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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the Quarter Ended June 30, 2002.
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 from _______ to __________
Commission file number 0-20766
----------------------------------------------------------
HCC Insurance Holdings, Inc.
- --------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
Delaware 76-0336636
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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)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports) and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No _____
-----
Indicate the number of shares outstanding of each of the issuer's classes of
common stock as of the latest practicable date.
On August 9, 2002, there were 62.3 million shares of common stock, $1.00 par
value issued and outstanding.
HCC INSURANCE HOLDINGS, INC.
INDEX
PAGE NO.
--------
Part I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Balance Sheets
June 30, 2002 and December 31, 2001 .......................................................3
Condensed Consolidated Statements of Earnings
For the six months and the three months ended June 30, 2002 and 2001 ......................4
Condensed Consolidated Statements of Changes in Shareholders'
Equity For the six months ended June 30, 2002 and for the
year ended December 31, 2001 .............................................................5
Condensed Consolidated Statements of Cash Flows
For the six months ended June 30, 2002 and 2001 ...........................................7
Notes to Condensed Consolidated Financial Statements............................................8
Item 2. Management's Discussion and Analysis...........................................................23
Item 3. Quantitative and Qualitative Disclosures About Market Risk.....................................31
Part II. OTHER INFORMATION.......................................................................................32
This report on Form 10-Q contains certain "forward-looking statements" within
the meaning of Section 27A of the Securities Act of 1933, and Section 21E of the
Securities Exchange Act of 1934, which are intended to be covered by the safe
harbors created by those laws. We have based these forward-looking statements on
our current expectations and projections about future events. These
forward-looking statements include information about possible or assumed future
results of our operations. All statements, other than statements of historical
facts, included or incorporated by reference in this report that address
activities, events or developments that we expect or anticipate may occur in the
future, including such things as future capital expenditures, business strategy,
competitive strengths, goals, growth of our business and operations, plans and
references to future successes may be considered forward-looking statements.
Also, when we use words such as "anticipate," "believe," "estimate," "expect,"
"intend," "plan," "probably" or similar expressions, we are making
forward-looking statements. Many risks and uncertainties may impact the matters
addressed in these forward-looking statements.
Many possible events or factors could affect our future financial results and
performance. These could cause our results or performance to differ materially
from those we express in our forward-looking statements. Although we believe
that the assumptions underlying our forward-looking statements are reasonable,
any of these assumptions, and therefore also the forward-looking statements
based on these assumptions, could themselves prove to be inaccurate. In light of
the significant uncertainties inherent in the forward-looking statements which
are included in this report, our inclusion of this information is not a
representation by us or any other person that our objectives and plans will be
achieved.
Our forward-looking statements speak only as of the date made and we will not
update these forward-looking statements unless the securities laws require us to
do so. In light of these risks, uncertainties and assumptions, any
forward-looking events discussed in this report may not occur.
2
HCC Insurance Holdings, Inc. and Subsidiaries
---------
Condensed Consolidated Balance Sheets
(unaudited, in thousands)
--------
June 30, 2002 December 31, 2001
------------- -----------------
ASSETS
Investments:
Fixed income securities, at market
(cost: 2002 - $619,439; 2001 - $513,674) $ 638,983 $ 525,428
Marketable equity securities, at market
(cost: 2002 - $16,380; 2001 - $16,431) 16,426 16,569
Short-term investments, at cost, which approximates market 297,402 338,904
Other investments, at estimated fair value
(cost: 2002 - $12,836; 2001 - $8,007) 12,187 7,565
---------- ----------
Total investments 964,998 888,466
Cash 19,457 16,891
Restricted cash 153,369 138,545
Premium, claims and other receivables 703,416 665,965
Reinsurance recoverables 869,092 899,128
Ceded unearned premium 110,450 71,140
Ceded life and annuity benefits 81,848 83,013
Deferred policy acquisition costs 50,717 32,071
Property and equipment, net 51,652 52,486
Goodwill 315,619 315,318
Other assets 35,493 56,097
---------- ----------
TOTAL ASSETS $3,356,111 $3,219,120
========== ==========
LIABILITIES
Loss and loss adjustment expense payable $1,095,584 $1,130,748
Life and annuity policy benefits 81,848 83,013
Reinsurance balances payable 127,096 88,637
Unearned premium 247,909 179,530
Deferred ceding commissions 31,108 16,681
Premium and claims payable 690,605 717,159
Notes payable 208,988 181,928
Accounts payable and accrued liabilities 50,173 57,971
---------- ----------
Total liabilities 2,533,311 2,455,667
SHAREHOLDERS' EQUITY
Common stock, $1.00 par value; 250.0 million shares authorized;
(shares issued and outstanding: 2002 - 62,232; 2001 - 61,438) 62,232 61,438
Additional paid-in capital 413,276 402,089
Retained earnings 335,724 293,426
Accumulated other comprehensive income 11,568 6,500
---------- ----------
Total shareholders' equity 822,800 763,453
---------- ----------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $3,356,111 $3,219,120
========== ==========
See Notes to Condensed Consolidated Financial Statements.
3
HCC Insurance Holdings, Inc. and Subsidiaries
--------
Condensed Consolidated Statements of Earnings
(unaudited, in thousands, except per share data)
--------
For the six months For the three months
ended June 30, ended June 30,
------------------------ ------------------------
2002 2001 2002 2001
--------- --------- --------- ---------
REVENUE
Net earned premium $ 226,105 $ 155,609 $ 114,627 $ 83,688
Management fees 38,995 29,635 19,583 13,885
Commission income 21,228 24,792 11,068 10,151
Net investment income 18,178 20,508 9,484 9,876
Net realized investment gain (loss) 1,169 (360) 667 464
Other operating income 1,946 5,464 483 2,492
--------- --------- --------- ---------
Total revenue 307,621 235,648 155,912 120,556
EXPENSE
Loss and loss adjustment expense 136,083 96,969 67,752 48,427
Operating expense:
Policy acquisition costs, net 25,534 12,253 12,480 7,979
Compensation expense 39,541 35,466 19,915 16,847
Other operating expense 23,992 27,540 11,392 13,125
--------- --------- --------- ---------
Net operating expense 89,067 75,259 43,787 37,951
Interest expense 4,841 5,161 2,463 1,814
--------- --------- --------- ---------
Total expense 229,991 177,389 114,002 88,192
--------- --------- --------- ---------
Earnings before income tax provision 77,630 58,259 41,910 32,364
Income tax provision 27,566 22,823 15,128 12,106
--------- --------- --------- ---------
Net earnings $ 50,064 $ 35,436 $ 26,782 $ 20,258
========= ========= ========= =========
BASIC EARNINGS PER SHARE DATA:
Earnings per share $ 0.81 $ 0.63 $ 0.43 $ 0.34
========= ========= ========= =========
Weighted average shares outstanding 62,087 56,374 62,236 58,998
========= ========= ========= =========
DILUTED EARNINGS PER SHARE DATA:
Earnings per share $ 0.80 $ 0.61 $ 0.43 $ 0.34
========= ========= ========= =========
Weighted average shares outstanding 62,805 57,793 62,889 60,470
========= ========= ========= =========
Cash dividends declared, per share $ 0.125 $ 0.12 $ 0.0625 $ 0.06
========= ========= ========= =========
See Notes to Condensed Consolidated Financial Statements.
4
HCC Insurance Holdings, Inc. and Subsidiaries
Condensed Consolidated Statements of Changes in Shareholders' Equity
For the six months ended June 30, 2002 and
for the year ended December 31, 2001
(unaudited, in thousands, except per share data)
--------
Accumulated
Additional other Total
Common paid-in Retained comprehensive shareholders'
stock capital earnings income equity
--------- ---------- ---------- ------------- -------------
BALANCE AS OF DECEMBER 31, 2000 $ 51,342 $ 196,999 $ 277,876 $ 4,713 $ 530,930
Net earnings -- -- 30,197 -- 30,197
Other comprehensive income -- -- -- 1,787 1,787
---------
Comprehensive income 31,984
6,900 shares of common stock issued
in public offering, net of costs 6,900 145,505 -- -- 152,405
2,715 shares of common stock issued for
exercise of options, including tax benefit of
$12,312 2,715 50,023 -- -- 52,738
300 shares of common stock issued
for purchased companies 300 8,031 -- -- 8,331
Issuance of 114 shares of
contractually issuable common stock 114 (114) -- -- --
Issuance of 67 shares of
contingently issuable common stock 67 1,645 -- -- 1,712
Cash dividends declared, $0.245 per share -- -- (14,647) -- (14,647)
--------- --------- --------- --------- ---------
BALANCE AS OF DECEMBER 31, 2001 $ 61,438 $ 402,089 $ 293,426 $ 6,500 $ 763,453
========= ========= ========= ========= =========
See Notes to Condensed Consolidated Financial Statements
5
HCC Insurance Holdings, Inc. and Subsidiaries
Condensed Consolidated Statements of Changes in Shareholders' Equity
For the six months ended June 30, 2002 and
for the year ended December 31, 2001
(unaudited, in thousands, except per share data)
(continued)
------
Accumulated
Additional other Total
Common paid-in Retained comprehensive shareholders'
stock capital earnings income equity
--------- ---------- --------- ------------- -------------
BALANCE AS OF DECEMBER 31, 2001 $ 61,438 $ 402,089 $ 293,426 $ 6,500 $ 763,453
Net earnings -- -- 50,064 -- 50,064
Other comprehensive income -- -- -- 5,068 5,068
---------
Comprehensive income 55,132
691 shares of common stock issued for
exercise of options, including tax benefit of
$2,720 691 11,290 -- -- 11,981
Issuance of 103 shares of
contractually issuable common stock 103 (103) -- -- --
Cash dividends declared, $0.125 per share -- -- (7,766) -- (7,766)
--------- --------- --------- --------- ---------
BALANCE AS OF JUNE 30, 2002 $ 62,232 $ 413,276 $ 335,724 $ 11,568 $ 822,800
========= ========= ========= ========= =========
See Notes to Condensed Consolidated Financial Statements.
6
HCC Insurance Holdings, Inc. and Subsidiaries
---------
Condensed Consolidated Statements of Cash Flows
(unaudited, in thousands)
---------
For the six months
ended June 30,
--------------------------
2002 2001
---------- ----------
Cash flows from operating activities:
Net earnings $ 50,064 $ 35,436
Adjustments to reconcile net earnings to net
cash provided by operating activities:
Change in premium, claims and other receivables (37,451) (51,749)
Change in reinsurance recoverables 30,036 (53,411)
Change in ceded unearned premium (39,310) 4,625
Change in loss and loss adjustment expense payable (35,164) 57,267
Change in reinsurance balances payable 38,459 (23,021)
Change in unearned premium 68,379 15,279
Change in premium and claims payable, net of restricted cash (41,378) 22,156
Depreciation and amortization expense 5,378 9,299
Other, net 7,669 655
--------- ---------
Cash provided by operating activities 46,682 16,536
Cash flows from investing activities:
Sales of fixed income securities 154,164 71,128
Maturity or call of fixed income securities 19,691 20,654
Sales of equity securities 3,417 2,471
Change in short-term investments 41,502 21,761
Cost of securities acquired (287,100) (135,512)
Purchases of property and equipment (2,838) (2,991)
--------- ---------
Cash used by investing activities (71,164) (22,489)
Cash flows from financing activities:
Issuance of notes payable 40,000 --
Sale of common stock, net of costs 9,261 161,837
Payments on notes payable (13,269) (158,500)
Dividends paid and other, net (8,944) (7,077)
--------- ---------
Cash provided (used) by financing activities 27,048 (3,740)
--------- ---------
Net change in cash 2,566 (9,693)
Cash at beginning of period 16,891 13,991
--------- ---------
CASH AT END OF PERIOD $ 19,457 $ 4,298
========= =========
See Notes to Condensed Consolidated Financial Statement
7
HCC Insurance Holdings, Inc. and Subsidiaries
---------
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands)
---------
(1) GENERAL INFORMATION
HCC Insurance Holdings, Inc. and its subsidiaries ("we," "us" and "our")
provide specialized property and casualty and accident and health insurance
coverages, underwriting agency and intermediary services to commercial
customers and individuals. Our lines of business include group life,
accident and health; aviation; property, marine and energy; and other
specialty insurance and reinsurance. We operate primarily in the United
States and in the United Kingdom, although some of our operations have a
broader international scope. We underwrite insurance on both a direct
basis, where we insure a risk in exchange for a premium, and a reinsurance
basis, where we insure all or a portion of another insurance company's risk
in exchange for all or portion of the premium. We market our products both
directly to customers and through a network of independent and affiliated
agents and brokers.
Basis of Presentation
The unaudited condensed consolidated financial statements have been
prepared in conformity with accounting principles generally accepted in the
United States of America and include all adjustments which are, in our
opinion, necessary for a fair presentation of the results of the interim
periods. All adjustments made to the interim periods are of a normal
recurring nature. The condensed consolidated financial statements include
the accounts of HCC Insurance Holdings, Inc. and those of our wholly-owned
subsidiaries. All significant intercompany balances and transactions have
been eliminated. The condensed consolidated financial statements for
periods reported should be read in conjunction with the annual audited
consolidated financial statements and related notes. The condensed
consolidated balance sheet as of December 31, 2001, and the condensed
consolidated statement of changes in shareholders' equity for the year then
ended were derived from audited financial statements, but do not include
all disclosures required by accounting principles generally accepted in the
United States of America.
Income Tax
For the six months ended June 30, 2002 and 2001, the income tax provision
has been calculated based on an estimated effective tax rate for each of
the fiscal years. The difference between our effective tax rate and the
Federal statutory rate is primarily the result of state income taxes, tax
exempt municipal bond interest and, in 2001, differences in goodwill
amortization.
Effects of Recent Accounting Pronouncements
Statement of Financial Accounting Standards ("SFAS") No. 142 entitled
"Goodwill and Other Intangible Assets" was issued in June, 2001, and became
effective for us on January 1, 2002. SFAS No. 142 requires goodwill to be
tested for impairment at a level referred to as a reporting unit. SFAS No.
142 requires us to perform the initial goodwill impairment test on all
reporting units no later than June 30, 2002. The first step is to compare
the fair value of a reporting unit with its book value. If the fair value
of a reporting unit is less than its book value, the second step will be to
calculate the impairment loss, if any, to be reported no later than
December 31, 2002. Any impairment loss from the initial adoption of SFAS
No. 142 would be a change in accounting principle. After the initial
adoption, goodwill of a reporting unit will be tested for impairment on an
annual basis and between annual tests if an event occurs or circumstances
change that would more likely than not reduce the fair value of a reporting
unit below its carrying amount. SFAS No. 142 also requires the
discontinuance of the amortization of
8
HCC Insurance Holdings, Inc. and Subsidiaries
---------
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands)
(continued)
(1) GENERAL INFORMATION, CONTINUED
goodwill effective January 1, 2002 and that and that goodwill recognized
for acquisitions which were consummated after July 1, 2001 not be
amortized. During the first six months of 2002 we determined our reporting
units, completed our initial goodwill impairment testing, completed our
first annual impairment testing as of June 30, 2002 and determined we do
not have to record an impairment charge. SFAS No. 142 is not expected to
have a material effect on our financial position or cash flows.
The tables below reconcile net earnings and earnings per share we reported
to adjusted amounts that we would have reported had we adopted SFAS No. 142
on January 1, 2001 instead of January 1, 2002:
For the six months ended For the three months ended
June 30, June 30,
--------------------------------- ---------------------------------
2002 2001 2002 2001
---------------- ---------------- ---------------- ----------------
Net earnings:
Reported net earnings $ 50,064 $ 35,436 $ 26,782 $ 20,258
Add back goodwill amortization -- 5,921 -- 3,098
Add back license amortization -- 313 -- 96
Less tax benefit from goodwill amortization -- (533) -- (260)
---------------- ---------------- ---------------- ----------------
ADJUSTED NET INCOME $ 50,064 $ 41,137 $ 26,782 $ 23,192
================ ================ ================ ================
Basic earnings per share:
Reported basic earnings per share $ 0.81 $ 0.63 $ 0.43 $ 0.34
Add back amortization, net of tax effect -- 0.10 -- 0.05
---------------- ---------------- ---------------- ------------------
ADJUSTED BASIC EARNINGS PER SHARE $ 0.81 $ 0.73 $ 0.43 $ 0.39
================ ================ ================ ==================
Diluted earnings per share:
Reported diluted earnings per share $ 0.80 $ 0.61 $ 0.43 $ 0.34
Add back amortization, net of tax effect -- 0.10 -- 0.04
---------------- ---------------- ---------------- ------------------
ADJUSTED DILUTED EARNINGS PER SHARE $ 0.80 $ 0.71 $ 0.43 $ 0.38
================ ================ ================ ==================
9
HCC Insurance Holdings, Inc. and Subsidiaries
---------
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands)
(continued)
(1) GENERAL INFORMATION, CONTINUED
The following tables show the balances of our intangible assets, which are
included in other assets on our condensed consolidated balance sheets,
after our adoption of SFAS No. 142 effective January 1, 2002:
Intangible assets not subject to amortization --
insurance company and other licenses $ 6,792
====================
Intangible assets subject to amortization:
Gross amounts recorded $ 10,231
Less accumulated amortization (722)
--------------------
NET INTANGIBLE ASSETS SUBJECT TO AMORTIZATION $ 9,509
====================
Amortization of intangible assets which are subject to amortization under
SFAS No. 142 amounted to $1.7 million during the first six months of 2002.
There was an insignificant amount of amortization for the same period of
2001, as substantially all of our intangible assets subject to amortization
were acquired in our October 2001 acquisitions. Estimated amortization
expense for 2002 and future years as of January 1, 2002 are as follows:
2002 $ 3,267
2003 2,294
2004 1,477
2005 972
2006 367
Thereafter 1,132
-------------------
TOTAL $ 9,509
===================
Reclassifications
Certain amounts in our 2001 condensed consolidated financial statements
have been reclassified to conform to the 2002 presentation. Such
reclassifications had no effect on our net earnings, shareholders' equity
or cash flows.
10
HCC Insurance Holdings, Inc. and Subsidiaries
--------
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands)
(continued)
(2) REINSURANCE
In the normal course of business our insurance companies cede a portion of
their premium to non-affiliated domestic and foreign reinsurers through
treaty and facultative reinsurance agreements. Although the ceding of
reinsurance does not discharge the primary insurer from liability to its
policyholder, our insurance companies participate in such agreements for
the purpose of limiting their loss exposure, protecting them against
catastrophic loss and diversifying their business. The following table
represents the effect of such reinsurance transactions on premium and loss
and loss adjustment expense:
Loss and Loss
Written Earned Adjustment
Premium Premium Expense
------------------- -------------------- --------------------
For the six months ended June 30, 2002:
Direct business $ 436,780 $ 378,086 $ 261,158
Reinsurance assumed 116,840 104,996 29,266
Reinsurance ceded (295,958) (256,977) (154,341)
------------------- -------------------- --------------------
NET AMOUNTS $ 257,662 $ 226,105 $ 136,083
=================== ==================== ====================
For the six months ended June 30, 2001:
Direct business $ 405,386 $ 397,062 $ 274,895
Reinsurance assumed 118,322 109,076 156,165
Reinsurance ceded (345,619) (350,529) (334,091)
------------------- -------------------- --------------------
NET AMOUNTS $ 178,089 $ 155,609 $ 96,969
=================== ==================== ====================
For the three months ended June 30, 2002:
Direct business $ 244,690 $ 193,527 $ 117,942
Reinsurance assumed 61,162 55,468 10,166
Reinsurance ceded (170,462) (134,368) (60,356)
------------------- -------------------- --------------------
NET AMOUNTS $ 135,390 $ 114,627 $ 67,752
=================== ==================== ====================
11
HCC Insurance Holdings, Inc. and Subsidiaries
--------
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands)
(continued)
(2) REINSURANCE, CONTINUED
Loss and Loss
Written Earned Adjustment
Premium Premium Expense
------------------- -------------------- --------------------
For the three months ended June 30, 2001:
Direct business $ 223,434 $ 200,652 $ 144,829
Reinsurance assumed 71,060 57,597 55,961
Reinsurance ceded (188,910) (174,561) (152,363)
------------------- -------------------- --------------------
NET AMOUNTS $ 105,584 $ 83,688 $ 48,427
=================== ==================== ====================
The table below represents the composition of reinsurance recoverables in
our condensed consolidated balance sheets:
June 30, 2002 December 31, 2001
----------------------- -----------------------
Reinsurance recoverable on paid losses $ 116,443 $ 86,653
Reinsurance recoverable on outstanding losses 373,104 414,428
Reinsurance recoverable on incurred but not reported losses 388,523 403,223
Reserve for uncollectible reinsurance (8,978) (5,176)
----------------------- -----------------------
TOTAL REINSURANCE RECOVERABLES $ 869,092 $ 899,128
======================= =======================
The tables below present the calculation of net reserves, net unearned
premium and net deferred policy acquisition costs:
June 30, 2002 December 31, 2001
----------------------- -----------------------
Loss and loss adjustment expense payable $ 1,095,584 $ 1,130,748
Reinsurance recoverable on outstanding losses (373,104) (414,428)
Reinsurance recoverable on incurred but not reported losses (388,523) (403,223)
----------------------- -----------------------
NET RESERVES $ 333,957 $ 313,097
======================= =======================
Unearned premium $ 247,909 $ 179,530
Ceded unearned premium (110,450) (71,140)
----------------------- -----------------------
NET UNEARNED PREMIUM $ 137,459 $ 108,390
======================= =======================
Deferred policy acquisition costs $ 50,717 $ 32,071
Deferred ceding commissions (31,108) (16,681)
----------------------- -----------------------
NET DEFERRED POLICY ACQUISITION COSTS $ 19,609 $ 15,390
======================= =======================
12
HCC Insurance Holdings, Inc. and Subsidiaries
--------
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands)
(continued)
(2) REINSURANCE, CONTINUED
Our insurance companies require their reinsurers not authorized by the
respective states of domicile of our insurance companies to collateralize
the reinsurance obligations due to us. The table below shows amounts held
by us as collateral plus other credits available for potential offset.
June 30, 2002 December 31, 2001
------------------------ -----------------------
Payables to reinsurers $ 222,456 $ 199,581
Letters of credit 148,076 145,796
Cash deposits 14,275 14,851
------------------------ -----------------------
TOTAL CREDITS $ 384,807 $ 360,228
======================== =======================
We have a reserve of $9.0 million as of June 30, 2002 for potential
collectibility issues related to reinsurance recoverables and associated
expenses. We increased the reserve for uncollectible reinsurance by $3.8
million and $1.9 million during the six and three months, respectively,
ended June 30, 2002. The adverse economic environment in the worldwide
insurance industry and the terrorist attacks on September 11, 2001 have
placed great pressure on reinsurers and the results of their operations.
Ultimately, these conditions could affect reinsurers' solvency.
Historically, there have been insolvencies following a period of
competitive pricing in the industry, such as the marketplace has
experienced for the last several years. While we believe that our overall
reserve is adequate based on currently available information, conditions
may change or additional information might be obtained which may result in
a future change in the reserve. We periodically review our financial
exposure to the reinsurance market and the level of our reserve and
continue to take actions in an attempt to mitigate our risk.
A number of reinsurers have delayed or suspended the payment of amounts
recoverable under certain reinsurance contracts to which we are a party.
Such delays have affected, although not materially to date, the investment
income of our insurance companies, but not to any extent their liquidity.
We limit our liquidity exposure by holding funds, letters of credit or
other security such that net balances due to us are significantly less than
the gross balances shown in our consolidated balance sheets. In some
instances, the reinsurers have withheld payment without reference to a
substantive basis for the delay or suspension. In other cases, the
reinsurers have claimed they are not liable for payment to us of all or
part of the amounts due under the applicable reinsurance agreement. We
believe these claims are without merit and expect to collect the full
amounts recoverable. We are currently in negotiations with most of these
parties, but if such negotiations do not result in a satisfactory
resolution of the matters in question, we may seek or be involved in a
judicial or arbitral determination of these matters. In some cases, the
final resolution of such disputes through arbitration or litigation may
extend over several years.
In this regard, as of June 30, 2002, our insurance companies had initiated
litigation or arbitration proceedings against six reinsurers and were
involved in one arbitration proceeding initiated by a reinsurer. These
proceedings primarily concern the collection of amounts owing under
reinsurance agreements. As of such date, our insurance companies had an
aggregate amount of $19.4 million which had not been paid to us under the
agreements and we estimate that there could be up to an additional $26.4
million of incurred losses
13
HCC Insurance Holdings, Inc. and Subsidiaries
--------
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands)
(continued)
(2) REINSURANCE, CONTINUED
and loss expenses and other balances due under the subject agreements.
During the six months ended June 30, 2002, we negotiated a settlement of
one arbitration with a reinsurer under which the reinsurer agreed to pay
the full amount due to our company, which we estimate to be $13.5 million.
In addition, because our insurance companies, principally Houston Casualty
Company, participated in facilities or pools of companies which were
managed by one of our underwriting agencies, they are indirectly involved
in any proceedings involving collections which affect the applicable
facilities or pools of companies. As of June 30, 2002, Houston Casualty
Company's allocated portion of these actions was $3.9 million and we
estimate that there could be up to an additional $2.7 million of incurred
losses and loss expenses. Neither Houston Casualty Company nor its
affiliated underwriting agency has any net exposure on the portion of the
amounts which are due to the non-affiliated companies who also participated
in the applicable facilities or pool of companies.
(3) SEGMENT AND GEOGRAPHIC INFORMATION
The performance of each segment is evaluated based upon net earnings and is
calculated after tax and after all corporate expense allocations, purchase
price allocations and intercompany eliminations have been charged or
credited to the individual segments. The following tables show information
by business segment and geographic location. Geographic location is
determined by physical location of our offices and does not represent the
location of insureds or reinsureds from whom the business was generated.
Effective January 1, 2001 and 2002, we consolidated the operations of three
and one of our underwriting agencies, respectively, into the operations of
our insurance companies. Policies incepting on or after the effective
dates, along with associated expenses, will be reported in the insurance
company segment. The administration of all policies incepting before the
effective dates, which are now in run off, along with associated expenses,
will continue to be reported in the underwriting agency segment. This
consolidation will affect the comparability of segment information between
periods.
SFAS No. 142, which we adopted effective January 1, 2002, required the
discontinuance of the amortization of goodwill and indefinite lived
intangible assets on a prospective basis. This will affect the
comparability of certain segment information between periods. Pro forma
segment information is shown in the tables for the six and three months
ended June 30, 2001, as if we had adopted SFAS No. 142 as of January 1,
2001.
14
HCC Insurance Holdings, Inc. and Subsidiaries
--------
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands)
(continued)
(3) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED
Insurance Underwriting Other
Company Agency Intermediary Operations Corporate Total
--------------------------------------------------------------------------------------------
For the six months ended June 30, 2002:
Revenue:
Domestic $ 210,079 $ 39,917 $ 12,502 $ 605 $ 790 $ 263,893
Foreign 33,948 591 9,189 -- -- 43,728
Inter-segment -- 12,878 355 -- -- 13,233
--------------------------------------------------------------------------------------------
TOTAL SEGMENT REVENUE $ 244,027 $ 53,386 $ 22,046 $ 605 $ 790 320,854
============================================================================
Inter-segment revenue (13,233)
----------------
CONSOLIDATED TOTAL REVENUE $ 307,621
================
Net earnings (loss):
Domestic $ 30,239 $ 11,399 $ 2,884 $ 295 $ 1,296 $ 46,113
Foreign 2,740 257 1,268 -- -- 4,265
--------------------------------------------------------------------------------------------
TOTAL SEGMENT NET EARNINGS $ 32,979 $ 11,656 $ 4,152 $ 295 $ 1,296 50,378
============================================================================
Inter-segment eliminations (314)
----------------
CONSOLIDATED NET EARNINGS $ 50,064
================
Other items:
Net investment income $ 15,974 $ 1,330 $ 464 $ 221 $ 189 $ 18,178
Depreciation and amortization 1,518 3,111 170 66 513 5,378
Interest expense (benefit) 73 3,880 1,288 -- (400) 4,841
Capital expenditures 1,007 800 695 -- 336 2,838
Income tax provision (benefit) 16,014 7,305 3,581 52 792 27,744
Inter-segment eliminations (178)
----------------
CONSOLIDATED INCOME TAX PROVISION $ 27,566
================
15
HCC Insurance Holdings, Inc. and Subsidiaries
--------
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands)
(continued)
(3) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED
Insurance Underwriting Other
Company Agency Intermediary Operations Corporate Total
--------------------------------------------------------------------------------------------
For the six months ended June 30, 2001:
Revenue:
Domestic $ 154,204 $ 31,792 $ 12,854 $ 4,421 $ 98 $ 203,369
Foreign 17,302 1,321 13,656 -- -- 32,279
Inter-segment -- 10,433 135 1,289 -- 11,857
--------------------------------------------------------------------------------------------
TOTAL SEGMENT REVENUE $ 171,506 $ 43,546 $ 26,645 $ 5,710 $ 98 247,505
============================================================================
Inter-segment revenue (11,857)
----------------
CONSOLIDATED TOTAL REVENUE $ 235,648
================
Net earnings (loss):
Domestic $ 20,659 $ 8,102 $ 2,742 $ 886 $ 372 $ 32,761
Foreign (293) 648 1,518 -- -- 1,873
--------------------------------------------------------------------------------------------
TOTAL SEGMENT NET EARNINGS $ 20,366 $ 8,750 $ 4,260 $ 886 $ 372 34,634
============================================================================
Inter-segment eliminations 802
----------------
CONSOLIDATED NET EARNINGS $ 35,436
================
SFAS No. 142 pro forma adjustments:
Net effect of goodwill and
intangible asset amortization $ 1,074 $ 2,870 $ 1,757 $ -- $ -- $ 5,701
--------------------------------------------------------------------------------------------
Pro forma segment net earnings $ 21,440 $ 11,620 $ 6,017 $ 886 $ 372 40,335
============================================================================
Inter-segment eliminations 802
----------------
PRO FORMA CONSOLIDATED NET EARNINGS $ 41,137
================
Other items:
Net investment income $ 15,324 $ 3,233 $ 1,717 $ 59 $ 175 $ 20,508
Depreciation and amortization 2,734 4,285 1,947 109 224 9,299
Interest expense 17 2,502 2,034 -- 608 5,161
Capital expenditures 1,679 450 369 66 427 2,991
Income tax provision 8,905 7,221 4,318 554 1,348 22,346
Inter-segment eliminations 477
----------------
CONSOLIDATED INCOME TAX
PROVISION $ 22,823
================
16
HCC Insurance Holdings, Inc. and Subsidiaries
--------
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands)
(continued)
(3) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED
Insurance Underwriting Other
Company Agency Intermediary Operations Corporate Total
--------------------------------------------------------------------------------------------
For the three months ended June 30, 2002:
Revenue:
Domestic $ 106,666 $ 20,211 $ 7,363 $ 312 $ 177 $ 134,729
Foreign 17,153 84 3,946 -- -- 21,183
Inter-segment -- 6,743 99 -- -- 6,842
--------------------------------------------------------------------------------------------
TOTAL SEGMENT REVENUE $ 123,819 $ 27,038 $ 11,408 $ 312 $ 177 162,754
============================================================================
Inter-segment revenue (6,842)
----------------
CONSOLIDATED TOTAL REVENUE $ 155,912
================
Net earnings (loss):
Domestic $ 15,875 $ 6,164 $ 2,319 $ 230 $ (52) $ 24,536
Foreign 2,204 (1) 124 -- -- 2,327
--------------------------------------------------------------------------------------------
TOTAL SEGMENT NET EARNINGS
(LOSS) $ 18,079 $ 6,163 $ 2,443 $ 230 $ (52) 26,863
============================================================================
Inter-segment eliminations (81)
----------------
CONSOLIDATED NET EARNINGS $ 26,782
================
Other items:
Net investment income $ 8,282 $ 615 $ 242 $ 201 $ 144 $ 9,484
Depreciation and amortization 760 1,504 84 16 267 2,631
Interest expense -- 1,894 644 -- (75) 2,463
Capital expenditures 505 376 405 -- 227 1,513
Income tax provision 8,695 4,168 1,880 61 343 15,147
Inter-segment eliminations (19)
----------------
CONSOLIDATED INCOME TAX
PROVISION $ 15,128
================
17
HCC Insurance Holdings, Inc. and Subsidiaries
--------
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands)
(continued)
(3) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED
Insurance Underwriting Other
Company Agency Intermediary Operations Corporate Total
--------------------------------------------------------------------------------------------
For the three months ended June 30, 2001:
Revenue:
Domestic $ 82,076 $ 14,762 $ 5,779 $ 1,989 $ (14) $ 104,592
Foreign 10,192 698 5,074 -- -- 15,964
Inter-segment -- 5,912 60 730 -- 6,702
--------------------------------------------------------------------------------------------
TOTAL SEGMENT REVENUE $ 92,268 $ 21,372 $ 10,913 $ 2,719 $ (14) 127,258
============================================================================
Inter-segment revenue (6,702)
----------------
CONSOLIDATED TOTAL REVENUE $ 120,556
================
Net earnings (loss):
Domestic $ 13,557 $ 4,084 $ 767 $ 370 $ 427 $ 19,205
Foreign 361 400 (106) -- -- 655
--------------------------------------------------------------------------------------------
TOTAL SEGMENT NET EARNINGS $ 13,918 $ 4,484 $ 661 $ 370 $ 427 19,860
============================================================================
Inter-segment eliminations 398
----------------
CONSOLIDATED NET EARNINGS $ 20,258
================
SFAS No. 142 pro forma adjustments:
Net effect of goodwill and
intangible asset amortization $ 505 $ 1,462 $ 967 $ -- $ -- $ 2,934
--------------------------------------------------------------------------------------------
Pro forma segment net earnings $ 14,423 $ 5,946 $ 1,628 $ 370 $ 427 22,794
============================================================================
Inter-segment eliminations 398
----------------
PRO FORMA CONSOLIDATED NET EARNINGS $ 23,192
================
Other items:
Net investment income $ 7,630 $ 1,418 $ 702 $ 21 $ 105 $ 9,876
Depreciation and amortization 1,334 2,230 1,061 73 80 4,778
Interest expense 14 1,154 941 -- (295) 1,814
Capital expenditures 994 139 228 18 313 1,692
Income tax provision 6,510 3,982 936 244 198 11,870
Inter-segment eliminations 236
----------------
CONSOLIDATED INCOME TAX
PROVISION $ 12,106
================
18
HCC Insurance Holdings, Inc. and Subsidiaries
--------
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands)
(continued)
(3) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED
The following tables present revenue by line of business within each
operating segment for the periods indicated:
For the six months ended June 30, For the three months ended June 30,
------------------------------------ --------------------------------------
2002 2001 2002 2001
--------------- ------------------- ------------------- -----------------
Insurance company:
Group life, accident and health $ 129,111 $ 86,653 $ 64,227 $ 46,392
Aviation 50,754 42,278 25,571 21,936
Property, marine and energy 17,159 9,137 8,977 5,158
Other specialty lines of business 16,259 6,824 9,921 4,349
--------------- ------------------- ------------------- -----------------
Subtotal 213,283 144,892 108,696 77,835
Discontinued lines of business 12,822 10,717 5,931 5,853
--------------- ------------------- ------------------- -----------------
TOTAL NET EARNED PREMIUM $ 226,105 $ 155,609 $ 114,627 $ 83,688
=============== =================== =================== =================
Underwriting agency:
Group life, accident and health $ 25,026 $ 25,026 $ 13,293 $ 11,649
Property and casualty 13,969 4,609 6,290 2,236
--------------- ------------------- ------------------- -----------------
TOTAL MANAGEMENT FEES $ 38,995 $ 29,635 $ 19,583 $ 13,885
=============== =================== =================== =================
Intermediary:
Group life, accident and health $ 16,480 $ 19,503 $ 8,458 $ 8,212
Property and casualty 4,748 5,289 2,610 1,939
--------------- ------------------- ------------------- -----------------
TOTAL COMMISSION INCOME $ 21,228 $ 24,792 $ 11,068 $ 10,151
=============== =================== =================== =================
Goodwill assigned to our operating segments after our adoption of SFAS
No. 142 effective January 1, 2002 is as follows:
Insurance company $ 130,504
Underwriting agency 107,598
Intermediary 77,216
----------------
TOTAL GOODWILL $ 315,318
================
19
HCC Insurance Holdings, Inc. and Subsidiaries
--------
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands)
(continued)
(4) EARNINGS PER SHARE
Basic earnings per share is based on the weighted average number of common
shares outstanding during the period divided into net earnings. Diluted
earnings per share is based on the weighted average number of common shares
outstanding plus the potential common shares outstanding during the period
divided into net earnings. Outstanding common stock options, when dilutive,
are considered to be potential common shares for the purpose of the diluted
calculation. The treasury stock method is used to calculate potential
common shares due to options. Contingent shares to be issued are included
in the earnings per share computation only when the underlying conditions
for issuance have been met.
The following table provides a reconciliation of the denominators used in
the earnings per share calculations:
For the six months ended June 30, For the three months ended June 30,
---------------------------------- --------------------------------------
2002 2001 2002 2001
--------------- ----------------- ----------------- ------------------
Net earnings $ 50,064 $ 35,436 $ 26,782 $ 20,258
=============== ================= ================= ==================
Reconciliation of shares outstanding:
Shares of common stock outstanding
at period end 62,232 59,026 62,232 59,026
Effect of common shares issued
during the period (197) (2,807) (48) (183)
Common shares contractually issuable in
the future 52 155 52 155
--------------- ----------------- ----------------- ------------------
Weighted average common
shares outstanding 62,087 56,374 62,236 58,998
Additional dilutive effect of
outstanding options (as determined by the
application of the treasury stock
method) 718 1,419 653 1,472
--------------- ----------------- ----------------- ------------------
Weighted average shares and
potential common shares outstanding 62,805 57,793 62,889 60,470
=============== ================= ================= ==================
Anti-dilutive shares not included
in computation 364 146 416 58
=============== ================= ================= ==================
20
HCC Insurance Holdings, Inc. and Subsidiaries
--------
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands)
(continued)
(5) SUPPLEMENTAL INFORMATION
Supplemental information is summarized below:
For the six months ended June 30, For the three months ended June 30,
-------------------------------------- ----------------------------------------
2002 2001 2002 2001
------------------ ------------------ ------------------ -------------------
Interest paid $ 2,417 $ 7,285 $ 347 $ 1,284
Income tax paid 13,020 8,597 11,455 5,116
Comprehensive income 55,132 38,245 35,011 19,313
Ceding commissions netted with
policy acquisition costs 66,164 100,638 32,953 47,876
(6) NOTES PAYABLE
The table below shows the composition of our notes payable as shown in our
condensed consolidated balance sheet.
June 30, 2002 December 31, 2001
---------------------- -----------------------
2% Convertible notes $ 172,500 $ 172,500
Bank facility 30,000 --
Acquisition notes 2,850 3,365
Mortgage note and other 3,638 6,063
---------------------- -----------------------
NET AMOUNTS 208,988 $ 181,928
====================== =======================
During April 2002, we drew down $40.0 million on our bank facility as
partial funding for a $50.0 million capital contribution to our largest
insurance company, Houston Casualty Company, to support its growth and
increased business opportunities. During June 2002, we repaid $10.0 million
on our bank facility using funds generated from operating cash flows. As of
June 30, 2002, the weighted average interest rate on our bank facility
outstanding debt was 2.8%.
Under the terms of the related indenture agreement, the 2% convertible
notes can be put, or sold back, to us on September 1, 2002 at the option of
the note holders. We have previously announced that we intend to pay cash
to the holders of the convertible notes who exercise their put option. We
plan to use available cash and, if necessary, amounts available under our
bank facility to provide the funding for any such repurchase, should it
occur.
21
HCC Insurance Holdings, Inc. and Subsidiaries
--------
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands)
(continued)
(7) COMMITMENTS AND CONTINGENCIES
In addition to the matters discussed in Note (2), Reinsurance, we are party
to numerous lawsuits and other proceedings that arise in the normal course
of our business. Many of these lawsuits and other proceedings involve
claims under policies that we underwrite as an insurer or reinsurer, the
liabilities for which we believe have been adequately included in our loss
reserves. Also, from time to time, we are party to lawsuits and other
proceedings which relate to disputes over contractual relationships with
third parties, or which involve alleged errors and omissions on the part of
our subsidiaries. We believe the resolution of any such lawsuit will not
have a material adverse effect on our financial position, results of
operations or cash flows.
22
MANAGEMENT'S DISCUSSION AND ANALYSIS
Statement of Financial Accounting Standards ("SFAS") No. 142 entitled "Goodwill
and Other Intangible Assets" became effective for us on January 1, 2002 and
required the discontinuance of the amortization of goodwill and indefinite lived
intangible assets on a prospective basis. This will affect the comparability of
financial results between periods. See "Effects of Recent Accounting
Pronouncements" for additional information.
Six Months ended June 30, 2002 versus six months ended June 30, 2001
Results of Operations
Total revenue increased 31% to $307.6 million for the first six months of 2002
from $235.6 million for the same period in 2001. The revenue increase resulted
principally from increased business and greater retention levels in the
insurance company segment. Revenue in the underwriting agency segment also
increased due to two acquisitions made in late 2001, somewhat offset by reduced
revenue in the intermediary and other operations segments as a result of market
conditions and the sale or other disposition of various operations in 2001.
Net investment income decreased to $18.2 million for the first six months of
2002 from $20.5 million for the same period in 2001. This decrease was due to
the decrease in interest rates partially offset by the higher level of invested
assets which resulted from cash flow provided by operating activities and
capital contributions made to our insurance company segment. Although we expect
continuing increases in cash flow from operating activities to increase
investment assets and investment income going forward, investment income is
unlikely to show much comparative growth until interest rates rise.
Compensation expense increased to $39.5 million during the first six months of
2002 from $35.5 million for the same period in 2001. Much of this increase was
due to agency subsidiaries acquired in late 2001, somewhat offset by a decrease
from operations sold or otherwise disposed of during the same period.
Other operating expense decreased to $24.0 million during the first six months
of 2002 compared to the $27.5 million for the same period in 2001. This decrease
results principally from the reduction in the amortization of goodwill,
operations sold in late 2001 and general expense savings, partially offset by
the effect of acquisitions made during the same period and an increase in the
provision for uncollectible reinsurance recoverables.
Interest expense was $4.8 million for the first six months of 2002 compared to
$5.2 million for the same period in 2001. The decrease is due to lower interest
rates on our outstanding debt. Included in the current period is $2.2 million
representing the amortization of underwriting discounts and other costs of our
August 2001 issuance of 2% convertible notes. These costs will be fully
amortized by August 2002.
Income tax expense was $27.6 million for the first six months of 2002 compared
to $22.8 million for the same period in 2001. Our effective tax rate was 35.5%
in the current period compared to 39.2% in 2001. Most of the reduction in the
effective tax rate is due to the fact that goodwill is not being amortized
during 2002 and was substantially not deductible for income tax purposes in
2001.
Net earnings increased 41% to $50.1 million, or $0.80 per diluted share, for the
first six months of 2002 from $35.4 million, or $0.61 per diluted share, for the
same period in 2001. The increase in net earnings resulted from improved
underwriting performance by the insurance company segment and from the
non-amortization of goodwill in accordance with SFAS No. 142. Had we adopted
SFAS No. 142 effective January 1, 2001 our net income for the first six months
of 2001 would have increased $5.7 million, or $0.10 per diluted share. The
percentage increase in net earnings was greater than the increase in diluted
earnings per share because of the effect of our shares outstanding increasing
due to our March 2001 public offering and shares issued during the past year in
connection with the exercise of options.
Our book value per share was $13.21 as of June 30, 2002, up from $12.40 as of
December 31, 2001.
23
SEGMENTS
Insurance Companies
The following tables provide information by line of business (in thousands):
Gross Net Net Net
written written earned loss
premium premium premium ratio
--------------- --------------- --------------- -----------
For the six months ended June 30, 2002:
Group life, accident and health $ 298,746 $ 130,161 $ 129,111 63.6%
Aviation 104,104 52,054 50,754 53.0
Property, marine and energy 76,259 46,575 17,159 34.8
Other specialty lines of business 68,253 24,099 16,259 76.6
--------------- --------------- --------------- -----------
Subtotal 547,362 252,889 213,283 59.8
Discontinued lines of business 6,258 4,773 12,822 67.2
--------------- --------------- --------------- -----------
TOTALS $ 553,620 $ 257,662 $ 226,105 60.2%
=============== =============== ===============
Expense ratio 25.7
-----------
Combined ratio 85.9%
===========
For the six months ended June 30, 2001:
Group life, accident and health $ 320,349 $ 88,868 $ 86,653 67.2%
Aviation 93,261 48,228 42,278 56.7
Property, marine and energy 51,141 16,464 9,137 25.1
Other specialty lines of business 7,780 6,824 6,824 66.0
--------------- --------------- --------------- -----------
Subtotal 472,531 160,384 144,892 61.4
Discontinued lines of business 51,177 17,705 10,717 74.5
--------------- --------------- --------------- -----------
TOTALS $ 523,708 $ 178,089 $ 155,609 62.3%
=============== =============== ===============
Expense ratio 27.0
-----------
Combined ratio 89.3%
===========
Gross written premium increased 6% to $553.6 million for the first six months of
2002 from $523.7 million for the same period in 2001. This increase was 16%
before the reduction due to discontinued lines of business. The increase
resulted from the following:
o Aviation premium writings increased primarily due to premium rate
increases;
o Property, marine and energy business written by the London branch of
Houston Casualty Company increased due to organic growth and premium
rate increases;
o New specialty liability lines of business including professional
indemnity and directors and officers liability, not previously
written; and
o Gross written premium increases were substantially offset by
reductions in discontinued lines of business and a reduction in the
group life, accident and health segment written premium as a result of
our significantly reducing the writing of accident and health
reinsurance, principally as a result of the lack of catastrophe and
retrocessional protection.
Gross written premium is expected to continue to increase into 2003.
24
Net written premium for the first six months of 2002 increased 45% to $257.7
million from $178.1 million for the same period in 2001, as our insurance
companies have increased retentions on the group life, accident and health and
the property, marine and energy segments, in addition to the effect of the
changes in gross premium described above. Net earned premium also increased 45%
to $226.1 million for the same reasons. Increases in net written and net earned
premiums were 58% and 47%, respectively, before the reduction in discontinued
lines of business. The increases in net written premium and net earned premium
are expected to continue.
Loss and loss adjustment expense was $136.1 million for the first six months of
2002 compared to $97.0 million for the same period in 2001. Prior year net
reserve redundancies included in loss and loss adjustment expense approximated
$1.9 million and $4.1 million for the first six months of 2002 and 2001,
respectively. The redundancies resulted from the settlement of claims for less
than the amounts previously reserved. The net loss ratio was slightly improved
at 60.2% for the first six months of 2002 compared to 62.3% for the same period
in 2001, but on substantially increased earned premiums. The gross loss ratio
was 60.1% in the first six months of 2002 compared to 85.2% for the same period
in 2001. During the first six months of 2001, we recorded a gross loss of
approximately $55.0 million (10.9% of the 2001 gross loss ratio) due to the
Petrobras 36 Brazilian offshore energy production platform sinking.
Additionally, in 2002, as a result of further evaluation, we reduced the gross
losses from our September 11 terrorist loss by $21.5 million which had the
effect of reducing the gross loss ratio by 4.5%.
Policy acquisition costs, which are net of commissions on reinsurance ceded,
increased to $25.5 million during the first six months of 2002, from $12.3
million in the same period in 2001. This increase is due to the higher net
earned premium and the reduction in ceding commissions as a result of our
retaining more business. The expense ratio improved to 25.7% for the first six
months of 2002 compared to 27.0% for the same period in 2001, as we were able to
increase net earned premium (the denominator) while incurring a smaller increase
in personnel and infrastructure costs.
Net earnings of our insurance companies increased to $33.0 million in the first
six months of 2002 from $20.4 million for the same period in 2001, due to
improved underwriting results. Barring any catastrophic event, we expect this
trend to continue into 2003. Only $1.1 million of the increase was due to the
adoption of SFAS No. 142.
Underwriting Agencies
Management fees increased 32% to $39.0 million for the first six months of 2002,
compared to $29.6 million for the same period in 2001. Subsidiaries acquired in
late 2001 accounted for much of the increase, partially offset by a decrease in
management fees from our other underwriting agencies as we continue the
consolidation of four of our pre-existing underwriting agency operations into
our insurance company operations. Net earnings of our underwriting agencies
increased to $11.7 million for the first six months of 2002 from $8.8 million in
2001 as a result of increased revenue and the adoption of SFAS No. 142. There
was $2.9 million (net of income tax) of goodwill amortization recorded in 2001
that was not recorded in 2002. The subsidiaries acquired in late 2001
contributed $3.2 million to net income during the first six months of 2002 after
absorbing the expense of interest on acquisition debt and corporate allocations.
This contribution was offset by the effect of the above mentioned consolidation.
We expect the increases in revenue and net earnings to continue for at least the
remainder of 2002.
Intermediaries
Commission income decreased to $21.2 million for the first six months of 2002,
compared to $24.8 million for the same period in 2001 due to general market
conditions and less ceded reinsurance being placed on behalf of our insurance
companies as they increased their retentions. Net earnings of our intermediaries
were flat for the first six months of 2002, $4.2 million, but the same period in
the previous year included a net charge of $1.8 million for goodwill
amortization.
25
Other Operations
The decrease in other operating income to $1.9 million during the first six
months of 2002 from $5.5 million for the same period in 2001 resulted
principally from the disposition or closure of certain operations during 2001.
Net earnings of other operations decreased to $0.3 million in 2002 from $0.9
million in 2001 for the same reasons. Period to period comparisons may vary
substantially depending on other operating investments or dispositions thereof
in any given period. Recent investments and future dispositions should have a
positive effect on this segment's revenue and earnings during the second half of
2002.
Corporate
The net income of the corporate segment was $1.3 million for the first six
months of 2002 compared to $0.4 million for the same period in 2001. This
improvement resulted from the reduction of interest expense as a result of lower
interest rates on our outstanding debt and the repayment of our debt under our
bank facility by using the proceeds from the March 2001 public offering of
common stock and part of the proceeds from the August 2001 offering of 2%
convertible notes.
Three months ended June 30, 2002 versus three months ended June 30, 2001
Results of Operations
Total revenue increased 29% to $155.9 million for the second quarter of 2002
from $120.6 million for the same period in 2001. The revenue increase resulted
principally from increased business and greater retention levels in the
insurance company segment. The revenue in the underwriting agency segment also
increased due to two acquisitions made in late 2001, somewhat offset by a
reduced revenue in the other operations segment as a result of the sale or
disposition of various operations in 2001.
Net investment income decreased to $9.5 million for the second quarter of 2002
from $9.9 million for the same period in 2001. This decrease was due to the
decrease in interest rates partially offset by the higher level of invested
assets which resulted from cash flow provided by operating activities and
capital contributions made to our insurance company segment. Although we expect
continuing increases in cash flow from operating activities to increase
investment assets and investment income going forward, investment income is
unlikely to show much comparative growth until interest rates rise.
Compensation expense increased to $19.9 million during the second quarter of
2002 from $16.8 million for the same period in 2001. Much of this increase was
due to agency subsidiaries acquired in late 2001, somewhat offset by a decrease
from operations sold or otherwise disposed of during the same period.
Other operating expense decreased to $11.4 million during the second quarter of
2002 compared to the $13.1 million in 2001. This decrease results principally
from the reduction in the amortization of goodwill, operations sold in late 2001
and general expense savings, partially offset by the effect of acquisitions made
during the same period and an increase in the provision for uncollectible
reinsurance recoverables.
Interest expense was $2.5 million for the second quarter of 2002 compared to
$1.8 million for the same period in 2001. Included in the current period is $1.1
million representing the amortization of underwriting discounts and other costs
of our August 2001 issuance of 2% convertible notes. These costs will be fully
amortized by August 2002.
Income tax expense was $15.1 million for the second quarter of 2002 compared to
$12.1 million for the same period in 2001. Our effective tax rate was 36.1% in
the current period compared to 37.4% in 2001. Most of the reduction in the
effective tax rate is due to the fact that goodwill is not being amortized
during 2002 and was substantially not deductible for income tax purposes in
2001.
26
Net earnings increased 32% to $26.8 million, or $0.43 per diluted share, for the
second quarter of 2002 from $20.3 million, or $0.34 per diluted share, for the
same period in 2001. The increase in net earnings resulted from an improved
underwriting performance by the insurance company segment and from the
non-amortization of goodwill in accordance with SFAS No. 142. Had we adopted
SFAS No. 142 effective January 1, 2001 our net income for the second quarter of
2001 would have increased $2.9 million, or $0.04 per diluted share.
Our book value per share was $13.21 as of June 30, 2002, up from $12.69 as of
March 31, 2002.
SEGMENTS
Insurance Companies
The following tables provide information by line of business (in thousands):
Gross Net Net Net
written written earned loss
premium premium premium ratio
--------------- --------------- --------------- -----------
For the three months ended June 30, 2002:
Group life, accident and health $ 152,863 $ 65,234 $ 64,227 63.0%
Aviation 59,990 29,421 25,571 47.7
Property, marine and energy 42,431 26,110 8,977 37.7
Other specialty lines of business 48,238 13,176 9,921 81.4
--------------- --------------- --------------- -----------
Subtotal 303,522 133,941 108,696 59.0
Discontinued lines of business 2,330 1,449 5,931 61.5
--------------- --------------- --------------- -----------
TOTALS $ 305,852 $ 135,390 $ 114,627 59.1%
=============== =============== ===============
Expense ratio 25.3
-----------
Combined ratio 84.4%
===========
For the three months ended June 30, 2001:
Group life, accident and health $ 169,711 $ 48,426 $ 46,392 64.6%
Aviation 58,323 29,963 21,936 54.6
Property, marine and energy 36,862 10,156 5,158 (2.4)
Other specialty lines of business 4,331 4,349 4,349 56.6
--------------- --------------- --------------- -----------
Subtotal 269,227 92,894 77,835 56.9
Discontinued lines of business 25,267 12,690 5,853 70.4
--------------- --------------- --------------- -----------
TOTALS $ 294,494 $ 105,584 $ 83,688 57.9%
=============== =============== ===============
Expense ratio 25.9
-----------
Combined ratio 83.8%
===========
Gross written premium increased to $305.9 million for the second quarter of 2002
from $294.5 million for the same period in 2001. This increase was 13% before
the reduction due to discontinued lines of business. The net increase resulted
from the following:
o Property, marine and energy business written by the London branch of
Houston Casualty Company increased due to organic growth and premium
rate increases;
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o New specialty liability lines of business including professional
indemnity and directors and officers liability, not previously
written; and
o Gross written premium increases were substantially offset by
reductions in discontinued lines of business and a reduction in the
group life, accident and health segment written premium as a result of
our significantly reducing the writing of accident and health
reinsurance, principally as a result of the lack of catastrophe and
retrocessional protection.
Gross written premium is expected to continue to increase into 2003.
Net written premium for the second quarter of 2002 increased 28% to $135.4
million from $105.6 million for the same period in 2001, as our insurance
companies have increased retentions on the group life, accident and health and
the property, marine and energy segments, in addition to the effect of the
changes in gross premium described above. Net earned premium increased 37% to
$114.6 million for the same reasons. Increases in net written and net earned
premiums were 44% and 40%, respectively, before the reduction in discontinued
lines of business. The increases in net written premium and net earned premium
are expected to continue.
Loss and loss adjustment expense was $67.8 million for the second quarter of
2002 compared to $48.4 million for the same period in 2001. Prior year net
reserve redundancies included in loss and loss adjustment expense approximated
$0.2 million and $4.5 million for the second quarter of 2002 and 2001,
respectively. The redundancies resulted from the settlement of claims for less
than amounts previously reserved which caused the negative loss ratio for the
property, marine and energy line of business for the second quarter of 2001. The
net loss ratio was slightly improved at 59.1% for the second quarter of 2002
from 57.9% for the same period in 2001, but on substantially increased earned
premiums. The gross loss ratio was 51.5% in the second quarter of 2002 compared
to 77.8% for the same period in 2001. In 2002, as a result of further
evaluation, we reduced the gross losses from our September 11 terrorist loss
by $21.5 million which had the effect of reducing the 2002 gross loss
ratio by 8.6%.
Policy acquisition costs, which are net of commissions on reinsurance ceded,
increased to $12.5 million during the second quarter of 2002, from $8.0 million
in the same period in 2001. This increase is due to the higher net earned
premium and the reduction in ceding commissions on business as a result of our
retaining more business. The expense ratio improved slightly to 25.3% for the
second quarter of 2002 compared to 25.9% for the same period in 2001.
Net earnings of our insurance companies increased to $18.1 million in the second
quarter of 2002 from $13.9 million for the same period in 2001, due to improved
underwriting results. Barring any catastrophic event, we expect this trend to
continue into 2003. Only $0.5 million of the increase was due to the adoption
of SFAS No. 142.
Underwriting Agencies
Management fees increased 41% to $19.6 million for the second quarter of 2002,
compared to $13.9 million for the same period in 2001. Subsidiaries acquired in
late 2001 accounted for much of the increase, partially offset by a decrease in
management fees from our other underwriting agencies as we continue the
consolidation of four of our pre-existing underwriting agency operations into
our insurance company operations. Net earnings of our underwriting agencies
increased to $6.2 million in the second quarter of 2002 from $4.5 million in
2001 as a result of increased revenue and the adoption of SFAS No. 142. There
was $1.5 million (net of income tax) of goodwill amortization recorded in 2001
that was not recorded in 2002. The two subsidiaries acquired in late 2001
contributed $1.7 million to net income during the second quarter of 2002 after
absorbing the expense of interest on acquisition debt and corporate allocations.
This contribution was offset by the effect of the above mentioned consolidation.
We expect the increases in revenue and net earnings to continue for at least the
remainder of 2002.
Intermediaries
Commission income increased to $11.1 million for the second quarter of 2002,
compared to $10.2 million for the same period in 2001, despite poor market
conditions and less ceded reinsurance being placed on behalf of our insurance
companies as they increased their retentions. Net earnings of our intermediaries
increased to $2.4 million for the second quarter of 2002 compared to $0.7
million for the same period of 2001 due to increased
28
revenue, the non-amortization of goodwill, plus a change in the mix of business,
which had a higher gross margin during the current quarter.
Other Operations
The decrease in other operating income to $0.5 million during the second quarter
of 2002 from $2.5 million for the same period in 2001 resulted principally from
the disposition or closure of certain operations during 2001. Net earnings of
other operations decreased to $0.2 million in 2002 from $0.4 million in 2001 for
the same reasons. Quarter to quarter comparisons may vary substantially
depending on other operating investments or dispositions thereof in any given
period. Recent investments and future dispositions should have a positive effect
on this segment's revenue and earnings during the second half of 2002.
Liquidity and Capital Resources
We receive substantial cash from premiums, collection of reinsurance
recoverables, management fees and commission income and, to a lesser extent,
investment income and proceeds from sales and redemptions of investments and
other assets. Our principal cash outflows are for the payment of claims and loss
adjustment expenses, payment of premiums to reinsurers, purchase of investments,
debt service, policy acquisition costs, operating expenses, income and other
taxes and dividends. Variations in operating cash flows, which were $46.7
million for the first six months of 2002 compared to $16.5 million for the same
period in 2001, can occur due to timing differences in either the payment of
claims and the collection of related recoverables or the collection of
receivables and the payment of related payable amounts. We limit our liquidity
exposure by holding funds, letters of credit and other security such that net
balances due to us are generally less than the gross balances shown in our
condensed consolidated balance sheets.
We maintain a substantial level of cash and liquid short-term investments which
are used to meet anticipated payment obligations. Our consolidated cash and
investment portfolio increased $79.1 million, or 9%, during 2002 and totaled
$984.5 million as of June 30, 2002, of which $316.9 million was cash and
short-term investments. The increase in investments resulted primarily from the
positive operating cash flows and the capital contribution we made to Houston
Casualty Company.
During April 2002, we drew down $40.0 million on our bank line of credit as
partial funding for a $50.0 million capital contribution to our largest
insurance company, Houston Casualty Company, to support its growth and increased
business opportunities. During June 2002, we repaid $10.0 million on our bank
facility using funds generated from operating cash flows. Because of the
utilization of our bank facility, our debt to total capital ratio increased to
20.3% as of June 30, 2002, compared to 19.2% as of December 31, 2001. As of June
30, 2002, the weighted average interest rate on our bank facility outstanding
debt was 2.8%.
Under the terms of the related indenture agreement, the 2% convertible notes can
be put, or sold back, to us on September 1, 2002 at the option of the note
holders. We have previously announced that we intend to pay cash to the holders
of the convertible notes who exercise their put option. We plan to use available
cash and, if necessary, amounts available under our bank facility to provide the
funding for any such repurchase, should it occur.
We have a reserve of $9.0 million as of June 30, 2002 for potential
collectibility issues related to reinsurance recoverables and associated
expenses. During the first six months of 2002, we increased the reserve for
uncollectible reinsurance by $3.8 million and $1.9 million during the six and
three months, respectfully, ended June 30, 2002. The adverse economic
environment in the worldwide insurance industry and the terrorist attacks on
September 11, 2001 have placed great pressure on reinsurers and the results of
their operations. Ultimately, these conditions could affect reinsurers'
solvency. Historically, there have been insolvencies following a period of
competitive pricing in the industry, such as the marketplace has experienced for
the last several years. While we believe that our overall reserve is adequate
based on currently available information, conditions may change or additional
information might be obtained which may result in a future change in the
reserve. We periodically review our financial exposure to the reinsurance market
and the level of our reserve and continue to take actions in an attempt to
mitigate our risk.
29
The reduction in the gross loss ratio, together with reduction in ceded premium,
is causing the reduction in ceded loss and loss adjustment expense and this is
having a positive effect on our reinsurance recoverable balances. We are also
making payments and collecting recoverables on the two catastrophe losses which
occurred during the third quarter 2001, the terrorist attacks on September 11
and the Total chemical factory near Toulouse, France. We expect this trend to
continue over the next few quarters, barring another catastrophe, despite the
reinsurance additions from our new specialty liability lines of business, which
are more heavily reinsured than most of our other lines of business.
A number of reinsurers have delayed or suspended the payment of amounts
recoverable under certain reinsurance contracts to which we are a party. Such
delays have affected, although not materially to date, the investment income of
our insurance companies, but not to any extent their liquidity. We limit our
liquidity exposure by holding funds, letters of credit or other security such
that net balances due to us are significantly less than the gross balances shown
in our consolidated balance sheets. In some instances, the reinsurers have
withheld payment without reference to a substantive basis for the delay or
suspension. In other cases, the reinsurers have claimed they are not liable for
payment to us of all or part of the amounts due under the applicable reinsurance
agreement. We believe these claims are without merit and expect to collect the
full amounts recoverable. We are currently in negotiations with most of these
parties, but if such negotiations do not result in a satisfactory resolution of
the matters in question, we may seek or be involved in a judicial or arbitral
determination of these matters. In some cases, the final resolution of such
disputes through arbitration or litigation may extend over several years.
In this regard, as of June 30, 2002, our insurance companies had initiated
litigation or arbitration proceedings against six reinsurers and were involved
in one arbitration proceeding initiated by a reinsurer. These proceedings
primarily concern the collection of amounts owing under reinsurance agreements.
As of such date, our insurance companies had an aggregate amount of $19.4
million which had not been paid to us under the agreements and we estimate that
there could be up to an additional $26.4 million of incurred losses and loss
expenses and other balances due under the subject agreements. During the six
months ended June 30, 2002, we negotiated a settlement of one arbitration with a
reinsurer under which the reinsurer agreed to pay the full amount due to our
company, which we estimate to be $13.5 million. In addition, because our
insurance companies, principally Houston Casualty Company, participated in
facilities or pools of companies which were managed by one of our underwriting
agencies, they are indirectly involved in any proceedings involving collections
which affect the applicable facilities or pools of companies. As of June 30,
2002, Houston Casualty Company's allocated portion of these actions was $3.9
million and we estimate that there could be up to an additional $2.7 million of
incurred losses and loss expenses. Neither Houston Casualty Company nor its
affiliated underwriting agency has any net exposure on the portion of the
amounts which are due to the non-affiliated companies who also participated in
the applicable facilities or pools of companies.
We believe that our operating cash flows, short-term investments and bank
facility will provide sufficient sources of liquidity to meet our operating
needs for the foreseeable future.
Effects of Recent Accounting Pronouncements
Statement of Financial Accounting Standards ("SFAS") No. 142 entitled "Goodwill
and Other Intangible Assets" was issued in June, 2001, and became effective for
us on January 1, 2002. SFAS No. 142 requires goodwill to be tested for
impairment at a level referred to as a reporting unit. SFAS No. 142 requires us
to perform the initial goodwill impairment test on all reporting units no later
than June 30, 2002. The first step is to compare the fair value of a reporting
unit with its book value. If the fair value of a reporting unit is less than its
book value, the second step will be to calculate the impairment loss, if any, to
be reported no later than December 31, 2002. Any impairment loss from the
initial adoption of SFAS No. 142 would be a change in accounting principle.
After the initial adoption, goodwill of a reporting unit will be tested for
impairment on an annual basis and between annual tests if an event occurs or
circumstances change that would more likely than not reduce the fair value of a
reporting unit below its carrying amount. SFAS No. 142 also requires the
discontinuance of the amortization of
30
goodwill effective January 1, 2002 and that goodwill recognized for acquisitions
which were consummated after July 1, 2001 not be amortized. During the first six
months of 2002 we determined our reporting units, completed our initial goodwill
impairment testing, completed our first annual impairment testing as of June 30,
2002 and determined we do not have to record an impairment charge. SFAS No. 142
is not expected to have a material effect on our financial position or cash
flows.
Significant Accounting Policies
Other than our adoption of SFAS No. 142 described above, we have made no changes
in our methods of application of our significant accounting policies from the
information provided in our Annual Report on Form 10-K for the year ended
December 31, 2001.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
There have been no material changes in market risk from the information provided
in Item 7A. "Quantitative and Qualitative Disclosures About Market Risk" of our
Annual Report on Form 10-K for the year ended December 31, 2001.
31
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
In addition to the matters discussed in Note (2), Reinsurance, we
are party to numerous lawsuits and other proceedings that arise
in the normal course of our business. Many of these lawsuits and
other proceedings involve claims under policies that we
underwrite as an insurer or reinsurer, the liabilities for which
we believe have been adequately included in our loss reserves.
Also, from time to time, we are party to lawsuits and other
proceedings which relate to disputes over contractual
relationships with third parties, or which involve alleged errors
and omissions on the part of our subsidiaries. We believe the
resolution of any such lawsuit will not have a material adverse
effect on our financial position, results of operations or cash
flows.
Item 4. Submission of Matters to Vote of Security Holders
On May 23, 2002, we held our 2002 Annual Meeting of Shareholders.
At such time the following items were submitted to a vote of
shareholders through the solicitation of proxies:
(a) Election of Directors.
The following persons were elected to serve on the Board of
Directors until the 2003 Annual Meeting of Shareholders or
until their successors have been duly elected and qualified.
The Directors received the votes set forth opposite their
respective names:
NAME FOR VOTES WITHHELD
--------------------- ---------- --------------
Stephen L. Way 43,566,808 12,062,356
Frank J. Bramanti 43,311,458 12,317,706
Marvin P. Bush 55,192,816 436,348
Patrick B. Collins 54,896,198 732,966
James R. Crane 55,197,658 431,506
J. Robert Dickerson 54,896,412 732,752
Edward H. Ellis, Jr. 43,601,958 12,027,206
James C. Flagg, Ph.D. 54,884,078 745,086
Edwin H. Frank, III 55,198,092 431,072
Allan W. Fulkerson 55,198,857 430,307
Walter J. Lack 55,141,652 487,512
(b) Amendment of the 2001 Flexible Incentive Plan.
Shareholders were requested to approve an amendment of the
2001 Flexible Incentive Plan to increase the number of
shares of our common stock for which options and other
awards may be granted from 3.0 million to 5.0 million. The
amendment was approved by the shareholders, who voted
43,074,175 shares in favor, 11,772,182 against and 782,807
abstained.
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Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
99.1 Certification with respect to quarterly report.
(b) Reports on Form 8-K
On May 10, 2002, we reported on Form 8-K our announcement of
financial results for the first quarter of 2002.
On June 26, 2002, we reported on Form 8-K the text materials
used for a presentation at an investor conference.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HCC Insurance Holdings, Inc.
-------------------------------------------------------------
(Registrant)
August 14, 2002 /s/ Stephen L. Way
- ----------------------------- -------------------------------------------------------------
(Date) Stephen L. Way, Chairman of the Board
and Chief Executive Officer
August 14, 2002 /s/ Edward H. Ellis, Jr.
- --------------------------- -------------------------------------------------------------
(Date) Edward H. Ellis, Jr., Executive Vice President and
Chief Financial Officer
33