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

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549-1004

FORM 10-K

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

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003

OR

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

COMMISSION FILE NUMBER 001-13790

HCC INSURANCE HOLDINGS, INC.
(Exact name of registrant as specified in its charter)

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

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

(713) 690-7300
(Registrant's telephone number, including area code)

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. [X]

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 30, 2003 (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 $1.8 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 February 27, 2004, was 64,368,384.

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.

HCC INSURANCE HOLDINGS, INC.

TABLE OF CONTENTS

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.

1

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 in this report 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 SOME OF 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 volatile and catastrophic risks. 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 effect 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.

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. Through reinsurance, we have the contractual
right to collect the amount above our retention from our reinsurers. 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. Accordingly, we bear credit risk with
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.
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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 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),
directors' and officers' liability (diversified financial products) 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; The Chubb Corporation and American International Group in our
diversified 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 larger than we are and
that have 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 attacks. 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 2004, we estimate that approximately 7% of our current business
(based on gross written premium) 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 between the major European currencies
(particularly the British pound sterling and the

3

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.

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 legislation to modernize financial services may
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 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 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.

4

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, whose 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 those entities and the
continued retention of those ratings cannot be assured. If our ratings are
reduced from their current levels by those entities, 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 delay 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, 2003, $1.2 billion of our $1.7 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 (97% 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 setbacks the ratings
on the fixed income securities could fall (with a concurrent fall in market
value) and, in a worse case scenario, the issuer 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

5

could adversely affect our shareholders' equity, total comprehensive income
and/or our cash flows. Unrealized pre-tax net investment gains (losses) on
investments in fixed-income securities were $(3.7) million, $22.0 million and
$0.7 million for the years ended December 31, 2003, 2002 and 2001, 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 AND THE CASH FLOW FROM OUR
NON-INSURANCE OPERATIONS IS NOT SUFFICIENT, WE MAY NOT BE ABLE TO MEET OUR
DEBT, DIVIDEND AND EXPENSE OBLIGATIONS.

Historically, we have had sufficient cash flow from our non-insurance
company subsidiaries to meet our corporate cash flow requirements for paying
principal and interest on outstanding debt obligations, dividends to
shareholders and corporate expenses. However, in the future we may rely on
dividends from our insurance companies to meet these requirements. 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, Spain and Bermuda, 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 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 1999 through 2002, which is the latest period for which industry
information is available, we had an average statutory combined ratio of 103.9%
versus the less favorable 110.3% (source: A.M. Best Company, Inc.) recorded by
the U.S. property and casualty insurance industry overall. During the period
1999 through 2003, our gross written premium increased from $568.3 million to
$1.7 billion, an increase of 206%, while net written premium increased 519% from
$139.9 million to $865.5 million. During this period, our revenue increased from
$338.1 million to $942.0 million, an increase of 179%.

During the period December 31, 1999 through December 31, 2003, our
shareholders' equity increased from $458.4 million to $1.0 billion, a 128%
increase. During the same period, our assets increased from $2.7 billion to $4.9
billion, an 81% increase.

6

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

- Diversified financial products

- London market account

- Aviation

- Other specialty lines

In the United States, American Contractors Indemnity Company (acquired in
January, 2004), 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.

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 non-affiliated 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
fee income and profit commissions and specialize in contingency (including
contest indemnification, event cancellation and weather coverages); directors'
and officers' liability; errors and omissions; individual disability (for
athletes and other high profile individuals); kidnap and ransom; life, accident
and health; marine; professional indemnity; and other specialty lines of
business. Our principal underwriting agencies are ASU International, Inc.,
Covenant Underwriters, Ltd., HCC Benefits Corporation, HCC Global Financial
Products, LLC, HCC Diversified Financial Products, Limited 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. A
reinsurance intermediary structures and arranges reinsurance between insurers
seeking to cede insurance risks and reinsurers willing to assume such risks. 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 negotiation
particular insurance risks. Our intermediaries specialize in placing reinsurance
for life, accident and health and property and casualty lines of business. Our
principal intermediaries are 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,
specialty 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.
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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, 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 increased 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 2003, 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 overall underwriting profitability. We anticipate
continued underwriting profitability during 2004. In response to these changing
market conditions, we plan to continue to expand the underwriting activities in
our insurance company operations and retain more of the risks and applicable
premiums.

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 and
net earnings, 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
catastrophic 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 acquisitions that have furthered our overall
business strategy. Our recent transactions are described below:

On October 1, 2002, we acquired all of the outstanding member interests of
MAG Global Financial Products, LLC, an underwriting agency specializing in
directors' and officers' liability and professional
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liability insurance. The total purchase price of the acquisition is based in
part on future earnings. We paid an initial $6.9 million for the acquisition in
2002 and paid an additional $4.1 million during 2003. We may pay additional
amounts in the future based upon the attainment of certain earnings benchmarks
through September, 2007. MAG Global Financial Products, LLC has been renamed HCC
Global Financial Products, LLC.

On December 24, 2002, we acquired all of the outstanding shares of
Manchester Dickson Holdings Limited, the parent Company of Dickson Manchester &
Company, Limited, an underwriting agency and Lloyd's broker specializing in U.K.
professional indemnity products. We paid $17.0 million as an initial amount and
during 2004, will pay an additional GBP6.8 million ($12.0 million at December
31, 2003 rate of exchange) in final payment for the acquisition. Dickson
Manchester & Company, Limited's underwriting operations have been renamed HCC
Diversified Financial Products Limited and its brokerage operations have been
consolidated with Rattner Mackenzie Limited.

On December 31, 2002, we acquired all of the outstanding shares of St. Paul
Holdings Limited. St. Paul Holdings Limited was a holding company for St. Paul
Espana Compania de Seguros y Reaseguros S.A., a Spanish insurer which now
operates as HCC Europe. Following adjustments, we paid $8.1 million for the
acquisition. HCC Europe writes surety, directors' and officers' liability and
professional liability insurance in Spain and other countries in the European
Union.

On July 1, 2003, we acquired all of the outstanding shares of Covenant
Underwriters Limited and Continental Underwriters Limited, an underwriting
agency and an intermediary, respectively, specializing in commercial marine
insurance. We paid $11.6 million and issued 314,537 shares of our common stock
in connection with the acquisition and may pay additional amounts if certain
earnings targets are reached through December 31, 2006.

On January 31, 2004, we acquired all of the shares of Surety Associates
Holding Co., Inc., the parent company of American Contractors Indemnity Company,
a California insurer specializing in court, specialty contract, license and
permit bonds. We paid $46.5 million for the acquisition.

We continue to evaluate possible acquisition candidates and we may complete
additional acquisitions during 2004. 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.

RECENT DISPOSITION

On December 31, 2003, we sold the business of our retail insurance agency
subsidiary, HCC Employee Benefits, Inc. We received $62.5 million in proceeds
from such sale and may receive additional amounts based upon the 2004 earnings
of the disposed operations.

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 underwriting agencies and intermediaries and by direct
marketing efforts. We also write facultative, or individual account,
reinsurance, as well as some 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 a complement to our medical stop-loss
products. Our underwriting agency, HCC Benefits Corporation, produces and
underwrites this business on behalf of two of our insurance companies: HCC Life
Insurance Company and Avemco Insurance Company. HCC Benefits Corporation began
underwriting this business in 1980 and has grown both internally and through
acquisitions. HCC Benefits Corporation is considered a market leader in medical
stop-loss insurance. We first began writing this business in our insurance
companies in 1997. In 1999, we acquired The Centris Group, Inc., doubling our
gross written premium at that time to approximately $400.0 million. We maintain
reinsurance on a proportional basis, where we

10

share a 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. 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.

DIVERSIFIED FINANCIAL PRODUCTS

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

- directors' and officers' liability

- employment practices liability

- errors and omissions or professional indemnity

- surety

We began to underwrite this line of business with our acquisition of
Professional Indemnity Agency, Inc. in October, 2001. We 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. In January
2004, we acquired American Contractors Indemnity Company, a California based
surety insurer. 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, particularly directors' and officers' liability, which were generally
caused by high profile corporate governance issues in U.S. public companies.
Gross written premium rose dramatically to $553.5 million in 2003 compared to
$178.7 million in 2002. We maintain reinsurance on our diversified financial
products line of business on both a proportional and excess of loss basis.
Although individual losses may have potential severity, there is a relatively
low risk of catastrophe exposure.

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 and to a lesser extent by HCC Europe.

We underwrite marine risks for ocean-going vessels including hull,
liabilities, protection and indemnity 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 2003, our gross written premium was $18.9
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

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In our energy business, we underwrite physical damage and business
interruption.

Rates have been relatively low in the past at levels where underwriting
profitability has been difficult to obtain. As a result, we have underwritten
energy risks on a very selective basis, striving for quality rather than
quantity. Since 2002, we have seen rates increase and gross written premium in
2003 was $69.6 million.

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

- factories

- hotels

- industrial plants

- office buildings

- retail locations

- utilities

The property 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 $40.8 million in 2002 and has increased to
$47.3 million in 2003.

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 $87.4 million in 2003.

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

AVIATION

We are a market leader in the general aviation insurance industry. We
insure 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, cargo and other ancillary coverages. 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 acquired Avemco Insurance Company and its subsidiary U.S.
Specialty Insurance Company. Avemco

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Insurance Company is one of the largest writers of personal aircraft insurance
in the United States and has been insuring aviation risks since 1959. Our
aviation premium has remained relatively stable since 1998. Our aviation gross
written premium for 2003 was $214.7 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.

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.

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,
diversified financial products and other specialty lines of business. Houston
Casualty Company's 2003 gross written premium was $907.5 million (including
Houston Casualty Company-London amounts). Houston Casualty Company is an issuing
carrier for HCC Global Financial Products, LLC and ASU International, LLC.

HOUSTON CASUALTY COMPANY-LONDON

Houston Casualty Company operates a full branch office in London, England.
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 some of the business that Houston Casualty Company
underwrites. Houston Casualty Company-London underwrites diversified financial
products and London market account business. Houston Casualty Company-London is
an issuing carrier for HCC Global Financial Products, LLC and HCC Diversified
Financial Products, Limited. Houston Casualty Company-London's 2003 gross
written premium was $306.7 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, accident and health and diversified
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 2003 was $232.2 million.

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 42 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 2003 was
$388.4 million.

13

AVEMCO INSURANCE COMPANY

Avemco Insurance Company is a Maryland-domiciled property and casualty
insurer and operates 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 accident and health business underwritten by our
underwriting agencies and an unaffiliated underwriting agency. Avemco Insurance
Company's gross written premium in 2003 was $179.9 million.

HCC EUROPE

HCC Europe is a Spanish insurer and underwrites diversified financial
products business throughout the European Union. HCC Europe is also an issuing
carrier for business underwritten by our underwriting agencies and has been in
operation since 1978. HCC Europe's gross written premium in 2003 was $84.1
million.

AMERICAN CONTRACTORS INDEMNITY COMPANY

American Contractors Indemnity Company was acquired on January 31, 2004 and
is a California-domiciled surety company. The results of operations of American
Contractors Indemnity Company will be included in our financial results as of
the date of acquisition. American Contractors Indemnity Company writes court,
specialty contract, license and permit bonds and operates on an admitted basis
in 44 states, the District of Columbia and two U.S. Territories and has been in
operation since 1990. American Contractors Indemnity Company's 2003 gross
written premium was $57.9 million.

HCC REINSURANCE COMPANY LIMITED

HCC Reinsurance Company Limited is a Bermuda-domiciled reinsurance company
which writes assumed reinsurance from our insurance companies and from
unaffiliated insurance companies. HCC Reinsurance Company Limited's gross
written premium in 2003 was $14.7 million. We expect to increase the
underwriting activity of HCC Reinsurance Company Limited in 2004.

HCC SPECIALTY INSURANCE COMPANY

HCC Specialty Insurance Company is an Oklahoma domiciled property and
casualty insurance company. HCC Specialty Insurance Company operates on a
surplus lines basis in Texas and writes diversified financial products and other
specialty lines business produced by our underwriting agencies. HCC Specialty
Insurance Company's gross written premium in 2003 was $9.5 million.

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 fee
income 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. Total segment revenue generated by our underwriting
agencies in 2003 amounted to $174.7 million.

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 and has been in operation since 1980.

14

PROFESSIONAL INDEMNITY AGENCY, INC.

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 diversified financial products, specializing in
directors' and officers' liability, errors and omissions liability, kidnap and
ransom and other specialty lines of business on behalf of affiliated and
unaffiliated insurance companies and has been in operation since 1977.

ASU INTERNATIONAL, LLC

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 and has been in operation since
1982.

HCC GLOBAL FINANCIAL PRODUCTS, LLC

HCC Global Financial Products, LLC 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
diversified financial products, specializing in directors' and officers'
liability business on behalf of affiliated insurance companies.

HCC DIVERSIFIED FINANCIAL PRODUCTS LIMITED

HCC Diversified Financial Products Limited is an underwriting agency based
in London, England and underwrites diversified financial products, specializing
in professional indemnity business in the European Union, on behalf of
affiliated insurance companies and has been in operation since 1997. Its Lloyd's
broker operations have been consolidated into Rattner Mackenzie Limited.

COVENANT UNDERWRITERS LIMITED

We acquired Covenant Underwriters Limited in July, 2003. Covenant
Underwriters Limited is an underwriting agency based in Covington, Louisiana,
specializing in commercial marine insurance underwritten on behalf of affiliated
and unaffiliated insurance companies and has been in operation through
predecessor entities since 1970.

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. Total segment revenue generated by our intermediaries in
2003 amounted to $48.6 million.

RATTNER MACKENZIE LIMITED

Rattner Mackenzie Limited is an intermediary based in London, England with
other operations in Bermuda and New York. Rattner Mackenzie Limited specializes
in group life, accident and health reinsurance and some specialty property and
casualty lines of business. Rattner Mackenzie Limited operates as a Lloyd's
broker for reinsurance business placed on behalf of unaffiliated and affiliated
insurance companies, reinsurance companies and underwriting agencies and has
been in operation since 1989.

15

CONTINENTAL UNDERWRITERS LIMITED

We acquired Continental Underwriters Limited in July, 2003. Continental
Underwriters Limited is an intermediary based in Covington, Louisiana
specializing in commercial marine insurance placed on behalf of affiliated and
unaffiliated insurance companies and has been in operation since 1970.

HCC RISK MANAGEMENT, INC.

HCC Risk Management, Inc., based in Houston, Texas, is an intermediary
specializing in placing reinsurance on behalf of affiliated and unaffiliated
insurance companies.

OTHER OPERATIONS

Other operating income consists of equity in the earnings of insurance
related companies in which we invest, dividends from certain other insurance
related investments and gains or losses from the disposition of these
investments and the profit or loss from an inventory of insurance related
trading securities. Other operating revenue was $13.2 million in 2003, but can
vary considerably from period to period depending on investment or disposition
activity.

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 2003 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.

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 $14.9 million as of December 31, 2003 for potential
collectibility issues and associated expenses related to reinsurance
recoverables. This includes the exposure we have with respect to disputed
amounts. 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.

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 net
written premium to surplus ratios substantially 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:

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

* Includes 3.9% related to a commutation loss.

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,

17

to net written 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:

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

* Includes 3.9% related to a commutation loss.

** 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. Including this information 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
independent actuaries. PricewaterhouseCoopers LLP certified the reserves of our
insurance companies in accordance with statutory accounting principles as of
December 31, 2003.

18

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 diversified financial
products, marine and offshore energy and workers' compensation insurance which
are or were underwritten by our insurance companies have historically had longer
elapsed 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.

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):

20

The gross deficiencies reflected in the above table for years after 1998
result from the following:

- During 2003 we recorded $132.9 million in gross losses related to 1999
and 2000 accident years on certain assumed accident and health
reinsurance contracts reported in discontinued lines of business due to
our processing of additional information received and our continuing
evaluation of reserves on this business.

- The 2000 and 1999 years in the table are also negatively affected by late
reporting loss information received during 2001 for certain discontinued
business.

As the losses related to the above two items 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.

- 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.

The following table provides a reconciliation of the gross liability of
loss and loss adjustment expenses on the basis of generally accepted accounting
principles for the three years ended December 31, 2003 (in thousands):

22

The net deficiencies reflected in the above table for years after 1999 are
due to a commutation loss of $28.8 million recorded in 2003, which primarily
affected the 1999 and 2000 accident years.

This table below provides a reconciliation of the liability for loss and
loss adjustment expense, net of reinsurance ceded, on the basis of generally
accepted accounting principles for the three years ended December 31, 2003 (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 net effect of the resolution of losses for other than the
reserve value and the subsequent adjustments of loss reserves.

During 2003, we had net loss and loss adjustment expense deficiency of
$23.8 million relating to prior year losses compared to redundancies of $6.8
million in 2002 and $10.7 million in 2001. The 2003 deficiency resulted from a
commutation charge of $28.8 million related to certain accident and health
business included in discontinued lines offset by a net redundancy of $5.0
million from all other sources. 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 our other insurance company subsidiaries,
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.

23

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, 2003, we had $1.7
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 engage a
nationally prominent investment advisor, General Re-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, 2003, our fixed income securities had a weighted average maturity of 4.5
years and a weighted average duration of 3.7 years. Our financial statements
reflect an unrealized gain of $30.0 million on fixed income securities available
for sale as of December 31, 2003.

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, 2003, we had cash and short-term investments of approximately
$614.9 million, of which $264.0 million were in our underwriting agencies and
intermediaries.

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, 2003 (dollars in thousands):

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This table summarizes, by rating, the market value of our investments in
fixed income securities as of December 31, 2003 (dollars in thousands):

The table set forth below indicates the expected maturity distribution of
the estimated market value of our fixed income securities as of December 31,
2003 (dollars in thousands):

The weighted average life of our structured securities is 2.8 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, 2003 that
would be subject to these tests and potential write downs is $1.4 million.

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

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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 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 42 states and the District of
Columbia. HCC Specialty Insurance Company is domiciled in Oklahoma and operates
on a surplus lines basis in Texas. American Contractors Indemnity Company is

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domiciled in California and operates on an admitted basis in 44 states, the
District of Columbia and two U.S. Territories. HCC Europe is domiciled in Spain
and operates on the equivalent of an "admitted" basis throughout the European
Union.

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 accounting principles, whereas under generally accepted
accounting principles there is no such provision unless the recoverables
are deemed to be doubtful of collectibility;

- under statutory accounting principles, life insurance companies record
investment related liabilities, the asset valuation reserve and interest
maintenance reserve, whereas there is no such liability under generally
accepted accounting principles;

- certain assets which are considered "non-admitted assets" are eliminated
from a balance sheet prepared in accordance with statutory accounting
principles but are included in a balance sheet prepared in accordance
with generally accepted accounting principles;

- only some of the deferred tax assets are recognized under statutory
accounting principles;

- fixed-income investments classified as available for sale are recorded at
market value for generally accepted accounting principles and at
amortized cost under statutory accounting principles;

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- outstanding losses and unearned premium are recorded on a gross basis
under generally accepted accounting principles and on a net basis under
statutory accounting principles; and

- under statutory accounting principles, policy acquisition costs are
expensed as incurred and under generally accepted accounting principles
such costs are deferred and amortized to expense as the related premium
is earned.

INSURANCE HOLDING COMPANY ACTS

Because we are an insurance holding company, we are subject to the
insurance holding company system regulatory requirements of a number of states.
Under these regulations, we are required to report information regarding our
capital structure, financial condition and management. We are also required to
provide prior notice to, or seek the prior approval of insurance regulatory
authorities of certain agreements and transactions between our affiliated
companies. These agreements and transactions must satisfy certain regulatory
requirements.

RISK-BASED CAPITAL

The National Association of Insurance Commissioners has developed a formula
for analyzing insurance companies called risk-based capital. The risk-based
capital formula is intended to establish minimum capital thresholds that vary
with the size and mix of a company's business and assets. It is designed to
identify companies with capital levels that may require regulatory attention. As
of December 31, 2003, each of our domestic insurance companies' total adjusted
capital is significantly in excess of the authorized control level risk-based
capital.

INSURANCE REGULATORY INFORMATION SYSTEM

The National Association of Insurance Commissioners has developed a rating
system, the Insurance Regulatory Information System, primarily intended to
assist state insurance departments in overseeing the financial condition of all
insurance companies operating within their respective states. The Insurance
Regulatory Information System consists of eleven key financial ratios that
address various aspects of each insurer's financial condition and stability. Our
insurance companies' Insurance Regulatory Information System ratios generally
fall within the usual prescribed ranges except in satisfactorily explainable
circumstances such as when there is a large reinsurance transaction, capital
change, merger or planned growth.

TERRORISM RISK INSURANCE ACT

In 2002, the Federal Terrorism Risk Insurance Act was enacted for the
purpose of ensuring the availability of insurance coverage for terrorist acts in
the United States. The law establishes a financial "backstop" program through
the end of 2005 to assist the commercial property and casualty insurance
industry in providing coverage related to future acts of terrorism within the
United States.

Under the Federal Terrorism Risk Insurance Act of 2002, we are required to
offer terrorism coverage to our commercial policyholders in certain lines of
business written in the United States, for which we may, when warranted, charge
an additional premium. The policyholders may or may not accept such coverage.
This law also established a deductible that each insurer would have to meet
before U.S. Federal reimbursement would occur. For 2004, our deductible is
approximately $37.4 million based on 10% of 2003 subject premium as defined
under the applicable regulations. Thereafter, the Federal government would
provide reimbursement for 90% of our covered losses up to the maximum amount set
out in the Act.

PENDING OR PROPOSED LEGISLATION

In recent years, state legislatures have considered or enacted laws that
modify and, in many cases, increase state authority to regulate insurance
companies and insurance holding company systems. State insurance regulators are
members of the National Association of Insurance Commissioners, which seeks to

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promote uniformity of and to enhance the state regulation of, insurance. In
addition, the National Association of Insurance Commissioners and state
insurance regulators, as part of the National Association of Insurance
Commissioners' state insurance department accreditation program and in response
to new federal laws, have re-examined existing state laws and regulations,
specifically focusing on insurance company investments, issues relating to the
solvency of insurance companies, licensing and market conduct issues,
streamlining agent licensing and policy form approvals,