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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
/X/ Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act
of 1934.
/ / Transaction report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.
For the fiscal year ended _______December 31, 1999_______________________
Commission file number _______0-20766____________________________________
HCC Insurance Holdings, Inc.
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(Exact name of registrant as specified in its
charter)
Delaware 76-0336636
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(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
13403 Northwest Freeway, Houston, Texas 77040-6094
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(Address of principal executive offices) (Zip Code)
(713) 690-7300
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(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12 (b) of the Act:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE OF WHICH REGISTERED:
COMMON STOCK, $1.00 PAR VALUE New York Stock Exchange
Securities registered pursuant to Section 12 (g) of the Act: NONE
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes __X__ No _____
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K (Section229.405 of this chapter) is not contained herein, and
will not be contained, to the best of registrant's knowledge, in definitive
proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K. / /
The aggregate market value on March 10, 2000, of the voting stock held by
non-affiliates of the registrant was approximately $501.7 million. For purposes
of the determination of the above stated amount, only directors and executive
officers are presumed to be affiliates, but neither the registrant nor any such
person concede that they are affiliates of the registrant.
The number of shares outstanding of the registrant's Common Stock, $1.00 par
value, as of March 10, 2000 was 49,095,126.
Documents incorporated by reference: Information called for in Part III of this
Form 10-K is incorporated by reference to the Registrant's definitive Proxy
Statement to be filed within 120 days of the close of the Registrant's fiscal
year in connection with the Registrant's annual meeting of shareholders.
TABLE OF CONTENTS
HCC INSURANCE HOLDINGS, INC.
PAGE
--------
PART I.
ITEM 1. Business.................................................... 3
ITEM 2. Properties.................................................. 26
ITEM 3. Legal Proceedings........................................... 26
ITEM 4. Submission of Matters to a Vote of Security Holders......... 26
PART II.
ITEM 5. Market for the Registrant's Common Equity and Related
Stockholder Matters......................................... 27
ITEM 6. Selected Financial Data..................................... 28
ITEM 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 30
ITEM 7A. Quantitative and Qualitative Disclosure About Market Risk... 42
ITEM 8. Financial Statements and Supplementary Data................. 43
ITEM 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosures................................... 43
PART III.
ITEM 10. Directors and Executive Officers of the Registrant.......... 44
ITEM 11. Executive Compensation...................................... 44
ITEM 12. Security Ownership of Certain Beneficial Owners and
Management.................................................. 44
ITEM 13. Certain Relationships and Related Transactions.............. 44
PART IV.
ITEM 14. Exhibits, Financial Statement Schedules and Reports on
Form 8-K.................................................... 45
SIGNATURES......................................................................... 46
THIS REPORT ON FORM 10-K (THIS "REPORT") CONTAINS CERTAIN FORWARD-LOOKING
STATEMENTS WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933, AS
AMENDED, AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED,
WHICH ARE INTENDED TO BE COVERED BY THE SAFE HARBORS CREATED THEREBY. INVESTORS
ARE CAUTIONED THAT ALL FORWARD-LOOKING STATEMENTS NECESSARILY INVOLVE RISKS AND
UNCERTAINTY, INCLUDING, WITHOUT LIMITATION, THE RISK OF A SIGNIFICANT NATURAL
DISASTER, THE INABILITY OF THE COMPANY TO REINSURE CERTAIN RISKS, THE ADEQUACY
OF ITS LOSS RESERVES, THE FINANCIAL VIABILITY OF REINSURERS, THE EXPANSION OR
CONTRACTION IN ITS VARIOUS LINES OF BUSINESS, THE IMPACT OF INFLATION, THE
IMPACT OF POTENTIAL YEAR 2000 INSURANCE COVERAGE ISSUES, CHANGING LICENSING
REQUIREMENTS AND REGULATIONS IN THE UNITED STATES AND IN FOREIGN COUNTRIES, THE
ABILITY OF THE COMPANY TO INTEGRATE ITS RECENTLY ACQUIRED BUSINESSES, THE EFFECT
OF PENDING OR FUTURE ACQUISITIONS AS WELL AS ACQUISITIONS WHICH HAVE RECENTLY
BEEN CONSUMMATED, GENERAL MARKET CONDITIONS, COMPETITION, LICENSING AND PRICING.
ALL STATEMENTS, OTHER THAN STATEMENTS OF HISTORICAL FACTS, INCLUDED OR
INCORPORATED BY REFERENCE IN THIS REPORT THAT ADDRESS ACTIVITIES, EVENTS OR
DEVELOPMENTS THAT THE COMPANY EXPECTS OR ANTICIPATES WILL OR MAY OCCUR IN THE
FUTURE, INCLUDING, WITHOUT LIMITATION, SUCH THINGS AS FUTURE CAPITAL
EXPENDITURES (INCLUDING THE AMOUNT AND NATURE THEREOF), BUSINESS STRATEGY AND
MEASURES TO IMPLEMENT SUCH STRATEGY, COMPETITIVE STRENGTHS, GOALS, EXPANSION AND
GROWTH OF THE COMPANY'S BUSINESSES AND OPERATIONS, PLANS, REFERENCES TO FUTURE
SUCCESS, AS WELL AS OTHER STATEMENTS WHICH INCLUDE WORDS SUCH AS "ANTICIPATE",
"BELIEVE", "ESTIMATE", "EXPECT", "INTEND", "PLAN", "PROBABLY" AND OTHER SIMILAR
EXPRESSIONS, CONSTITUTE FORWARD-LOOKING STATEMENTS. ALTHOUGH THE COMPANY
BELIEVES THAT THE ASSUMPTIONS UNDERLYING THE FORWARD-LOOKING STATEMENTS
CONTAINED HEREIN ARE REASONABLE, ANY OF THE ASSUMPTIONS COULD OVER TIME PROVE TO
BE INACCURATE AND THEREFORE, THERE CAN BE NO ASSURANCE THAT THE FORWARD-LOOKING
STATEMENTS INCLUDED IN THIS REPORT WILL THEMSELVES PROVE TO BE ACCURATE. IN
LIGHT OF THE SIGNIFICANT UNCERTAINTIES INHERENT IN THE FORWARD-LOOKING
STATEMENTS INCLUDED HEREIN, THE INCLUSION OF SUCH INFORMATION SHOULD NOT BE
REGARDED AS A REPRESENTATION BY THE COMPANY OR ANY OTHER PERSON THAT THE
OBJECTIVES AND PLANS OF THE COMPANY WILL BE ACHIEVED.
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PART I
ITEM 1. BUSINESS
GENERAL
HCC Insurance Holdings, Inc. ("HCC") is a Delaware corporation with
principal and executive offices located at 13403 Northwest Freeway, Houston,
Texas 77040. HCC and its consolidated subsidiaries are collectively referred to
herein as the "Company" unless the context otherwise requires. HCC, through its
subsidiaries, provides specialized property and casualty and life and health
insurance coverages, underwriting agency and intermediary services and other
insurance related services both to commercial customers and individuals. The
Company's insurance products are underwritten on both a direct and reinsurance
basis and are marketed directly by the Company and through a network of
independent and affiliated agents and brokers. The Company's principal insurance
company subsidiaries are Houston Casualty Company ("HC") in Houston, Texas and
London, England; HCC Life Insurance Company ("HCCL") in Houston, Texas; U.S.
Specialty Insurance Company ("USSIC") in Houston, Texas; and Avemco Insurance
Company ("AIC") in Frederick, Maryland. The principal underwriting agency
subsidiaries are LDG Reinsurance Corporation ("LDG Re") in Wakefield,
Massachusetts and New York City, New York; LDG Re (London), Ltd. ("LDG
Re-London") in London, England; HCC Aviation Insurance Group, Inc. ("HCCA") in
Dallas, Texas and Glendale, California; HCC Employer Services, Inc. ("HCCES") in
Northbrook, Illinois, Montgomery, Alabama and Dallas, Texas; and HCC Benefits
Corporation ("HCCB") in Atlanta, Georgia, Costa Mesa, California, Wakefield,
Massachusetts, Minneapolis, Minnesota and Dallas, Texas. The Company's principal
intermediary subsidiaries are HCC Intermediaries, Inc. ("HCCI") in Houston,
Texas; HCC Employee Benefits, Inc. ("HCCEB") in Houston, Texas; and Rattner
Mackenzie Limited ("RML") in London, England.
Since its founding in 1974, the Company and its predecessor companies have
been consistently profitable on an annual basis, generally reporting annual
increases in gross written premium ("GWP"), management fees, brokerage income
and total revenue. During the period 1997 through 1999, the Company's insurance
company subsidiaries had an average combined ratio, before the effects of the
provision for reinsurance recorded in 1999, of 88.6% versus the less favorable
105.0% recorded by the U.S. property and casualty insurance industry overall.
During the same period, the Company's GWP increased from $346.4 million to
$568.3 million, an increase of 64%; management fees increased from
$51.0 million to $90.7 million, an increase of 78%; commission income increased
from $24.2 million to $54.6 million, an increase of 125%; and total revenue
increased from $280.3 million to $341.9 million, an increase of 22%.
The Company's insurance companies' underwriting activities are focused on
providing accident and health reinsurance, aviation, marine, offshore energy,
property, workers' compensation, group health and medical stop-loss insurance.
As an insurer in the United States, the Company operates on a surplus lines or a
non-admitted basis through HC and on an admitted basis through HCCL, AIC and
USSIC.
The Company's insurance company subsidiaries HC, AIC and USSIC are rated
"A+" (Superior) by A.M. Best Company ("A.M. Best") and are rated "AA" (Very
Strong) by Standard & Poor's Corporation ("S&P"). HCCL, a life insurance
company, is rated "A-" (Excellent) by A.M. Best. An A.M. Best or S&P rating is
intended to provide an independent opinion of an insurer's ability to meet its
obligations to policyholders and should not be considered as an investment
recommendation.
The Company's underwriting agencies underwrite on behalf of affiliated and
non-affiliated insurance companies. These agency operations specialize in
aviation, medical stop-loss, occupational accident and workers' compensation
insurance and a variety of accident and health related reinsurance products.
Beginning in 1996 with the acquisition of LDG Re, the Company commenced a
strategy of acquiring through merger or purchase, a number of companies whose
business was underwriting agency activities, primarily in the aviation, medical
stop-loss and workers' compensation insurance businesses. This was done in an
effort to further diversify the Company's operations and to enhance the
Company's ability to
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anticipate and capitalize on opportunities resulting from changing market
conditions in the insurance industry. The Company continued this expansion in
December, 1999, with the acquisition of The Centris Group, Inc. ("Centris") with
its underwriting agency subsidiary, USBenefits Insurance Services, Inc. ("USB"),
the operations of which have been integrated with HCCB. During 1999, the
Company's management fees from underwriting agencies were $90.7 million,
generated by $848.1 million in written premium. Management fees and written
premium are expected to increase in 2000 with the inclusion of USB's business.
Brokerage operations are performed by the Company's intermediary
subsidiaries. The Company's intermediary operations consist of marketing,
placing, consulting on and servicing insurance risks for its clients, which
include insurance companies and other risk taking entities. The Company's
intermediary subsidiaries specialize in employee benefits on a retail basis and
reinsurance for both accident and health and property and casualty clients. In
recent years, the Company has significantly expanded its intermediary operations
internally and through acquisitions. The latest acquisition in this area, RML,
was consummated in January, 1999. During 1999, the Company's commission income
from its intermediary operations was $54.6 million.
Subsidiaries of the Company also provide insurance claims adjustment and
servicing to the Company's insurance company and agency subsidiaries and for
unrelated entities. Additionally, from time to time, the Company will make
strategic investments, generally in companies or operations in or related to the
insurance industry. Certain of these investments are intended to enhance the
Company's operations through strategic partnering in areas common to the
investee and the Company. The Company's revenue from these investments is
comprised of equity in earnings of the investee, dividends and gains on the sale
of these investments.
STRATEGY
The Company's operating philosophy as an insurer is to maximize underwriting
profits while protecting shareholders' equity. The Company concentrates its
writings in selected, narrowly defined lines of business in which it believes
there is a substantial opportunity to achieve underwriting profits. The Company
primarily underwrites lines of business which have relatively short lead times
between the occurrence of an insured event and the reporting of claims to the
Company. The Company's insurance products are marketed both directly and through
independent and affiliated agents. With respect to its underwriting management,
marketing and related services, the Company seeks to offer quality underwriting,
decision-making, support, reinsurance capacity and financial and other resources
to take advantage of market opportunities.
The property and casualty insurance underwriting business has historically
been cyclical and particular lines of business even experience their own cycles.
These cycles are characterized by periods of excess capital and significant
competition in policy pricing, terms and conditions, followed by periods of
capital shortages, typically resulting from adverse loss experience, which lead
to decreased competition, higher premium rates and stricter underwriting
standards. The position of a particular line of business in its respective
underwriting cycle depends on prevailing premium rates, availability and cost of
reinsurance, and other market conditions. The Company considers each of these
factors in determining when to increase or decrease premium volume in each line.
With this approach, the Company focuses on increasing net earnings rather than
premium volume or market share.
The Company purchases a substantial amount of reinsurance to limit its net
loss from both individual and catastrophic risks. The degree to which the
Company reinsures varies by, among other things, the particular risks inherent
in the policies underwritten, pricing of available reinsurance and competitive
conditions within the relevant line of business.
In its insurance company operations, the Company believes its operational
flexibility, experienced underwriting personnel and access to and expertise in
the reinsurance marketplace allow the Company to
4
implement its strategy of emphasizing more profitable lines of business during
periods of increased premium rates and de-emphasizing less profitable lines of
business during periods of severe competition. In addition, through its
acquisition and ownership of insurance underwriting agencies and intermediary
businesses, the Company believes that those service based businesses can both
complement the Company's underwriting activities and serve as a source of
revenue which may not be subject to the same level of volatility as traditional
underwriting revenues. Many of the Company's insurance underwriting agency and
intermediary subsidiaries act as agents or intermediaries on behalf of the
Company's insurance company subsidiaries as well as for non-affiliated insurers.
Additionally, claims adjusting and servicing subsidiaries provide services for
the insurance company subsidiaries and their customers. The ability of the
Company's insurance company subsidiaries to utilize an affiliated insurance
underwriting agency, intermediary or service provider, and the corollary ability
of such insurance underwriting agency, intermediary and service subsidiaries to
place business with or provide other services to an affiliated insurer, permits
the Company to earn a greater portion of the total income derived from generated
premium.
The Company's business plan is to expand its underwriting activities and
continue the growth of its insurance underwriting agency and intermediary
operations. The Company will also, from time to time, make strategic investments
in companies that present an opportunity for future profit from sale or for
enhancement of the Company's business. However, the Company's business plan is
shaped by its underlying operating philosophy, which is to maximize underwriting
profit opportunities, while protecting shareholders' equity. The Company expects
to continue to seek to acquire complementary businesses with established
managements and reputations in the insurance industry, whose business, the
Company believes, can be enhanced through the synergism created by the Company's
underwriting capabilities and its other insurance related businesses. As a
result, the Company's primary interests are not necessarily in expanding market
share or GWP, but rather in increasing net earnings. To accomplish this
objective, the Company: (i) has been and is prepared to emphasize or reduce
underwritings in certain lines of business as premium rates, the availability
and cost of reinsurance and other market conditions warrant; (ii) will continue
to attempt to limit its net loss exposure through the effective, prudent and
conservative use of reinsurance; and (iii) will continue to review the possible
acquisition of other specialty insurance companies and of other strategic
operational investments.
INDUSTRY SEGMENT INFORMATION
Financial information concerning the Company's operations by industry
segment is set forth in the Consolidated Financial Statements and the Notes
thereto.
MAJOR ACQUISITIONS
On May 24, 1996, the Company issued 6,250,000 shares of its Common Stock to
acquire all of the outstanding shares of LDG. LDG, now operating as LDG Re, acts
on behalf of insurance and reinsurance companies as a reinsurance underwriting
manager in the following lines of business: accident and health, special risks
and alternative workers' compensation.
On June 17, 1997, the Company issued 8,511,625 shares of its Common Stock
and 604,575 options to purchase its Common Stock in order to acquire all of the
outstanding shares and options to purchase shares of Avemco Corporation
("Avemco"), the parent corporation of a group of insurance companies,
underwriting agencies and insurance related service companies. Avemco, through
its insurance company subsidiaries, provided property and casualty insurance
principally in the general aviation line of business. Avemco's primary insurance
company subsidiaries were AIC and USSIC. The operations of USSIC were relocated
to Houston, Texas and it became a subsidiary of HC.
On February 27, 1998, the Company issued 1,600,000 shares of its Common
Stock to acquire all of the outstanding shares of The Kachler Corporation
("Kachler"), now known as HCCEB. Kachler was a retail
5
insurance agency specializing in life, accident and health insurance for
employee benefit plans of medium and large commercial customers throughout the
United States.
On January 31, 1999, the Company acquired all of the outstanding stock of
PEPYS Holdings, Limited ("PEPYS"). PEPYS is the sole shareholder of RML. The
total initial consideration was $54.8 million in cash and deferred payments of
$8.3 million in cash and 414,207 shares of the Company's Common Stock.
Additional amounts may be paid in the future based upon the attainment of
certain earnings benchmarks over the next four years. RML, the operating entity,
provides intermediary services for reinsurance business placed by the Company's
insurance company subsidiaries as well as unaffiliated insurance and reinsurance
companies and underwriting agencies, primarily in the accident and health
marketplace.
On December 20, 1999, the Company acquired all of the outstanding shares of
Centris following a tender offer at a price of $12.50 per share. The total
consideration paid by the Company in connection with the Centris acquisition was
$149.5 million. Centris was the parent corporation of a group of insurance
companies and underwriting agencies principally operating in the medical
stop-loss line of business. Centris' primary insurance company subsidiary was
the entity now known as HCCL, whose operations are being relocated to Houston,
and it has become a subsidiary of HC. The medical stop-loss underwriting agency
operations of Centris have been combined with HCCB's operations.
The Company continues to evaluate possible acquisition candidates and may
complete one or more acquisitions during the remainder of 2000. The Company
believes these future acquisitions will expand and strengthen its existing lines
of business and perhaps provide access to additional specialty sectors, which
management expects will contribute to the growth of the Company.
DISPOSITIONS
In January, 1999, the Company sold its 21% interest in Underwriters
Indemnity Holdings, the parent of Underwriters Indemnity Company, to RLI
Corporation for $8.2 million. The Company realized a pre-tax gain of
$4.9 million in connection with the sale. The Company's investment in
Underwriters Indemnity Holdings was not material to the Company's' financial
position and results of operations.
In March, 2000, the Company sold Trafalgar Insurance Company ("TIC"), its
Oklahoma domiciled surplus lines insurance company subsidiary, for consideration
which approximated TIC's shareholders' equity determined on a GAAP basis. The
operations of TIC and the gain realized on the sale were not material to the
Company's revenue or net earnings.
INSURANCE COMPANY OPERATIONS
LINES OF BUSINESS
The following table sets forth the Company's insurance company subsidiaries'
GWP by line of business and the percent to total GWP for the three years ended
December 31, 1999 (dollars in thousands):
1999 1998 1997
------------------- ------------------- -------------------
Accident and health reinsurance............... $157,719 28% $114,787 23% $ 39,845 12%
Aviation...................................... 210,029 37 203,573 40 164,519 47
Marine........................................ 11,967 2 13,259 3 22,847 6
Medical stop-loss............................. 69,258 12 7,046 1 3,388 1
Offshore energy............................... 6,727 1 21,682 5 7,469 2
Property...................................... 63,309 11 106,515 21 85,379 25
Workers' compensation......................... 27,747 5 8,958 2 -- --
Other......................................... 21,575 4 22,456 5 22,952 7
-------- --- -------- --- -------- ---
Total GWP................................... $568,331 100% $498,276 100% $346,399 100%
======== === ======== === ======== ===
6
The following table sets forth the Company's insurance company subsidiaries'
net written premium ("NWP") by line of business and the percent to total NWP for
the three years ended December 31, 1999 (dollars in thousands):
1999 1998 1997
------------------- ------------------- -------------------
Accident and health reinsurance............... $ 37,725 27% $ 39,949 33% $ 24,777 17%
Aviation...................................... 68,513 49 53,030 44 75,280 53
Marine........................................ 5,483 4 5,654 5 17,271 12
Medical stop-loss............................. 20,332 15 3,415 3 3,388 2
Offshore energy............................... 1,133 1 2,324 2 1,416 1
Property...................................... 2,945 2 8,356 6 8,636 6
Workers' compensation......................... 673 -- 1,059 1 -- --
Other......................................... 3,120 2 8,096 6 12,085 9
-------- --- -------- --- -------- ---
Total NWP................................... $139,924 100% $121,883 100% $142,853 100%
======== === ======== === ======== ===
UNDERWRITING
DIRECT--The Company underwrites direct business produced through independent
agents and brokers, affiliated intermediaries, and, by direct marketing efforts,
primarily in small general aviation business.
REINSURANCE ASSUMED--The Company's current reinsurance underwriting
activities are primarily in: 1) the accident and health lines of business where
the Company's insurance company subsidiaries participate in various insurance
and reinsurance underwriting pools managed by its underwriting agency
subsidiaries, and 2) facultative (individual account) reinsurance, particularly
in the aviation and property lines of business. Typically, the facultative
reinsurance is on international business in order to comply with local licensing
requirements or as reinsurance of captives, and usually can be considered direct
business, as the Company maintains underwriting and claims control. However, all
of this business is recorded under the caption of "Reinsurance Assumed".
AVIATION--Aviation underwriting was the Company's largest overall line of
business in 1999 and in recent years the Company has grown into a market leader
in the aviation insurance industry. The Company insures general aviation risks,
including private aircraft owners and pilots, fixed base operations, rotor wing
aircraft, corporate aircraft, cargo operations, commuter airlines and similar
operations, both domestically and internationally. At this time, the Company
does not generally insure major airlines, major manufacturers or satellites. The
coverages underwritten include hull (including engines, avionics and other
systems), liabilities, war, cargo and various ancillary coverages. Insurance
claims related to general aviation business tend to be seasonal, with the bulk
of claims incurring during the spring and summer months.
The Company has been underwriting aviation risks since 1981 through HC. AIC
has been insuring aviation risks since 1959. GWP has risen consistently since
1997, increasing from a combined $164.5 million to $210.0 million in 1999. This
growth has occurred due to internal growth and acquisitions. Although, due to
market conditions, domestic risks had not been a focus for the Company since the
early 1990's, HC increased its writing of domestic general aviation risks late
in 1996. With the acquisition of AIC and USSIC in mid-1997, the Company achieved
the position of a major participant in the domestic general aviation insurance
market. The Company's position is further enhanced by its aviation underwriting
agency, HCCA. In 1997 and 1998, the Company experienced a decline in NWP due to
the implementation of the Company's reinsurance program at AIC following its
acquisition in 1997. Aviation NWP increased during 1999 as HCC increased its
retentions.
Reinsurance is maintained on both a proportional and an excess of loss basis
to protect the Company against individual risk severity of loss and catastrophe
exposure. Management believes that the aviation risks underwritten by the
Company carry a relatively low level of catastrophe exposure.
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MARINE--The Company underwrites marine risks for ocean going vessels ("Blue
Water"), inland and coastal trading vessels ("Brown Water") and fishing vessels.
The coverages written include hull and machinery, liabilities (including
protection and indemnity), marine cargo and various ancillary coverages.
The Company has underwritten marine risks since 1984, primarily in HC.
Premium rates were adequate through 1995 but competition has created downward
pressure on these rates causing a reduction in the Company's GWP from
$22.8 million in 1997 to $12.0 million in 1999 and a corresponding decrease in
NWP from $17.3 million to $5.5 million for the same period. Underwriting
operations have been moved to HC's branch office in London, where a substantial
amount of the Company's business originates and experienced underwriters are
more available.
Reinsurance is maintained on an excess of loss basis to protect the Company
against individual risk severity of loss and catastrophe exposure. Management
believes that the marine risks underwritten by the Company carry a relatively
low level of catastrophe exposure.
OFFSHORE ENERGY--The Company has been underwriting offshore energy risks
since 1988, primarily in HC. Offshore energy risks include drilling rigs,
production and gathering platforms, and pipelines. Coverages underwritten
include physical damage, liabilities, business interruption and various
ancillary coverages.
Rates have declined significantly during the past few years to levels where
underwriting profitability is unlikely. Underwriting has been on a very
selective basis, striving for quality rather than quantity. The
disproportionately high GWP and NWP during 1998 was the result of one large
policy that was substantially reinsured. Underwriting operations have been moved
to HC's branch office in London, where a substantial amount of the Company's
business originates and experienced underwriters are more available.
Reinsurance is maintained on both a proportional and an excess of loss basis
to protect the Company against individual risk severity of loss and the
catastrophic exposure that exists, for example, from a hurricane in the Gulf of
Mexico or a major platform explosion.
PROPERTY--The Company specializes in writing the property risks of large,
often multinational, corporations covering such commercial risks as hotels,
office buildings, retail locations, factories, industrial plants, utilities,
refineries, natural gas facilities and petrochemical plants. Coverage includes
business interruption and physical damage and catastrophe risks including flood
and earthquake.
The Company has written property business since 1986, primarily in HC.
During 1996, premium rates began to soften and this trend has continued through
1999 due in a large part to excess capacity and the absence of significant
catastrophe losses. GWP has declined from $85.4 million in 1997 to
$63.3 million in 1999 and is expected to decline further in 2000. NWP also
declined from $8.6 million to $2.9 million in the same period. Property NWP will
always be substantially less than GWP due to the amount of reinsurance purchased
in order to protect the Company from catastrophe exposure. Underwriting
operations have been moved to HC's branch office in London, where a substantial
amount of the Company's business originates and experienced underwriters are
more available.
Reinsurance is maintained on both a proportional and an excess of loss basis
to ensure adequate protection, particularly against catastrophic exposures. As
an example, through December 31, 1999, the Company had gross losses of
$60.8 million with respect to hurricanes Georges and Mitch both of which
occurred during 1998. The after-tax net loss, after reinsurance, with respect to
these hurricanes was $4.3 million. The Company conservatively estimates its
aggregate exposure in any individual catastrophe zone and maintains catastrophe
reinsurance to cover its exposure to any one occurrence.
ACCIDENT AND HEALTH REINSURANCE--The Company began underwriting accident and
health reinsurance risks in HC during 1996. These risks are underwritten
primarily by LDG Re, which was acquired by the Company during that year. The
risks underwritten include reinsurance in the accident and health special risks
and alternative workers' compensation areas and occupational accident insurance
for self-employed
8
truckers. The Company's GWP increased from $39.8 million in 1997 to
$157.7 million in 1999. This growth is from the Company's increased
participation in and the growth of the business underwritten by LDG Re. NWP has
not increased as dramatically as HC does not retain a large percentage of this
premium.
MEDICAL STOP-LOSS--Medical stop-loss business is written on an aggregate and
specific basis for employer sponsored self-insured health plans. This business
is underwritten by HCCB. The Company first began writing this business in 1996,
and GWP and NWP have increased as a result of greater participation in and the
growth of the business underwritten by HCCB. This growth is expected to continue
in the future.
WORKERS' COMPENSATION--The Company began writing statutory workers'
compensation business primarily in USSIC in 1998 by participating in the
business underwritten by HCCES. It is the intent of the Company to grow this
line of business in the future internally and possibly through acquisition. GWP
and NWP will rise in 2000, although substantial proportional reinsurance will
continue to be purchased. There is relatively no catastrophe exposure in this
line of business as there is very little business currently written in
California or Florida. Losses in this line of business generally take longer to
develop than in the Company's other lines of business.
INSURANCE COMPANY SUBSIDIARIES
HOUSTON CASUALTY COMPANY--HC, the Company's principal insurance company
subsidiary, is a Texas domiciled property and casualty insurer. HC is rated "A+,
VIII" by A.M. Best and "AA" by Standard & Poor's and operates worldwide in most
of the lines of business in which the Company specializes. HC's business is
produced by independent agents and brokers, the group's underwriting agency and
intermediary subsidiaries, and other insurance and reinsurance companies
worldwide. HC has a highly experienced staff of underwriters trained to deal
with the high value, complicated exposures prevailing in many of the lines of
business in which the Company specializes. As of December 31, 1999, HC had
statutory policyholders' surplus of $250.2 million.
HOUSTON CASUALTY COMPANY--LONDON--HC was authorized by Her Majesty's
Treasury in 1998 to operate a full branch office in the United Kingdom. HC
established its London branch operation in order to more closely align its
underwriting operations with the London market, a historical focal point for
many of the markets in which HC operates. To this end, the Company has
transferred most of the underwriting responsibility for the lines of business HC
writes, except aviation and, to some extent, accident and health to this branch.
HCC LIFE INSURANCE COMPANY--HCCL is an Indiana domiciled life insurance
company and former subsidiary of Centris, which became a direct subsidiary of HC
in December, 1999 following the Centris acquisition. HCCL is rated "A-"
(Excellent) by A.M. Best and operates as an accident and health insurer on an
admitted basis in 41 states and the District of Columbia. The Company expects to
expand HCCL's operations through its utilization as an insurer of medical
stop-loss and related life insurance products underwritten by HCCB. At
December 31, 1999, HCCL had statutory policyholder's surplus of $70.5 million.
U.S. SPECIALTY INSURANCE COMPANY--USSIC is a Texas domiciled property and
casualty insurance company. It is a direct subsidiary of HC. USSIC is rated "A+,
VII" by A.M. Best and "AA" by Standard & Poor's. USSIC operates on an admitted
basis throughout the United States primarily writing general aviation, workers'
compensation and alternative workers' compensation insurance produced by
underwriting agency subsidiaries of the Company. As of December 31, 1999, USSIC
had statutory policyholders' surplus of $104.4 million.
AVEMCO INSURANCE COMPANY--AIC was organized in 1959 and became a subsidiary
of the Company in June, 1997. AIC is a Maryland domiciled property and casualty
insurer, is rated "A+, VI" by A.M. Best and "AA" by Standard & Poor's and
operates primarily as a direct market underwriter of general aviation
9
business on an admitted basis throughout the United States and Canada (except
Quebec). In addition, as a part of the Company's overall operations, AIC has
become an insurer of medical stop-loss products underwritten by HCCB. At
December 31, 1999, AIC had statutory policyholders' surplus of $62.5 million.
UNDERWRITING AGENCY OPERATIONS
The Company's underwriting agency subsidiaries act on behalf of insurance
and reinsurance companies, conducting business in the areas of insurance
underwriting management and claims administration. The underwriting agency
subsidiaries do not assume any insurance or reinsurance risk themselves and the
revenues generated are based entirely on management fees and profit commissions.
These subsidiaries are in a position to direct and control business that they
produce. In addition, certain of the business written by the underwriting
agencies is insured or reinsured by the Company's insurance company
subsidiaries. In some cases, the insurance company subsidiaries serve as policy
issuing companies for this business. The insurance company subsidiaries may
retain a portion of the risk and reinsure the remainder with other unaffiliated
insurance companies or reinsure all of the risk.
LINES OF BUSINESS
The following table sets forth the Company's underwriting agency
subsidiaries' premium by lines of business for the three years ended
December 31, 1999 (dollars in thousands):
1999 1998 1997
------------------- ------------------- -------------------
Accident and health reinsurance................ $452,017 53% $356,530 50% $258,716 55%
Aviation....................................... 91,156 11 92,668 13 49,581 10
Medical stop-loss.............................. 184,302 22 182,528 26 93,435 20
Occupational accident.......................... 54,000 6 48,100 7 46,909 10
Workers' compensation.......................... 52,758 6 4,429 1 -- --
Other.......................................... 13,883 2 21,932 3 24,798 5
-------- --- -------- --- -------- ---
Total premium.............................. $848,116 100% $706,187 100% $473,439 100%
======== === ======== === ======== ===
UNDERWRITING AGENCY SUBSIDIARIES
LDG REINSURANCE CORPORATION--LDG Re, with operations in Wakefield,
Massachusetts and New York City, New York, acts as an underwriting manager
writing accident and health, special risks and alternative workers' compensation
reinsurance. In 1999, LDG Re generated approximately $360.2 million of written
premium, the majority of which was written on behalf of non-affiliated insurance
companies.
LDG RE (LONDON), LTD.--LDG Re-London, located in London, England, is an
underwriting manager writing accident and health reinsurance business. During
1999, LDG Re-London generated approximately $90.1 million of written premium.
During 2000, LDG Re-London will underwrite primarily on behalf of HC-London.
HCC BENEFITS CORPORATION--HCCB, with its home office in Atlanta, Georgia and
regional offices in Costa Mesa, California, Wakefield, Massachusetts,
Minneapolis, Minnesota and Dallas, Texas, acts as an underwriting manager
writing medical stop-loss and excess medical insurance products to employer
sponsored self-insured health plans. In 1999, HCCB generated approximately
$184.3 million of medical stop-loss written premium and $6.7 million of other
written premium, the majority of which was underwritten on behalf of
non-affiliated insurance companies. In 1999, the acquired Centris agencies
generated approximately $214.2 million of written premium. It is expected that
in 2000 a substantial part of the overall written premium for HCCB will be
issued through HCCL and AIC.
HCC AVIATION GROUP, INC.--HCCA, with offices in Dallas, Texas and Glendale,
California, together with the Company's insurance company subsidiary AIC,
provides the base for the Company's presence in
10
the domestic general aviation market. HCCA acts as an underwriting manager on
behalf of USSIC in the areas of private and corporate aircraft, commercial
agricultural aircraft, antique and vintage military aircraft, small to medium
sized airports, and commercial operators. During 1999, HCCA generated
approximately $91.1 million of written premium.
HCC EMPLOYER SERVICES, INC.--HCCES, with operations in Northbrook, Illinois,
Montgomery, Alabama and Dallas, Texas, acts as an underwriting manager on behalf
of affiliated and non-affiliated insurance companies, providing occupational
accident and health insurance to self-employed truckers and workers'
compensation insurance to small and medium size businesses. HCCES generated
approximately $101.6 million in premium in 1999.
Management fees generated by underwriting agency subsidiaries in 1999
amounted to $90.7 million, an increase of 23% over 1998.
COMBINED INSURANCE COMPANY AND UNDERWRITING AGENCY OPERATIONS
The Company's combined GWP was over $1.1 billion, after intercompany
eliminations, in 1999 with its insurance company operations writing
$568.3 million and its underwriting agency operations writing $848.1 million,
before intercompany eliminations.
INTERMEDIARY OPERATIONS
The services performed by the Company's insurance intermediary subsidiaries
consist of marketing, placing, consulting on and servicing insurance risks for
their clients, which include medium to large corporations, insurance and
reinsurance companies or other risk taking entities. The intermediary
subsidiaries earn commission income and to a lesser extent fees for certain
services, generally from the underwriters with whom the business is placed.
Certain of these risks may be initially underwritten by the Company's insurance
company subsidiaries who may retain a portion of the risk.
HCC EMPLOYEE BENEFITS, INC.,--HCCEB, based in Houston, Texas, is a retail
insurance agency and consulting firm specializing in life, accident and health
insurance for employee benefit plans of medium and large commercial customers
throughout the United States.
HCC INTERMEDIARIES, INC.--HCCI, based in Houston, Texas, is an intermediary
specializing in marketing and servicing large, complicated insurance and
reinsurance programs placed on behalf of multinational clients operating in the
same lines of business that the Company underwrites. This business is placed
with domestic and international insurance companies, including affiliated
insurance companies, on a direct basis and through other intermediaries. In
addition, HCCI acts as a reinsurance intermediary on behalf of affiliated and
non-affiliated insurance companies.
RATTNER MACKENZIE LIMITED--RML is an intermediary based in London, England.
RML is a Lloyd's broker specializing in accident and health reinsurance and
certain specialty property and casualty lines of business. Management believes
that RML is considered a market leader in its core businesses. RML serves as an
intermediary for reinsurance business placed by unaffiliated insurance and
reinsurance companies and underwriting agencies as well as the Company's
insurance company subsidiaries.
Commission income generated by intermediary subsidiaries in 1999 amounted to
$54.6 million, an increase of 42% over 1998.
11
OTHER OPERATIONS
The Company's other operations consist of subsidiaries that are not
insurance companies, underwriting agencies or intermediaries. These operations
generally are insurance related services that may be performed for the Company's
subsidiaries, its reinsurers or unaffiliated entities. The revenue earned from
these services primarily consist of fees, commissions or the sales price of
products sold. The subsidiaries currently operating in this segment provide
insurance claims adjusting services and the development and sale of insurance
industry related software. Additionally, other operations include the returns
received from certain insurance related strategic operational investments which
the Company makes from time to time. Certain of these investments provide
strategic partnering opportunities. These returns may be in the form of equity
in the earnings of the investee, dividends or gains from the disposition of
these investments.
Other operating income was $28.5 million in 1999, up 28% from 1998.
REINSURANCE CEDED
The Company principally utilizes reinsurance to reduce its net liability on
individual risks, to protect against catastrophic losses and to achieve a
desired ratio of NWP to policyholders' surplus. Various intermediaries,
including HCCI and RML, facilitate the placement of this reinsurance coverage on
behalf of the Company and are compensated, directly or indirectly, by the
reinsurers.
Reinsurance is ceded on both a proportional and an excess of loss basis.
Management believes that the Company reinsures its risks to a greater extent
than most of its competitors and most other insurance companies. This strategy
greatly reduces the likelihood of a significant net loss from insurance company
operations and is also intended to protect the Company's shareholders' equity.
Under its current reinsurance protections, the Company has limited its net
retained loss, across any single line of business, to a maximum of approximately
$1.0 million for any one risk, but significantly less on most risks.
The type, cost and limits of reinsurance purchased can vary from year to
year based upon the Company's desired retention levels and the availability of
quality reinsurance at a reasonable price. The Company's reinsurance programs
renew throughout the year. Excess of loss programs that expired in 1999 have
been renewed with some increase in reinsurance costs. Additionally, the Company
retained higher percentages of its business in connection with certain lines of
business reinsured on a proportional basis. The Company plans to continue to
increase its retentions as underwriting conditions improve.
The availability of reinsurance continues to be an important part of the
Company's business plan, protecting shareholders' equity from catastrophe losses
and the inconsistencies of the insurance cycle. Important relationships have
been built up over the years with many core reinsurers who have supported the
Company in good and bad times. The Company intends to continue to share its
business with these partners as underwriting profitability returns, to allow
them to recoup losses and build even stronger relationships for the future.
Management believes that increased retentions during profitable periods are made
possible not at the sacrifice of core reinsurers but through reduction of
facultative reinsurance and the natural attrition of certain reinsurers who exit
lines of business or severely curtail their writings. This reduction in
reinsurance market capacity causes rates to rise but the increased rates
historically have been passed on to the primary market clients.
The Company structures a specific reinsurance program for each line of
business it underwrites. This reinsurance is placed in order to protect the
Company from exposure to foreseeable events. The Company places reinsurance
proportionally to cover loss frequency and catastrophe exposure. The Company
places additional reinsurance on an excess of loss basis to cover individual
risk severity of loss and on a catastrophe basis to cover exposure from
occurrences involving multiple risks, such as those resulting from a hurricane
or an earthquake. The Company does not intend to expose itself to any net loss
in excess of its reinsurance protection.
12
The Company writes business in areas exposed to catastrophic losses and has
exposures to this type of loss in California, the Atlantic Coast of the United
States, certain United States Gulf Coast states, particularly in Florida and
Texas, the Caribbean and Mexico. The Company carefully assesses its overall
exposures to a single catastrophic event and applies procedures that it believes
are more conservative than are typically used by the industry to ascertain the
Company's probable maximum loss ("PML") from any single event. The Company
maintains reinsurance protection which it believes is sufficient to cover any
foreseeable event.
The Company receives an overriding (ceding) commission on the premium ceded
to reinsurers. This compensates the Company for the direct costs associated with
the production of the premium, the servicing of the business during the term of
the policies ceded and the costs associated with the placement of the related
reinsurance. In addition, certain of the Company's reinsurance treaties allow
the Company to share with the reinsurers in any net profits generated under such
treaties.
The ceding of reinsurance does not discharge the Company from liability to
its policyholders. The Company is required to pay losses even if the reinsurer
fails to meet its obligations under the reinsurance contract. To minimize its
exposure to reinsurance credit risk, the Company places its reinsurance with a
diverse group of financially sound reinsurers. The Company's 2000 treaty
reinsurance programs were placed with more than 92 domestic and foreign
reinsurers. As of December 31, 1999, the total amount recoverable from
reinsurers with respect to property and casualty insurance was approximately
$683.3 million, of which $91.3 million represents paid losses recoverable (in
the ordinary course of business) and $597.5 million represents outstanding
losses and estimated incurred but not reported loss recoverables, less a
$5.5 million reserve for potentially uncollectible reinsurance. In addition,
ceded unearned premium was $133.7 million. Of the $683.3 million,
$122.8 million was added as a result of the Centris acquisition in late
December, 1999. As of December 31, 1999, the Company held $154.1 million of
irrevocable letters of credit and $19.9 million in cash to collateralize a
portion of the total amount recoverable and had other payable balances due to
its reinsurers of $213.0 million as potential offsets against reinsurance
recoverables. The estimated duration for the Company's outstanding losses is two
years, as the majority of the Company's business has historically had shorter
lead times between the occurrence of an insured event and the final settlements.
The following table shows property and casualty reinsurance balances relating to
the reinsurers with net recoverable balances greater than $10.0 million as of
December 31, 1999. The total recoverables column includes paid loss recoverable,
outstanding loss recoverable, IBNR recoverable and ceded unearned premium.
LETTERS OF CREDIT,
A.M. BEST TOTAL CASH DEPOSITS AND
REINSURER RATING LOCATION RECOVERABLES OTHER PAYABLES NET
- --------- ------------ --------------- ------------ ------------------ ------------
December 31, 1999:
Underwriters at Lloyd's................... A United Kingdom $156,650,000 $22,805,000 $133,845,000
Underwriters Indemnity Company *.......... A- Texas 50,451,000 4,201,000 46,250,000
SCOR Reinsurance Company.................. A+ New York 41,137,000 1,740,000 39,397,000
AXA Reinsurance Company................... A+ Delaware 37,690,000 5,013,000 32,677,000
NAC Reinsurance Company **................ A+ New York 23,153,000 6,105,000 17,048,000
Transamerica Occidental Life Ins. Co...... A+ California 22,481,000 6,102,000 16,379,000
St. Paul Fire and Marine Insurance Co..... A+ Minnesota 17,577,000 1,721,000 15,856,000
Odyssey America Reinsurance Corp.......... A Connecticut 19,114,000 5,891,000 13,223,000
Sun Life Assurance Company of Canada...... A++ Canada 17,996,000 4,786,000 13,210,000
GE Reinsurance............................ A++ Illinois 16,535,000 4,869,000 11,666,000
Chartwell Reinsurance Company ***......... A Minnesota 12,736,000 2,074,000 10,662,000
- ------------------------------
* Underwriters Indemnity Company was acquired by RLI Corporation in January,
1999.
** NAC Reinsurance Corporation was acquired by XL Capital, Ltd. in June, 1999.
*** Chartwell Reinsurance Company was acquired by Trenwick Group, Inc. in
October, 1999.
13
Prior to our acquisition of Centris, its life insurance company subsidiary,
now HCCL, sold its entire block of life insurance and annuity business to Life
Reassurance Corporation of America in the form of an indemnity reinsurance
contract. Ceded life and annuity benefits amounted to $95.8 million as of
December 31, 1999.
In 1999, the Company recorded a $43.5 million provision for reinsurance to
reflect an estimated $29.5 million pre-tax loss for the insolvency of one of the
Company's reinsurers and an estimated $14.0 million pre-tax loss, the majority
of which represents the discount on ceded reserves, related to the commutation
of all liabilities with another reinsurer. This commutation, made at the
Company's request, was finalized and settled in February, 2000. In connection
with the commutation, the Company received cash and other amounts totaling
$56.5 million. Additionally, as of December 31, 1999 the Company has established
a reserve of $5.5 million which management believes is sufficient to absorb any
potential losses related to its reinsurance recoverables. However, the adverse
economic environment in the worldwide insurance industry has placed great
pressure on reinsurers and the results of their operations and these conditions
could, ultimately, affect reinsurers' solvency. Historically, there have been
insolvencies following a period of competitive pricing in the industry, such as
the marketplace has experienced for the last several years. Therefore, while
management believes that the reserve is adequate based upon current available
information, conditions may change or additional information might be obtained
that would affect management's estimate of the adequacy of the level of the
reserve and which may result in a future increase or decrease in the reserve.
Management continually reviews the Company's financial exposure to the
reinsurance market and will continue to take actions to protect shareholders'
equity.
OPERATING RATIOS
PREMIUM TO SURPLUS RATIO
The following table shows, for the periods indicated, the ratio of statutory
GWP and NWP to statutory policyholders' surplus for the Company's property and
casualty insurance company subsidiaries:
FOR THE YEARS ENDED DECEMBER 31,
(DOLLARS IN THOUSANDS)
----------------------------------------------------
1999 1998 1997 1996 1995
-------- -------- -------- -------- --------
GWP....................................... $576,184 $500,962 $346,094 $340,367 $338,753
NWP....................................... 150,261 123,315 143,068 189,022 184,028
Policyholders' surplus.................... 315,474 369,401 331,922 288,863 251,125
GWP ratio................................. 182.6% 135.6% 104.3% 117.8% 134.9%
GWP industry average (1).................. * 147.9 154.7 179.9 194.0
NWP ratio................................. 47.6% 33.4% 43.1% 65.4% 73.3%
NWP industry average (1).................. * 84.3 89.7 105.2 113.0
- ------------------------
* Not available
(1) Source: A.M. Best.
While there is no statutory requirement regarding a permissible premium to
surplus ratio, guidelines established by the National Association of Insurance
Commissioners ("NAIC") provide that a property and casualty insurer's annual
statutory GWP should not exceed 900% and NWP should not exceed 300% of its
policyholders' surplus. However, industry standards and rating agency criteria
place these ratios at 300% and 200%, respectively. In keeping with its
philosophy of protecting its shareholders' equity and limiting its aggregate
loss exposure, the Company maintains premium to surplus ratios significantly
lower than such guidelines and generally well below industry norms. These ratios
are expected to increase, however, as the Company's insurance company
subsidiaries continue to increase their participation as policy issuers for
business written by the Company's underwriting agency subsidiaries and their
retention of that business.
14
COMBINED RATIO
The underwriting experience of a property and casualty insurance company is
indicated by its combined ratio. The Company's insurance subsidiaries' loss
ratio, expense ratio and combined ratio, determined on the basis of statutory
accounting principles ("SAP"), are shown in the following table:
1999 1998 1997 1996 1995
-------- -------- -------- -------- --------
Loss ratio.......................................... 107.1% 67.2% 61.6% 64.4% 66.4%
Expense ratio....................................... 22.8 15.7 17.2 19.2 18.1
----- ----- ----- ----- -----
Combined ratio...................................... 129.9% 82.9% 78.8% 83.6% 84.5%
===== ===== ===== ===== =====
Combined ratio excluding the effects of the
provision for reinsurance in 1999................. 104.1%
=====
Industry average (1)................................ 107.7% 105.6% 101.6% 105.7% 106.3
- ------------------------
(1) Source: A.M. Best.
The SAP basis ratio data is not intended to be a substitute for results of
operations on the basis of generally accepted accounting principles ("GAAP").
The differences between SAP and GAAP are described in Note (15) of the Company's
consolidated financial statements. Including this information on a SAP basis is
meaningful and useful to allow a comparison of the Company's operating results
with those of other companies in the insurance industry. A.M. Best reports on
insurer performance on a SAP basis to provide for more standardized comparisons
among individual companies, as well as overall industry performance.
RESERVES
Applicable insurance laws and regulations require that reserves be
maintained for the payment of loss and loss adjustment expense ("LAE") with
respect to both reported and incurred but not reported ("IBNR") claims under
insurance and reinsurance policies issued by the Company's insurance company
subsidiaries. In most cases, the Company establishes reserves through an
evaluation of individual claims. In some types of aviation claims, an average
reserving method is utilized until more information becomes available which will
permit a more specific individual evaluation of claims. In the case of direct
and facultative reinsurance business, loss reserves are determined by evaluating
reported claims on the basis of the type of loss, jurisdiction of the
occurrence, knowledge of the circumstances surrounding the claim, severity of
injury or damage, potential for ultimate exposure, experience with the insured
and the line of business and policy provisions relating to the particular type
of claim. The Company establishes loss reserves for excess of loss and
proportional reinsurance claims based on information and reports received from
ceding companies. Loss reserves for IBNR losses are determined in part on the
basis of statistical information and in part on industry experience with respect
to the probable number and nature of claims arising from occurrences which have
not been reported. The Company does not discount any of its loss reserves.
With respect to some classes of risks, the period of time between the
occurrence of an insured event and the final settlement of a claim may be many
years, and during this period it often becomes necessary to adjust the claim
estimates either upward or downward. Certain classes of marine and offshore
energy insurance and workers' compensation insurance underwritten by the Company
have historically had longer lead times between the occurrence of an insured
event, reporting of the claim to the Company, and final settlement. In such
cases, the Company is forced to estimate reserves over long periods of time with
the possibility of several adjustments to reserves. Other classes of insurance
the Company underwrites, such as most aviation, property and medical stop-loss,
historically have shorter lead times between the occurrence of an insured event,
reporting of the claim to the Company and final settlement. The reserves with
respect to such classes are, therefore, less likely to be adjusted. The classes
of insurance with shorter lead times
15
currently represent the majority of the risks underwritten by the Company's
insurance company operations.
The reserving process is intended to provide implicit recognition of the
impact of inflation and other factors affecting loss payments by taking into
account changes in historical payment patterns and perceived probable trends.
However, there is no precise method for the subsequent evaluation of the
adequacy of the consideration given to inflation, or to any other specific
factor, some of which are interdependent.
The Company underwrites, directly and through reinsurance, risks which are
denominated in a number of foreign currencies, and therefore establishes and
maintains loss reserves with respect to these policies in the respective
currencies. These reserves are subject to exchange rate fluctuations, which may
have an effect on the Company's earnings. From time to time, the Company may
attempt to limit its exposure to future currency fluctuations through the use of
foreign currency forward contracts.
The following loss development triangles show changes in reserves in
subsequent years from the prior loss estimates based on experience as of the end
of each succeeding year on the basis of GAAP. The estimate is increased or
decreased as more information becomes known about the frequency and severity of
losses for individual years. A redundancy means the original estimate was higher
than the current estimate; a deficiency means that the current estimate is
higher than the original estimate.
The first line of each loss development triangle presents, for each of the
years indicated, the gross reserve liability including the reserve for IBNR
losses. The first section of each table shows, by year, the cumulative amounts
of loss and LAE paid as of the end of each succeeding year. The second section
sets forth the re-estimates in later years of incurred losses, including
payments, for the years indicated. The "cumulative redundancy (deficiency)"
represents, as of December 31, 1999, the difference between the latest
re-estimated liability and the reserves as originally estimated.
The following loss development triangle shows development in loss reserves
on a gross basis:
1999 1998 1997 1996 1995 1994 1993 1992
-------- -------- -------- -------- -------- -------- -------- ---------
Balance sheet
reserves:.......... $871,104 $460,511 $275,008 $229,049 $200,756 $170,957 $144,178 $ 129,503
Cumulative paid as
of:
One year later..... 229,746 160,324 119,453 118,656 97,580 82,538 83,574
Two years later.... 209,724 179,117 167,459 143,114 126,290 130,379
Three years
later............ 193,872 207,191 166,541 157,509 158,973
Four years later... 214,046 192,540 176,472 182,193
Five years later... 195,930 195,269 192,512
Six years later.... 197,147 213,052
Seven years
later............ 215,280
Re-estimated
liability as of:
End of year........ 871,104 460,511 275,008 229,049 200,756 170,957 144,178 129,503
One year later..... 550,545 308,501 252,236 243,259 186,898 163,967 162,827
Two years later.... 316,250 249,013 248,372 207,511 183,015 176,817
Three years
later............ 250,817 247,053 214,738 203,137 194,419
Four years later... 248,687 220,695 211,546 215,531
Five years later... 217,892 218,182 222,746
Six years later.... 214,498 234,115
Seven years
later............ 231,269
Cumulative redundancy
(deficiency)....... $(90,034) $(41,242) $(21,768) $(47,931) $(46,935) $(70,320) $(101,766)
16
The gross deficiencies result from three principal conditions. The first is
the development of large claims on individual policies which were either
reported late by or for which reserves were increased as subsequent information
became available from the insurance companies that are responsible for adjusting
the claims. However, as these policies were substantially reinsured, there was
no material effect to the Company's net earnings. Secondly, during 1999 in
connection with the insolvency of one of the Company's reinsurers and with the
commutation, finalized subsequent to year-end, of all liabilities with another,
the Company re-evaluated all reserves and IBNR related to business placed with
these reinsurers to determine the ultimate losses it might conservatively
expect. These reserves were then used as the basis for the determination of the
provision for reinsurance recorded in 1999. Thirdly, for the years prior to
1997, the runoff of the retrocessional excess of loss business, which the
Company underwrote between 1988 and 1991, experienced gross development. This
development is due primarily to the delay in reporting of losses by the London
insurance market, coupled with the unprecedented number of catastrophe losses
during that period. This business is substantially reinsured, thereby not having
a material effect on the Company's net earnings.
17
The following loss development triangle shows development in loss reserves
on a net basis:
1999 1998 1997 1996 1995 1994 1993 1992
-------- -------- -------- -------- -------- -------- -------- --------
Gross reserves for loss and LAE.... $871,104 $460,511 $275,008 $229,049 $200,756 $170,957 $144,178 $129,503
Less reinsurance recoverables...... 597,498 341,599 155,374 111,766 101,497 95,279 82,289 81,075
-------- -------- -------- -------- -------- -------- -------- --------
Reserves for loss and LAE, net of
reinsurance...................... 273,606 118,912 119,634 117,283 99,259 75,678 61,889 48,428
Effect on loss reserves of 1999
write off of ceded outstanding
and IBNR reinsurance
recoverables..................... -- 63,851 15,008 2,636 1,442 51 -- --
-------- -------- -------- -------- -------- -------- -------- --------
Reserves for loss and LAE net of
reinsurance and adjusted for
writeoff......................... 273,606 182,763 134,642 119,919 100,701 75,729 61,889 48,428
Cumulative paid, net of
reinsurance, as of:
One year later................... 56,052 48,775 47,874 41,947 36,500 29,258 18,978
Two years later.................. 64,213 66,030 56,803 49,283 41,207 32,733
Three years later................ 72,863 64,798 56,919 46,576 36,536
Four years later................. 67,355 60,441 51,536 38,480
Five years later................. 61,781 53,110 40,327
Six years later.................. 53,879 40,550
Seven years later................ 41,133
Eight years later................
Nine years later.................
Ten years later..................
Re-estimated liability, net of
reinsurance, as of:
End of year...................... 273,606 182,763 134,642 119,919 100,701 75,729 61,889 48,428
One year later................... 187,377 120,049 116,145 95,764 72,963 59,659 45,812
Two years later.................. 116,745 101,595 94,992 74,887 60,079 44,964
Three years later................ 97,353 85,484 76,474 62,224 46,129
Four years later................. 80,890 73,660 64,377 48,993
Five years later................. 69,528 64,103 50,785
Six years later.................. 59,408 50,585
Seven years later................ 46,071
Eight years later................
Nine years later.................
Ten years later..................
Cumulative redundancy
(deficiency)..................... $ (4,614) $ 17,897 $ 22,566 $ 19,811 $ 6,201 $ 2,481 $ 2,357
1991 1990 1989
-------- -------- --------
Gross reserves for loss and LAE.... $123,248 $108,027 $96,477
Less reinsurance recoverables...... 83,727 60,194 45,160
-------- -------- -------
Reserves for loss and LAE, net of
reinsurance...................... 39,521 47,833 51,317
Effect on loss reserves of 1999
write off of ceded outstanding
and IBNR reinsurance
recoverables..................... -- -- --
-------- -------- -------
Reserves for loss and LAE net of
reinsurance and adjusted for
writeoff......................... 39,521 47,833 51,317
Cumulative paid, net of
reinsurance, as of:
One year later................... 18,416 23,450 22,660
Two years later.................. 23,057 33,815 34,300
Three years later................ 31,903 35,912 40,806
Four years later................. 33,875 42,465 41,878
Five years later................. 34,970 43,422 46,734
Six years later.................. 36,203 43,690 47,164
Seven years later................ 35,413 44,611 47,229
Eight years later................ 35,960 43,715 47,928
Nine years later................. 44,203 46,308
Ten years later.................. 46,646
Re-estimated liability, net of
reinsurance, as of:
End of year...................... 39,521 47,833 51,317
One year later................... 38,575 44,887 49,475
Two years later.................. 38,656 45,435 47,313
Three years later................ 39,176 44,689 48,085
Four years later................. 40,407 45,507 47,884
Five years later................. 43,418 46,805 47,933
Six years later.................. 45,142 48,932 48,086
Seven years later................ 43,924 50,190 49,392
Eight years later................ 39,858 49,732 50,324
Nine years later................. 47,422 50,101
Ten years later.................. 48,479
Cumulative redundancy
(deficiency)..................... $ (337) $ 411 $ 2,838
18
The Company believes that its loss reserves are adequate to provide for all
material net incurred losses.
The following table provides a reconciliation of the gross liability of loss
and LAE on a GAAP basis for the three years ended December 31, 1999 (dollars in
thousands):
1999 1998 1997
-------- -------- --------
Reserves for loss and LAE at beginning of year.............. $460,511 $275,008 $229,049
Reserves acquired with purchase of subsidiaries............. 146,233 3,877 1,919
Provision for loss and LAE for claims occurring in the
current year.............................................. 595,425 461,429 269,505
Increase in estimated loss and LAE for claims occurring in
prior years (1)........................................... 90,034 33,493 23,187
-------- -------- --------
Incurred loss and LAE....................................... 685,459 494,922 292,692
-------- -------- --------
Loss and LAE payments for claims occurring during:
Current year.............................................. 191,353 152,972 129,199
Prior years............................................... 229,746 160,324 119,453
-------- -------- --------
Loss and LAE payments....................................... 421,099 313,296 248,652
-------- -------- --------
Reserves for loss and LAE at end of the year................ $871,104 $460,511 $275,008
======== ======== ========
- ------------------------
(1) Changes in loss and LAE reserves on a GAAP basis, for losses occurring in
prior years, reflect the gross effect of the resolution of losses for other
than the reserve value and the subsequent adjustments of loss reserves.
The following table provides a reconciliation of the liability for loss and
LAE, net of reinsurance ceded, on a GAAP basis for the three years ended
December 31, 1999 (dollars in thousands):
1999 1998 1997
-------- -------- --------
Reserves for loss and LAE at beginning of year.............. $118,912 $119,634 $117,283
Reserves acquired with purchase of subsidiaries............. 55,523 3,877 1,919
Effect on loss reserves of write off of ceded outstanding
and IBNR reinsurance recoverables......................... 82,343 -- --
Provision for loss and LAE for claims occurring in the
current year.............................................. 105,036 105,895 100,288
Increase (decrease) in estimated loss and LAE for claims
occurring in prior years (2).............................. 4,614 (14,593) (3,774)
-------- -------- --------
Incurred loss and LAE....................................... 109,650 91,302 96,514
-------- -------- --------
Loss and LAE payments for claims occurring during:
Current year.............................................. 36,770 47,126 48,208
Prior years............................................... 56,052 48,775 47,874
-------- -------- --------
Loss and LAE payments....................................... 92,822 95,901 96,082
-------- -------- --------
Reserves for loss and LAE at end of the year................ $273,606 $118,912 $119,634
======== ======== ========
- ------------------------
(2) Changes in loss and LAE reserves on a GAAP basis, for losses occurring in
prior years, reflect the net effect of the resolution of losses for other
than the reserve value and the subsequent adjustments of loss reserves.
Although the Company experienced a gross loss deficiency during the three
years ended December 31, 1999, because the business is substantially reinsured
in the lines where adverse development has occurred, there is no material
adverse effect on a net loss basis.
19
During 1999, the Company had net loss and LAE deficiency of $4.6 million
relating to prior year losses compared to redundancies of $14.6 million in 1998
and $3.8 million in 1997. The deficiencies and redundancies in the net reserves
result from the Company's and its actuaries' continued review of its loss
reserves and the increase or reduction of such reserves as losses are finally
settled and claims exposures are reduced. The Company believes it has provided
for all material net incurred losses.
AIC, acquired in June, 1997, recorded a $10.0 million increase in loss and
LAE reserves during December, 1997, predominately related to 1995 and 1996
claims incurred prior to the Company's acquisition of AIC. This deficiency is
included in the net redundancy recorded for 1997. This increase in reserves was
made in an effort to bring AIC's reserving practices consistent with the more
conservative method used by the Company's other insurance company operations.
The Company expects the increase in loss reserves to be adequate to cover any
subsequent adverse development of AIC's prior losses.
The Company has no material exposure to environmental pollution losses, as
HC only began writing business in 1981 and policies issued by HC normally
contain pollution exclusion clauses which limit pollution coverage to "sudden
and accidental" losses only, thus excluding intentional (dumping) and seepage
claims. Policies issued by HCCL, AIC and USSIC, because of the types of risks
insured, are not considered to have significant environmental exposures.
Therefore, the Company does not expect to experience any material development in
reserves from environmental pollution claims.
INVESTMENTS
Insurance company investments must comply with applicable laws and
regulations which prescribe the type, quality and concentration of investments.
In general, these laws and regulations permit investments, within specified
limits and subject to certain qualifications, in Federal, state and municipal
obligations, corporate bonds and preferred and common equity securities. As of
December 31, 1999, the Company had $581.3 million of investment assets, the
majority of which were held by its insurance company subsidiaries.
The Company's investment policy is determined by the Company's Board of
Directors and its Investment Committee and is reviewed on a regular basis.
Pursuant to its investment policy, the Company concentrates its investments in
obligations of states, municipalities and political subdivisions, the interest
income from which is predominantly exempt from Federal income tax. The Company
generally intends to hold such securities to maturity, however, the Company
regularly re-evaluates its position based upon market conditions, which may
cause the Company to restructure its portfolio and realize gains or losses in
order to maximize its total return on investments. Accordingly, all fixed income
securities are classified as available for sale and are recorded at market
value.
The Company engaged a nationally prominent investment advisor, New England
Asset Management, a subsidiary of Berkshire Hathaway, Inc., in January, 2000 to
oversee the Company's investments, subject to the Company's investment policies.
Previously, the Company had managed its own investments. Therefore, it is
possible that the Company's investment policies may be changed based on the
advice of the investment advisor, although no material change is anticipated.
The insurance companies acquired in the Centris acquisition had portfolios
of preferred and common stocks which are recorded at market value for financial
reporting purposes. It has not been the Company's policy to invest in equity
securities. These equity securities were sold during the first quarter of 2000.
The Company's financial statements reflect an unrealized loss on fixed
income securities available for sale as of December 31, 1999, of $893,000. Since
the Company's intention is to hold these securities until maturity, it does not
currently expect to realize any significant gain or loss on these investments.
The Company has maintained a substantial level of cash and liquid short-term
instruments in its insurance company subsidiaries in order to maintain the
ability to fund losses of the Company's insureds. The underwriting agencies and
intermediaries typically have short-term investments, which are fiduciary funds
held on behalf of others. As of December 31, 1999, the Company had cash and
short-term
20
investments of approximately $242.2 million, of which, $73.8 million are in the
Company's insurance company subsidiaries.
The following tables reflect the investments of the Company (dollars are
expressed in thousands). The table set forth below reflects the average amount
of investments, income earned, and the yield thereon for the three years ended
December 31, 1999:
1999 1998 1997
-------- -------- --------
Average investments......................................... $552,654 $522,209 $496,010
Net investment income....................................... 30,933 29,335 27,587
Average yield (1)........................................... 5.6% 5.6% 5.6%
Average tax equivalent yield (1)............................ 7.1% 7.3% 7.3%
- ------------------------
(1) Excluding realized and unrealized capital gains and losses.
The table set forth below summarizes, by type, the investments of the
Company as of December 31, 1999:
AMOUNT PERCENT OF TOTAL
-------- ----------------
Short-term investments...................................... $215,694 37%
U.S. Treasury securities.................................... 57,505 10
Obligations of states, municipalities and political
subdivisions.............................................. 99,459 17
Special revenue............................................. 163,644 28
Other fixed income securities............................... 22,033 4
Marketable equity securities................................ 19,970 3
Other investments........................................... 3,017 1
-------- ---
Total investments......................................... $581,322 100%
======== ===
The table set forth below indicates the expected maturity distribution of
the Company's fixed income securities as of December 31, 1999:
AMOUNT PERCENT OF TOTAL
-------- ----------------
One year or less............................................ $ 37,052 11%
One year to five years...................................... 107,647 32
Five years to ten years..................................... 97,250 28
Ten years to fifteen years.................................. 68,695 20
More than fifteen years..................................... 31,997 9
-------- ---
Total fixed income securities............................. $342,641 100%
======== ===
The value of the Company's portfolio of fixed income securities is inversely
correlated to changes in market interest rates. In addition, some of the
Company's fixed income securities have call or prepayment options. This could
subject the Company to reinvestment risk should interest rates fall or issuers
call their securities and the Company invests the proceeds at lower interest
rates. The Company mitigates this risk by investing in securities with varied
maturity dates, so that only a portion of the portfolio will mature at any point
in time. The Company's fixed income securities have a weighted average maturity
of seven years and a weighted average duration of five years.
BANK LOAN
On December 17, 1999, the Company entered into a Loan Agreement (the
"Facility") with a group of banks. The Facility includes a $300.0 million
Revolving Loan Facility. Borrowing under the Facility may be made from time to
time by the Company for general corporate purposes until the Facility's
expiration on
21
December 18, 2004. Outstanding advances under the Facility bear interest at
agreed upon rates. The Facility is collateralized in part by the pledge of the
stock of HC, HCCL, AIC and USSIC and by the pledge of stock and guarantees
entered into by the Company's principal underwriting agency and intermediary
subsidiaries. The Facility agreement contains certain restrictive covenants,
including, without limitation, minimum net worth requirements for the Company
and certain subsidiaries, restrictions on certain extraordinary corporate
actions, notice requirements for certain material occurrences, and required
maintenance of specified financial ratios. Management believes that the
restrictive covenants and other obligations of the Company which are contained
in the Facility agreement are typical for financing arrangements comparable to
the Facility. The initial funding available under the Facility was used, among
other things, to refinance existing indebtedness of the Company including all
outstanding indebtedness under the Company's $150.0 million Revolving Credit
Facility and $100.0 million Short-term Revolving Loan Facility entered into as
of March 8, 1999, which has been terminated, and to partially fund the Centris
acquisition. As of December 31, 1999, total debt outstanding under the Facility
was $235.0 million. Unrelated to the Facility, in December, 1999, the Company
entered into an $80 million bridge loan with a bank in connection with the
Centris acquisition. The full amount of the bridge loan was repaid prior to
December 31, 1999, immediately following the Centris acquisition.
FOREIGN EXCHANGE
The Company's balances denominated in foreign currency fluctuate as
transactions are recorded and settled. On a very limited basis in the past, the
Company has entered into foreign currency forward contracts as a hedge against
foreign currency fluctuations. RML, purchased by the Company during January,
1999, has a revenue stream in US Dollars but incurs expenses in British Pound
Sterling ("GBP"). To mitigate the foreign exchange risk, the Company entered
into foreign currency forward contracts expiring at staggered times through
December, 2000. As of December 31, 1999, the Company had forward contracts to
sell US $12.0 million for GBP at an average rate of 1.00 GBP equals US $1.60.
The foreign currency forward contracts are used to convert currency at a known
rate in an amount which approximates average monthly expenses. Thus, the effect
of these transactions is to limit the foreign currency exchange risk of the
recurring monthly expenses. In the future, the Company may continue to limit its
exposure to currency fluctuations through the use of foreign currency forward
contracts. The Company utilizes these foreign currency forward contracts
strictly as a hedge against existing exposure to foreign currency fluctuations
rather than as a form of speculative or trading investment.
COMPETITION
The insurance business is generally highly competitive. The Company faces
competition from domestic and foreign insurers, underwriting agencies and
intermediaries. The Company's profitability is affected by many other factors,
including rate competition, severity and frequency of claims, interest rates,
state regulations, the judicial climate and general business conditions, all of
which are outside the control of the Company. In addition to competition in the
operation of its business, the Company faces competition from a variety of
sources in attracting and retaining qualified employees.
REGULATION
The activities of the Company are subject to licensing requirements and
extensive regulation under the laws of the United States and its various states,
territories and possessions, as well as the laws of other countries in which the
Company's subsidiaries operate. Currently, insurance companies are generally not
subject to any Federal regulation of their insurance business because of the
existence of a Federal law commonly known as the McCarran-Ferguson Act, which
provides the insurance industry with immunity from certain aspects of the
Federal anti-trust law and exempts the business of insurance from Federal
regulation. Therefore, in the United States, the Company's operations are
regulated primarily at the state level. The Company's business depends on the
validity of, and continued good standing under, the licenses
22
and approvals pursuant to which it operates, as well as compliance with
pertinent regulations. The Company therefore devotes significant efforts toward
obtaining and maintaining its licenses and compliance with a diverse and complex
regulatory structure.
The Company's insurance subsidiaries, in common with other insurers, are
subject to regulation and supervision by the states and by other jurisdictions
in which they do business. Within the states, the method of such regulation
varies but generally has its source in statutes that delegate regulatory powers
to an insurance official. The regulation relates primarily to approval of policy
forms and rates, the standards of solvency that must be met and maintained,
including risk based capital measurements, the licensing of insurers and their
agents, the nature of and limitations of investments, restrictions of the size
of risks which may be insured under a single policy, deposits of securities for
the benefit of policyholders, methods of accounting, periodic examinations of
the affairs of insurance companies, the form and content of records of financial
condition required to be filed, and reserves for unearned premiums, losses and
other purposes. In general, such regulations are intended primarily for the
protection of policyholders rather than shareholders. Compliance is monitored by
the state insurance departments through periodic reporting procedures and
examinations. The quarterly and annual financial reports to the regulators in
the United States utilize accounting principles which are different from the
GAAP used by the Company in its reports to shareholders. SAP, in keeping with
the intent to assure the protection of policyholders, is generally based on a
liquidation concept while GAAP is based on a going-concern concept.
In addition to the regulatory supervision of the insurance company
subsidiaries of the Company, as an insurance holding company, the Company is
subject to the insurance holding company system regulatory requirements of the
states of California, Indiana, Maryland, Missouri, Pennsylvania and Texas. Under
such regulations, the Company is required to report information regarding its
capital structure, financial condition and management. The Company is also
required to provide prior notice to insurance regulatory authorities of certain
agreements and transactions between the Company and its affiliates. These
agreements and transactions must satisfy certain regulatory requirements.
State insurance laws regulate the payment of dividends and other
distributions by insurance companies to their shareholders. Generally, insurance
companies are limited by such laws to the payment of dividends above a specified
level. Dividends in excess of those thresholds are "extraordinary dividends" and
subject to prior regulatory approval.
Additionally, the underwriting agency, intermediary and services operations
of the Company are subject to state insurance laws and regulations which may
require the licensing of insurance agents, brokers, reinsurance intermediaries,
reinsurance underwriting managers, third party administrators and underwriting
agents and which regulate certain aspects of their business. These laws and
regulations may include requirements for certain provisions in contracts entered
into between the Company and various insurers or reinsurers, record keeping and
reporting requirements, limitations on authority, advertising and business
practice rules, and other matters. The manner of operating the Company's agency
activities in particular states may vary according to the licensing requirements
of the particular state, which may require, among other things, that a firm
operate in the state through a local corporation. In a few states, licenses are
issued only to individual residents or locally-owned business entities. In such
cases, the Company may have arrangements with residents or business entities
licensed to act in the state.
In all jurisdictions, the applicable laws and regulations are subject to
amendment or interpretation by regulatory authorities. Generally, such
authorities are vested with relatively broad discretion to grant, renew and
revoke licenses and approvals, and to implement regulations, and licenses may be
denied or revoked for various reasons, including the violation of such
regulations. In some instances, the Company follows practices based on its
interpretations, or those that it believes may be generally followed by the
industry, of laws and regulations, which may be different from requirements or
interpretations of regulatory authorities. There can be no assurance that the
Company has all such required licenses, approvals or complying contracts or that
such licenses, approvals or complying contracts can always be
23
obtained or continued. Accordingly, the possibility exists that the Company may
be precluded or temporarily suspended from carrying on some or all of its
activities or otherwise penalized in a given jurisdiction. Such preclusion or
suspension could have a material adverse effect on the business and results of
operations of the Company.
HC is domiciled in Texas. It operates on an admitted basis in Texas and may
write reinsurance on all lines of business that it may write on a direct basis.
HC is an accredited reinsurer in 34 states and is an approved surplus lines
insurer or is otherwise permitted to write surplus lines insurance in 46 states,
three U.S. territories and the District of Columbia. When a reinsurer obtains
accreditation from a particular state, insurers within that state are permitted
to obtain statutory credit for risks ceded to the reinsurer. Surplus lines
insurance is offered by non-admitted companies on risks which are not insured by
admitted companies. All surplus lines insurance is written through licensed
surplus lines insurance brokers, who are required to be knowledgeable of and
follow specific state laws prior to placing a risk with a surplus lines insurer.
Additionally, HC operates a branch office in London, England which is subject to
regulation by regulatory authorities in the United Kingdom. AIC is domiciled in
Maryland and operates as a licensed admitted insurer in all states, the District
of Columbia, and all Canadian provinces (except Quebec). USSIC is domiciled in
Texas and operates as a licensed admitted insurer in all states and the District
of Columbia. HCCL is domiciled in Indiana, and operates as a licensed admitted
insurer in 41 states and the District of Columbia.
The NAIC has developed a formula for analyzing insurance companies called
risk-based capital. The risk-based capital formula is intended to establish
"minimum" capital threshold levels that vary with the size and mix of a
company's business. It is designed to identify companies with the capital levels
that may require regulatory attention. As of December 31, 1999, each of the
Company's domestic insurance company subsidiaries' total adjusted capital is
significantly in excess of the NAIC authorized control level risk-based capital.
The NAIC has also developed a rating system, the Insurance Regulatory
Information System ("IRIS"), primarily intended to assist state insurance
departments in overseeing the financial condition of all insurance companies
operating within their respective states. IRIS consists of eleven key financial
ratios that address various aspects of each insurer's financial condition and
stability. The Company's insurance company subsidiaries IRIS ratios generally
fall within the usual prescribed ranges except in satisfactorily explainable
circumstances such as when there is a large reinsurance transaction, capital
change or merger.
PENDING OR PROPOSED LEGISLATION
In recent years, state legislatures have considered or enacted laws that
modify and, in many cases, increase state authority to regulate insurance
companies and insurance holding company systems. The majority of state insurance
regulators are members of the NAIC, which seeks to promote uniformity of, and to
enhance the state regulation of, insurance. In addition, the NAIC and state
insurance regulators, as part of the NAIC's state insurance department
accreditation program, have re-examined existing laws and regulations,
specifically focusing on insurance company investments, issues relating to the
solvency of insurance companies, licensing and market conduct issues,
interpretations of existing laws, the development of new laws, and the
definition of extraordinary dividends. Also, Congress and certain Federal
agencies have conducted investigations of the current condition of the insurance
industry in the United States to determine whether to impose Federal regulation
of insurers and reinsurers. In the past several years there have been a number
of recommendations that the McCarran-Ferguson Act (which generally exempts the
insurance business from Federal regulation) be repealed entirely or modified to
remove the industry's anti-trust exemption and subject it to Federal regulation.
If the McCarran-Ferguson Act were to be repealed or modified, state regulation
of the insurance business would likely continue. This could result in an
additional layer of Federal regulation. In addition, in recent years, various
measures have been proposed at the Federal level to reform the current process
of Federal and state regulation of the financial services industries in the
United States, which are generally considered to include the banking, insurance
24
and securities industries. Such measures, which are often referred to as
financial services modernization, have as a principal objective the elimination
or modification of current regulatory impediments to cross-industry combinations
involving banks, securities firms and insurance companies. A form of financial
services modernization legislation was enacted at the Federal level in 1999
through the Gramm-Leach-Bliley Act of 1999. Such legislation could have
significant implications on the banking, insurance and securities industries and
could result in significant cross-industry consolidations among banks, insurance
companies and securities firms and increased competition in many of the areas of
the Company's operations. Also from time to time, Congress and certain states
have considered various legislative proposals which would provide for
governmental earthquake insurance coverage. The Company does not know at this
time the full extent to which such Federal or state legislative or regulatory
initiatives will or may affect the Company's operations, and no assurance can be
given that they would not, if adopted, have a material adverse effect on the
Company or its results of operations.
The NAIC adopted Statements of Statutory Accounting Principles ("SSAPs") in
March, 1998 as a product of its attempt to codify statutory accounting
principles. While subject to adoption by the individual states, the NAIC has
established an effective date of January 1, 2001 for the SSAPs. Prior to the
codification project, a comprehensive guide to statutory accounting principles
did not exist. Codification is new and will evolve over time. Based upon the
SSAPs as currently published, the Company does not expect their adoption to have
a material effect on the policyholders' surplus of its individual insurance
company subsidiaries. The only material effect on statutory net income is that
the statutory net income for HC will be decreased or increased by a change in
the method of recording equity in earnings or losses of subsidiaries. Currently
HC records the equity in earnings or losses of its subsidiaries as a component
of statutory net income. When codification becomes effective, the equity in
earnings or losses of subsidiaries will be recorded as an unrealized gain or
loss which is a direct increase or decrease to policyholders' surplus. Income
will not be recognized until such time (if any) that dividends are received from
the subsidiaries and recorded in statutory net income.
EMPLOYEES
As of December 31, 1999, the Company had 1,182 employees, including
employees of the acquired Centris entities. The Company is in the process of
reorganizing and combining Centris' operations with HCCB's operations. In
accordance with the restructuring and integration plans, the Company expects to
eliminate 86 employee positions. The employees who are expected to remain after
the Centris integration include five executive officers, 11 senior management,
111 management and 969 other personnel. Of this number, 168 are employed by the
Company's insurance subsidiaries, 585 are employed by the Company's underwriting
agency subsidiaries, 129 are employed by the Company's insurance intermediary
subsidiaries, 144 are employed by the Company's insurance services subsidiaries
and 70 are employed at the corporate headquarters. The Company is not a party to
any collective bargaining agreement and has not experienced work stoppages or
strikes as a result of labor disputes. The Company considers relations with its
employees to be good.
25
ITEM 2. PROPERTIES
The Company's principal and executive offices are located in Houston, Texas,
in an approximately 51,000 square foot building owned by HC. HC also owns an
77,000 square foot building, acquired in 1998, adjacent to its home office
building. The Company also maintains sales and administration offices or other
facilities in over 40 locations elsewhere in the United States and in England.
The majority of these additional locations are in leased facilities.
Principal office facilities of the Company, other than HC's owned
facilities, are as follows:
SQUARE
SUBSIDIARY LOCATION FOOTAGE LEASE TERMINATION DATE
- ---------- ------------------------ --------- ----------------------
LDG Re Wakefield, Massachusetts 34,000 October 31, 2001
AIC Frederick, Maryland 40,000 Owned
HCCB Costa Mesa, California 22,000 March 31, 2007
Atlanta, Georgia 21,000 January 31, 2006
HCCA Dallas, Texas 40,000 March 31, 2004
HCCEB Houston, Texas 27,000 August 31, 2001 and
October 31, 2002
HCCES Northbrook, Illinois 19,000 April 1, 2005
RML London, England 15,000 September 29, 2003
ITEM 3. LEGAL PROCEEDINGS
The Company is a party to numerous claims and lawsuits which arise in the
normal course of its business. Many of such claims or lawsuits involve claims
under policies underwritten or reinsured by the Company, the liabilities for
which management believes have been adequately included in its established loss
reserves. The Company believes the resolution of these lawsuits or claims will
not have a material adverse effect on its financial condition, results of
operations or cash flows.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the
fourth quarter of 1999.
26
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
MARKET INFORMATION
The Company's Common Stock trades on the New York Stock Exchange ("NYSE")
under the ticker symbol "HCC".
The high and low sales prices for quarterly periods during the period
January 1, 1998 through December 31, 1999, as reported by the NYSE were as
follows:
1999 1998
----------------------------- -----------------------------
HIGH LOW HIGH LOW
------------- ------------- ------------- -------------
First quarter.............................................. 21 7/16 16 23 15/16 15 5/8
Second quarter............................................. 22 11/16 17 15/16 23 11/16 19 5/8
Third quarter.............................................. 25 1/8 13 7/8 22 15/16 18 1/8
Fourth quarter............................................. 16 11/16 8 21 1/4 16 1/16
On March 24, 2000, the closing sales price of the Company's Common Stock as
reported by the NYSE was $13 7/8.
SHAREHOLDERS
The Company has one class of authorized capital stock: 250,000,000 shares of
Common Stock, par value $1.00 per share. As of March 10, 2000, there were
49,095,126 shares of issued and outstanding Common Stock held by 1,119
shareholders of record; however, the Company believes there are in excess of
15,000 beneficial owners.
DIVIDENDS
Beginning in June, 1996, the Company announced a planned quarterly program
of paying cash dividends to shareholders. The Company paid a cash dividend in
July, 1996 of $0.02 per share and in each succeeding quarter through the first
quarter of 1997. The Company increased the quarterly cash dividend to $0.03 per
share in April, 1997, to $0.04 per share beginning in April, 1998 and to $0.05
per share beginning in April, 1999. The Board of Directors may review the
Company's dividend policy from time to time, and any determination with respect
thereto will be made in light of regulatory and other conditions then existing,
including the Company's earnings, financial condition, capital requirements,
loan covenants, and other related factors. Under the terms of the Facility, the
Company is prohibited from paying dividends in excess of an agreed upon maximum
amount in any fiscal year. Such limitation will not affect the ability of the
Company to pay dividends in a manner consistent with its past practice and
current expectations.
27
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial data set forth below has been derived
from the Consolidated Financial Statements. All information contained herein
should be read in conjunction with the Consolidated Financial Statements, the
related notes thereto and Management's Discussion and Analysis of Financial
Condition and Results of Operations included elsewhere in this Report.
FOR THE YEARS ENDED DECEMBER 31,
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)(3)
----------------------------------------------------
1999 1998 1997 1996 1995
-------- -------- -------- -------- --------
STATEMENT OF EARNINGS DATA:
Revenue
Net earned premium...................... $141,362 $143,100 $162,571 $170,068 $158,632
Management fees......................... 90,713 74,045 51,039 28,651 25,373
Commission income....................... 54,552 38,441 24,209 21,477 21,053
Net investment income................... 30,933 29,335 27,587 23,593 21,757
Net realized investment gain (loss)..... (4,164) 845 (328) 8,341 1,636
Other operating income.................. 28,475 22,268 15,239 18,656 10,371
-------- -------- -------- -------- --------
Total revenue......................... 341,871 308,034 280,317 270,786 238,822
Expense
Loss and LAE............................ 109,650 91,302 96,514 114,464 105,374
Operating expense
Policy acquisition costs, net......... 8,177 10,978 13,580 8,218 10,634
Compensation expense.................. 77,488 56,077 51,458 42,102 48,162
Provision for reinsurance............. 43,462 -- -- -- --
Restructuring expense................. 5,489 -- -- -- --
Other operating expense............... 47,247 36,063 31,628 26,382 26,540
Merger expense........................ -- 107 8,069 26,160 --
-------- -------- -------- -------- --------
Total operating expense............. 181,863 103,225 104,735 102,862 85,336
Interest expense.......................... 12,964 6,021 6,004 4,993 6,471
-------- -------- -------- -------- --------
Total expense....................... 304,477 200,548 207,253 222,319 197,181
-------- -------- -------- -------- --------
Earnings before income tax provision...... 37,394 107,486 73,064 48,467 41,641
Income tax provision...................... 12,271 35,208 23,305 9,885 9,896
-------- -------- -------- -------- --------
Net earnings........................ $ 25,123 $ 72,278 $ 49,759 $ 38,582 $ 31,745
======== ======== ======== ======== ========
BASIC EARNINGS PER SHARE DATA:
Earnings per share (1).................... $ 0.51 $ 1.51 $ 1.06 $ 0.86 $ 0.75
======== ======== ======== ======== ========
Weighted average shares outstanding (1)... 49,061 47,920 46,995 44,795 42,577
======== ======== ======== ======== ========
DILUTED EARNINGS PER SHARE DATA:
Earnings per share (1).................... $ 0.51 $ 1.48 $ 1.03 $ 0.84 $ 0.74
======== ======== ======== ======== ========
Weighted average shares outstanding (1)... 49,649 48,936 48,209 46,043 43,113
======== ======== ======== ======== ========
Cash dividends declared, per share........ $ 0.20 $ 0.16 $ 0.12 $ 0.06
======== ======== ======== ========
28
DECEMBER 31,
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)(3)
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1999 1998 1997 1996 1995
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