are currently assessing whether the adoption of SFAS 157 will have an impact on our consolidated financial statements.

The Securities and Exchange Commission has issued Staff Accounting Bulletin (SAB) No.108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. SAB 108 establishes a standard approach for quantifying the materiality of errors to current and prior period financial statements. SAB 108’s guidelines must be applied in the fourth quarter, and adjustments, if any, will be recorded either by restating prior year financial statements or recording a cumulative effect adjustment as of January 1, 2006. We believe the requirements of SAB 108 will have no effect on our consolidated financial statements.

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/A for the year ended December 31, 2005.

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/A for the year ended December 31, 2005.

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Item 4. Controls and Procedures

a. Disclosure Controls and Procedures

Background of Restatement

As disclosed in Explanatory Note — Late Filing of Quarterly Report on page 3 of this Form 10-Q and in Note 2 to the Condensed Consolidated Financial Statements, in August 2006, our Board of Directors formed a Special Committee of independent directors to commence an investigation of our past stock option granting practices for the period 1995 through 2005. On November 17, 2006, we announced that the Special Committee found that we had used incorrect accounting measurement dates for stock option grants covering a significant number of employees and members of our Board of Directors during the period 1997 through 2005 and that certain option grants were retroactively priced. Additionally, at the direction of the Special Committee, we reviewed our stock option granting practices from 1992, the year of our initial public stock offering, through 1994 and in 2006 and found incorrect measurement dates due to retroactive pricing were used in 2006. In substantially all of these instances, the price on the actual measurement date was higher than the price on the stated grant date.

The Special Committee concluded that mis-priced option grants, the effect of which, together with certain other adjustments, resulted in a cumulative net decrease in shareholders’ equity at December 31, 2005 of $3.3 million, affected all levels of employees. The Special Committee found that Stephen L. Way, Chief Executive Officer, retroactively priced options, that he should have known he was granting options in a manner that conflicted with our stock option plans and public statements, and that this constituted a failure to align the stock option granting process with our stock option plans and public statements. Although finding his actions were inconsistent with the duties and obligations of a chief executive officer of a publicly-traded company, the Special Committee also found that Mr. Way’s motivation appeared to be the attraction and retention of talent and to provide employees with the best option price. The Special Committee also concluded that Christopher L. Martin, Executive Vice President and General Counsel, was aware that options were being retroactively priced in a manner inconsistent with applicable plan terms and the procedures memoranda that he had prepared, that granting in-the-money options had accounting implications, and that he did not properly document our Compensation Committee’s informal delegation of authority to Mr. Way. The Special Committee also found that there was no evidence that Mr. Way or Mr. Martin intended to falsify the consolidated financial statements.

Before the Board of Directors reviewed the results of the investigation, the chairman of our Compensation Committee tendered his resignation from the Board of Directors on November 8, 2006. After reviewing the results of the investigation, the Board of Directors determined that it would be appropriate to accept the resignations of Mr. Way and Mr. Martin, which both tendered on November 17, 2006.

We determined that, in accordance with Accounting Principles Board (APB) No. 25, Accounting for Stock Issued to Employees, and its related interpretations, we should have recorded compensation expense related to these mis-priced options for the excess of the market price of our stock on the actual accounting measurement date over the exercise price of the option. As a result, we concluded that we needed to amend our Annual Report on Form 10-K for the year ended December 31, 2005 to restate our consolidated financial statements and the related disclosures for the years ended December 31, 2005, 2004 and 2003 and the condensed consolidated financial statements for the quarter ended March 31, 2006 and all quarters for the years ended December 31, 2005 and 2004, and to record an adjustment to the condensed consolidated financial statements for the quarters ended June 30, 2006 and September 30, 2006. In addition, as discussed below, we concluded that we had a material weakness in our internal control over financial reporting as of September 30, 2006.

As part of the restatement process, we recorded other adjustments in the period 2000 through 2005 that were not recorded in the originally filed financial statements due to their immateriality. We evaluated the control deficiencies that resulted in these adjustments and concluded that these immaterial errors were the result of control deficiencies that did not constitute a material weakness, individually or in the aggregate, in our internal control over financial reporting.

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Act)) that are designed to ensure that required information is recorded, processed, summarized and reported within the required timeframe, as specified in rules set forth by the Securities and Exchange Commission. Our disclosure controls and procedures are also designed to ensure that information required to be disclosed is accumulated and communicated to management, including the Chief Executive Officer (CEO) and Chief Financial Officer (CFO), to allow timely decisions regarding required disclosures.

As of September 30, 2006, an evaluation was carried out under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the Act). Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were not effective to ensure that information required to be disclosed by us to comply with our disclosure obligations under the Act is recorded, processed, summarized and reported by us within the timeframes specified by the Securities and Exchange Commission in order to comply with our disclosure obligations under the Act because of the material weakness in internal control over financial reporting described below. Notwithstanding this material weakness, our current management has concluded that our consolidated financial statements for the periods covered by and included in this Quarterly Report on Form 10-Q are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) and fairly present, in all material respects, our financial position, results of operations and cash flows for each of the periods presented herein.

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Material Weakness in Internal Control Over Financial Reporting

A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. Our current management identified the following material weakness in our internal control over financial reporting as of September 30, 2006.

We did not maintain an effective control environment based on the criteria established in the COSO framework. We did not maintain adequate controls to prevent or detect management override by certain former members of senior management related to our stock option granting practices and procedures. This lack of an effective control environment permitted certain former members of senior management to override controls and retroactively price stock option grants, resulting in ineffective controls over our stock option granting practices and procedures. Effective controls, including monitoring and adequate communication, were not maintained to ensure the accuracy, valuation and presentation of activity related to our stock option granting practices and procedures. This control deficiency resulted in misstatement of our stock-based compensation expense, additional paid-in capital and related income tax accounts and related disclosures, and in the restatement of our consolidated financial statements for the years ended December 31, 2005, 2004 and 2003 and the condensed consolidated financial statements for the quarter ended March 31, 2006 and all quarters for the years ended December 31, 2005 and 2004, and the adjustment of the condensed consolidated financial statements for the quarters ended June 30, 2006 and September 30, 2006. This control deficiency could result in misstatement of the aforementioned accounts and disclosures that would result in a material misstatement of our annual or interim consolidated financial statements that would not be prevented or detected. Accordingly, management has determined this control deficiency constitutes a material weakness.

Changes in Internal Control Over Financial Reporting

There have been no changes in our internal control over financial reporting during the last quarter of the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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Remediation Plans

We are committed to remediating the material weakness identified above by implementing changes to our internal control over financial reporting to enhance our control environment. During 2006, we implemented or are in the process of implementing new policies and controls related to our stock option granting practices and procedures, as follows:

• Before the Board of Directors reviewed the results of the investigation, the Chairman of our Compensation Committee tendered his resignation from the Board of Directors on November 8, 2006. After reviewing the results of the investigation, our Board of Directors determined that it would be appropriate to accept the resignations of our former CEO and General Counsel, which both tendered on November 17, 2006. Our Board of Directors has appointed a new Chairman of our Compensation Committee and a new CEO who, together with other members of our senior management, are committed to achieving transparency through effective corporate governance, a strong control environment, application of business standards reflected in our Code of Business Conduct and Ethics, and completeness and integrity of our financial reporting and disclosure.

• We have changed our option granting approval policies and procedures to require Compensation Committee approval of all new option grants on the day of each Compensation Committee meeting preceding the regularly scheduled quarterly Board of Directors meeting. All grants will be appropriately approved and documented in minutes of the meeting, taken contemporaneously with the meeting. All grants will be priced at the market closing price on the day of each such Compensation Committee meeting. We have established processes and procedures to increase the level of communication between the Compensation Committee, senior management and our financial reporting and accounting personnel regarding stock option grants.

We are actively engaged in the implementation of other remediation efforts to address the material weakness identified in our internal control over financial reporting. Although we have not fully remediated the material weakness as of the date of this Form 10-Q filing, we believe we have made substantial progress.

Part II — Other Information

Item 1. Legal Proceedings

As described in Note 2 to our Consolidated Financial Statements included in this Form 10-K/A, based on the Special Committee’s voluntary independent investigation of our past practices related to granting stock options, we determined that the price on the actual measurement date for a number of our stock option grants during the period 1997 through 2005 and into 2006 did not correspond to the price on the stated grant date and that certain option grants were retroactively repriced. The investigation was conducted with the help of a law firm that was not previously involved with our stock option plans and procedures. The SEC has commenced an informal inquiry. In connection with its inquiry, we received a document request from the SEC. We intend to fully cooperate with the informal inquiry. We are unable to predict the outcome of or the future costs related to the informal investigation.

We are party to lawsuits, arbitrations and other proceedings that arise in the normal course of our business. Many of such lawsuits, arbitrations 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, arbitrations and other proceedings that relate to disputes over contractual relationships with third parties, or that involve alleged errors and omissions on the part of our subsidiaries. We have provided accruals for these items to the extent we deem the losses probable and reasonably estimable.

In April 2006, we were named as a defendant in a complaint related to insurance marketing and producer compensation practices. The lawsuit was filed in Federal District Court in Georgia by a number of corporate plaintiffs against approximately 100 insurance entity defendants. The suit has been transferred to the multi-district litigation proceeding pending in the United States District Court for the District of New Jersey for coordinated or consolidated pre-trial proceedings with suits previously transferred that appear to the court to involve common questions of fact. The complaint alleges violations of Federal antitrust law, the Racketeering Influence and Corrupt Organization Act and various state anti-fraud laws. The lawsuit seeks unspecified damages. We are vigorously contesting this action.

Although the ultimate outcome of the matters cannot be determined at this time, based on present information, the availability of insurance coverage and advice received from our outside legal counsel, we believe the resolution of these matters will not have a material adverse effect on our consolidated financial position, results of operations or cash flows.

Item 1A. Risk Factors

There have been no material changes in our risk factors described in our Annual Report on Form 10-K/A for the year ended December 31, 2005.

Item 6. Exhibits

a.	Exhibits
	23	Consent of Independent Registered Public Accounting Firm — PricewaterhouseCoopers LLP dated December 22, 2006
	31.1	Certification by Chief Executive Officer
	31.2	Certification by Chief Financial Officer
	32.1	Certification with Respect to Quarterly Report

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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)
December 26, 2006	/s/ Frank J. Bramanti
(Date)	Frank J. Bramanti, Chief Executive Officer
December 26, 2006	/s/ Edward H. Ellis, Jr.
(Date)	Edward H. Ellis, Jr., Executive Vice President and Chief Financial Officer

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INDEX TO EXHIBITS

23	Consent of Independent Registered Public Accounting Firm — PricewaterhouseCoopers LLP dated December 22, 2006
31.1	Certification by Chief Executive Officer
31.2	Certification by Chief Financial Officer
32.1	Certification with Respect to Quarterly Report

EX-23.1

Exhibit 23

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We hereby consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 333-89905, 333-99551 and 333-46432) of HCC Insurance Holdings, Inc. of our report dated March 15, 2006, except for the restatement described in Note 2 to the consolidated financial statements and the matter discussed in the penultimate paragraph of Management’s Report on Internal Control Over Financial Reporting, as to which the date is December 22, 2006, relating to the consolidated financial statements, financial statement schedules, management’s assessment of the effectiveness of internal control over financial reporting and the effectiveness of internal control over financial reporting which appears in the HCC Insurance Holdings Inc.’s Report on Form 10-K/A for the year ended December 31, 2005.

PricewaterhouseCoopers LLP
Houston, Texas
December 22, 2006

EX-31.1

Exhibit 31.1

CERTIFICATION BY CHIEF EXECUTIVE OFFICER

I, Frank J. Bramanti, certify that:

1. I have reviewed this quarterly report on Form 10-Q of HCC Insurance Holdings, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order 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 report;

3. Based on my knowledge, the financial statements, and other financial information included in this 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 report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

a.	Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, 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 report is being prepared;
b.	Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
c.	Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
d.	Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing equivalent functions):

a.	All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
b.	Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

December 26, 2006	/s/ Frank J. Bramanti
(Date)	Frank J. Bramanti, Chief Executive Officer

EX-31.2

Exhibit 31.2

CERTIFICATION BY CHIEF FINANCIAL OFFICER

I, Edward H. Ellis, Jr., certify that:

1. I have reviewed this quarterly report on Form 10-Q of HCC Insurance Holdings, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order 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 report;

3. Based on my knowledge, the financial statements, and other financial information included in this 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 report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

a.	Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, 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 report is being prepared;
b.	Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
c.	Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
d.	Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing equivalent functions):

a.	All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
b.	Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

December 26, 2006	/s/ Edward H. Ellis, Jr.
(Date)	Edward H. Ellis, Jr., Executive Vice President and Chief Financial Officer

EX-32.1

Exhibit 32.1

CERTIFICATION WITH RESPECT TO
QUARTERLY REPORT OF
HCC INSURANCE HOLDINGS, INC.

     The undersigned, being the Chief Executive Officer and Chief Financial Officer of HCC Insurance Holdings, Inc. (the Company), pursuant to 18 U.S.C. §1350 as adopted pursuant to §906 of the Sarbanes-Oxley Act of 2002, do hereby certify to the best of their knowledge with respect to the Quarterly Report of the Company on Form 10-Q, as filed with the Securities and Exchange Commission for the quarter ended September 30, 2006 (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 as of and for the periods presented in the Report.

December 26, 2006	/s/ Frank J. Bramanti
(Date)	Frank J. Bramanti, Chief Executive Officer
December 26, 2006	/s/ Edward H. Ellis, Jr.
(Date)	Edward H. Ellis, Jr., Executive Vice President and Chief Financial Officer

A signed original of this written statement required by §906 has been provided to HCC Insurance Holdings, Inc. and will be retained by HCC Insurance Holdings, Inc. and furnished to the Securities and Exchange Commission or its staff upon request.