HCC INSURANCE HOLDINGS INC/DE/ - 10-K Annual Report

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934.
[ ] TRANSACTION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934.

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002

COMMISSION FILE NUMBER 0-20766
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HCC INSURANCE HOLDINGS, INC.
(Exact name of registrant as specified in its charter)

DELAWARE 76-0336636
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)

13403 NORTHWEST FREEWAY, 77040-6094
HOUSTON, TEXAS (Zip Code)
(Address of principal executive offices)

(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
(713) 690-7300

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: NONE

Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 (the "Act") during the preceding 12 months (or for such shorter period that
the Registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [ ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K (sec.229.405 of this chapter) is not contained herein, and
will not be contained, to the best of Registrant's knowledge, in definitive
proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K. [ ]

Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [ ]

The aggregate market value on June 28, 2002 (the last business day of the
Registrant's most recently completed second fiscal quarter), of the voting stock
held by non-affiliates of the Registrant was approximately $1.6 billion. For
purposes of the determination of the above stated amount, only directors and
executive officers are presumed to be affiliates, but neither the Registrant nor
any such person concede that they are affiliates of the Registrant.

The number of shares outstanding of the Registrant's Common Stock, $1.00
par value, as of March 14, 2003 was 62.7 million.

Documents incorporated by reference: Information called for in Part III of
this Form 10-K is incorporated by reference to the Registrant's definitive Proxy
Statement to be filed within 120 days of the close of the Registrant's fiscal
year in connection with the Registrant's annual meeting of shareholders.
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TABLE OF CONTENTS

HCC INSURANCE HOLDINGS, INC.

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

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

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

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PART I

ITEM 1. BUSINESS

TERMINOLOGY

HCC Insurance Holdings, Inc. is a Delaware corporation, which was formed in
1991. Its predecessor corporation was formed in 1974. Our principal executive
offices are located at 13403 Northwest Freeway, Houston, Texas 77040 and our
telephone number is (713) 690-7300. We maintain an Internet web-site at
www.hcch.com. The reference to our Internet web-site address does not constitute
the incorporation by reference of the information contained at this site in this
report. We will make available, free of charge through publication on our
Internet web-site, a copy of our Annual Report on Form 10-K and quarterly
reports on Form 10-Q and any current reports on Form 8-K or amendments to those
reports, filed or furnished to the Securities and Exchange Commission as soon as
reasonably practicable after we have filed or furnished such materials with the
Securities and Exchange Commission.

As used in this report, unless otherwise required by the context, the terms
"we," "us" and "our" refer to HCC Insurance Holdings, Inc. and its consolidated
subsidiaries, and the term "HCC" refers only to HCC Insurance Holdings, Inc. All
trade names or trademarks appearing in this report are the property of their
respective holders.

RISK FACTORS

The following factors as well as other information contained in this report
should be considered.

IF WE CANNOT OBTAIN ADEQUATE REINSURANCE PROTECTION FOR THE RISKS WE HAVE
UNDERWRITTEN, WE WILL EITHER BE EXPOSED TO GREATER LOSSES FROM THESE RISKS OR WE
WILL REDUCE THE LEVEL OF BUSINESS WE UNDERWRITE, WHICH WILL REDUCE OUR REVENUES.

We purchase reinsurance for significant amounts of risk underwritten by our
insurance companies, especially catastrophe risks. We also purchase reinsurance
on risks underwritten by others which we reinsure through a retrocession
agreement. Market conditions beyond our control determine the availability and
cost of the reinsurance protection we purchase, which may affect the level of
our business and profitability. For instance, the natural attrition of
reinsurers who exit lines of business, or who curtail their writings, for
economic or other reasons, reduces the capacity of the reinsurance market,
causing rates to rise. In addition, the historical results of reinsurance
programs and the availability of capital also affect the availability of
reinsurance. Our reinsurance facilities are generally subject to annual renewal.
We cannot assure you that we can maintain our current reinsurance facilities or
that we can obtain other reinsurance facilities in adequate amounts and at
favorable rates. Further, we cannot determine what the effect of catastrophic
losses will have on the reinsurance market in general and on our ability to
obtain reinsurance in adequate amounts and at favorable rates in particular. If
we are unable to renew our expiring facilities or to obtain new reinsurance
facilities, either our net exposures would increase or, if we are unwilling to
bear an increase in net exposures, we would have to reduce the level of our
underwriting commitments, especially catastrophe exposed risks. Either of these
potential developments could have a material adverse effect on our business. The
lack of available reinsurance may also adversely affect our ability to generate
fee and commission income in our underwriting agency and reinsurance
intermediary operations. A reinsurance intermediary structures and arranges
reinsurance between insurers seeking to cede insurance risks and reinsurers
willing to assume such risks.

IF THE COMPANIES THAT PROVIDE OUR REINSURANCE DO NOT PAY ALL OF OUR CLAIMS, WE
COULD INCUR SEVERE LOSSES.

We purchase reinsurance by transferring, or ceding, part of the risk we
have assumed to a reinsurance company in exchange for part of the premium we
receive in connection with the risk. The part of the risk we retain for our own
account is known as the retention. Although reinsurance makes the reinsurer
liable to us to the extent the risk is transferred or ceded to the reinsurer, it
does not relieve us, the reinsured, of our full liability to our policyholders,
never the amount above our retention. Accordingly, we bear credit risk with

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respect to our reinsurers. We cannot assure you that our reinsurers will pay all
of our reinsurance claims, or that they will pay our claims on a timely basis.

If we become liable for risks we have ceded to reinsurers or if our
reinsurers cease to meet their obligations to us, whether because they are in a
weakened position as a result of the incurred losses or otherwise, our financial
position, results of operations and cash flows could be materially adversely
affected.

IF WE ARE UNSUCCESSFUL IN COMPETING AGAINST LARGER OR MORE WELL-ESTABLISHED
BUSINESS RIVALS, OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION WILL BE
ADVERSELY AFFECTED.

In our specialty insurance operations, we compete in narrowly-defined niche
classes of business such as the insurance of private aircraft (aviation), and
employer sponsored, self-insured medical plans (medical stop-loss), as
distinguished from such general lines of business as automobile or homeowners
insurance. We compete with a large number of other companies in our selected
lines of business, including: American International Group and U.S. Aviation
Insurance Group (a subsidiary of Berkshire Hathaway, Inc.) in our aviation line
of business; SAFECO Corporation and Hartford Life, Inc. in our group life,
accident and health line of business; Underwriters at Lloyd's and ACE Limited in
our London market account line of business and The Chubb Corporation and
Travelers Property Casualty Corp. in our global financial products line of
business. We face competition both from specialty insurance companies,
underwriting agencies and intermediaries as well as from diversified financial
services companies that are significantly larger than we are and that have
significantly greater financial, marketing and other resources than we do. Some
of these competitors also have longer experience and more market recognition
than we do. In addition to competition in the operation of our business, we face
competition from a variety of sources in attracting and retaining qualified
employees.

We cannot assure you that we will maintain our current competitive position
in the markets in which we operate, or that we will be able to expand our
operations into new markets. If we fail to do so, our business could be
materially adversely affected.

BECAUSE WE ARE A PROPERTY AND CASUALTY INSURER, UNFORESEEN CATASTROPHIC LOSSES
MAY ADVERSELY AFFECT OUR RESULTS OF OPERATIONS, LIQUIDITY AND FINANCIAL
CONDITION.

Property and casualty insurers are subject to claims arising out of
catastrophes that may have a significant effect on their results of operations,
liquidity and financial condition. Catastrophic losses have had a significant
impact on our results. Catastrophes can be caused by various events, including
hurricanes, windstorms, earthquakes, hailstorms, explosions, severe winter
weather and fires and may include man-made events, such as the September 11,
2001 terrorist attack on the World Trade Center. The incidence, frequency and
severity of catastrophes are inherently unpredictable. The extent of losses from
a catastrophe is a function of both the total amount of insured exposure in the
area affected by the event and the severity of the event. Most catastrophes are
restricted to small geographic areas; however, hurricanes, earthquakes and
terrorist attacks may produce significant damage in large, heavily populated
areas. Catastrophes can cause losses in a variety of our property and casualty
lines, and most of our past catastrophe-related claims have resulted from
hurricanes and earthquakes; however, as a result of the September 11, 2001
terrorist attack, we experienced the largest single loss to our insurance
company operations in our history. Insurance companies are not permitted to
reserve for a catastrophe until it has occurred. In 2003, we estimate that
approximately 10% of our current business may be affected by catastrophes. It is
therefore possible that a catastrophic event or multiple catastrophic events
could have material adverse effect upon our results of operations, liquidity and
financial condition.

BECAUSE WE OPERATE INTERNATIONALLY, FLUCTUATIONS IN CURRENCY EXCHANGE RATES MAY
AFFECT OUR RECEIVABLE AND PAYABLE BALANCES AND OUR RESERVES, WHICH MAY ADVERSELY
AFFECT OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION.

We underwrite insurance coverages which are denominated in a number of
foreign currencies, and we establish and maintain our loss reserves with respect
to these policies in their respective currencies. Our net earnings could be
adversely affected by exchange rate fluctuations, which would adversely affect
receivable and payable balances and reserves. Our principal area of exposure
relates to fluctuations in exchange rates
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between the major European currencies (particularly the British pound sterling
and the Euro) and the U.S. dollar. Consequently, a change in the exchange rate
between the U.S. dollar and the British pound sterling or the Euro could have an
adverse effect on our net earnings.

On a limited basis, we enter into foreign currency forward contracts as a
hedge against foreign currency fluctuations. The foreign currency forward
contracts are used to convert U.S. dollars at a known rate in an amount that
approximates or is less than monthly British pound sterling expenses of certain
of our London operations. Thus, the effect of these transactions is to limit the
foreign currency exchange risk of the recurring monthly expenses. We use these
foreign currency forward contracts strictly as a cash flow hedge against
existing exposure to foreign currency fluctuations rather than as a form of
speculative or trading investment.

IF WE FAIL TO COMPLY WITH EXTENSIVE STATE, FEDERAL AND FOREIGN REGULATIONS, WE
WILL BE SUBJECT TO PENALTIES, WHICH MAY INCLUDE FINES AND SUSPENSION AND WHICH
MAY ADVERSELY AFFECT OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION.

We are subject to extensive governmental regulation and supervision. Most
insurance regulations are designed to protect the interests of policyholders
rather than shareholders and other investors. This regulation, generally
administered by a department of insurance in each state in which we do business,
relates to, among other things:

- approval of policy forms and premium rates;

- standards of solvency, including risk-based capital measurements (which
are a measure developed by the National Association of Insurance
Commissioners and used by state insurance regulators to identify
insurance companies that potentially are inadequately capitalized);

- licensing of insurers and their agents;

- restrictions on the nature, quality and concentration of investments;

- restrictions on the ability of our insurance companies to pay dividends
to us;

- restrictions on transactions between insurance companies and their
affiliates;

- restrictions on the size of risks insurable under a single policy;

- requiring deposits for the benefit of policyholders;

- requiring certain methods of accounting;

- periodic examinations of our operations and finances;

- prescribing the form and content of records of financial condition
required to be filed; and

- requiring reserves for unearned premium, losses and other purposes.

State insurance departments also conduct periodic examinations of the
affairs of insurance companies and require the filing of annual and other
reports relating to the financial condition of insurance companies, holding
company issues and other matters.

Recently adopted federal financial services modernization legislation is
expected to lead to additional federal regulation of the insurance industry in
the coming years. Also, foreign governments regulate our international
operations. Our business depends on compliance with applicable laws and
regulations and our ability to maintain valid licenses and approvals for our
operations.

Some regulatory authorities have relatively broad discretion to grant,
renew, or revoke licenses and approvals. Regulatory authorities may deny or
revoke licenses for various reasons, including the violation of regulations. In
some instances, we follow practices based on our interpretations of regulations,
or those that we believe to be generally followed by the industry, which may be
different from the requirements or interpretations of regulatory authorities. If
we do not have the requisite licenses and approvals and do not comply with
applicable regulatory requirements, the insurance regulatory authorities could
preclude or temporarily suspend us from carrying on some or all of our
activities or otherwise penalize us. That type of
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action could have a material adverse effect on our business. Also, changes in
the level of regulation of the insurance industry (whether federal, state or
foreign), or changes in laws or regulations themselves or interpretations by
regulatory authorities, could have a material adverse effect on our business.

IF THE RATING AGENCIES DOWNGRADE OUR COMPANY OR OUR INSURANCE COMPANIES, OUR
RESULTS OF OPERATIONS AND COMPETITIVE POSITION IN THE INDUSTRY MAY SUFFER.

Ratings have become an increasingly important factor in establishing the
competitive position of insurance companies. Our insurance companies are rated
by A.M. Best Company, Inc. and Standard & Poor's Corporation. A.M. Best Company,
Inc. and Standard & Poor's Corporation ratings reflect their opinions of an
insurance company's and insurance holding company's financial strength,
operating performance, strategic position, and ability to meet its obligations
to policyholders, and are not evaluations directed to investors. Our ratings are
subject to periodic review by A.M. Best Company, Inc. and Standard & Poor's
Corporation and the continued retention of those ratings cannot be assured. If
our ratings are reduced from their current levels by A.M. Best Company, Inc.
and/or Standard & Poor's Corporation, our results of operations could be
adversely affected.

OUR LOSS RESERVES ARE BASED ON AN ESTIMATE OF OUR FUTURE LIABILITY. IF ACTUAL
CLAIMS PROVE TO BE GREATER THAN OUR RESERVES, OUR RESULTS OF OPERATIONS AND
FINANCIAL CONDITION MAY BE ADVERSELY AFFECTED.

We maintain loss reserves to cover our estimated liability for unpaid
losses and loss adjustment expenses, including legal and other fees as well as a
portion of our general expenses, for reported and unreported claims incurred as
of the end of each accounting period. Reserves do not represent an exact
calculation of liability. Rather, reserves represent an estimate of what we
expect the ultimate settlement and administration of claims will cost. These
estimates, which generally involve actuarial projections, are based on our
assessment of facts and circumstances then known, as well as estimates of future
trends in claims severity, frequency, judicial theories of liability and other
factors. These variables are affected by both internal and external events, such
as changes in claims handling procedures, inflation, judicial trends and
legislative changes. Many of these items are not directly quantifiable in
advance. Additionally, there may be a significant reporting lag between the
occurrence of the insured event and the time it is reported to us. The inherent
uncertainties of estimating reserves are greater for certain types of
liabilities, particularly those in which the various considerations affecting
the type of claim are subject to change and in which long periods of time may
elapse before a definitive determination of liability is made. Reserve estimates
are continually refined in a regular and ongoing process as experience develops
and further claims are reported and settled. Adjustments to reserves are
reflected in the results of the periods in which such estimates are changed.
Because setting reserves is inherently uncertain, there can be no assurance that
current reserves will prove adequate in light of subsequent events.

WE INVEST A SIGNIFICANT AMOUNT OF OUR ASSETS IN FIXED INCOME SECURITIES THAT
HAVE EXPERIENCED MARKET FLUCTUATIONS. FLUCTUATIONS IN THE FAIR MARKET VALUE OF
FIXED INCOME SECURITIES MAY GREATLY REDUCE THE VALUE OF OUR INVESTMENT
PORTFOLIO, AND AS A RESULT, OUR FINANCIAL CONDITION MAY SUFFER.

As of December 31, 2002, $841.5 million of our $1.2 billion investment
portfolio was invested in fixed income securities. The fair market value of
these fixed income securities and the related investment income fluctuate
depending on general economic and market conditions. With respect to our
investments in fixed income securities, the fair market value of these
investments generally increases or decreases in an inverse relationship with
fluctuations in interest rates, while net investment income realized by us from
future investments in fixed income securities will generally increase or
decrease with interest rates. In addition, actual net investment income and/or
cash flows from investments that carry prepayment risk (such as mortgage-backed
and other asset-backed securities) may differ from those anticipated at the time
of investment as a result of interest rate fluctuations. An investment has
prepayment risk when there is a risk that the timing of cash flows that result
from the repayment of principal might occur earlier than anticipated because of
declining interest rates or later than anticipated because of rising interest
rates. Although we maintain an investment grade portfolio (96% are rated "A" or
better), our fixed income securities are also subject to credit risk. If any of
the issuers of our fixed income securities suffer financial set backs, the
ratings on the fixed income securities could fall (with a concurrent fall in
market value) and, in a worst case scenario, the issuer
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could default on its financial obligations. Historically, the impact of market
fluctuations has affected our financial statements. Because all of our fixed
income securities are classified as available for sale, changes in the fair
market value of our securities are reflected in our other comprehensive income.
Similar treatment is not available for liabilities. Therefore, interest rate
fluctuations could adversely affect our shareholders' equity, total
comprehensive income and/or our cash flows. Unrealized pre-tax net investment
gains on investments in fixed-income securities were $22.0 million, $0.7 million
and $11.9 million for the years ended December 31, 2002, 2001 and 2000,
respectively.

IF STATES DRASTICALLY INCREASE THE ASSESSMENT OUR INSURANCE COMPANIES ARE
REQUIRED TO PAY, OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION WILL SUFFER.

Our insurance companies are subject to assessments in most states where we
are licensed for the provision of funds necessary for the settlement of covered
claims under certain policies provided by impaired, insolvent or failed
insurance companies or for the issuance of insurance policies to "high risk" or
otherwise uninsured individuals. Maximum contributions required by law in any
one year vary by state and have historically been between 1% and 2% of annual
premiums written. We cannot predict with certainty the amount of future
assessments. Significant assessments could have a material adverse effect on our
financial condition or results of operations.

IF WE ARE UNABLE TO OBTAIN DIVIDENDS IN NEEDED AMOUNTS FROM OUR INSURANCE
COMPANIES AS A RESULT OF REGULATORY RESTRICTIONS, WE MAY NOT BE ABLE TO MEET OUR
DEBT, DIVIDEND, AND EXPENSE OBLIGATIONS.

Our principal assets are the shares of capital stock of our insurance
companies. We may rely on dividends from our insurance companies to meet our
obligations for paying principal and interest on outstanding debt obligations,
dividends to shareholders and corporate expenses. The payment of dividends by
our insurance companies is subject to regulatory restrictions and will depend on
the surplus and future earnings of these subsidiaries, as well as the regulatory
restrictions. As a result, should our other sources of funds prove to be
inadequate, we may not be able to receive dividends from our insurance companies
at times and in amounts necessary to meet our obligations.

BUSINESS OVERVIEW

We provide group life, accident and health and property and casualty
insurance coverages, underwriting agency and intermediary services both to
commercial customers and individuals. We concentrate our activities in selected
narrowly defined specialty lines of business. We operate primarily in the United
States, the United Kingdom and Spain, although some of our operations have a
broader international scope. We underwrite insurance both on a direct basis,
where we insure a risk in exchange for a premium, and on a reinsurance basis,
where we insure all or a portion of another insurance company's risk in exchange
for all or a portion of the premium. We market our insurance products both
directly to customers and through a network of independent or affiliated agents
and brokers.

Since our founding, we have been consistently profitable, generally
reporting annual increases in gross written premium and total revenue. During
the period 1998 through 2001, we had an average statutory combined ratio of
103.2% versus the less favorable 109.8% (source: A.M. Best Company, Inc.)
recorded by the U.S. property and casualty insurance industry overall. During
the period 1998 through 2002, our gross written premium increased from $498.3
million to $1.2 billion, an increase of 133% while net written premium increased
348% from $121.9 million to $545.9 million. During this period, our revenue
increased from $310.4 million to $669.4 million, an increase of 116%.

During the period December 31, 1998 through December 31, 2002, our
shareholders' equity increased from $440.4 million to $882.9 million, a 100%
increase. During the same period, our assets increased from $1.7 billion to $3.7
billion, a 117% increase.

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Our insurance companies are risk-bearing and focus their underwriting
activities on providing insurance and/or reinsurance in the following lines of
business:

- group life, accident and health

- aviation

- London market account

- global financial products

- other specialty lines

In the United States, Avemco Insurance Company, U.S. Specialty Insurance
Company and HCC Life Insurance Company operate on an admitted, or licensed,
basis. Houston Casualty Company and HCC Specialty Insurance Company operate on a
surplus lines basis as a non-admitted, or unlicensed, insurer offering insurance
coverage not otherwise available from an admitted insurer in the relevant state.
Houston Casualty Company operates a registered branch office in London and
offers insurance in the United Kingdom and selected other countries. Houston
Casualty Company Europe Seguros y Reaseguros S.A., which does business as HCC
Europe, operates from its Madrid, Spain offices and offers insurance throughout
the European Union and in selected other countries.

Our operating insurance companies are rated "A+ (Superior)" (2nd of 16
ratings) by A.M. Best Company , Inc. and "AA (Very Strong)" (3rd of 22 ratings)
by Standard and Poor's Corporation, two nationally recognized independent rating
agencies. These ratings are intended to provide an independent opinion of an
insurer's ability to meet its obligations to policyholders and are not
evaluations directed at investors.

Our underwriting agencies underwrite on behalf of our insurance companies
and other insurance companies. They receive fees for these services and do not
bear any of the insurance risk of the companies for which they underwrite. Our
underwriting agencies generate revenues based entirely on management fees and
profit commissions and specialize in life, accident and health, contingency
(including contest indemnification, event cancellation, and weather coverages),
directors and officers liability, individual disability (for athletes and other
high profile individuals), kidnap and ransom, professional liability and other
specialty lines of business. Our principal underwriting agencies are ASU
International, LLC, Dickson Manchester & Company Limited, HCC Benefits
Corporation, HCC Global Financial Products and Professional Indemnity Agency,
Inc.

Our intermediaries provide insurance and reinsurance brokerage services for
our insurance companies and our clients, and receive fees for their services.
Our intermediaries do not bear any of the insurance risks of their client
companies. They earn commission income and to a lesser extent fees for certain
services, generally paid by the insurance and reinsurance companies with whom
the business is placed. These operations consist of consulting with clients by
providing information about insurance coverage and marketing, placing and
negotiating particular insurance risks.

Our intermediaries specialize in developing and marketing employee benefit
plans on a retail basis and in placing reinsurance for life, accident and
health, and property and casualty lines of business. Our principal
intermediaries are HCC Employee Benefits, Inc., HCC Risk Management, Inc. and
Rattner Mackenzie Limited.

OUR STRATEGY

Our business philosophy as an insurer is to maximize underwriting profits
while limiting risk in order to preserve shareholders' equity and maximize
earnings. We concentrate our insurance writings in selected, narrowly defined
lines of business where we believe we can achieve an underwriting profit. We
market our insurance products both directly to customers and through independent
or affiliated agents and brokers.

The property and casualty insurance industry and individual lines of
business within the industry are cyclical in that there are times when a large
number of companies offer insurance on certain lines of business,
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causing premiums to trend downward, and other times where insurance companies
decide to limit their writings in certain lines of business or suffer from
excessive losses, which results in an increase in premiums for those companies
that continue to write insurance in those lines of business. In our insurance
company operations, we believe our operational flexibility, which permits us to
shift the focus of our insurance underwriting activity amongst our various lines
of business and also to shift the emphasis from our insurance risk-bearing
business to our non-insurance fee-based business, as well as our experienced
underwriting personnel and access to, and expertise in, the reinsurance
marketplace allow us to implement a strategy of emphasizing more profitable
lines of business during periods of increased premium rates and de-emphasizing
less profitable lines of business during periods of severe competition. In
addition, we believe that our underwriting agencies and intermediaries
complement our insurance underwriting activities. Our ability to utilize
affiliated insurers, underwriting agencies and intermediaries permits us to
retain a greater portion of the gross revenue derived from written premium.

Reinsurance enables us to transfer part of the risk we have underwritten
through the process of ceding this risk to a reinsurance company in exchange for
part of the premium we receive in connection with the risk. We purchase
reinsurance to limit the net loss to our insurance companies from both
individual and catastrophic risks. The amount of reinsurance we purchase varies
by, among other things, the particular risks inherent in the policies
underwritten, the pricing of reinsurance and the competitive conditions within
the relevant line of business.

In 2002, due to a continuing hardening of the insurance market, premium
rates increased in varying amounts across all of our lines of business,
substantially improving our underwriting profitability. We anticipate continued
underwriting profitability during 2003. In response to these changing market
conditions, we plan to continue to expand the underwriting activities in our
insurance company operations.

We also acquire or make strategic investments in companies that present an
opportunity for future profits or for enhancement of our business. We expect to
continue to acquire complementary businesses. We believe that we can enhance
acquired businesses through the synergies created by our underwriting
capabilities and our other operations. However, our business plan is shaped by
our underlying business philosophy, which is to maximize underwriting profit,
while preserving shareholders' equity. As a result, our primary objective is to
increase net earnings rather than market share or gross written premium.

In our ongoing operations, we will continue to:

- emphasize the underwriting of lines of business in which premium rates,
the availability and cost of reinsurance, and market conditions warrant;

- limit our net loss exposure to our insurance companies from a catastrophe
loss through the use of reinsurance; and

- review the potential acquisition of specialty insurance operations and
other strategic investments.

INDUSTRY SEGMENT INFORMATION

Financial information concerning our operations by industry segment is set
forth in the Consolidated Financial Statements and the Notes thereto.

RECENT ACQUISITIONS

We have made a series of strategic acquisitions that have furthered our
overall business strategy. Our recent transactions are described below:

On October 22, 2001, we acquired all of the outstanding shares of Marshall
Rattner, Inc. Marshall Rattner, Inc. is a holding company for Professional
Indemnity Agency, Inc. and its related companies. We paid $63.0 million in cash
and 300,000 shares of our common stock for the Marshall Rattner, Inc./
Professional Indemnity Agency, Inc. acquisition. Professional Indemnity Agency,
Inc. is an underwriting agency specializing in the errors and omissions, kidnap
and ransom and professional liability areas.

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On October 30, 2001, we acquired all of the outstanding shares of ASU
International, Inc. and the membership interests in its affiliate, ASU
International, LLC. We paid $29.2 million for the ASU International, LLC
acquisition. ASU International, LLC is an underwriting agency specializing in
contingency and disability insurance. We may pay additional amounts in the
future based upon the attainment of certain earnings benchmarks through December
31, 2004.

On October 1, 2002, we acquired all of the outstanding member interests of
MAG Global Financial Products, LLC. We paid $6.9 million for the MAG Global
Financial Products, LLC acquisition. MAG Global Financial Products, LLC is an
underwriting agency specializing in directors and officers liability,
professional liability and errors and omissions insurance. MAG Global Financial
Products, LLC has been renamed HCC Global Financial Products, LLC. We may pay
additional amounts in the future based upon the attainment of certain earnings
benchmarks through September, 2007.

On December 24, 2002, we acquired all of the outstanding shares of
Manchester Dickson Holdings Limited, the parent Company of Dickson Manchester &
Company Limited. We paid $17.0 million for the Dickson Manchester & Company
Limited acquisition. Dickson Manchester & Company Limited is an underwriting
agency and Lloyd's broker specializing in U.K. professional liability products.
We may pay additional amounts in the future based upon the attainment of certain
earnings benchmarks through December 31, 2005.

On December 31, 2002, we acquired all of the outstanding shares of St. Paul
Holdings Limited. St. Paul Holdings Limited is a holding company for St. Paul
Espana Compania de Seguros y Reaseguros S.A., a Spanish insurer. We paid $18.9
million for the St. Paul acquisition, subject to adjustment based upon the
finalization of the closing date balance sheet. St. Paul Espana writes foreign
surety, directors and officers liability and professional liability insurance in
Spain and other countries in the European Union. St. Paul Espana now operates as
HCC Europe.

We continue to evaluate possible acquisition candidates and we may complete
additional acquisitions during 2003. Any future acquisitions will be designed to
expand and strengthen our existing lines of business and perhaps provide access
to additional specialty sectors, which we expect to contribute to our overall
growth.

9

INSURANCE COMPANY OPERATIONS

LINES OF BUSINESS

This table shows our insurance companies' total premium written, otherwise
known as gross written premium, by line of business and the percentage of each
line to total gross written premium for the years indicated (dollars in
thousands):

This table shows our insurance companies' actual premium retained,
otherwise known as net written premium, by line of business and the percentage
of each line to total net written premium for the years indicated (dollars in
thousands):

UNDERWRITING

We underwrite direct business produced through independent agents and
brokers, affiliated intermediaries, and by direct marketing efforts. Our
insurance companies write facultative, or individual account, reinsurance, as
well as a treaty reinsurance business.

GROUP LIFE, ACCIDENT AND HEALTH

We write medical stop-loss business for employer-sponsored, self-insured
health plans. Our medical stop-loss insurance provides coverages to companies,
associations and public entities that elect to self-insure their employee's
medical coverage for losses within specified levels, allowing them to manage the
risk of excessive health insurance exposure by limiting aggregate and specific
losses to a predetermined amount. We also underwrite a small program of group
life insurance offered to our insureds as complement to our medical stop-loss
products. Our underwriting agency, HCC Benefits Corporation, produces and
underwrites this business on behalf of our insurance companies. We first began
writing this business in our insurance companies in 1997 and gross written
premium and net written premium have increased as a result of greater
participation by our insurance companies, primarily HCC Life Insurance Company
and Avemco Insurance Company. In 1999, we acquired The Centris Group, Inc.,
doubling our gross written premium to approximately $400.0 million. HCC Benefits
Corporation began underwriting this business in 1980 and has grown both
internally and through acquisitions during the past five years. We maintain
reinsurance on a proportional basis, where we share a

10

proportional part of the original premium and losses with reinsurers, and
believe that these risks carry a relatively low level of catastrophe exposure.

We began writing alternative workers' compensation and occupational
accident insurance in 1996. We transfer liability, premium and loss with respect
to this business on a non-proportional basis above our net retention to
reinsurers. The business is currently written through U.S. Specialty Insurance
Company. We maintain specific reinsurance on an excess of loss basis and we
believe there is a relatively low level of catastrophe exposure in this
business.

AVIATION

We are a market leader in the aviation insurance industry. We insure
general aviation risks, both domestically and internationally, including:

- antique and vintage military aircraft

- cargo operations

- commuter airlines

- corporate aircraft

- fixed base operations

- military and law enforcement aircraft

- private aircraft owners and pilots

- rotor wing aircraft

We offer coverages that include hulls, engines, avionics and other systems,
liabilities, war, cargo and other ancillary coverages. At this time, we do not
generally insure major airlines, major manufacturers or satellites. Insurance
claims related to general aviation business tend to be seasonal, with the
majority of the claims being incurred during the spring and summer months.

We have been underwriting aviation risks through Houston Casualty Company
since 1981 and in 1997 purchased Avemco Insurance Company, one of the largest
writers of personal aircraft insurance in the United States. Avemco Insurance
Company has been insuring aviation risks since 1959. Our aviation premium has
remained relatively stable since 1998, during which time it returned to
underwriting profitability. Our aviation gross written premium for 2002 was
$212.5 million.

We maintain reinsurance on both a proportional and excess of loss basis and
believe that the aviation risks we underwrite carry a relatively low level of
catastrophe exposures.

LONDON MARKET ACCOUNT

Our London market account business consists of marine, energy, property and
accident and health business and is underwritten by Houston Casualty Company's
London branch office.

We underwrite marine risks for oceangoing vessels as well as inland,
coastal trading and fishing vessels. The marine risks we write include hull,
liabilities and marine cargo.

We have underwritten marine risks on both a direct and reinsurance basis
since 1984, and currently write a relatively small book of business due to the
competitive state of the market. In 2002, our gross written premium was $8.8
million.

We have been underwriting energy risks since 1988, which include:

- drilling rigs

- natural gas facilities

- petrochemical plants

- pipelines

- gas production and gathering platforms

- refineries

We underwrite physical damage, liabilities and business interruption.

Rates have been relatively low during the past few years at levels where
underwriting profitability has been difficult to obtain. As a result, we have
underwritten offshore energy risks on a very selective basis, striving for
quality rather than quantity. During 2001 and 2002 we have seen rate increases
that are encouraging and we expect this trend to continue in 2003. In 2002,
gross written premium was $68.3 million.
11

We underwrite property business specializing in risks of large, often
multinational, corporations, covering a variety of commercial risks including:

- factories

- hotels

- industrial plants

- office buildings

- retail locations

- utilities

The insurance we offer includes business interruption, physical damage and
catastrophe risks including flood and earthquake.

We have written property business since 1986, and due to severe
competition, our gross written premium declined to $45.0 million in 2001 and
$40.8 million in 2002.

We began writing London market accident and health risks in 1996 including:
trip accident, medical and disability and have steadily increased premiums. Our
gross written premium was $81.9 million in 2002.

Our London market account business is reinsured both proportionally and on
an excess of loss basis where we transfer liability, premium and loss on a
non-proportional basis, for individual and catastrophe risks, above our net
retention of risk to reinsurers. Catastrophe exposure is more concentrated in
our energy and property lines of business.

GLOBAL FINANCIAL PRODUCTS

We underwrite a variety of financial insurance risks in our global
financial products line of business. These risks include:

- directors and officers liability

- employment practices liability

- errors and omissions

- surety

We began to underwrite this line of business with our acquisition of
Professional Indemnity Agency, Inc. in October, 2001 and have substantially
increased our level of business in this area through our October, 2002
acquisition of HCC Global Financial Products, LLC and December, 2002
acquisitions of Dickson Manchester & Company Limited and HCC Europe. Each of the
acquired entities has substantial experience in their respective specialty
within this line of business.

In 2002, we experienced substantial rate increases throughout this line of
business generally caused by high profile corporate governance issues in U.S.
public companies. Gross written premium rose dramatically to $178.6 million
compared to $46 thousand in 2001. We maintain reinsurance on our global
financial products line of business on both a proportional and excess of loss
basis. Although individual losses have potential severity, there is a relatively
low risk of catastrophe exposure.

OTHER SPECIALTY LINES

In addition to the above, we underwrite various other specialty lines of
business, of which individual premiums by line of business are not at this time
significant to our overall results of operations.

PRINCIPAL INSURANCE COMPANIES

Our operating insurance companies are rated "A+ (Superior)" (2nd of 16
ratings) by A.M. Best Company , Inc. and "AA (Very Strong)" (3rd of 22 ratings)
by Standard and Poor's Corporation, two nationally recognized independent rating
agencies. These ratings are intended to provide an independent opinion of an
insurer's ability to meet its obligations to policyholders and are not
evaluations directed at investors.

12

HOUSTON CASUALTY COMPANY

Houston Casualty Company is our principal insurance company subsidiary.
Houston Casualty Company operates worldwide and is domiciled and licensed in
Texas and operates on a surplus lines basis in 49 states. Houston Casualty
Company receives business through independent agents and brokers, our
underwriting agencies and intermediaries, and other insurance and reinsurance
companies. Houston Casualty Company writes aviation, London market account,
global financial products and other specialty lines business. Houston Casualty
Company's 2002 gross written premium was $490.2 million.

HOUSTON CASUALTY COMPANY -- LONDON

Houston Casualty Company operates a full branch office in the United
Kingdom. Houston Casualty Company established its London branch operation in
order to more closely align its underwriting operations with the London market,
a historical focal point for much of the business that Houston Casualty Company
underwrites. Houston Casualty Company-London underwrites global financial
products and London market account business.

HCC LIFE INSURANCE COMPANY

HCC Life Insurance Company is an Indiana-domiciled life insurance company
and a subsidiary of Houston Casualty Company. It operates as a group life,
accident and health insurer on an admitted basis in 41 states and the District
of Columbia. HCC Life Insurance Company is an issuing carrier for HCC Benefits
Corporation. HCC Life Insurance Company's gross written premium in 2002 was
$326.1 million.

U.S. SPECIALTY INSURANCE COMPANY

U.S. Specialty Insurance Company is a Texas-domiciled property and casualty
insurance company. It is a direct subsidiary of Houston Casualty Company. U.S.
Specialty Insurance Company operates on an admitted basis throughout the United
States, primarily writing aviation, group life, accident and health and global
financial products business. U.S. Specialty Insurance Company acts as an issuing
carrier for certain business underwritten by our underwriting agencies. U.S.
Specialty Insurance Company's gross written premium in 2002 was $143.9 million.

AVEMCO INSURANCE COMPANY

Avemco Insurance Company is a Maryland-domiciled property and casualty
insurer, and is operating as a direct market underwriter of aviation business on
an admitted basis throughout the United States. Avemco Insurance Company is also
an issuing carrier for group life, accident and health business underwritten by
our underwriting agencies and an unaffiliated underwriting agency. Avemco
Insurance Company's gross written premium in 2002 was $203.1 million.

HCC SPECIALTY INSURANCE COMPANY

HCC Specialty Insurance Company is an Oklahoma domiciled company. HCC
Specialty Insurance Company operates on a surplus lines basis in Texas and
writes global financial products and other specialty lines business produced by
our underwriting agencies. HCC Specialty Insurance Company's gross written
premium in 2002 was $1.7 million.

HCC EUROPE

HCC Europe was acquired on December 31, 2002. HCC Europe is a Spanish
insurer and underwrites global financial products business throughout the
European Union and in selected other countries. We also intend to utilize HCC
Europe as an issuing carrier for the business produced by our underwriting
agencies.

13

UNDERWRITING AGENCY OPERATIONS

Our underwriting agencies act on behalf of affiliated and non-affiliated
insurance companies and provide insurance underwriting management and claims
administration services. Our underwriting agencies do not assume any insurance
or reinsurance risk themselves and generate revenues based entirely on
management fees and profit commissions. These subsidiaries are in a position to
direct and control business that they produce. Our insurance companies serve as
policy issuing companies for the majority of the business written by our
underwriting agencies. In instances where our insurance companies are not the
policy issuing company, our insurance companies may reinsure the business
written by the underwriting agencies. Management fees generated by our
underwriting agencies in 2002 amounted to $77.1 million.

LINES OF BUSINESS

This table shows our underwriting agencies' revenue by line of business for
the years indicated (dollars in thousands):

HCC BENEFITS CORPORATION

HCC Benefits Corporation has its home office in Atlanta, Georgia and
regional offices in Costa Mesa, California; Wakefield, Massachusetts;
Minneapolis, Minnesota; and Dallas, Texas. HCC Benefits Corporation underwrites
group life, accident and health business on behalf of affiliated insurance
companies.

PROFESSIONAL INDEMNITY AGENCY, INC.

We acquired Professional Indemnity Agency, Inc. in October, 2001.
Professional Indemnity Agency, Inc., with its home office in Mount Kisco, New
York and a branch office in San Francisco, California, acts as an underwriting
manager for global financial products business on behalf of affiliated and
unaffiliated insurance companies.

ASU INTERNATIONAL, LLC

We acquired ASU International, LLC in October, 2001. ASU International,
LLC, with its home office in Woburn, Massachusetts and a branch office in
London, England acts as an underwriting manager for group life, accident and
health and other specialty lines of business on behalf of affiliated and
unaffiliated insurance companies.

HCC GLOBAL FINANCIAL PRODUCTS, LLC

We acquired HCC Global Financial Products, LLC in October, 2002. HCC Global
Financial Products, LLC was formerly known as MAG Global Financial Products, LLC
and has offices in Farmington, Connecticut, Houston, Texas, Jersey City, New
Jersey, Barcelona, Spain and London, England. HCC Global Financial Products, LLC
acts as an underwriting manager for global financial products business on behalf
of affiliated insurance companies.

DICKSON MANCHESTER & COMPANY LIMITED

We acquired Dickson Manchester & Company Limited in December, 2002. Dickson
Manchester & Company Limited is an underwriting agency and Lloyd's broker based
in London, England and underwrites global financial products business on behalf
of affiliated and unaffiliated insurance companies.

14

INTERMEDIARY OPERATIONS

Our intermediaries provide a variety of services, including marketing,
placing, consulting on and servicing insurance risks for their clients, which
include medium to large corporations, unaffiliated and affiliated insurance and
reinsurance companies and other risk taking entities. The intermediaries earn
commission income and to a lesser extent fees for certain services, generally
paid by the underwriters with whom the business is placed. Some of these risks
may be initially underwritten by our insurance companies, which may retain a
portion of the risk. Commission income generated by our intermediaries in 2002
amounted to $41.6 million.

This table shows our intermediaries' revenue by line of business for the
years indicated (dollars in thousands):

RATTNER MACKENZIE LIMITED

Rattner Mackenzie Limited is an intermediary based in London, England with
other operations in Bermuda. Rattner Mackenzie Limited is a Lloyd's broker
specializing in group life, accident and health reinsurance and some specialty
property and casualty lines of business. Rattner Mackenzie Limited is considered
a market leader in its core businesses. Rattner Mackenzie Limited serves as an
intermediary for reinsurance business placed by unaffiliated and affiliated
insurance companies and reinsurance companies and underwriting agencies.

HCC EMPLOYEE BENEFITS, INC.

HCC Employee Benefits, Inc., with operations in Houston, Texas and Atlanta,
Georgia, is a retail insurance agency and consulting firm specializing in group
life, accident and health insurance for employee benefit plans of medium and
large commercial customers throughout the United States. We acquired Schanen
Consulting Corporation of Atlanta, Georgia in January, 2001 and consolidated its
operations with those of HCC Employee Benefits, Inc.

HCC RISK MANAGEMENT, INC.

HCC Risk Management, Inc., based in Houston, Texas, is an intermediary
specializing in marketing and servicing large, complicated insurance and
reinsurance programs placed on behalf of multinational clients operating in our
lines of business. This business is placed with domestic and international
insurance companies, including our insurance companies, on a direct basis and
through other intermediaries. In addition, HCC Risk Management, Inc. acts as a
reinsurance intermediary on behalf of affiliated and unaffiliated insurance
companies.

OTHER OPERATIONS

Our other operations historically consisted of insurance related services
offered to our subsidiaries, our reinsurers and unaffiliated entities. The
revenue earned from these services primarily consisted of fees or commissions.
Additionally, other operating income may be in the form of equity in the
earnings of insurance related companies in which we invest, or dividends or
gains or losses from the disposition of these investments. Other operating
revenue was $7.0 million in 2002, but can vary considerably from period to
period depending on investment or disposition activity.

15

REINSURANCE CEDED

We purchase reinsurance to reduce our net liability on individual risks, to
protect against catastrophe losses and to achieve a desired ratio of net written
premium to policyholders' surplus. We purchase reinsurance on both a
proportional and an excess of loss basis. The type, cost and limits of
reinsurance we purchase can vary from year to year based upon our desired
retention levels and the availability of quality reinsurance at an acceptable
price. Our reinsurance programs renew throughout the year and during 2002 some
of those renewed contained price increases which are not material to our
underwriting results.

We structure a specific reinsurance program for each line of business we
underwrite. We place reinsurance proportionally to cover loss frequency and
catastrophe exposure. We obtain reinsurance on an excess of loss basis to cover
individual risk severity of loss and catastrophe exposure. Additionally, we may
also obtain facultative reinsurance protection on a single risk. Our reinsurance
generally does not cover war or terrorism risks, which are excluded from many of
our policies.

Subsequent to the terrorist attack on September 11, 2001, where possible,
we canceled all terrorist coverage under the terms of existing in-force
policies, primarily in the property and energy book of the London market account
line of business. Our reinsurance protections in these books have been renewed
without coverage for acts of terrorism. We thus only have exposure on policies
that contained such coverage and are still in force. This exposure is
diminishing as these policies expire and with respect to some risks, would be
covered by the provisions of the Federal Terrorism Risk Insurance Act of 2002.

In our proportional reinsurance programs, we generally receive an
overriding (ceding) commission on the premium ceded to reinsurers. This
compensates our insurance companies for the direct costs associated with the
production of the business, the servicing of the business during the term of the
policies ceded and the costs associated with the placement of the related
reinsurance. In addition, certain of our reinsurance treaties allow us to share
with the reinsurers in any net profits generated under such treaties. Various
intermediaries, including HCC Risk Management, Inc. and Rattner Mackenzie
Limited, arrange for the placement of this reinsurance coverage on our behalf
and are compensated, directly or indirectly, by the reinsurers.

We have a reserve of $7.1 million as of December 31, 2002 for potential
collectibility issues and associated expenses related to reinsurance
recoverables. The adverse economic environment in the worldwide insurance
industry, the decline in the market value of investments in equity securities
and the terrorist attack on September 11, 2001 have placed great pressure on
reinsurers and the results of their operations. Ultimately, these conditions
could affect reinsurers' solvency. Historically, there have been insolvencies
following a period of competitive pricing in the industry. While we believe that
the reserve is adequate based on currently available information, conditions may
change or additional information might be obtained which may result in a future
change in the reserve. We periodically review our financial exposure to the
reinsurance market and the level of our reserve and continue to take actions in
an attempt to mitigate our exposure to possible loss.

A number of reinsurers have delayed or suspended the payment of amounts
recoverable under certain reinsurance contracts to which we are a party. Such
delays have affected, although not materially to date, the investment income of
our insurance companies, but not to any extent their liquidity. We limit our
liquidity exposure by holding funds, letters of credit or other security such
that net balances due are significantly less than the gross balances shown in
our consolidated balance sheets. In some instances, the reinsurers have withheld
payment without reference to a substantive basis for the delay or suspension. In
other cases, the reinsurers have claimed they are not liable for payment to us
of all or part of the amounts due under the applicable reinsurance agreement. We
believe these claims are without merit and expect to collect the full amounts
recoverable. We are currently in negotiations with most of these parties, but if
such negotiations do not result in a satisfactory resolution of the matters in
question, we may seek or be involved in a judicial or arbitral determination of
these matters. In some cases, the final resolution of such disputes through
arbitration or litigation may extend over several years. In this regard, as of
December 31, 2002, our insurance companies had initiated two litigation
proceedings against reinsurers. As of such date, our insurance companies had an
aggregate amount of $5.8 million which had not been paid to us under the
agreements and we estimate that there could be up to an additional $10.7 million
of incurred losses and loss expenses and other balances due under the subject
agreements.
16

OPERATING RATIOS

PREMIUM TO SURPLUS RATIO

This table shows, for the years indicated, the ratio of statutory gross
written premium and net written premium to statutory policyholders' surplus for
our property and casualty insurance companies (dollars in thousands):

- ---------------

(1) Source: A.M. Best Company, Inc.

* Not available

While there is no statutory requirement regarding a permissible premium to
policyholders' surplus ratio, guidelines established by the National Association
of Insurance Commissioners provide that a property and casualty insurer's annual
statutory gross written premium should not exceed 900% and net written premium
should not exceed 300% of its policyholders' surplus. However, industry
standards and rating agency criteria place these ratios at 300% and 200%,
respectively. Our property and casualty insurance companies have maintained
premium to surplus ratios generally lower than such guidelines.

COMBINED RATIO IN ACCORDANCE WITH GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

The underwriting experience of a property and casualty insurance company is
indicated by its combined ratio. Under generally accepted accounting principles,
the combined ratio is a combination of the loss ratio in accordance with
generally accepted accounting principles, or the ratio of incurred losses and
loss adjustment expenses to net earned premium, and the expense ratio in
accordance with generally accepted accounting principles, which is the ratio of
policy acquisition costs and other underwriting expenses, net of ceding
commissions, to net earned premium. Our insurance companies' loss ratios,
expense ratios and combined ratios in accordance with generally accepted
accounting principles are shown in the following table for the years indicated:

COMBINED RATIO IN ACCORDANCE WITH STATUTORY ACCOUNTING PRINCIPLES

The combined ratio in accordance with statutory accounting principles is a
combination of the loss ratio in accordance with statutory accounting
principles, or the ratio of incurred losses and loss adjustment expenses to net
earned premium, and the expense ratio in accordance with statutory accounting
principles, which is the ratio of policy acquisition costs and other
underwriting expenses, net of ceding commissions, to net written

17

premium. Our insurance companies' loss ratios, expense ratios and combined
ratios in accordance with statutory accounting principles are shown in the
following table for the years indicated:

- ---------------

* Not available

The ratio data in accordance with statutory accounting principles is not
intended to be a substitute for results of operations in accordance with
generally accepted accounting principles. The differences between statutory
accounting principles and generally accepted accounting principles are described
in Note (14) of our consolidated financial statements included in this report.
Including this information on the basis of statutory accounting principles is
meaningful and useful to allow a comparison of our operating results with those
of other companies in the insurance industry. The source of the industry average
is A.M. Best Company, Inc. A.M. Best Company, Inc. reports on insurer
performance on the basis of statutory accounting principles to provide for more
standardized comparisons among individual companies, as well as overall industry
performance.

RESERVES

Applicable insurance laws require us to maintain reserves to cover our
estimated ultimate liability for reported and incurred but not reported losses
under insurance and reinsurance policies that we wrote and for loss adjustment
expenses relating to the investigation and settlement of policy claims. In most
cases, we estimate such losses and claims costs through an evaluation of
individual claims. However, for some types of claims, we use an average
reserving method until more information becomes available to permit an
evaluation of individual claims.

We establish loss reserves for individual claims by evaluating reported
claims on the basis of:

- jurisdiction of the occurrence;

- our experience with the insured and the line of business and policy
provisions relating to the particular type of claim;

- our knowledge of the circumstances surrounding the claim;

- the information and reports received from ceding insurance companies
where applicable;

- the potential for ultimate exposure;

- the severity of injury or damage; and

- the type of loss.

We establish loss reserves for incurred but not reported losses based in
part on statistical information and in part on industry experience with respect
to the probable number and nature of claims arising from occurrences that have
not been reported. We also establish our reserves based on predictions of future
events, our estimates of future trends in claims severity, and other subjective
factors. Insurance companies are not permitted to reserve for a catastrophe
until it has occurred. Reserves are recorded on an undiscounted basis, except
for reserves acquired in transactions recorded using the purchase method of
accounting. The reserves of each of our insurance companies are established in
conjunction with and reviewed by our in-house actuarial staff and our reserves
in accordance with statutory accounting principles are certified annually by our

18

independent actuaries. PricewaterhouseCoopers LLP certified the reserves of our
insurance companies in accordance with statutory accounting principles as of
December 31, 2002.

With respect to some classes of risks, the period of time between the
occurrence of an insured event and the final settlement of a claim may be many
years, and during this period it often becomes necessary to adjust the claim
estimates either upward or downward. Certain classes of marine and offshore
energy and workers' compensation insurance which are or were underwritten by our
insurance companies have historically had longer lead times between the
occurrence of an insured event, reporting of the claim, and final settlement. In
such cases, we are forced to estimate reserves over long periods of time with
the possibility of several adjustments to reserves. Other classes of insurance
that we underwrite, such as most aviation, property and medical stop-loss,
historically have shorter lead times between the occurrence of an insured event,
reporting of the claim and final settlement. Reserves with respect to these
classes are, therefore, less likely to be adjusted.

The reserving process is intended to reflect the impact of inflation and
other factors affecting loss payments by taking into account changes in
historical payment patterns and perceived trends. However, there is no precise
method for the subsequent evaluation of the adequacy of the consideration given
to inflation, or to any other specific factor, or to the way one factor may
impact another.

We underwrite, directly and through reinsurance, risks which are
denominated in a number of foreign currencies, and therefore maintain loss
reserves with respect to these policies in the respective currencies. These
reserves are subject to exchange rate fluctuations, which may have an effect on
our earnings. We may attempt to limit our exposure to future currency
fluctuations through the use of foreign currency forward contracts.

The loss development triangles below show changes in our reserves in
subsequent years from the prior loss estimates based on experience as of the end
of each succeeding year on the basis of generally accepted accounting
principles. The estimate is increased or decreased as more information becomes
known about the frequency and severity of losses for individual years. A
redundancy means the original estimate was higher than the current estimate; a
deficiency means that the current estimate is higher than the original estimate.

The first line of each loss development triangle presents, for the years
indicated, our gross or net reserve liability including the reserve for incurred
but not reported losses. The first section of each table shows, by year, the
cumulative amounts of loss and loss adjustment expense paid as of the end of
each succeeding year. The second section sets forth the re-estimates in later
years of incurred losses, including payments, for the years indicated. The
"cumulative redundancy (deficiency)" represents, as of the date indicated, the
difference between the latest re-estimated liability and the reserves as
originally estimated.

19

This loss development triangle shows development in loss reserves on a
gross basis (in thousands):

The gross redundancy for 2001 resulted from the following items:

- A $21.5 million reduction in gross losses from the September 11 terrorist
attack and a $14.0 million reduction in gross losses from the Total Oil
Company loss. Both of these losses were substantially reinsured and thus
they had no material net effect.

- $36.2 million in negative development due to late reporting of an
aggregate program that we no longer write. As this program is
substantially reinsured, there was no material net effect.

- A $7.7 million charge related to certain business included in
discontinued lines.

- $31.5 million in other positive development spread across the group life,
accident and health, aviation and London market account lines of
business. On average these losses were 55% ceded, which created net
positive development of approximately $14.5 million.

The gross deficiencies reflected in the table for 2000 and 1999 result from
late reported loss information received during 2001. These losses primarily came
from assumed reinsurance business written by one of our insurance companies.
However, as these policies were substantially reinsured, there was no material
effect to our net earnings.

The gross deficiencies reflected in the table for the years prior to 1999
result from three principal conditions:

- The development of large claims on individual policies which were either
reported late or for which reserves were increased as subsequent
information became available. However, as these policies were
substantially reinsured, there was no material effect to our net
earnings.

20

- During 1999, in connection with the insolvency of one of our reinsurers
and the commutation of all liabilities with another, we re-evaluated all
loss reserves and incurred but not reported loss reserves related to
business placed with these reinsurers to determine the ultimate losses we
might conservatively expect. These reserves were then used as the basis
for the determination of the provision for reinsurance recorded in 1999.

- For the years prior to 1997, the runoff of the retrocessional excess of
loss business, which we underwrote between 1988 and 1991, experienced
gross development. This development was due primarily to the delay in
reporting of losses by the London insurance market, coupled with the
unprecedented number of catastrophe losses during that period. This
business was substantially reinsured and there was no material effect to
our net earnings.

This loss development triangle shows development in loss reserves on a net
basis (in thousands):

We believe that our loss reserves are adequate to provide for all material
net incurred losses.

21

The following table provides a reconciliation of the gross liability of
loss and loss adjustment expenses on the basis of generally accepted accounting
principles in the United States for the three years ended December 31, 2002 (in
thousands):

- ---------------

(1) Changes in loss and loss adjustment expense reserves (on the basis of
generally accepted accounting principles) for losses occurring in prior
years reflect the gross effect of the resolution of losses for other than
the reserve value and the subsequent adjustments of loss reserves.

This table provides a reconciliation of the liability for loss and loss
adjustment expense, net of reinsurance ceded, on the basis of generally accepted
accounting principles in the United States for the three years ended December
31, 2002 (in thousands):

22

- ---------------

(2) Changes in loss and loss adjustment expense reserves (on the basis of
generally accepted accounting principles) for losses occurring in prior
years reflect the net effect of the resolution of losses for other than the
reserve value and the subsequent adjustments of loss reserves.

Although we experienced a gross loss deficiency during 2001, the business
was substantially reinsured and, therefore, there was no material effect to our
insurance companies on a net loss basis.

During 2002, we had net loss and loss adjustment expense redundancy of $6.8
million relating to prior year losses compared to redundancies of $10.7 million
in 2001 and $9.6 million in 2000. The 2002 redundancy resulted from a deficiency
of $7.7 million due to a third quarter charge related to certain business
included in discontinued lines, offset by a net redundancy of $14.5 million from
all other sources. Deficiencies and redundancies in the reserves occur as we
continually review our loss reserves with our actuaries, increasing or reducing
loss reserves as a result of such reviews and as losses are finally settled and
claims exposures are reduced. We believe we have provided for all material net
incurred losses.

We have no material exposure to environmental pollution losses, because
Houston Casualty Company only began writing business in 1981 and its policies
normally contain pollution exclusion clauses which limit pollution coverage to
"sudden and accidental" losses only, thus excluding intentional (dumping) and
seepage claims. Policies issued by HCC Life Insurance Company, Avemco Insurance
Company and U.S. Specialty Insurance Company, because of the types of risks
covered, are not considered to have significant environmental exposures. We do
not expect to experience any material development in reserves for environmental
pollution claims. Likewise, we have no material exposure to asbestos claims.

INVESTMENTS

Insurance company investments must comply with applicable regulations which
prescribe the type, quality and concentration of investments. These regulations
permit investments, within specified limits and subject to certain
qualifications, in federal, state and municipal obligations, corporate bonds,
and preferred and common equity securities. As of December 31, 2002, we had $1.2
billion of investment assets. The majority of our investment assets are held by
our insurance companies. All of our securities are classified as available for
sale and are recorded at market value.

Our investment policy is determined by our Board of Directors and our
Investment and Finance Committee and is reviewed on a regular basis. We continue
to engage a nationally prominent investment advisor, New England Asset
Management, a subsidiary of Berkshire Hathaway, Inc., to oversee our investments
and to make recommendations to our Board's Investment and Finance Committee.
Although we generally intend to hold fixed income securities to maturity, we
regularly re-evaluate our position based upon market conditions. As of December
31, 2002, our fixed income securities had a weighted average maturity of 4.2
years and a weighted average duration of 3.5 years. Our financial statements
reflect an unrealized gain on fixed income securities available for sale as of
December 31, 2002, of $33.8 million.

We have maintained a substantial level of cash and liquid short-term
instruments in our insurance companies in order to maintain the ability to fund
losses of our insureds. Our underwriting agencies and intermediaries typically
have short-term investments, which are fiduciary funds held on behalf of others.
As of December 31, 2002, we had cash and short-term investments of approximately
$347.5 million, of which $239.6 million were in our underwriting agencies and
intermediaries.

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This table shows a profile of our investments. The table shows the average
amount of investments, income earned, and the yield thereon for the periods
indicated (dollars in thousands):

- ---------------

(1) Excluding realized and unrealized capital gains and losses.

This table summarizes, by type, the estimated market value of our
investments as of December 31, 2002 (dollars in thousands):

This table summarizes, by rating, the market value of our investments in
fixed income securities as of December 31, 2002 (dollars in thousands):

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The table set forth below indicates the expected maturity distribution of
the estimated market value of our fixed income securities as of December 31,
2001 (dollars in thousands):

The weighted average life of our structured securities is five years. The
value of our portfolio of fixed income securities is inversely correlated to
changes in market interest rates. In addition, some of our fixed income
securities have call or prepayment options. This could subject us to a
reinvestment risk should interest rates fall or issuers call their securities
and we are forced to invest the proceeds at lower interest rates. We mitigate
this risk by investing in securities with varied maturity dates, so that only a
portion of the portfolio will mature at any point in time. Some of our
asset-backed securities are subject to re-evaluation and additional specialized
impairment tests. Under this guidance, these securities have to be written down
in value if certain tests are met. Any write down is recouped prospectively
through net investment income, if contractual cash flows are ultimately
received. The total amount of securities held by us as of December 31, 2002 that
would be subject to these tests and potential write downs is $9.4 million.

2% CONVERTIBLE NOTES AND BANK LOAN

In a public offering on August 23, 2001, we issued an aggregate $172.5
million principal amount of 2% Convertible Notes due in 2021. Our debt
securities are rated A by Standard & Poor's (3rd of 10 ratings). Each $1
thousand principal amount of notes is convertible into 31.25 shares of our
common stock, which represents an initial conversion price of $32.00 per share.
The initial conversion price is subject to change under certain conditions.
Interest is to be paid by us on March 1 and September 1 each year. Holders may
surrender notes for conversion into shares of our common stock in any calendar
quarter if, as of the last day of the preceding calendar quarter, the closing
sale price of our common stock for at least 20 trading days in the period of 30
consecutive trading days ending on the last trading day of the quarter is more
than 120% ($38.40 per share) of the conversion price per share of our common
stock on the last trading day of the quarter. We can redeem the notes for cash
at any time on or after September 1, 2006. Holders of the notes may require us
to repurchase the notes on September 1, 2004, 2006, 2008, 2011 and 2016. If the
holders exercise this option, we may choose to pay the purchase price in cash,
in shares of our common stock, or a combination thereof. On September 1, 2002,
the first repurchase date of the notes, $49 thousand of the notes were tendered
to us and we repurchased them with cash. We used the proceeds from this offering
to repay our remaining indebtedness under our bank facility, assist in financing
the recent acquisitions, make a $60.0 million capital contribution to our
insurance companies and for general corporate purposes.

On December 17, 1999, we entered into a $300.0 million Revolving Loan
Facility with a group of banks. At our request, the amount available under the
facility was reduced to $200.0 million by an amendment on June 6, 2001. We can
borrow up to the maximum allowed by the facility on a revolving basis until the
facility expires on December 17, 2004. The facility is collateralized in part by
the pledge of our insurance companies stock and guarantees entered into by our
underwriting agencies and intermediaries. The facility agreement contains
certain restrictive covenants, which we believe are typical for similar
financing arrangements. As of December 31, 2002, there was an outstanding
balance of $53.0 million on this facility bearing interest at an average
interest rate of 3.2%.

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REGULATION

The business of insurance is extensively regulated by the government. At
this time, the insurance business in the United States is regulated primarily by
the individual states. However, a form of federal financial services
modernization legislation enacted in 1999 is expected to result in additional
federal regulation of the insurance industry. In addition, some insurance
industry trade groups are actively lobbying for legislation that would allow an
option for a separate federal charter for insurance companies. The full extent
to which the federal government will determine to directly regulate the business
of insurance has not been determined by lawmakers. Also, various foreign
governments regulate our international operations.

Our business depends on our compliance with applicable laws and regulations
and our ability to maintain valid licenses and approvals for our operations. We
devote a significant effort toward obtaining and maintaining our licenses and
compliance with a diverse and complex regulatory structure. In all
jurisdictions, the applicable laws and regulations are subject to amendment or
interpretation by regulatory authorities. Generally, regulatory authorities are
vested with broad discretion to grant, renew and revoke licenses and approvals
and to implement regulations governing the business and operations of insurers
and insurance agents.

INSURANCE COMPANIES

Our insurance companies, in common with other insurers, are subject to
regulation and supervision by the states and by other jurisdictions in which
they do business. Regulation by the states varies, but generally involves
regulatory and supervisory powers of a state insurance official. The regulation
and supervision of our insurance operations relates primarily to:

- approval of policy forms and premium rates;

- licensing of insurers and their agents;

- periodic examinations of our operations and finances;

- prescribing the form and content of records of financial condition
required to be filed;

- requiring deposits for the benefit of policyholders;

- requiring certain methods of accounting;

- requiring reserves for unearned premium, losses and other purposes;

- restrictions on the ability of our insurance companies to pay dividends
to us;

- restrictions on the nature, quality and concentration of investments;

- restrictions on transactions between insurance companies and their
affiliates;

- restrictions on the size of risks insurable under a single policy; and

- standards of solvency, including risk-based capital measurements (which
is a measure developed by the National Association of Insurance
Commissioners and used by state insurance regulators to identify
insurance companies that potentially are inadequately capitalized.)

In general, state insurance regulations are intended primarily for the
protection of policyholders rather than shareholders. The state insurance
departments monitor compliance with regulations through periodic reporting
procedures and examinations. The quarterly and annual financial reports to the
state insurance regulators utilize accounting principles which are different
from the generally accepted accounting principles we use in our reports to
shareholders. Statutory accounting principles, in keeping with the intent to
assure the protection of policyholders, are generally based on a liquidation
concept while generally accepted accounting principles are based on a
going-concern concept.

Houston Casualty Company is domiciled in Texas. It operates on an admitted
basis in Texas and may write reinsurance on all lines of business that it may
write on a direct basis. Houston Casualty Company is an

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accredited reinsurer in 39 states and an approved surplus lines insurer or is
otherwise permitted to write surplus lines insurance in 49 states, three United
States territories and the District of Columbia. When a reinsurer obtains
accreditation from a particular state, insurers within that state are permitted
to obtain statutory credit for risks ceded to the reinsurer. Surplus lines
insurance is offered by non-admitted companies on risks which are not insured by
admitted companies. All surplus lines insurance is required to be written
through licensed surplus lines insurance brokers, who are required to be
knowledgeable of and follow specific state laws prior to placing a risk with a
surplus lines insurer.

Houston Casualty Company's branch office in London, England is subject to
regulation by regulatory authorities in the United Kingdom. Avemco Insurance
Company is domiciled in Maryland and operates as a licensed admitted insurer in
all states and the District of Columbia. U.S. Specialty Insurance Company is
domiciled in Texas and operates as a licensed admitted insurer in all states and
the District of Columbia. HCC Life Insurance Company is domiciled in Indiana,
and operates as a licensed admitted insurer in 41 states and the District of
Columbia. HCC Specialty Insurance Company is domiciled in Oklahoma and operates
on a surplus lines basis in Texas. HCC Europe is domiciled in Spain and operates
on the equivalent of an "admitted" basis throughout the European Union and
operates in selected other countries as permitted under local regulations.

State insurance regulations also affect the payment of dividends and other
distributions by insurance companies to their shareholders. Generally, insurance
companies are limited by these regulations to the payment of dividends above a
specified level. Dividends in excess of those thresholds are "extraordinary
dividends" and subject to prior regulatory approval.

UNDERWRITING AGENCIES AND INTERMEDIARIES

In addition to the regulation of insurance companies, the states impose
licensing and other requirements on the insurance agency and service operations
of our other subsidiaries. These regulations relate primarily to:

- advertising and business practice rules;

- contractual requirements;

- financial security;

- licensing as agents, brokers, intermediaries, managing general agents or
third party administrators;

- limitations on authority; and

- recordkeeping requirements.

The manner of operating our underwriting agency and intermediary activities
in particular states may vary according to the licensing requirements of the
particular state, which may require, among other things, that we operate in the
state through a local corporation. In a few states, licenses are issued only to
individual residents or locally-owned business entities. In such cases, we may
have arrangements with residents or business entities licensed to act in the
state. The majority of states, however, have recently enacted legislation in
response to the Federal Gramm-Leach-Bliley Act that streamlines and makes more
uniform the licensing requirements.

STATUTORY ACCOUNTING PRINCIPLES

The principal differences between statutory accounting principles and
generally accepted accounting principles, the method by which we report our
financial results to our shareholders are:

- a liability is recorded for certain reinsurance recoverables under
statutory account