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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

     
þ   Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the Quarter Ended June 30, 2004.
     
o   Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 from _______ to __________

Commission file number 001-13790

HCC Insurance Holdings, Inc.


(Exact name of registrant as specified in its charter)
     
Delaware   76-0336636

 
 
 
(State or other jurisdiction of
incorporation or organization)
  (IRS Employer
Identification No.)
     
13403 Northwest Freeway, Houston, Texas   77040-6094

 
 
 
(Address of principal executive offices)   (Zip Code)
     
(713) 690-7300

 
(Registrant’s telephone number, including area code)

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

Yes       þ                      No       o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12B-2 of the Act).

Yes       þ                      No       o

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

On July 30, 2004, there were approximately 64.7 million shares of common stock, $1.00 par value issued and outstanding.

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HCC INSURANCE HOLDINGS, INC.
INDEX

                 
            Page No.
Part I.   FINANCIAL INFORMATION        
    Item 1.          
            3  
            4  
            5  
            6  
            7  
    Item 2.       21  
    Item 3.       33  
    Item 4.       33  
Part II.   OTHER INFORMATION        
    Item 1.       34  
    Item 4.       35  
    Item 6.       35  
Signatures     36  
 Certification by Chief Executive Officer
 Certification by Chief Financial Officer
 Certification with respect to quarterly report

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

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

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

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HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

(unaudited, in thousands, except per share data)

                 
    June 30,
2004

  December 31,
2003

ASSETS
               
Investments:
               
Fixed income securities, at market (cost: 2004 — $1,395,833; 2003 — $1,134,128)
  $ 1,401,867     $ 1,164,166  
Marketable equity securities, at market (cost: 2004 — $12,007; 2003 — $12,007)
    12,055       12,002  
Short-term investments, at cost, which approximates market
    570,024       518,482  
Other investments, at cost, which approximates fair value
    17,506       8,696  
 
   
 
     
 
 
Total investments
    2,001,452       1,703,346  
 
               
Cash
    37,968       96,416  
Restricted cash and cash investments
    188,087       210,301  
Premium, claims and other receivables
    969,851       899,031  
Reinsurance recoverables
    985,677       916,190  
Ceded unearned premium
    301,193       291,591  
Ceded life and annuity benefits
    75,412       77,548  
Deferred policy acquisition costs
    136,584       106,943  
Goodwill
    400,795       386,507  
Other assets
    188,255       176,423  
 
   
 
     
 
 
Total assets
  $ 5,285,274     $ 4,864,296  
 
   
 
     
 
 
LIABILITIES
               
Loss and loss adjustment expense payable
  $ 1,720,050     $ 1,535,288  
Life and annuity policy benefits
    75,412       77,548  
Reinsurance balances payable
    269,842       296,916  
Unearned premium
    705,572       592,311  
Deferred ceding commissions
    88,311       88,129  
Premium and claims payable
    797,450       745,559  
Notes payable
    322,396       310,404  
Accounts payable and accrued liabilities
    177,551       171,221  
 
   
 
     
 
 
Total liabilities
    4,156,584       3,817,376  
 
               
SHAREHOLDERS’ EQUITY
               
Common stock, $1.00 par value; 250.0 million shares authorized (shares issued and outstanding: 2004 — 64,643; 2003 — 63,964)
    64,643       63,964  
Additional paid-in capital
    463,937       447,671  
Retained earnings
    590,458       509,159  
Accumulated other comprehensive income
    9,652       26,126  
 
   
 
     
 
 
Total shareholders’ equity
    1,128,690       1,046,920  
 
   
 
     
 
 
Total liabilities and shareholders’ equity
  $ 5,285,274     $ 4,864,296  
 
   
 
     
 
 

See Notes to Condensed Consolidated Financial Statements.

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HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Statements of Earnings

(unaudited, in thousands, except per share data)

                                 
    For the six months ended
June 30,

  For the three months ended
June 30,

    2004
  2003
  2004
  2003
REVENUE
                               
Net earned premium
  $ 469,133     $ 345,914     $ 252,070     $ 183,492  
Fee and commission income
    89,945       63,715       46,102       38,063  
Net investment income
    29,402       22,865       14,967       11,868  
Net realized investment gain
    569       184       51       205  
Other operating income
    6,239       5,134       4,080       4,240  
 
   
 
     
 
     
 
     
 
 
Total revenue
    595,288       437,812       317,270       237,868  
EXPENSE
                               
Loss and loss adjustment expense, net
    273,762       220,112       147,898       120,080  
Operating expense:
                               
Policy acquisition costs, net
    98,641       65,964       55,422       34,001  
Compensation expense
    46,438       38,611       23,625       19,865  
Other operating expense
    33,175       26,038       17,796       12,939  
 
   
 
     
 
     
 
     
 
 
Total operating expense
    178,254       130,613       96,843       66,805  
Interest expense
    3,958       3,596       1,746       1,914  
 
   
 
     
 
     
 
     
 
 
Total expense
    455,974       354,321       246,487       188,799  
 
   
 
     
 
     
 
     
 
 
Earnings from continuing operations before income tax provision
    139,314       83,491       70,783       49,069  
Income tax provision from continuing operations
    48,132       30,037       24,403       17,955  
 
   
 
     
 
     
 
     
 
 
Earnings from continuing operations
    91,182       53,454       46,380       31,114  
Earnings (loss) from discontinued operations, net of income taxes (benefit) of $(110), $1,905, $36 and $1,165
    (199 )     3,281       35       1,854  
 
   
 
     
 
     
 
     
 
 
Net earnings
  $ 90,983     $ 56,735     $ 46,415     $ 32,968  
 
   
 
     
 
     
 
     
 
 
Basic earnings per share data:
                               
Earnings from continuing operations
  $ 1.42     $ 0.85     $ 0.72     $ 0.49  
Earnings (loss) from discontinued operations
    (0.01 )     0.05             0.03  
 
   
 
     
 
     
 
     
 
 
Net earnings
  $ 1.41     $ 0.90     $ 0.72     $ 0.52  
 
   
 
     
 
     
 
     
 
 
Weighted average shares outstanding
    64,399       62,753       64,538       62,867  
 
   
 
     
 
     
 
     
 
 
Diluted earnings per share data:
                               
Earnings from continuing operations
  $ 1.39     $ 0.84     $ 0.71     $ 0.49  
Earnings from discontinued operations
          0.05             0.03  
 
   
 
     
 
     
 
     
 
 
Net earnings
  $ 1.39     $ 0.89     $ 0.71     $ 0.52  
 
   
 
     
 
     
 
     
 
 
Weighted average shares outstanding
    65,557       63,667       65,686       63,990  
 
   
 
     
 
     
 
     
 
 
Cash dividends declared, per share
  $ 0.15     $ 0.13     $ 0.075     $ 0.065  
 
   
 
     
 
     
 
     
 
 

See Notes to Condensed Consolidated Financial Statements.

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HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Statement of Changes in Shareholders’ Equity

For the six months ended June 30, 2004

(unaudited, in thousands, except per share data)

                                         
                            Accumulated    
            Additional           other   Total
    Common   paid-in   Retained   comprehensive   shareholders'
    stock
  capital
  earnings
  income
  equity
Balance as of December 31, 2003
  $ 63,964     $ 447,671     $ 509,159     $ 26,126     $ 1,046,920  
Net earnings
                90,983             90,983  
Other comprehensive loss
                      (16,474 )     (16,474 )
 
                                   
 
 
Comprehensive income
                                    74,509  
645 shares of common stock issued upon exercise of options, including tax benefit of $2,715
    645       15,140                   15,785  
34 shares of common stock issued to acquire strategic investment
    34       1,126                   1,160  
Cash dividends declared, $0.15 per share
                (9,684 )           (9,684 )
 
   
 
     
 
     
 
     
 
     
 
 
Balance as of June 30, 2004
  $ 64,643     $ 463,937     $ 590,458     $ 9,652     $ 1,128,690  
 
   
 
     
 
     
 
     
 
     
 
 

See Notes to Condensed Consolidated Financial Statements.

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HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(unaudited, in thousands, except per share data)

                                 
    For the six months ended   For the three months ended
    June 30,
  June 30,
    2004
  2003
  2004
  2003
Cash flows from operating activities:
                               
Net earnings
  $ 90,983     $ 56,735     $ 46,415     $ 32,968  
Adjustments to reconcile net earnings to net cash provided by operating activities:
                               
Change in premium, claims and other receivables
    (65,155 )     (169,946 )     37,833       (107,729 )
Change in reinsurance recoverables
    (64,772 )     (64,084 )     (21,154 )     (17,052 )
Change in ceded unearned premium
    (6,642 )     (65,813 )     1,724       (41,382 )
Change in loss and loss adjustment expense payable
    169,225       149,833       75,602       70,912  
Change in reinsurance balances payable
    (28,803 )     64,265       (28,840 )     35,430  
Change in unearned premium
    86,183       166,720       58,551       110,496  
Change in premium and claims payable, net of restricted cash
    74,105       58,845       (23,340 )     18,965  
Depreciation and amortization expense
    7,368       5,564       3,978       2,588  
Other, net
    (48,858 )     (2,847 )     (38,000 )     (7,795 )
 
   
 
     
 
     
 
     
 
 
Cash provided by operating activities
    213,634       199,272       112,769       97,401  
Cash flows from investing activities:
                               
Sales of fixed income securities
    133,694       123,181       30,602       27,952  
Maturity or call of fixed income securities
    72,340       69,086       39,224       41,728  
Sales of equity securities
    4,671       1,165       4,371       182  
Other proceeds
          16,846             16,846  
Change in short-term investments
    (8,807 )     (89,563 )     50,238       58,636  
Cost of securities acquired
    (406,263 )     (407,875 )     (192,909 )     (243,638 )
Payments for purchase of subsidiaries, net of cash received
    (71,038 )     (4,079 )     (27,731 )     (4,079 )
Other, net
    72       (3,135 )     (2,194 )     (1,612 )
 
   
 
     
 
     
 
     
 
 
Cash used by investing activities
    (275,331 )     (294,374 )     (98,399 )     (103,985 )
Cash flows from financing activities:
                               
Issuance of notes payable, net of costs
    2,000       134,845       2,000        
Sale of common stock
    13,070       11,969       3,146       8,238  
Payments on notes payable
    (2,185 )     (67,622 )     (2,094 )     (95 )
Dividends paid
    (9,636 )     (8,137 )     (4,836 )     (4,076 )
 
   
 
     
 
     
 
     
 
 
Cash provided (used) by financing activities
    3,249       71,055       (1,784 )     4,067  
 
   
 
     
 
     
 
     
 
 
Net change in cash
    (58,448 )     (24,047 )     12,586       (2,517 )
Cash at beginning of period
    96,416       40,306       25,382       18,776  
 
   
 
     
 
     
 
     
 
 
Cash at end of period
  $ 37,968     $ 16,259     $ 37,968     $ 16,259  
 
   
 
     
 
     
 
     
 
 

See Notes to Condensed Consolidated Financial Statements

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HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, in thousands, except per share data)

(1)   GENERAL INFORMATION
 
    HCC Insurance Holdings, Inc. and its subsidiaries (“we,” “us” and “our”) provide specialized property and casualty, surety and accident and health insurance coverages and related agency and brokerage services to commercial customers. Our lines of business include group life, accident and health; diversified financial products (which includes directors’ and officers’ liability, errors and omissions, employment practices liability and surety); our London market account (which includes energy, marine, property and accident and health); aviation; and other specialty lines of insurance. We operate primarily in the United States, the United Kingdom, Spain and Bermuda, although some of our operations have a broader international scope. We market our products both directly to customers and through a network of independent and affiliated agents and brokers.
 
    Basis of Presentation
 
    The unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and include all adjustments which are, in our opinion, necessary for a fair presentation of the results of the interim periods. All adjustments made to the interim periods are of a normal recurring nature. The condensed consolidated financial statements include the accounts of HCC Insurance Holdings, Inc. and those of our wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated. The condensed consolidated financial statements for periods reported should be read in conjunction with the annual audited consolidated financial statements and related notes. The condensed consolidated balance sheet as of December 31, 2003 was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America.
 
    During the third quarter of 2003, we completed one acquisition. The results of operations of this entity are included in our consolidated financial statements beginning on the effective date of the transaction. Thus, our condensed consolidated statements of earnings and cash flows for the six months and three months ended June 30, 2003 do not contain any activity generated by this entity. See Note (2) for discussion of our 2004 acquisition.
 
    In the second quarter of 2004, we completed our annual assessment of the impairment of goodwill. Based upon this test, the fair value of each of our reporting units exceeded its carrying amount by a satisfactory margin.
 
    Income Tax
 
    For the six months and three months ended June 30, 2004 and 2003, the income tax provision has been calculated based on an estimated effective tax rate for each of the fiscal years. The difference between our effective tax rate and the United States federal statutory rate is primarily the result of state income taxes and tax exempt municipal bond interest.

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HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

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

(1)   GENERAL INFORMATION, continued
 
    Stock Options
 
    We account for stock options granted to employees using the intrinsic value method of APB Opinion No. 25 entitled “Accounting for Stock Issued to Employees”. All options have been granted at fixed exercise prices at the market price of our common stock at the grant date. Because of that, no stock-based employee compensation cost is reflected in our reported net income. However, the Financial Accounting Standards Board has issued an exposure draft of a pronouncement that, if adopted in its present form, will require stock-based employee compensation to be deducted from net income beginning in 2005. Options vest over a period of up to seven years and expire four to ten years after grant date. The following table illustrates the effects on net income and earnings per share if we had used the fair value method of SFAS No. 123 entitled “Accounting for Stock-Based Compensation”.

                                 
    For the six months ended   For the three months ended
    June 30,
  June 30,
    2004
  2003
  2004
  2003
Reported net earnings
  $ 90,983     $ 56,735     $ 46,415     $ 32,968  
Stock-based compensation using fair value method, net of income tax
    (2,453 )     (3,871 )     (1,233 )     (1,932 )
 
   
 
     
 
     
 
     
 
 
Pro forma net earnings
  $ 88,530     $ 52,864     $ 45,182     $ 31,036  
 
   
 
     
 
     
 
     
 
 
Reported basic earnings per share
  $ 1.41     $ 0.90     $ 0.72     $ 0.52  
Fair value stock-based compensation
    (0.04 )     (0.06 )     (0.02 )     (0.03 )
 
   
 
     
 
     
 
     
 
 
Pro forma basic earnings per share
  $ 1.37     $ 0.84     $ 0.70     $ 0.49  
 
   
 
     
 
     
 
     
 
 
Reported diluted earnings per share
  $ 1.39     $ 0.89     $ 0.71     $ 0.52  
Fair value stock-based compensation
    (0.04 )     (0.06 )     (0.02 )     (0.03 )
 
   
 
     
 
     
 
     
 
 
Pro forma diluted earnings per share
  $ 1.35     $ 0.83     $ 0.69     $ 0.49  
 
   
 
     
 
     
 
     
 
 

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HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

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

(1)   GENERAL INFORMATION, continued
 
    Discontinued Operations
 
    In December 2003, we sold the business of our retail brokerage subsidiary HCC Employee Benefits, Inc. In the fourth quarter of 2003, we began reporting this business as discontinued operations and prior year financial information has been reclassified to reflect this presentation. Summarized financial data for discontinued operations is shown below. Earnings before income tax provision exclude allocated general corporate overhead expenses of $0.8 million and $0.4 million, respectively, for the six months and three months ended June 30, 2003.

                                   
    For the six months ended   For the three months ended
    June 30,
  June 30,
    2004
  2003
  2004
  2003
Revenue
  $ (197 )   $ 10,499     $     $ 6,050  
Earnings (loss) before income tax provision
    (309 )     5,186       71       3,019  

    Reclassifications
 
    Certain amounts in our 2003 condensed consolidated financial statements have been reclassified to conform to the 2004 presentation. Such reclassifications had no effect on our net earnings, shareholders’ equity or cash flows.

(2)   ACQUISITION
 
    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 surety company specializing in court, specialty contract, license and permit bonds. American Contractors Indemnity Company will further expand our diversified financial products segment. We paid $46.9 million in cash. This business combination has been recorded using the purchase method of accounting. The results of operations of American Contractors Indemnity Company have been included in our consolidated financial statements beginning on the effective date of the transaction. We are still in the process of completing the purchase price allocation for this acquisition, as we are still gathering some of the information, including information related to litigation contingencies, needed to make the required calculations. Goodwill resulting from this acquisition will not be deductible for United States federal income tax purposes.

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HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

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

(2)   ACQUISITION, continued
 
    The following table summarizes the combined estimated fair values of assets acquired and liabilities assumed at the acquisition date.

         
    January 31, 2004
Total investments
  $ 87,873  
Premium, claims and other receivables
    5,665  
Reinsurance recoverables
    4,715  
Other policy related assets
    15,118  
Goodwill and intangible assets
    14,618  
All other assets
    1,587  
 
   
 
 
Total assets acquired
    129,576  
Loss and loss adjustment expense payable
    15,537  
Unearned premium
    27,078  
Other policy related liabilities
    1,729  
All other liabilities
    38,323  
 
   
 
 
Total liabilities assumed
    82,667  
 
   
 
 
Assets acquired in excess of liabilities assumed
  $ 46,909  
 
   
 
 

    The following unaudited pro forma summary presents information as if this acquisition had occurred at the beginning of 2004 and 2003 after giving effect to certain adjustments, including estimated amortization of intangible assets, presumed interest expense from debt issued to fund the acquisition and income taxes. The pro forma summary is for information purposes only, does not necessarily reflect the actual results that would have occurred, nor is it necessarily indicative of future results of the combined companies. American Contractors Indemnity Company incurred $2.6 million in acquisition related expenses, primarily for bonuses and other incentive compensation and related employment taxes immediately prior to the completion of the acquisition.

                                 
    For the six months   For the three months
    ended June 30,
  ended June 30,
Unaudited Pro forma Information
  2004
  2003
  2004
  2003
Revenue
  $ 599,135     $ 459,149     $ 317,270     $ 249,114  
Net earnings
    90,007       59,971       46,415       34,398  
Basic earnings per share
    1.40       0.96       0.72       0.55  
Diluted earnings per share
    1.37       0.94       0.71       0.54  

    In the first six months of 2004, we paid $27.7 million related to year end accruals for consideration based on the terms of prior acquisition agreements.

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HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

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

(3)   REINSURANCE
 
    In the normal course of business our insurance companies cede a portion of their premium to domestic and foreign reinsurers through treaty and facultative reinsurance agreements. Although the ceding of reinsurance does not discharge the primary insurer from liability to its policyholder, our insurance companies participate in such agreements for the purpose of limiting their loss exposure, protecting them against catastrophic loss and diversifying their business. The following table represents the effect of such reinsurance transactions on premium and loss and loss adjustment expense:

                         
                    Loss and Loss
    Written   Earned   Adjustment
    Premium
  Premium
  Expense
For the six months ended June 30, 2004:
                       
Direct business
  $ 828,804     $ 743,736     $ 416,885  
Reinsurance assumed
    151,967       148,911       129,621  
Reinsurance ceded
    (435,955 )     (423,514 )     (272,744 )
 
   
 
     
 
     
 
 
Net amounts
  $ 544,816     $ 469,133     $ 273,762  
 
   
 
     
 
     
 
 
For the six months ended June 30, 2003:
                       
Direct business
  $ 654,610     $ 538,255     $ 335,912  
Reinsurance assumed
    202,117       153,833       168,660  
Reinsurance ceded
    (413,135 )     (346,174 )     (284,460 )
 
   
 
     
 
     
 
 
Net amounts
  $ 443,592     $ 345,914     $ 220,112  
 
   
 
     
 
     
 
 
For the three months ended June 30, 2004:
                       
Direct business
  $ 456,843     $ 385,657     $ 205,777  
Reinsurance assumed
    64,347       74,685       71,632  
Reinsurance ceded
    (212,329 )     (208,272 )     (129,511 )
 
   
 
     
 
     
 
 
Net amounts
  $ 308,861     $ 252,070     $ 147,898  
 
   
 
     
 
     
 
 
For the three months ended June 30, 2003:
                       
Direct business
  $ 357,830     $ 282,384     $ 168,696  
Reinsurance assumed
    119,449       91,885       116,833  
Reinsurance ceded
    (226,188 )     (190,777 )     (165,449 )
 
   
 
     
 
     
 
 
Net amounts
  $ 251,091     $ 183,492     $ 120,080  
 
   
 
     
 
     
 
 

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Notes to Condensed Consolidated Financial Statements

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

(3)   REINSURANCE, continued
 
    The table below represents the composition of reinsurance recoverables in our condensed consolidated balance sheets:

                 
    June 30, 2004
  December 31, 2003
Reinsurance recoverable on paid losses
  $ 97,916     $ 101,013  
Reinsurance recoverable on outstanding losses
    436,614       425,609  
Reinsurance recoverable on incurred but not reported losses
    468,102       404,479  
Reserve for uncollectible reinsurance
    (16,955 )     (14,911 )
 
   
 
     
 
 
Total reinsurance recoverables
  $ 985,677     $ 916,190  
 
   
 
     
 
 

    Our insurance companies require their reinsurers not authorized by the respective states of domicile of our insurance companies to collateralize the reinsurance obligations due to us. The table below shows amounts held by us as collateral plus other credits available for potential offset.

                 
    June 30, 2004
  December 31, 2003
Payables to reinsurers
  $ 398,709     $ 393,214  
Letters of credit
    238,525       195,329  
Cash deposits
    10,224       11,195  
 
   
 
     
 
 
Total credits
  $ 647,458     $ 599,738  
 
   
 
     
 
 

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

                 
    June 30, 2004
  December 31, 2003
Loss and loss adjustment expense payable
  $ 1,720,050     $ 1,535,288  
Reinsurance recoverable on outstanding losses
    (436,614 )     (425,609 )
Reinsurance recoverable on incurred but not reported losses
    (468,102 )     (404,479 )
 
   
 
     
 
 
Net loss and loss adjustment expense payable
  $ 815,334     $ 705,200  
 
   
 
     
 
 
Unearned premium
  $ 705,572     $ 592,311  
Ceded unearned premium
    (301,193 )     (291,591 )
 
   
 
     
 
 
Net unearned premium
  $ 404,379     $ 300,720  
 
   
 
     
 
 
Deferred policy acquisition costs
  $ 136,584     $ 106,943  
Deferred ceding commissions
    (88,311 )     (88,129 )
 
   
 
     
 
 
Net deferred policy acquisition costs
  $ 48,273     $ 18,814  
 
   
 
     
 
 

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Notes to Condensed Consolidated Financial Statements

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

(3)   REINSURANCE, continued
 
    We have a reserve of $17.0 million as of June 30, 2004 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.
 
    Certain reinsurers have delayed or suspended the payment of amounts recoverable under reinsurance contracts to which we are a party. Such delays have not materially affected the investment income of our insurance companies nor 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. We generally expect to collect the full amounts recoverable and 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. In some cases, the final resolution of such disputes through arbitration or litigation may extend over several years. Our insurance companies had an aggregate amount of $3.2 million which had not been paid to us under contracts that are subject to arbitration proceedings we initiated and we estimate that there could be up to an additional $11.0 million of incurred losses and loss expenses and other balances due under the subject contracts.
 
(4)   SEGMENT AND GEOGRAPHIC INFORMATION
 
    The performance of each segment is evaluated based upon net earnings and is calculated after tax and after all corporate expense and purchase price allocations have been charged or credited to the individual segments. The following tables show information by business segment and geographic location. Geographic location is determined by physical location of our offices and does not represent the location of insureds or reinsureds from whom the business was generated. In December 2003, we sold our retail brokerage subsidiary that was a significant portion of our intermediary segment. As a result, operationally we have combined the underwriting agency and intermediary segments (excluding the former retail brokerage subsidiary, which is now shown as discontinued operations) to form the agency segment, and we have reflected this change in our 2003 presentation.

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HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

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

(4)   SEGMENT AND GEOGRAPHIC INFORMATION, continued

                                         
    Insurance           Other        
    Company
  Agency
  Operations
  Corporate
  Total
For the six months ended June 30, 2004
                                       
Revenue:
                                       
Domestic
  $ 402,632     $ 42,466     $ 4,827     $ 824     $ 450,749  
Foreign
    120,388       24,151                   144,539  
Inter-segment
    351       44,207                   44,558  
 
   
 
     
 
     
 
     
 
     
 
 
Total segment revenue
  $ 523,371     $ 110,824     $ 4,827     $ 824       639,846  
 
   
 
     
 
     
 
     
 
         
Inter-segment revenue
                                    (44,558 )
 
                                   
 
 
Consolidated total revenue
                                  $ 595,288  
 
                                   
 
 
Net earnings:
                                       
Domestic
  $ 48,451     $ 16,794     $ 2,857     $ (861 )   $ 67,241  
Foreign
    18,319       8,671                   26,990  
 
   
 
     
 
     
 
     
 
     
 
 
Total segment net earnings (loss)
  $ 66,770     $ 25,465     $ 2,857     $ (861 )     94,231  
 
   
 
     
 
     
 
     
 
         
Inter-segment eliminations
                                    (3,049 )
Loss from discontinued operations
                                    (199 )
 
                                   
 
 
Consolidated net earnings
                                  $ 90,983  
 
                                   
 
 
Other items:
                                       
Net investment income
  $ 27,354     $ 1,508     $ 186     $ 354     $ 29,402  
Depreciation and amortization
    2,125       4,572       238       433       7,368  
Interest expense (benefit)
    366       4,062       377       (847 )     3,958  
Capital expenditures
    1,527       745       16       1,535       3,823  
 
Income tax provision (benefit)
    31,819       17,128       906       359       50,212  
Inter-segment eliminations
                                    (2,080 )
 
                                   
 
 
Consolidated income tax provision from continuing operations
                                  $ 48,132  
 
                                   
 
 

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Notes to Condensed Consolidated Financial Statements

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

(4)   SEGMENT AND GEOGRAPHIC INFORMATION, continued

                                         
    Insurance           Other        
    Company
  Agency
  Operations
  Corporate
  Total
For the six months ended June 30, 2003
                                       
Revenue:
                                       
Domestic
  $ 284,796     $ 28,846     $ 4,654     $ 786     $ 319,082  
Foreign
    101,273       17,457                   118,730  
Inter-segment
          48,004                   48,004  
 
   
 
     
 
     
 
     
 
     
 
 
Total segment revenue
  $ 386,069     $ 94,307     $ 4,654     $ 786       485,816  
 
   
 
     
 
     
 
     
 
         
Inter-segment revenue
                                    (48,004 )
 
                                   
 
 
Consolidated total revenue
                                  $ 437,812  
 
                                   
 
 
Net earnings:
                                       
Domestic
  $ 31,960     $ 19,348     $ 1,933     $ 478     $ 53,719  
Foreign
    7,201       4,940                   12,141  
 
   
 
     
 
     
 
     
 
     
 
 
Total segment net earnings (loss)
  $ 39,161     $ 24,288     $ 1,933     $ 478       65,860  
 
   
 
     
 
     
 
     
 
         
Inter-segment eliminations
                                    (12,406 )
Earnings from discontinued operations
                                    3,281  
 
                                   
 
 
Consolidated net earnings
                                  $ 56,735  
 
                                   
 
 
Other items:
                                       
Net investment income
  $ 20,227     $ 1,827     $ 8     $ 803     $ 22,865  
Depreciation and amortization (1)
    1,617       2,457       327       1,080       5,481  
Interest expense (benefit)
    25       5,201       387       (2,017 )     3,596  
Capital expenditures (1)
    1,231       1,408             348       2,987  
 
 
                                       
Income tax provision (benefit)
    19,201       15,203       868       1,085       36,357  
Inter-segment eliminations
                                    (6,320 )
 
                                   
 
 
Consolidated income tax provision from continuing operations
                                  $ 30,037  
 
                                   
 
 


(1)   Excludes immaterial amounts related to discontinued operations.

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Notes to Condensed Consolidated Financial Statements

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

(4)   SEGMENT AND GEOGRAPHIC INFORMATION, continued

                                         
    Insurance           Other        
    Company
  Agency
  Operations
  Corporate
  Total
For the three months ended June 30, 2004:
                                       
Revenue:
                                       
Domestic
  $ 212,731     $ 23,479     $ 2,673     $ 426     $ 239,309  
Foreign
    66,592       11,369                   77,961  
Inter-segment
    351       22,511                   22,862  
 
   
 
     
 
     
 
     
 
     
 
 
Total segment revenue
  $ 279,674     $ 57,359     $ 2,673     $ 426       340,132  
 
   
 
     
 
     
 
     
 
         
Inter-segment revenue
                                    (22,862 )
 
                                   
 
 
Consolidated total revenue
                                  $ 317,270  
 
                                   
 
 
Net earnings:
                                       
Domestic
  $ 23,821     $ 9,898     $ 1,664     $ (130 )   $ 35,253  
Foreign
    9,429       3,480                   12,909  
 
   
 
     
 
     
 
     
 
     
 
 
Total segment net earnings (loss)
  $ 33,250     $ 13,378     $ 1,664     $ (130 )     48,162  
 
   
 
     
 
     
 
     
 
         
Inter-segment eliminations
                                    (1,782 )
Earnings from discontinued operations
                                    35  
 
                                   
 
 
Consolidated net earnings
                                  $ 46,415  
 
                                   
 
 
Other items:
                                       
Net investment income
  $ 14,001     $ 668     $ 97     $ 201     $ 14,967  
Depreciation and amortization
    1,314       2,137       112       415       3,978  
Interest expense (benefit)
    18       2,022       187       (481 )     1,746  
Capital expenditures
    674       614       12       894       2,194  
 
Income tax provision (benefit)
    16,097       8,928       488       (258 )     25,255  
Inter-segment eliminations
                                    (852 )
 
                                   
 
 
Consolidated income tax provision from continuing operations
                                  $ 24,403  
 
                                   
 
 

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Notes to Condensed Consolidated Financial Statements

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

(4)   SEGMENT AND GEOGRAPHIC INFORMATION, continued

                                         
    Insurance           Other        
    Company
  Agency
  Operations
  Corporate
  Total
For the three months ended June 30, 2003:
                                       
Revenue:
                                       
Domestic
  $ 147,560     $ 17,806     $ 4,207     $ 785     $ 170,358  
Foreign
    56,951       10,559                   67,510  
Inter-segment
          21,010                   21,010  
 
   
 
     
 
     
 
     
 
     
 
 
Total segment revenue
  $ 204,511     $ 49,375     $ 4,207     $ 785       258,878  
 
   
 
     
 
     
 
     
 
         
Inter-segment revenue
                                    (21,010 )
 
                                   
 
 
Consolidated total revenue
                                  $ 237,868  
 
                                   
 
 
Net earnings:
                                       
Domestic
  $ 15,987     $ 10,227     $ 2,523     $ 697     $ 29,434  
Foreign
    3,814       2,612                   6,426  
 
   
 
     
 
     
 
     
 
     
 
 
Total segment net earnings (loss)
  $ 19,801     $ 12,839     $ 2,523     $ 697       35,860  
 
   
 
     
 
     
 
     
 
         
Inter-segment eliminations
                                    (4,746 )
Earnings from discontinued operations
                                    1,854  
 
                                   
 
 
Consolidated net earnings
                                  $ 32,968  
 
                                   
 
 
Other items:
                                       
Net investment income
  $ 10,197     $ 895     $ 4     $ 772     $ 11,868  
Depreciation and amortization (1)
    796       821       88       841       2,546  
Interest expense (benefit)
    16       2,751       194       (1,047 )     1,914  
Capital expenditures (1)
    791       660             83       1,534  
 
Income tax provision (benefit)
    10,440       7,929       1,150       327       19,846  
Inter-segment eliminations
                                    (1,891 )
 
                                   
 
 
Consolidated income tax provision from continuing operations
                                  $ 17,955  
 
                                   
 
 


(1)   Excludes immaterial amounts related to discontinued operations.

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Notes to Condensed Consolidated Financial Statements

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

(4)   SEGMENT AND GEOGRAPHIC INFORMATION, continued
 
    The following table presents selected revenue items by line of business for the periods indicated:

                                 
    For the six months ended   For the three months ended
    June 30,
  June 30,
    2004
  2003
  2004
  2003
Group life, accident and health
  $ 159,890     $ 147,509     $ 80,501     $ 75,526  
Diversified financial products
    130,113       44,818       73,714       26,512  
London market account
    61,522       66,457       35,408       37,081  
Aviation
    57,267       48,237       32,998       24,355  
Other specialty lines of business
    28,291       207       15,720       153  
 
   
 
     
 
     
 
     
 
 
 
    437,083       307,228       238,341       163,627  
Discontinued lines of business
    32,050       38,686       13,729       19,865  
 
   
 
     
 
     
 
     
 
 
Net earned premium
  $ 469,133     $ 345,914     $ 252,070     $ 183,492  
 
   
 
     
 
     
 
     
 
 
Group life, accident and health
  $ 29,595     $ 30,963     $ 16,603     $ 15,484  
Property and casualty
    60,350       32,752       29,499       22,579  
 
   
 
     
 
     
 
     
 
 
Fee and commission income
  $ 89,945     $ 63,715     $ 46,102     $ 38,063  
 
   
 
     
 
     
 
     
 
 

(5)   EARNINGS PER SHARE
 
    Basic earnings per share is based on the weighted average number of common shares outstanding during the period divided into net earnings. Diluted earnings per share is based on the weighted average number of common shares outstanding plus the potential common shares outstanding during the period divided into net earnings. Outstanding common stock options, when dilutive, are considered to be potential common shares for the purpose of the diluted calculation. The treasury stock method is used to calculate potential common shares due to options. The dilutive effect of our contingently convertible notes is not included in the diluted earnings per share computation until the market price trigger requirement is met.

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Notes to Condensed Consolidated Financial Statements

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

(5)   EARNINGS PER SHARE, continued
 
    The following table provides a reconciliation of the denominators used in the earnings per share calculations:

                                 
    For the six months ended   For the three months ended
    June 30,
  June 30,
    2004
  2003
  2004
  2003
Net earnings
  $ 90,983     $ 56,735     $ 46,415     $ 32,968  
 
   
 
     
 
     
 
     
 
 
Weighted average common shares outstanding
    64,399       62,753       64,538       62,867  
Additional dilutive effect of outstanding options (as determined by the application of the treasury stock method)
    1,158       914       1,148       1,123  
 
   
 
     
 
     
 
     
 
 
Weighted average common shares and potential common shares outstanding
    65,557       63,667       65,686       63,990  
 
   
 
     
 
     
 
     
 
 
Anti-dilutive stock options not included in treasury stock method computation
          499             174  
 
   
 
     
 
     
 
     
 
 

(6)   SUPPLEMENTAL INFORMATION

                                 
    For the six months ended   For the three months ended
    June 30,
  June 30,
    2004
  2003
  2004
  2003
Interest paid
  $ 3,522     $ 2,721     $ 252     $ 290  
Income tax paid
    72,009       32,102       40,451       26,171  
Comprehensive income
    74,509       63,584       24,928       40,640  
Ceding commissions netted with policy acquisition costs
    53,680       54,313       23,788       29,934  

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Notes to Condensed Consolidated Financial Statements

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

(7)   COMMITMENTS AND CONTINGENCIES
 
    We are party to lawsuits, arbitrations and other proceedings that arise in the normal course of our business. Many of such lawsuits, arbitrations and other proceedings involve claims under policies that we underwrite as an insurer or reinsurer, the liabilities for which we believe have been adequately included in our loss reserves. Also, from time to time, we are a party to lawsuits, arbitrations and other proceedings which relate to disputes over contractual relationships with third parties, or which involve alleged errors and omissions on the part of our subsidiaries.
 
    A subsidiary has been named along with several other defendants in legal proceedings by certain insurance company members of a discontinued workers’ compensation reinsurance facility commonly known as the Unicover Pool. During 1997 and 1998, our subsidiary was one of two co-intermediaries for the facility. Other defendants in the current proceedings include the other reinsurance intermediary, the former managing underwriter for the facility and various individuals, none of whom are affiliated with us. It is claimed in the proceedings that the actions of the various defendants resulted in the recission of certain reinsurance contracts in an arbitration to which we were not a party and include allegations of breach of fiduciary duty, negligence, fraud and other allegations. The claims in the proceedings are for unspecified or substantial compensatory and punitive damages. We believe that we have meritorious defenses to the allegations and intend to vigorously defend against the claims made in the proceedings. The current court proceedings have been subjected to an indefinite judicial stay pending the resolution of an arbitration among the managing underwriter of the facility and the various facility members. We are not a party to such arbitration.
 
    In addition, we are presently engaged in litigation initiated by the appointed liquidator of a former reinsurer concerning payments made to us prior to the date of the appointment of the liquidator. The disputed payments were made by the now insolvent reinsurer in connection with a commutation agreement. Our understanding is that such litigation is one of a number of similar actions brought by the liquidator. We intend to vigorously contest the action.
 
    Although the ultimate outcome of these matters may not be determined at this time, based upon present information, the availability of insurance coverage and advice received from our outside legal counsel, we do not believe the resolution of any of these matters, some of which include allegations of damages in material amounts, will have a material adverse effect on our financial condition, results of operations or cash flows.

20


Table of Contents

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

Overview

We primarily receive our revenue from earned premium derived from our insurance company operations, fee and commission income generated by our agency operations, proceeds from ceded reinsurance (ceding commissions in excess of acquisition costs) earned by our insurance company subsidiaries, investment income from all of our operations and other operating income. Our core underwriting activities involve providing insurance products in the group life, accident and health, diversified financial products, London market account, aviation and other specialty lines of business, each of which is marketed by our insurance companies and our agencies either directly to customers or through a network of agents, third party administrators and brokers.

The results of operations of Surety Associates Holding Co., Inc. and its subsidiary American Contractors Indemnity Company, which were acquired in the first quarter of 2004, and Covenant Underwriters Limited and Continental Underwriters Limited, which were acquired in the third quarter of 2003, are included in our condensed consolidated financial statements beginning on the respective effective dates of their acquisitions. Thus, our condensed consolidated statements of earnings and cash flows for the six months and three months ended June 30, 2003 do not include the operations of these companies.

Results of Operations

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

                                 
    For the six months   For the three months
    ended June 30,
  ended June 30,
    2004
  2003
  2004
  2003
Net earned premium
    78.8 %     79.0 %     79.5 %     77.1 %
Fee and commission income
    15.1       14.6       14.5       16.0  
Net investment income
    4.9       5.2       4.7       5.0  
Net realized investment gain
    0.1                   0.1  
Other operating income
    1.1       1.2       1.3       1.8  
 
   
 
     
 
     
 
     
 
 
Total revenue
    100.0       100.0       100.0       100.0  
Loss and loss adjustment expense, net
    46.0       50.3       46.6       50.5  
Total operating expense
    29.9       29.8       30.5       28.1  
Interest expense
    0.7       0.8       0.6       0.8  
 
   
 
     
 
     
 
     
 
 
Earnings from continuing operations before income tax provision
    23.4       19.1       22.3       20.6  
Income tax provision
    8.1       6.9       7.7       7.5  
 
   
 
     
 
     
 
     
 
 
Earnings from continuing operations
    15.3 %     12.2 %     14.6 %     13.1 %
 
   
 
     
 
     
 
     
 
 

Six months ended June 30, 2004 versus six months ended June 30, 2003

Total revenue increased 36% to $595.3 million for 2004 driven by significant increases in net earned premium, fee and commission income and investment income. Most of this growth was either organic or resulted from increased retentions. In addition, $27.5 million came from subsidiaries acquired in the past twelve months. We expect revenue growth to continue for the rest of 2004 and into 2005.

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Fee and commission income increased 41% to $89.9 million in 2004 due principally to organic growth in our agency subsidiaries. Additionally, 2003 fee and commission income included a charge of $6.5 million due to the cumulative effect on prior years of our 2003 restatement to change our accounting for certain fee and commission income. The table below shows the composition of fee and commission income for the six months ended June 30, 2004 and 2003 (amounts in thousands):

                 
    2004
  2003
Continuing subsidiaries
  $ 86,295     $ 70,243  
Subsidiaries acquired during past year
    3,650        
2003 charge
          (6,528 )
 
   
 
     
 
 
Total fee and commission income
  $ 89,945     $ 63,715  
 
   
 
     
 
 

Net investment income increased 29% to $29.4 million in 2004. This increase was due to higher investment assets, which increased to $2.0 billion as of June 30, 2004 compared to $1.7 billion as of December 31, 2003 resulting primarily from significant cash flow from operations and to a lesser extent the acquisition of American Contractors Indemnity Company in January 2004. Net investment income increased despite low yields on our fixed income and short-term investments. We expect investment assets to continue to increase and produce additional growth in investment income for the balance of 2004. If market interest rates were to rise, the growth in investment income would be expected to accelerate as our current portfolio has a relatively short duration and would become available to be invested on a longer-term basis to take advantage of higher rates. Our weighted average tax equivalent yield was 3.7% in 2004 and 4.3% in 2003. As of June 30, 2004, the weighted average duration of our fixed income portfolio was 3.88 years and the weighted average maturity was 4.67 years.

Compensation expense increased as a result of acquisitions and a slight increase in staffing levels to manage growth and additional reporting requirements under Sarbanes-Oxley. However, the rate of increase in compensation expense is less than the rate of increase in revenue, thereby contributing to higher margins and increased net earnings. Compensation expense for the six months ended June 30, 2004 and 2003 (amounts in thousands) and the number of employees as of June 30 of each year are shown below:

                 
Compensation Expense
  2004
  2003
Continuing subsidiaries
  $ 41,479     $ 38,611  
Subsidiaries acquired during past year
    4,959        
 
   
 
     
 
 
Total compensation expense
  $ 46,438     $ 38,611  
 
   
 
     
 
 
                 
Number of Employees
               
Continuing subsidiaries
    1,075       1,051  
Subsidiaries acquired during past year
    165        
Subsidiaries sold during past year
          58  
 
   
 
     
 
 
Total number of employees
    1,240       1,109  
 
   
 
     
 
 

Other operating expense increased during 2004 compared to 2003, as shown in the following table (amounts in thousands). During 2003 there was a one-time currency gain of $1.3 million from the settlement of an advance of funds to an unaffiliated entity.

                   
    2004
  2003
Subsidiaries acquired during past year
  $ 3,623     $
2003 currency conversion transaction gain
          (1,287 )
Litigation accruals
    1,775       245  
Other expense
    27,777       27,080  
 
   
 
     
 
 
 
  $ 33,175     $ 26,038
 
   
 
     
 
 

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Income tax expense from continuing operations was $48.1 million in 2004 compared to $30.0 million in 2003. Our effective tax rate was 34.5% in 2004 compared to 36.0% in 2003. We expect a decrease in our income tax rate in 2004 compared to 2003 because a higher percentage of our pre-tax income is earned by our insurance company subsidiaries and is not subject to State income taxes and our tax exempt interest income is increasing.

Net earnings increased 60% to $91.0 million, or $1.39 per diluted share, in 2004 from $56.7 million, or $0.89 per diluted share, in 2003. Growth in net earned premium, fee and commission income and investment income and continuing favorable underwriting results caused the increase in 2004 net earnings. Net earnings in 2004 include $3.5 million from subsidiaries acquired during the past year. Also included in 2003 net earnings is a charge of $3.9 million, or $0.06 per share, due to the cumulative effect on prior years of our 2003 restatement to change our accounting for certain fee and commission income.

At June 30, 2004, book value per share was $17.46, up from $17.12 as of March 31, 2004 and $16.37 as of December 31, 2003 (despite a reduction of $0.22 per share since year end 2003 due to the reduction in net after tax unrealized gains on our investments as a result of rising interest rates). Total assets were $5.3 billion and shareholders’ equity was $1.1 billion, up from $4.9 billion and $1.0 billion, respectfully, at December 31, 2003.

SEGMENTS

Insurance Companies

The following table sets forth certain premium amounts and percentages of gross written premium for the six months ended June 30, 2004 and 2003 (amounts in thousands):

                                 
    2004
  2003
    Amount
  Percentage
  Amount
  Percentage
Direct
  $ 828,804       85 %   $ 654,610       76 %
Reinsurance assumed
    151,967       15       202,117       24  
 
   
 
     
 
     
 
     
 
 
Gross written premium
    980,771       100       856,727       100  
Reinsurance ceded
    (435,955 )     (44 )     (413,135 )     (48 )
 
   
 
     
 
     
 
     
 
 
Net written premium
    544,816       56       443,592       52  
Change in unearned premium
    (75,683 )     (8 )     (97,678 )     (12 )
 
   
 
     
 
     
 
     
 
 
Net earned premium
  $ 469,133       48 %   $ 345,914       40 %
 
   
 
     
 
     
 
     
 
 

The following tables provide information by line of business (amounts in thousands):

                                                                         
    Gross Written Premium
  Net Written Premium
  Net Earned Premium
                    %                   %                   %
    2004
  2003
  Change
  2004
  2003
  Change
  2004
  2003
  Change
Group life, accident & health
  $ 293,855     $ 283,482       4 %   $ 161,312     $ 157,353       3 %   $ 159,890     $ 147,509       8 %
Diversified financial products
    391,663       250,426       56       167,814       82,214       104       130,113       44,818       190  
London market account
    117,344       140,152       (16 )     81,886       102,554       (20 )     61,522       66,457       (7 )
Aviation
    96,993       108,960       (11 )     75,081       51,204       47       57,267       48,237       19  
Other specialty lines of business
    63,994       6,845     nm     38,809       2,222     nm     28,291       207     nm
 
   
 
     
 
     
 
     
 
     
 
     
 
     
 
     
 
     
 
 
 
    963,849       789,865       22       524,902       395,547       33       437,083       307,228       42  
Discontinued lines of business
    16,922       66,862     nm     19,914       48,045     nm     32,050       38,686     nm
 
   
 
     
 
     
 
     
 
     
 
     
 
     
 
     
 
     
 
 
 
  $ 980,771     $ 856,727       14 %   $ 544,816     $ 443,592       23 %   $ 469,133     $ 345,914       36 %
 
   
 
     
 
     
 
     
 
     
 
     
 
     
 
     
 
     
 
 


nm-Not meaningful    

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Gross written premium increased 14% to $980.8 million in the first six months of 2004. Net written premium increased 23% to $544.8 million and net earned premium increased 36% to $469.1 million, both due principally to organic growth and increased retentions on some lines. The increase in premium is expected to continue into 2005. The growth in gross written premium results principally from the following factors:

    The largest growth was in our diversified financial products line of business primarily as a result of organic growth in directors’ and officers’ and errors and omissions business, as well as an increase in surety business due to our acquisition of American Contractors Indemnity Company in January 2004. We are seeing some softness in premium rates but no change in deductibles or policy conditions. The underwriting profit margins are all still very adequate.
 
    Our other specialty lines of business increased significantly due to new business activities commenced during the past year. These activities include underwriting of marine insurance on the Gulf Coast of the United States, our quota-share reinsurance participation in a book of surplus lines insurance and our participation in a Lloyds syndicate writing UK liability insurance.
 
    Our London market account experienced somewhat reduced premium writings due to more selective underwriting, as premium rates softened.

The tables below show the composition of net and gross incurred loss and loss adjustment expense for the six months ended June 30, 2004 and 2003 (amounts in thousands):

                                 
    2004
  2003
    Amount
  Loss Ratio
  Amount
  Loss Ratio
Net
                               
Deficiency
  $ 2,852       0.6 %   $ 9,830       2.8 %
All other net incurred loss and loss adjustment expense
    270,910       57.8       210,282       60.8  
 
   
 
     
 
     
 
     
 
 
Net incurred loss and loss adjustment expense
  $ 273,762       58.4 %   $ 220,112       63.6 %
 
   
 
     
 
     
 
     
 
 
Gross
                               
Discontinued line of business adjustments
  $ 34,212       3.8 %   $ 76,100       11.0 %
Reduce incurred but not reported losses
    (17,300 )     (1.9 )            
All other gross incurred loss and loss adjustment expense
    529,594       59.3       428,472       61.9  
 
   
 
     
 
     
 
     
 
 
Gross incurred loss and loss adjustment expense
  $ 546,506       61.2 %   $ 504,572       72.9 %
 
   
 
     
 
     
 
     
 
 

We have no material exposure to environmental or asbestos losses and believe we have provided for all material net incurred losses.

Our gross loss ratio was 61.2% for 2004 compared to 72.9% for 2003. We continue to experience gross development on certain business included in the discontinued line of business, but at a slower pace than in 2003. Also, during 2004, we reduced gross incurred but not reported losses on prior accident years on certain of our London market account business. Since all of these contracts were substantially reinsured, the effect on our net losses was not material.

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The following table provides comparative net loss ratios by line of business for the six months ended June 30, 2004 and 2003 (amounts in thousands):

                                 
    2004
  2003
    Net   Net   Net   Net
    Earned   Loss   Earned   Loss
    Premium
  Ratio
  Premium
  Ratio
Group life, accident and health
  $ 159,890       62.7 %   $ 147,509       63.7 %
Diversified financial products
    130,113       45.7       44,818       47.9  
London market accounts
    61,522       45.5       66,457       52.8  
Aviation
    57,267       59.1       48,237       63.6  
Other specialty lines of business
    28,291       60.4       207       54.6  
 
   
 
     
 
     
 
     
 
 
 
    437,083       54.6       307,228       59.0  
Discontinued lines of business
    32,050       109.7       38,686       100.4  
 
   
 
     
 
     
 
     
 
 
Totals
  $ 469,133       58.4 %   $ 345,914       63.6 %
 
   
 
             
 
         
Expense ratio
            26.6               25.3  
 
           
 
             
 
 
Combined ratio
            85.0 %             88.9 %
 
           
 
             
 
 

Comments on net loss ratios by line of business are below:

    Group life, accident and health — The 2004 loss ratio is slightly lower than expected because of a reduction in reserves for redundancies from prior accident years.

    Diversified financial products — The decrease in loss ratio is due to changes in overall mix of business. The surety business of American Contractors Indemnity Company, acquired in January 2004, has a lower loss ratio compared to the other business in this line.

    London market accounts — Underwriting results generally improved due to more selective underwriting and we have moved to excess business where there is less loss frequency.

    Aviation — Underwriting results improved.

    Other specialty lines — The current loss ratio is as expected for new business activities commenced during the past year.

    Discontinued lines of business — Both periods have been affected by reserve additions resulting from our ongoing review of outstanding claims. Additionally, given the limited amount of earned premium in this line of business, a minor adjustment to the reserves can significantly impact the loss ratio.

Policy acquisition costs, which are net of the related portion of commissions on reinsurance ceded, increased to $98.6 million during the first six months of 2004, from $66.0 million in the same period in 2003. This increase is due to the increase in net earned premium. The increase in the expense ratio is due to the reduction in ceding commissions as a result of higher retentions plus the addition of surety business at American Contractors Indemnity Company, acquired in January 2004, which, as is common to the surety business, has a higher expense ratio than the rest of our business, although a much lower expected loss ratio.

Net earnings of our insurance companies increased 71% to $66.8 million in 2004 due to increased premium volume, continuing profitable underwriting results and increased investment income. We expect growth in the net earnings of our insurance companies to continue through 2005. Our increasingly profitable underwriting results are reflected in a 2004 combined ratio of 85.0% compared to 88.9% in 2003.

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Table of Contents

Agency

Revenue from our agency segment increased 18% to $110.8 million in 2004. This results primarily from increased new business and an acquisition made in 2003 which accounted for $5.3 million of the increased revenue. Net earnings of our agency segment increased 5% to $25.5 million in 2004 for the same reasons. Higher corporate cost allocations in 2004 caused the increase in segment net earnings to be less than the comparable increase in segment revenue. Also, in 2004 a discontinued agency operation recorded a $1.6 million (before tax) accrual for certain pending litigation.

Other Operations

The increase in other operating income in 2004 is primarily due to income from strategic investments. Period to period comparisons may vary substantially depending on other operating investments or dispositions of such investments in any given period.

Three months ended June 30, 2004 versus three months ended June 30, 2003

Total revenue increased 33% to $317.3 million for 2004 driven by significant increases in net earned premium, fee and commission income and investment income. Most of this growth was either organic or resulted from increased retentions. In addition, $18.3 million came from subsidiaries acquired in the past twelve months. We expect revenue growth to continue for the rest of 2004 and into 2005.

Fee and commission income increased 21% to $46.1 million in 2004 due principally to organic growth in our agency subsidiaries. The table below shows the composition of fee and commission income for the three months ended June 30, 2004 and 2003 (amounts in thousands):

                 
    2004
  2003
Continuing subsidiaries
  $ 43,766     $ 38,063  
Subsidiaries acquired during past year
    2,336        
 
   
 
     
 
 
Total fee and commission income
  $ 46,102     $ 38,063  
 
   
 
     
 
 

Net investment income increased 26% to $15.0 million in 2004. This increase was due to higher investment assets, which increased to $2.0 billion as of June 30, 2004 compared to $1.7 billion as of December 31, 2003 resulting primarily from significant cash flow from operations and to a lesser extent the acquisition of American Contractors Indemnity Company in January 2004. Net investment income increased despite low yields on our fixed income and short-term investments. We expect investment assets to continue to increase and produce additional growth in investment income for the balance of 2004. If market interest rates were to rise, the growth in investment income would be expected to accelerate as our current portfolio has a relatively short duration and would become available to be invested on a longer-term basis to take advantage of higher rates. Our weighted average tax equivalent yield was 3.6% in 2004 and 4.4% in 2003.

Compensation expense increased as a result of acquisitions and a slight increase in staffing levels to manage growth and additional reporting requirements under Sarbanes-Oxley. However, the rate of increase in compensation expense is less than the rate of increase in revenue, thereby contributing to higher margins and increased net earnings. Compensation expense for the three months ended June 30, 2004 and 2003 (amounts in thousands):

                 
    2004
  2003
Continuing subsidiaries
  $ 20,509     $ 19,865  
Subsidiaries acquired during past year
    3,116        
 
   
 
     
 
 
Total compensation expense
  $ 23,625     $ 19,865  
 
   
 
     
 
 

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Other operating expense increased during 2004 compared to 2003, as shown in the following table (amounts in thousands). During 2003 there was a one-time currency gain of $1.3 million from the settlement of an advance of funds to an unaffiliated entity.

                 
    2004
  2003
 
Subsidiaries acquired during past year
  $ 2,024     $  
2003 currency conversion transaction gain
          (1,287 )      
Litigation accruals (reversal)
    1,775       (355 )
Other expense
    13,997       14,581      
 
   
 
     
 
       
 
  $ 17,796     $ 12,939  
 
   
 
     
 
     

Income tax expense from continuing operations was $24.4 million in 2004 compared to $18.0 million in 2003. Our effective tax rate was 34.5% in 2004 compared to 36.6% in 2003. We expect a decrease in our income tax rate in 2004 compared to 2003 because a higher percentage of our pre-tax income is earned by our insurance company subsidiaries and is not subject to State income taxes and our tax exempt interest income is increasing.

Net earnings increased 41% to $46.4 million, or $0.71 per diluted share, in 2004 from $33.0 million, or $0.52 per diluted share, in 2003. Growth in net earned premium, fee and commission income and investment income and continuing favorable underwriting results increased 2004 net earnings. Net earnings in 2004 include $2.6 million from subsidiaries acquired during the past year.

SEGMENTS

Insurance Companies

The following table sets forth certain premium amounts and percentages of gross written premium for the three months ended June 30, 2004 and 2003 (amounts in thousands):

                                 
    2004
  2003
    Amount
  Percentage
  Amount
  Percentage
Direct
  $ 456,843       88 %   $ 357,830       75 %
Reinsurance assumed
    64,347       12       119,449       25  
 
   
 
     
 
     
 
     
 
 
Gross written premium
    521,190       100       477,279       100  
Reinsurance ceded
    (212,329 )     (41 )     (226,188 )     (47 )
 
   
 
     
 
     
 
     
 
 
Net written premium
    308,861       59       251,091       53  
Change in unearned premium
    (56,791 )     (11 )     (67,599 )     (15 )
 
   
 
     
 
     
 
     
 
 
Net earned premium
  $ 252,070       48 %   $ 183,492       38 %
 
   
 
     
 
     
 
     
 
 

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The following tables provide information by line of business (amounts in thousands):

                                                                         
    Gross Written Premium
  Net Written Premium
  Net Earned Premium
                    %                   %                   %
    2004
  2003
  Change
  2004
  2003
  Change
  2004
  2003
  Change
Group life, accident & health
  $ 147,201     $ 144,162       2 %   $ 83,345     $ 81,168       3 %   $ 80,501     $ 75,526       7 %
Diversified financial products
    220,797       143,106       54       96,306       48,907       97       73,714       26,512       178  
London market account
    60,644       79,434       (24 )     49,169       65,322       (25 )     35,408       37,081       (5 )
Aviation
    53,860       64,429       (16 )     54,131       30,525       77       32,998       24,355       35  
Other specialty lines of business
    32,974       5,381     nm     19,904       2,183     nm     15,720       153     nm
 
   
 
     
 
     
 
     
 
     
 
     
 
     
 
     
 
     
 
 
 
    515,476       436,512       18       302,855       228,105       33       238,341       163,627       46  
Discontinued lines of business
    5,714       40,767     nm     6,006       22,986     nm     13,729       19,865     nm
 
   
 
     
 
     
 
     
 
     
 
     
 
     
 
     
 
     
 
 
 
  $ 521,190     $ 477,279       9 %   $ 308,861     $ 251,091       23 %   $ 252,070     $ 183,492       37 %
 
   
 
     
 
     
 
     
 
     
 
     
 
     
 
     
 
     
 
 


nm-Not meaningful    

Gross written premium increased 9% to $521.2 million in the second quarter of 2004. Net written premium increased 23% to $308.9 million and net earned premium increased 37% to $252.1 million, both due principally to organic growth and increased retentions on some lines. The increase in premium is expected to continue into 2005. The growth in gross written premium results principally from the following factors:

    The largest growth was in our diversified financial products line of business primarily as a result of organic growth in directors’ and officers’ and errors and omissions business, as well as an increase in surety business due to our acquisition of American Contractors Indemnity Company in January 2004. We are seeing some softness in premium rates but no change in deductibles or policy conditions. The underwriting profit margins are all still very adequate.
 
    Our other specialty lines of business increased significantly due to new business activities commenced during the past year. These activities include underwriting of marine insurance on the Gulf Coast of the United States, our quota-share reinsurance participation in a book of surplus lines insurance and our participation in a Lloyds syndicate writing UK liability insurance.
 
    Our London market account experienced somewhat reduced premium writings due to more selective underwriting, as premium rates have softened.

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The tables below show the composition of net and gross incurred loss and loss adjustment expense for the three months ended June 30, 2004 and 2003 (amounts in thousands):

                                 
    2004
  2003
    Amount
  Loss Ratio
  Amount
  Loss Ratio
Net
                               
Deficiency
  $ 699       0.3 %   $ 8,535       4.6 %
All other net incurred loss and loss adjustment expense
    147,199       58.4       111,545       60.8  
 
   
 
     
 
     
 
     
 
 
Net incurred loss and loss adjustment expense
  $ 147,898       58.7 %   $ 120,080       65.4 %
 
   
 
     
 
     
 
     
 
 
Gross
                               
Discontinued line of business adjustments
  $ 19,212       4.2 %   $ 61,100       16.3 %
Reduce incurred but not reported losses
    (17,300 )     (3.8 )            
All other gross incurred loss and loss adjustment expense
    275,497       59.9       224,429       60.0  
 
   
 
     
 
     
 
     
 
 
Gross incurred loss and loss adjustment expense
  $ 277,409       60.3 %   $ 285,529       76.3 %
 
   
 
     
 
     
 
     
 
 

We have no material exposure to environmental or asbestos losses and believe we have provided for all material net incurred losses.

Our gross loss ratio was 60.3% for 2004 compared to 76.3% for 2003. We continue to experience gross development on certain business included in the discontinued line of business, but at a slower pace than in 2003. Also, during 2004, we reduced gross incurred but not reported losses on prior accident years on certain of our London market account business. Since all of these contracts were substantially reinsured, the effect on our net losses was not material.

The following table provides comparative net loss ratios by line of business for the three months ended June 30, 2004 and 2003 (amounts in thousands):

                                 
    2004
  2003
    Net   Net   Net   Net
    Earned   Loss   Earned   Loss
    Premium
  Ratio
  Premium
  Ratio
Group life, accident and health
  $ 80,501       62.5 %   $ 75,526       63.7 %
Diversified financial products
    73,714       45.2       26,512       50.8  
London market accounts
    35,408       57.2       37,081       61.3  
Aviation
    32,998       56.6       24,355       61.9  
Other specialty lines of business
    15,720       59.8       153       58.2  
 
   
 
     
 
     
 
     
 
 
 
    238,341       55.4       163,627       60.8  
Discontinued lines of business
    13,729       115.8       19,865       103.8  
 
   
 
     
 
     
 
     
 
 
Totals
  $ 252,070       58.7 %   $ 183,492       65.4 %
 
   
 
             
 
         
Expense ratio
            27.6               23.7  
 
           
 
             
 
 
Combined ratio
            86.3 %             89.1 %
 
           
 
             
 
 

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Comments on net loss ratios by line of business are below:

    Group life, accident and health — The 2004 loss ratio is slightly lower than expected because of a reduction in reserves for redundancies from prior accident years.
 
    Diversified financial products — The decrease in loss ratio is due to changes in overall mix of business. The surety business of American Contractors Indemnity Company, acquired in January 2004, has a lower loss ratio compared to the other business in this line.
 
    London market accounts — Underwriting results generally improved due to more selective underwriting and we have moved to excess business where there is less loss frequency.
 
    Aviation — Underwriting results improved.
 
    Other specialty lines — The current loss ratio is as expected for new business activities commenced during the past year.
 
    Discontinued lines of business — Both quarters have been affected by reserve additions resulting from our ongoing review of outstanding claims. Additionally, given the limited amount of earned premium in this line of business, a minor adjustment to the reserves can significantly impact the loss ratio.

Policy acquisition costs, which are net of the related portion of commissions on reinsurance ceded, increased to $55.4 million during the second quarter of 2004, from $34.0 million in the same period in 2003. This increase is due to the increase in net earned premium. The increase in the expense ratio is due to the reduction in ceding commissions as a result of higher retentions plus the addition of surety business at American Contractors Indemnity Company, acquired in January 2004, which, as is common to the surety business, has a higher expense ratio than the rest of our business, although a much lower expected loss ratio.

Net earnings of our insurance companies increased 68% to $33.3 million in 2004 due to increased premium volume, continuing profitable underwriting results and increased investment income. We expect growth in the net earnings of our insurance companies to continue through 2005. Our increasingly profitable underwriting results are reflected in a 2004 combined ratio of 86.3% compared to 89.1% in 2003.

Agency

Revenue from our agency segment increased 16% to $57.4 million in 2004. This results primarily from increased new business and an acquisition made in 2003 which accounted for $2.7 million of the increased revenue. Net earnings of our agency segment increased 4% to $13.4 million in 2004 for the same reasons. Higher corporate cost allocations in 2004 caused the increase in segment net earnings to be less than the comparable increase in segment revenue. Also, in 2004 a discontinued agency operation recorded a $1.6 million (before tax) accrual for certain pending litigation.

Other Operations

The decrease in other operating income in 2004 is primarily due to less gains on securities trading activities. Quarter to quarter comparisons may vary substantially depending on other operating investments or dispositions of such investments in any given quarter.

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Liquidity and Capital Resources

We receive substantial cash from premiums, reinsurance recoverables, fee and commission income and, to a lesser extent, investment income and proceeds from sales and redemptions of investments and other assets. Our principal cash outflows are for the payment of claims and loss adjustment expenses, payment of premiums to reinsurers, purchases of investments, debt service, policy acquisition costs, operating expenses, income and other taxes and dividends. Variations in operating cash flows can occur due to timing differences in either the payment of claims and the collection of related recoverables or the collection of receivables and the payment of related payable amounts.

We maintain a substantial level of cash and liquid short-term investments which are used to meet anticipated payment obligations. Our consolidated cash and investment portfolio increased $239.7 million, or 13%, during the first six months of 2004 and totaled $2.0 billion as of June 30, 2004, of which $608.0 million was cash and short-term investments. The increase resulted primarily from operating cash flows and the acquisition of American Contractors Indemnity Company. Included in short-term investments as of June 30, 2004 is $190.0 million of funds held by underwriting agencies for the benefit of insurance or reinsurance clients. We earn the interest income on these funds.

During the first six months of 2004, due primarily to changes in market interest rates, the net after tax unrealized gain on our investments recorded in other comprehensive income decreased $14.2 million. However, during the month of July we estimate that our net after tax unrealized gain increased approximately $1.5 million, again primarily due to changes in market interest rates.

We have filed registration statements with the United States Securities and Exchange Commission, which provide shelf registrations for an aggregate of $750.0 million of our securities, of which we have $625.0 million available to be issued. These securities may be debt securities, equity securities or a combination thereof.

Notes payable as of June 30, 2004 and December 31, 2003 are shown in the table below (amounts in thousands):

                 
    2004
  2003
1.3% Convertible notes
  $ 125,000     $ 125,000  
2% Convertible notes
    172,451       172,451  
Other debt
    24,945       12,953  
 
   
 
     
 
 
Total notes payable
  $ 322,396     $ 310,404  
 
   
 
     
 
 
Debt to total capital
    22.2 %     22.9 %
 
   
 
     
 
 

Our $200.0 million Revolving Loan Facility, which had no outstanding borrowings as of June 30, 2004, expires on December 17, 2004. We expect to replace the facility with another facility.

Holders of our 2% Convertible Notes due in 2021 may require us to repurchase the notes at par on September 1, 2004. Because the recent market price of these notes ($110.00 as of August 4, 2004) is in excess of the par value, we do not expect that any of the notes will be tendered for repurchase. In the event that any such notes are tendered for repurchase we would expect to use funds from our revolving loan facility to repurchase the notes for cash.

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The following table shows the composition of our gross, ceded and net reserves at the respective balance sheet dates (amounts in thousands):

                         
    Gross
  Ceded
  Net
As of June 30, 2004:
                       
Reported losses
  $ 879,290     $ 436,614     $ 442,676  
Incurred but not reported losses
    840,760       468,102       372,658  
 
   
 
     
 
     
 
 
Total loss and loss adjustment expense payable
  $ 1,720,050     $ 904,716     $ 815,334  
 
   
 
     
 
     
 
 
As of December 31, 2003:
                       
Reported losses
  $ 721,979     $ 425,609     $ 296,370  
Incurred but not reported losses
    813,309       404,479       408,830  
 
   
 
     
 
     
 
 
Total loss and loss adjustment expense payable
  $ 1,535,288     $ 830,088     $ 705,200  
 
   
 
     
 
     
 
 

Reserves and recoverables continue to grow primarily due to our large account directors’ and officers’ liability business and our professional indemnity business. These claims have a longer duration and tend to be more highly reinsured than our other lines of business due to their potential volatility.

We have a reserve of $17.0 million as of June 30, 2004 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.

Certain reinsurers have delayed or suspended the payment of amounts recoverable under reinsurance contracts to which we are a party. Such delays have not materially affected the investment income of our insurance companies nor 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. We generally expect to collect the full amounts recoverable and 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. In some cases, the final resolution of such disputes through arbitration or litigation may extend over several years. Our insurance companies had an aggregate amount of $3.2 million which had not been paid to us under contracts that are subject to arbitration proceedings we initiated and we estimate that there could be up to an additional $11.0 million of incurred losses and loss expenses and other balances due under the subject contracts.

We believe that our operating cash flows, short-term investments, bank facility and shelf registrations on file with the United States Securities and Exchange Commission will provide sufficient sources of liquidity to meet our operating needs for the foreseeable future.

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Critical Accounting Policies

We have made no changes in our methods of application of our critical accounting policies from the information provided in our Annual Report on Form 10-K for the year ended December 31, 2003.

Item 3.   Quantitative and Qualitative Disclosures about Market Risk

There have been no material changes in market risk from the information provided in Item 7A. “Quantitative and Qualitative Disclosures About Market Risk” in our Annual Report on Form 10-K for the year ended December 31, 2003.

Item 4.   Controls and Procedures

a. Evaluation of disclosure controls and procedures.

The term “disclosure controls and procedures” is defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, or the Exchange Act. This term refers to the controls and procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commission. Our management, including our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this quarterly report. Based upon the evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.

b. Changes in internal controls.

There were no changes to our internal control over financial reporting during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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Part II — Other Information

Item 1.   Legal Proceedings
 
    We are party to lawsuits, arbitrations and other proceedings that arise in the normal course of our business. Many of such lawsuits, arbitrations and other proceedings involve claims under policies that we underwrite as an insurer or reinsurer, the liabilities for which we believe have been adequately included in our loss reserves. Also, from time to time, we are a party to lawsuits, arbitrations and other proceedings which relate to disputes over contractual relationships with third parties, or which involve alleged errors and omissions on the part of our subsidiaries.
 
    A subsidiary has been named along with several other defendants in legal proceedings by certain insurance company members of a discontinued workers’ compensation reinsurance facility commonly known as the Unicover Pool. During 1997 and 1998, our subsidiary was one of two co-intermediaries for the facility. Other defendants in the current proceedings include the other reinsurance intermediary, the former managing underwriter for the facility and various individuals, none of whom are affiliated with us. It is claimed in the proceedings that the actions of the various defendants resulted in the recission of certain reinsurance contracts in an arbitration to which we were not a party and include allegations of breach of fiduciary duty, negligence, fraud and other allegations. The claims in the proceedings are for unspecified or substantial compensatory and punitive damages. We believe that we have meritorious defenses to the allegations and intend to vigorously defend against the claims made in the proceedings. The current court proceedings have been subjected to an indefinite judicial stay pending the resolution of an arbitration among the managing underwriter of the facility and the various facility members. We are not a party to such arbitration.
 
    In addition, we are presently engaged in litigation initiated by the appointed liquidator of a former reinsurer concerning payments made to us prior to the date of the appointment of the liquidator. The disputed payments were made by the now insolvent reinsurer in connection with a commutation agreement. Our understanding is that such litigation is one of a number of similar actions brought by the liquidator. We intend to vigorously contest the action.
 
    Although the ultimate outcome of these matters may not be determined at this time, based upon present information, the availability of insurance coverage and advice received from our outside legal counsel, we do not believe the resolution of any of these matters, some of which include allegations of damages in material amounts, will have a material adverse effect on our financial condition, results of operations or cash flows.

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Item 4.   Submission of Matters to a Vote of Security Holders
 
    On May 13, 2004, we held our 2004 Annual Meeting of Shareholders. At such time the following items were submitted to a vote of shareholders through the solicitation of proxies:

  (a)   Election of Directors.

      The following persons were elected to serve on the Board of Directors until the 2005 Annual Meeting of Shareholders or until their successors have been duly elected and qualified. The Directors received the votes set forth opposite their respective names:

                 
NAME
  FOR
  VOTES WITHHELD
Stephen L. Way
    53,840,774       1,450,428  
Frank J. Bramanti
    53,930,974       1,360,228  
Patrick B. Collins
    54,074,925       1,216,277  
James R. Crane
    54,897,259       393,943  
J. Robert Dickerson
    53,928,464       1,362,738  
Edward H. Ellis, Jr.
    53,293,378       1,997,824  
James C. Flagg, Ph.D.
    54,078,105       1,213,097  
Allan W. Fulkerson
    53,828,372       1,462,830  
Walter J. Lack
    54,167,420       1,123,782  
Michael A. F. Roberts
    54,897,509       393,693  

  (b)   Adoption of the 2004 Flexible Incentive Plan.

      Shareholders were requested to approve the adoption of the 2004 Flexible Incentive Plan. The plan was approved by the shareholders, who voted 39,347,051 shares in favor, 11,238,598 against, and 60,024 abstained.

Item 6.   Exhibits and Reports on Form 8-K

  (a)   Exhibits

  31.1
31.2
32.1
  Certification by Chief Executive Officer.
Certification by Chief Financial Officer.
Certification with respect to quarterly report.

  (b)   Reports on Form 8-K

      On May 4, 2004, we furnished on Form 8-K our announcement of financial results for the first quarter of 2004.
 
      On May 5, 2004, we furnished on Form 8-K the text materials used for presentations at various investor conferences.
 
      On June 23, 2004, we furnished on Form 8-K the text materials used for presentations at various investor conferences.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

     
    HCC Insurance Holdings, Inc.

(Registrant)
 
 
August 6, 2004

                  (Date)
  /s/ Stephen L. Way

Stephen L. Way, Chairman of the Board
Chief Executive Officer and President
 
 
August 6, 2004

                  (Date)
  /s/ Edward H. Ellis, Jr.

Edward H. Ellis, Jr., Executive Vice President
and Chief Financial Officer

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EXHIBIT INDEX

     
31.1
  Certification by Chief Executive Officer.
31.2
  Certification by Chief Financial Officer.
32.1
  Certification with respect to quarterly report.