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

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

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

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001

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

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

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

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

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

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

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

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

The aggregate market value on March 15, 2002, of the voting stock held by
non-affiliates of the registrant was approximately $1.6 billion. For purposes of
the determination of the above stated amount, only directors and executive
officers are presumed to be affiliates, but neither the registrant nor any such
person concede that they are affiliates of the registrant.

The number of shares outstanding of the registrant's Common Stock, $1.00
par value, as of March 15, 2002 was 62.0 million.

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

HCC INSURANCE HOLDINGS, INC.

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

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

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

1

PART I

ITEM 1. BUSINESS

TERMINOLOGY

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

RISK FACTORS

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

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

We purchase reinsurance for significant amounts of risk underwritten by our
insurance companies, especially catastrophe risks. We also purchase reinsurance
on risks underwritten by others which we reinsure through a retrocession
agreement. Market conditions beyond our control determine the availability and
cost of the reinsurance protection we purchase, which may affect the level of
our business and profitability. For instance, the natural attrition of
reinsurers who exit lines of business, or who curtail their writings, for
economic or other reasons, reduces the capacity of the reinsurance market,
causing rates to rise. In addition, the historical results of reinsurance
programs and the availability of capital also affect the availability of
reinsurance. Our reinsurance facilities are generally subject to annual renewal.
We cannot assure you that we can maintain our current reinsurance facilities or
that we can obtain other reinsurance facilities in adequate amounts and at
favorable rates. Further, we cannot determine at this time what the present and
longer term effects of the September 11, 2001 attacks or other future possible
terrorist attacks which result in catastrophic losses will have on the
reinsurance market in general and on our ability to obtain reinsurance in
adequate amounts and at favorable rates in particular. If we are unable to renew
our expiring facilities or to obtain new reinsurance facilities, either our net
exposures would increase or, if we are unwilling to bear an increase in net
exposures, we would have to reduce the level of our underwriting commitments,
especially catastrophe exposed risks. Either of these potential developments
could have a material adverse effect on our business. The lack of available
reinsurance may also adversely affect our ability to generate fee and commission
income in our underwriting agency and reinsurance intermediary operations. A
reinsurance intermediary structures and arranges reinsurance between insurers
seeking to cede insurance risks and reinsurers willing to assume such risks.

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

We purchase reinsurance by transferring, or ceding, part of the risk we
have assumed to a reinsurance company in exchange for part of the premium we
receive in connection with the risk. Although reinsurance makes the reinsurer
liable to us to the extent the risk is transferred or ceded to the reinsurer, it
does not relieve us, the reinsured, of our liability to our policyholders.
Accordingly, we bear credit risk with respect to our reinsurers. We cannot
assure you that our reinsurers will pay all of our reinsurance claims, or that
they will pay our claims on a timely basis.

It is presently unclear what effect the attacks of September 11, 2001 will
ultimately have on the financial position of our reinsurers. At present, we can
neither determine the extent to which we will be liable, as a result of the
terrorist attacks of September 11, for risks we have ceded to reinsurers, nor
can we determine the extent to which our credit risk with respect to our
reinsurers may have increased because the reinsurers are in a weakened financial
position as a result of the September 11 attacks. If we become liable for risks
we have ceded with respect to the September 11 attacks or if our reinsurers
cease to meet their obligations to us, whether because they are in a weakened
position as a result of the September 11 attacks or otherwise, our results of
operations and financial position could be materially adversely affected.

2

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

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

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

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

Property and casualty insurers are subject to claims arising out of
catastrophes that may have a significant effect on their results of operations,
liquidity and financial condition. Catastrophic losses have had a significant
impact on our results. Catastrophes can be caused by various events, including
hurricanes, windstorms, earthquakes, hailstorms, explosions, severe winter
weather and fires and may include man-made events, such as the September 11,
2001 terrorist attacks on the World Trade Center. The incidence, frequency and
severity of catastrophes are inherently unpredictable. The extent of losses from
a catastrophe is a function of both the total amount of insured exposure in the
area affected by the event and the severity of the event. Most catastrophes are
restricted to small geographic areas; however, hurricanes, earthquakes and
terrorist attacks may produce significant damage in large, heavily populated
areas. Catastrophes can cause losses in a variety of our property and casualty
lines, and most of our past catastrophe-related claims have resulted from
hurricanes and earthquakes; however, as a result of the September 11, 2001
terrorist attacks, we experienced the largest single loss to our insurance
company operations in our history. Insurance companies are not permitted to
reserve for a catastrophe until it has occurred. In 2002, we expect that
approximately 10% of our current business may be affected by catastrophes. It is
therefore possible that a catastrophic event or multiple catastrophic events
could have material adverse effect upon our results of operations, liquidity and
financial condition.

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

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

On a limited basis, we enter into foreign currency forward contracts as a
hedge against foreign currency fluctuations. The foreign currency forward
contracts are used to convert currency at a known rate in an amount that
approximates average monthly expenses. Thus, the effect of these transactions is
to limit the foreign

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currency exchange risk of the recurring monthly expenses. We use these foreign
currency forward contracts strictly as a hedge against existing exposure to
foreign currency fluctuations rather than as a form of speculative or trading
investment.

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

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

- approval of policy forms and premium rates;

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

- licensing of insurers and their agents;

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

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

- restrictions on transactions between insurance companies and their
affiliates;

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

- requiring deposits for the benefit of policyholders;

- requiring certain methods of accounting;

- periodic examinations of our operations and finances;

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

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

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

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

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

4

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

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

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

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

We have recorded a pre-tax gross loss related to the terrorist attacks of
September 11, 2001 of $141.0 million and a pre-tax net loss of $35.0 million. We
believe our estimates of gross and net losses to be reasonable, but they may be
subject to adjustment as we receive additional information from our clients and
producers. It is difficult to fully estimate our losses from the September 11,
2001 attacks given the uncertain nature of the damage theories related to
insurance claims made in connection with the attacks.

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

As of December 31, 2001, $525.4 million of our $888.5 million investment
portfolio was invested in fixed income securities. The fair market value of
these fixed income securities and the investment income from these fixed income
securities fluctuate depending on general economic and market conditions. With
respect to our investments in fixed income securities, the fair market value of
these investments generally increases or decreases in an inverse relationship
with fluctuations in interest rates, while net investment income realized by us
from future investments in fixed income securities will generally increase or
decrease with interest rates. In addition, actual net investment income and/or
cash flows from investments that carry prepayment risk (such as mortgage-backed
and other asset-backed securities) may differ from those anticipated at the time
of investment as a result of interest rate fluctuations. An investment has
prepayment risk when there is a risk that the timing of cash flows that result
from the repayment of principal might occur earlier than anticipated because of
declining interest rates or later than anticipated because of rising interest
rates. Historically, the impact of market fluctuations has affected our
financial statements. Because all of our fixed income securities
5

are classified as available for sale, changes in the fair market value of our
securities are reflected in our other comprehensive income. Similar treatment is
not available for liabilities. Therefore, interest rate fluctuations could
adversely affect our generally accepted accounting principles, or GAAP,
shareholders' equity, total comprehensive income and/or our cash flows.
Historically, the impact of market fluctuations has affected our financial
statements. Unrealized pre-tax net investment gains (losses) on investments in
fixed-income securities were $0.7 million, $11.9 million and ($19.0) million for
the years ended 2001, 2000 and 1999, respectively.

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

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

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

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

BUSINESS OVERVIEW

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

HCC Insurance Holdings, Inc. is a Delaware corporation, which was formed in
1991. Its predecessor corporation was formed in 1974. Our principal executive
offices are located at 13403 Northwest Freeway, Houston, Texas 77040 and our
telephone number is (713) 690-7300. We maintain a World Wide Web-site at
www.hcch.com. The reference to our World Wide Web address does not constitute
the incorporation by reference of the information contained at this site in this
report.

Since our founding, we have been consistently profitable, generally
reporting annual increases in gross written premium and total revenue. During
the period 1997 through 2001, we had an average statutory combined ratio of
98.3% versus the less favorable 106.3% (1997-2000) recorded by the U.S. property
and casualty insurance industry overall. During the same period, our gross
written premium increased from $346.4 million to $1.0 billion, an increase of
192% while net written premium increased 161% from $142.9 million to $373.0
million. During this period, our revenue increased from $281.5 million to $505.5
million, an increase of 80%.

During the period December 31, 1997 through December 31, 2001, our
shareholders' equity increased from $365.8 million to $763.5 million, a 109%
increase. During the same period, our assets increased from $1.2 billion to $3.2
billion, a 169% increase.
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Our insurance companies are risk-bearing and focus their underwriting
activities on providing insurance and/or reinsurance in the following lines of
business:

- life, accident and health

- aviation

- marine, energy and property

- other specialty lines

In the United States, Avemco Insurance Company, U.S. Specialty Insurance
Company and HCC Life Insurance Company operate on an admitted, or licensed,
basis. Houston Casualty Company operates on a surplus lines basis as a
non-admitted, or unlicensed, insurer offering insurance coverage not otherwise
available from an admitted insurer in the relevant state.

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

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

In 2001 and 2002 we consolidated the operations of several of our agencies
with certain of our insurance companies to improve operational efficiencies.

Our combined gross written premium in 2001 was over $1.3 billion, after
intercompany eliminations. Our insurance companies wrote $1.0 billion of gross
premium and our underwriting agencies wrote $808.1 million of premium, before
intercompany eliminations.

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

- consulting on risks by providing information to clients about insurance
coverage;

- marketing risks by providing information and assistance on pricing a
particular insurance risk;

- placing risks by negotiating with insurers and reinsurers to accept an
insurance risk; and

- servicing risks by facilitating the collection of premiums and resolution
of claims on behalf of their clients.

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

OUR STRATEGY

Our business philosophy as an insurer is to maximize underwriting profits
while limiting risk in order to preserve shareholders' equity and maximize
earnings. We concentrate our insurance writings in selected, narrowly defined
lines of business where we believe we can achieve an underwriting profit. We
focus on lines of business that have relatively short lead times between the
occurrence of an insured event and the reporting of

7

claims. We market our insurance products both directly to customers and through
independent or affiliated agents and brokers.

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

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

In 2001, due to a continuing hardening of the respective markets, premium
rates in the life, accident and health, aviation and marine, energy and property
lines of business increased. We anticipate continued improvements in these
markets and in all of our lines of business during 2002. In response to these
changing market conditions, we plan to continue to expand the underwriting
activities in our insurance company operations.

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

In our ongoing operations, we will continue to:

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

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

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

INDUSTRY SEGMENT INFORMATION

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

8

MAJOR ACQUISITIONS

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

On January 31, 1999, we acquired PEPYS Holdings Limited. PEPYS is a holding
company for Rattner Mackenzie Limited. The initial consideration was $54.8
million in cash and deferred payments of $8.3 million in cash and 414,207 shares
of our common stock. As of December 31, 2001, we have accrued $0.7 million and
may pay additional amounts in the future based upon the attainment of certain
earnings benchmarks through December 31, 2003. Rattner Mackenzie Limited
provides intermediary services for reinsurance business placed by our insurance
companies as well as other insurance and reinsurance companies and underwriting
agencies, primarily in the accident and health area.

On December 20, 1999, we acquired all of the outstanding shares of the
publicly traded The Centris Group, Inc. following a tender offer at a price of
$12.50 per share in cash. We paid $149.5 million for The Centris Group, Inc.'s
acquisition. The Centris Group, Inc. was the parent corporation of a group of
insurance companies and underwriting agencies principally operating in the
medical stop-loss line of business. The Centris Group, Inc.'s primary insurance
company subsidiary was the entity now known as HCC Life Insurance Company. HCC
Life Insurance Company's operations were relocated to Houston, and it has become
a subsidiary of Houston Casualty Company. The medical stop-loss underwriting
agency operations of The Centris Group, Inc. have been combined with HCC
Benefits' Corporation operations.

On January 19, 2001, we issued 996,805 shares of our common stock to
acquire the Schanen Consulting Corporation and its operating subsidiary, The
Schanen Consulting Group, LLC. The Schanen Consulting Group, LLC provides
employee benefit consulting and retail insurance intermediary services and has
been consolidated with HCC Employee Benefits, Inc.'s operations.

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

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

We continue to evaluate possible acquisition candidates and we may complete
additional acquisitions during 2002. Any future acquisitions will be designed to
expand and strengthen our existing lines of business and perhaps provide access
to additional specialty sectors, which we expect to contribute to our overall
growth.

DISPOSITIONS

In March, 2000, we sold Trafalgar Insurance Company, an Oklahoma domiciled
insurance company subsidiary, for a price which approximated its shareholder's
equity determined in accordance with generally accepted accounting principles in
the United States, or GAAP.

In September, 2000, we sold a substantial portion of the assets of The
Wheatley Group, Ltd., a subsidiary of Avemco Corporation.

In September, 2001, we sold substantially all of the assets of Universal
Loss Management, Inc., our aviation claims administration services company for
$5.6 million plus an additional amount based on future revenue of the operation.

9

In September, 2001, we sold USF Insurance Company, a Pennsylvania domiciled
insurance company and former subsidiary of The Centris Group, Inc. for
approximately $2.0 million in excess of its shareholder's equity in accordance
with generally accepted accounting principles.

None of these operations were material to our financial condition, results
of operations or cash flows.

INSURANCE COMPANY OPERATIONS

LINES OF BUSINESS

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

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

UNDERWRITING

Direct

We underwrite direct business produced through independent agents and
brokers, affiliated intermediaries, and by direct marketing efforts. Our direct
underwriting includes general aviation, medical stop-loss and professional
liability business.

Reinsurance

In 2001 and prior years, our insurance companies participated in certain
insurance and reinsurance underwriting pools managed by our underwriting
agencies, in the life, accident and health line of business. Our insurance
companies also write facultative, or individual account, reinsurance,
particularly in the aviation and marine, energy and property lines of business.
Our facultative underwriting is typically on international business in order to
comply with local licensing requirements or as reinsurance of captive insurance
companies controlled by others, and can be considered direct business for most
purposes, since we maintain underwriting

10

and claims control. However, we record all of this business under the caption of
"Reinsurance Assumed" in our financial statements.

Life, Accident and Health

We began writing accident and health reinsurance risks through Houston
Casualty Company in 1996 through its participation in reinsurance facilities
managed by LDG Reinsurance Corporation. Our gross written premium increased from
$114.8 million in 1998 to $128.2 million in 2001. Net written premium in this
area increased because Houston Casualty Company retained a larger percentage of
the increased gross premium. During 2001, we began to produce and underwrite
this business directly through Houston Casualty Company and at the beginning of
2002, we completed the consolidation of LDG Reinsurance Corporation's new
business operations into Houston Casualty Company. We maintain reinsurance on an
excess of loss basis, where we transfer liability, premium and loss on a
non-proportional basis above our net retention of risk to reinsurers, to protect
us against severe losses on individual risks and catastrophe exposures.

We write medical stop-loss business for employer-sponsored, self-insured
health plans. Our medical stop-loss insurance provides coverages to companies,
associations and public entities that elect to self-insure their employee's
medical coverage for losses within specified levels, allowing them to manage the
risk of excessive health insurance exposure by limiting aggregate and specific
losses to a predetermined amount. When measured on a gross written premium
basis, medical stop-loss was our largest single line of business in 2001. We
also underwrite a limited program of group life insurance offered to our
insureds as complement to our medical stop-loss products. Group life gross
premium in 2001 amounted to $0.7 million. Our underwriting agency, HCC Benefits
Corporation, produces and underwrites this business on behalf of our insurance
companies. We first began writing this business in our insurance companies in
1997 and gross written premium and net written premium have increased as a
result of greater participation by our insurance companies, primarily HCC Life
Insurance Company and Avemco Insurance Company. HCC Benefits Corporation's
business has grown both internally and through acquisitions, most notably of The
Centris Group, Inc. HCC Benefits Corporation began underwriting this business in
1980. The 2001 gross written premium in our medical stop-loss line of business
underwritten in our insurance companies was $426.6 million and net written
premium was $140.9 million. We maintain reinsurance on a proportional basis,
where we share a proportional part of the original premium and losses with
reinsurers, and believe that these risks carry a relatively low level of
catastrophe exposure.

We began writing alternative workers' compensation and occupational
accident insurance to independent truckers in 1996. This business is currently
written through U.S. Specialty Insurance Company. We maintain reinsurance on an
excess of loss basis. We believe there is a relatively low level of catastrophe
exposure in our alternative workers' compensation line of business.

Aviation

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

- antique and vintage military aircraft

- cargo operations

- commuter airlines

- corporate aircraft

- fixed base operations

- military and law enforcement aircraft

- private aircraft owners and pilots

- rotor wing aircraft

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

We have been underwriting aviation risks through Houston Casualty Company
since 1981. Avemco Insurance Company has been insuring aviation risks since
1959. Our gross written premium has remained
11

relatively flat during the period 1998 to 2001. During this period we have
successfully re-underwritten our book of business, removing under-performing
classes of business where premium rates were insufficient and focusing on areas
where increasing rates were able to generate profitable business. Our aviation
net written premium increased during the period because we increased our
retentions, i.e., the portion of risk that we retain for our own account.

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

Marine, Energy and Property

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

- hull and machinery

- liabilities, including protection and
indemnity

- marine cargo

- various ancillary coverages

We have underwritten marine risks since 1984, primarily in Houston Casualty
Company. Competition has created downward pressure on premium rates since 1996,
causing a reduction in our gross written premium since 1997 and a corresponding
decrease in net written premium. During 2001 we have seen rate increases that
are encouraging and we expect this trend to continue in 2002.

We maintain marine reinsurance on both a facultative and an excess of loss
basis. We believe that the marine risks we underwrite carry a relatively low
level of catastrophe exposure.

We have been underwriting energy risks since 1988, primarily in Houston
Casualty Company. The energy risks we write include:

- drilling rigs

- natural gas facilities

- petrochemical plants

- pipelines

- production and gathering platforms

- refineries

We underwrite physical damage, liabilities, business interruption and
various ancillary coverages.

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

We maintain energy reinsurance on both a facultative basis and an excess of
loss basis to protect us against severe losses on individual risks and the
catastrophe exposure that exists, for example, from a hurricane or a major
platform explosion.

In the property area, we specialize in writing risks of large, often
multinational, corporations, covering a variety of commercial risks including:

- factories

- hotels

- industrial plants

- office buildings

- retail locations

- utilities

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

We have written property business since 1986, primarily through Houston
Casualty Company. Gross written premium declined from $106.5 million in 1998 to
$45.0 million in 2001 as premium rates were soft due in a large part to excess
capacity and the absence of significant catastrophe losses. Net written premium

12

increased slightly from $8.4 million to $9.5 million in the same period. Our
property gross written premium exceeds our net written premium by a substantial
amount due to the amount of facultative reinsurance, which is the separately
negotiated reinsurance of all or part of the coverage provided by a single
policy, and other reinsurance purchased in order to protect us from catastrophe
losses. During 2001 we have seen rate increases that are encouraging and we
expect this trend to continue in 2002.

We maintain reinsurance on both a proportional basis and an excess of loss
basis in an effort to ensure adequate reinsurance protection, particularly
against catastrophe exposures. We estimate our aggregate probable maximum loss
in any individual catastrophe zone and maintain catastrophe reinsurance in an
amount we believe will cover such exposure to any one occurrence.

Other Specialty Lines

In addition to the above, we underwrite insurance in a variety of other
specialty lines of business, but the specific lines of business included in this
caption are too small at this time to break out separately.

Exited and Discontinued Lines of Business

Our exited and discontinued lines of business include provider excess,
lender's single interest, program property and casualty and primary statutory
workers' compensation business.

PRINCIPAL INSURANCE COMPANIES

Houston Casualty Company

Houston Casualty Company is our principal insurance company subsidiary. It
is rated "A+ (Superior), IX (policyholders' surplus between $250.0 million and
$500.0 million)" by A.M. Best Company, Inc. and "AA (Very Strong)" by Standard &
Poor's Corporation. Houston Casualty Company operates worldwide and is domiciled
and licensed in Texas and operates on a surplus lines basis in 47 states.
Houston Casualty Company receives business through independent agents and
brokers, our underwriting agencies and intermediaries, and other insurance and
reinsurance companies. Houston Casualty Company has a highly experienced staff
of underwriters trained to deal with the high value, complicated exposures
prevailing in many of the lines of business in which we specialize. It is our
intention to utilize Houston Casualty Company as an issuing carrier for certain
business underwritten by ASU International, LLC and Professional Indemnity
Agency, Inc. and in 2002 Houston Casualty Company began writing directors and
officers liability and professional liability. As of December 31, 2001, Houston
Casualty Company's policyholders' surplus was $285.4 million, which is its total
admitted assets less total liabilities determined in accordance with statutory
accounting principles. Houston Casualty Company's shareholder's equity in
accordance with generally accepted accounting principles was $379.3 million as
of December 31, 2001.

In 2001 and 2002, we consolidated the new business operations of our
accident and health reinsurance underwriting agency, LDG Reinsurance
Corporation, with those of Houston Casualty Company.

Houston Casualty Company - London

Houston Casualty Company operates a full branch office in the United
Kingdom. Houston Casualty Company established its London branch operation in
order to more closely align its underwriting operations with the London market,
a historical focal point for much of the business that Houston Casualty Company
underwrites. Houston Casualty Company - London underwrites accident and health
reinsurance, marine, energy and property business.

HCC Life Insurance Company

HCC Life Insurance Company is an Indiana-domiciled life insurance company
which became a direct subsidiary of Houston Casualty Company in December, 1999
following The Centris Group, Inc. acquisition. HCC Life Insurance Company is
rated "A (Excellent), VII (policyholders' surplus between $50.0 million and
$100.0 million)" by A.M. Best Company, Inc. and operates as a life, accident and
health insurer on an

13

admitted basis in 41 states and the District of Columbia. HCC Life Insurance
Company is an issuing carrier for medical stop-loss products produced and
underwritten by HCC Benefits Corporation. As of December 31, 2001, HCC Life
Insurance Company had statutory policyholders' surplus of $77.1 million and
shareholder's equity in accordance with generally accepted accounting principles
of $88.4 million.

U.S. Specialty Insurance Company

U.S. Specialty Insurance Company is a Texas-domiciled property and casualty
insurance company. It is a direct subsidiary of Houston Casualty Company. U.S.
Specialty Insurance Company is rated "A+ (Superior), VIII (policyholders'
surplus between $100.0 million and $250.0 million)" by A.M. Best Company, Inc.
and "AA (Very Strong)" by Standard & Poor's Corporation. U.S. Specialty
Insurance Company operates on an admitted basis throughout the United States,
primarily writing general aviation, occupational accident and alternative
workers' compensation insurance. In September, 2001, we decided that U.S.
Specialty Insurance Company would exit the statutory workers' compensation
market. It is our intention to utilize U.S. Specialty Insurance Company as an
issuing carrier for certain business underwritten by ASU International, LLC and
Professional Indemnity Agency, Inc., and in 2002 U.S. Specialty Insurance
Company began writing directors and officers liability and professional
liability business produced by Professional Indemnity Agency, Inc. As of
December 31, 2001, U.S. Specialty Insurance Company had statutory policyholders'
surplus of $105.9 million and shareholder's equity in accordance with generally
accepted accounting principles of $116.3 million.

Avemco Insurance Company

Avemco Insurance Company is a Maryland-domiciled property and casualty
insurer, is rated "A+ (Superior), VIII (policyholders' surplus between $100.0
million and $250.0 million)" by A.M. Best Company, Inc. and "AA (Very Strong)"
by Standard & Poor's Corporation, and is operating as a direct market
underwriter of general aviation business on an admitted basis throughout the
United States and Canada (except Quebec). In addition, Avemco Insurance Company
is an issuing carrier for medical stop-loss products produced and underwritten
by HCC Benefits Corporation and for indemnity accident and health business
produced by an unaffiliated agency. The latter business is fully reinsured. As
of December 31, 2001, Avemco Insurance Company had statutory policyholders'
surplus of $107.1 million and shareholder's equity in accordance with generally
accepted accounting principles of $117.2 million.

UNDERWRITING AGENCY OPERATIONS

Our underwriting agencies act on behalf of our insurance companies and
those of other firms, and provide insurance underwriting management and claims
administration services. Our underwriting agencies do not assume any insurance
or reinsurance risk themselves and generate revenues based entirely on
management fees and profit commissions. These subsidiaries are in a position to
direct and control business that they produce. Our insurance companies serve as
policy issuing companies for the majority of the business written by our
underwriting agencies. Our insurance companies may retain a portion of the risk
and reinsure the remainder with unaffiliated insurance companies or reinsure all
of the risk. In instances where our insurance companies are not the policy
issuing company, our insurance companies may reinsure the business written by
the underwriting agencies. Management fees generated by our underwriting
agencies in 2001 amounted to $61.8 million.

LINES OF BUSINESS

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

14

HCC BENEFITS CORPORATION

HCC Benefits Corporation, with its home office in Atlanta, Georgia and
regional offices in Costa Mesa, California; Wakefield, Massachusetts;
Minneapolis, Minnesota; and Dallas, Texas, acts as an underwriting manager
writing medical stop-loss products for employer sponsored self-insured health
plans. In 2001, HCC Benefits Corporation generated approximately $51.4 million
in management fees. Substantially all of the business was underwritten on behalf
of HCC Life Insurance Company and Avemco Insurance Company.

PROFESSIONAL INDEMNITY AGENCY, INC.

We acquired Professional Indemnity Agency, Inc. in October, 2001.
Professional Indemnity Agency, Inc., with its home office in Mount Kisco, New
York and branch offices in San Francisco, California and Palm Beach Gardens,
Florida, acts as an underwriting manager writing directors and officers
liability, kidnap and ransom and professional liability insurance coverages. For
the full year 2001, Professional Indemnity Agency, Inc. generated $20.4 million
in management fees on premium written on behalf of unaffiliated insurers.
Professional Indemnity Agency, Inc. will underwrite some of the above lines of
business on behalf of our insurance companies in 2002.

ASU INTERNATIONAL, LLC

We acquired ASU International, LLC in October, 2001. ASU International,
LLC, with its home office in Woburn, Massachusetts and a branch office in
London, England acts as an underwriting manager of specialty insurance for the
sports, entertainment and promotion marketing industries. ASU International, LLC
offers contingency insurance (including contest indemnity, event cancellation
and weather coverages) and individual disability insurance for athletes and
other high profile individuals. For the full year 2001, ASU International, LLC
generated $13.8 million in management fees on premium written on behalf of
unaffiliated insurers. ASU International, LLC will underwrite selected risks in
some of the above lines of business on behalf of our insurance companies in
2002.

OTHER AGENCY OPERATIONS

We have consolidated certain of our other underwriting agencies with
certain of our insurance companies for the purpose of improving the operational
efficiencies of our business. We have consolidated the operations of our
domestic general aviation underwriting agency, HCC Aviation Insurance Group,
Inc., and our occupational accident and alternative workers' compensation
underwriting agency, HCC Employer Services, Inc. into U.S. Specialty Insurance
Company. We have also consolidated both offices of our accident and health
reinsurance underwriting agency, LDG Reinsurance Corporation, into Houston
Casualty Company.

INTERMEDIARY OPERATIONS

Our intermediaries provide a variety of services, including marketing,
placing, consulting on and servicing insurance risks for their clients, which
include medium to large corporations, insurance and reinsurance companies and
other risk taking entities. The intermediaries earn commission income and to a
lesser extent fees for certain services, generally paid by the underwriters with
whom the business is placed. Some of these risks may be initially underwritten
by our insurance companies, which may retain a portion of the risk. Commission
income generated by our intermediaries in 2001 amounted to $43.4 million.

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

15

RATTNER MACKENZIE LIMITED

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

HCC EMPLOYEE BENEFITS, INC.

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

HCC INTERMEDIARIES, INC.

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

OTHER OPERATIONS

Our other operations historically consisted of insurance related services
offered to our subsidiaries, our reinsurers and unaffiliated entities. The
revenue earned from these services primarily consisted of fees or commissions.
The primary operating entities in this segment provided insurance claims
adjusting services. During 2001, we sold the last of our service operations,
which will result in a decrease in other operating income in future years.
Additionally, other operating income may be in the form of equity in the
earnings of a company in which we invest, or dividends or gains or losses from
the disposition of these investments. Other operating income was $17.4 million
in 2001. Revenue and earnings can vary considerably from period to period
depending on investment or disposition activity.

REINSURANCE CEDED

We purchase reinsurance to reduce our net liability on individual risks, to
protect against catastrophe losses and to achieve a desired ratio of net written
premium to policyholders' surplus. We purchase reinsurance on both a
proportional and an excess of loss basis. We believe that we reinsure our risks
to a greater extent than most of our competitors and most other insurance
companies. We use this strategy to protect our shareholders' equity.

The type, cost and limits of reinsurance we purchase can vary from year to
year based upon our desired retention levels and the availability of quality
reinsurance at an acceptable price. Our reinsurance programs renew throughout
the year and during 2001 some of those renewed contained price increases which
are not material to our underwriting results. Additionally, we retained higher
percentages of our business in connection with certain lines of business which
are reinsured on a proportional basis. We plan to continue to increase our
retentions as underwriting conditions improve in many of our lines of business.

We consider the maintenance of reinsurance protection to be an important
part of our business plan, protecting shareholders' equity from catastrophe
losses and fluctuations in the insurance market cycles of the insurance
industry. We have built important relationships over the years with many core
reinsurers. We intend to continue to share our business with these partners as
underwriting profitability returns in an improving market in order to build even
stronger relationships for the future. We believe that increased retentions
during

16

profitable periods are made possible not at the sacrifice of core reinsurers but
through reduction of facultative reinsurance and the natural attrition of
certain reinsurers who exit lines of business or curtail their writings for
other reasons. This reduction in reinsurance market capacity causes rates to
rise but the increased rates historically have been passed on to the original
insureds.

We structure a specific reinsurance program for each line of business we
underwrite. We place this reinsurance in order to protect our insurance
companies from exposure to foreseeable events. We place reinsurance
proportionally to cover loss frequency and catastrophe exposure. We obtain
additional reinsurance on an excess of loss basis to cover individual risk
severity of loss and on a catastrophe basis to cover exposure from occurrences
involving multiple risks, such as those resulting from a hurricane, an
earthquake or a man-made event, such as a terrorist attack. Additionally, we may
also obtain facultative reinsurance protection on an excess of loss or
proportionate basis on any single risk. We do not intend to expose our assets to
any net loss in excess of our reinsurance protection.

Certain of our lines of business are exposed to catastrophe losses in a
greater degree than others. We have exposures to this type of loss primarily in
our accident and health reinsurance, energy and property lines of business. We
carefully assess our overall exposure to a single catastrophic event and apply
procedures that we believe are more conservative than are typically used by the
industry to ascertain our probable maximum loss from any single event.

Subsequent to the terrorist attacks on September 11, 2001, where possible,
we canceled all terrorist coverage under the terms of existing in-force
policies, primarily in the property and energy lines of business. All new and
renewal policies are written with an appropriate terrorist exclusion except for
lines of business, such as aviation, where reinsurance for acts of terrorism is
available at an economic cost or where we feel comfortable with the net
exposure.

At January 1, 2002, and February 1, 2002, respectively, our onshore energy
and property reinsurance protections were renewed without coverage for acts of
terrorism. Therefore, to the extent that certain existing, in-force policies
contain such coverage, then we would have a net exposure to any applicable
losses. The actual amount of this exposure is not determinable but could
represent a catastrophic loss, a risk for which we would usually purchase
reinsurance protection. We do not believe that any loss would severely impact
our capital. As each month goes by, existing in-force policies will expire and
the overall exposure continues to reduce substantially.

In general, we receive an overriding (ceding) commission on the premium
ceded to reinsurers. This compensates our insurance companies for the direct
costs associated with the production of the business, the servicing of the
business during the term of the policies ceded and the costs associated with the
placement of the related reinsurance. In addition, certain of our reinsurance
treaties allow us to share with the reinsurers in any net profits generated
under such treaties.

Various intermediaries, including HCC Intermediaries, Inc. and Rattner
Mackenzie Limited, arrange for the placement of this reinsurance coverage on our
behalf and are compensated, directly or indirectly, by the reinsurers.

17

The table below shows property and casualty reinsurance balances relating
to our reinsurers with net recoverable balances greater than $15.0 million as of
December 31, 2001. The total recoverables column includes paid loss recoverable,
outstanding loss recoverable, incurred but not reported recoverables and ceded
unearned premium (in thousands).

Ratings for companies are published by A.M. Best Company, Inc. Ratings for
individual syndicates are published by Moody's Investors Services, Inc. "NR"
indicates that the indicated Lloyd's syndicate had not been rated. Lloyd's of
London is an insurance and reinsurance marketplace composed of many independent
underwriting syndicates financially supported by a central trust fund.

HCC Life Insurance Company previously sold its entire block of life
insurance and annuity business to Life Reassurance Corporation of America (rated
A++ by A.M. Best Company, Inc.) in the form of an indemnity reinsurance
contract. Ceded life and annuity benefits amounted to $83.0 million as of
December 31, 2001.

We have a reserve of $5.2 million as of December 31, 2001 for potential
collectibility issues related to reinsurance recoverables and associated
expenses. The adverse economic environment in the worldwide insurance industry
and the terrorist attacks on September 11 have placed great pressure on
reinsurers and the results of their operations. Ultimately, these conditions
could affect reinsurers' solvency. Historically, there have been insolvencies
following a period of competitive pricing in the industry, such as the
marketplace has experienced for the last several years. While we believe that
the reserve is adequate based on currently available information, conditions may
change or additional information might be obtained that would affect our
estimate of the adequacy of the level of the reserve and which may result in a
future change in the reserve. We continually review our financial exposure to
the reinsurance market and continue to take actions to mitigate our position.

A number of reinsurers have delayed or suspended the payment of amounts
recoverable under certain reinsurance contracts to which we are a party. Such
delays have affected, although not materially to date, the investment income of
our insurance companies, but not to any extent their liquidity. We limit our
liquidity exposure by holding funds, letters of credit or other security such
that net balances due are significantly less than the gross balances shown in
our consolidated balance sheets. In some instances, the reinsurers have withheld
payment without reference to a substantive basis for the delay or suspension. In
other cases, the reinsurers have claimed they are not liable to for payment to
us of all or part of the amounts due under the applicable reinsurance agreement.
We believe these claims are without merit and expect to collect the full amounts
recoverable. We are currently in negotiations with most of these parties, but if
such negotiations do not result in a satisfactory resolution of the matters in
question, we may seek or be involved in a judicial or

18

arbitral determination of these matters. In some cases, the final resolution of
such disputes through arbitration or litigation may extend over several years.

In this regard, as of December 31, 2001, our insurance companies had
initiated litigation or arbitration proceedings against five reinsurers and were
involved in one arbitration proceeding initiated by a reinsurer. These
proceedings primarily concern the collection of amounts owing under reinsurance
agreements. As of such date, our insurance companies had an aggregate amount of
$15.3 million which had not been paid to us under the disputed agreements and we
estimate that there could be an additional $31.2 million of incurred losses and
loss expenses under the subject agreements. In addition, because our insurance
companies, principally Houston Casualty Company, participated in facilities
which were managed by one of our underwriting agencies, they are indirectly
involved in any reinsurance disputes which affect the applicable facilities. As
of December 31, 2001, Houston Casualty Company's allocated portion of aggregate
amounts which had not been reimbursed to the applicable facilities under the
disputed agreements was $4.8 million and we estimate that there could be an
additional $4.0 million of incurred losses and loss expenses under the subject
agreements allocated to Houston Casualty Company. Houston Casualty Company has
no net exposure on disputed amounts due to the non-affiliated companies who also
participated in the applicable facilities.

During 1999, we recorded a provision for reinsurance totaling $29.5 million
in connection with the insolvency of a reinsurer. We continue to expect this
provision to be sufficient. We also recorded a $14.0 million provision following
a commutation (the contractual settlement of outstanding and future liabilities)
with another reinsurer, the majority of which represents the present value
discount of ceded losses.

OPERATING RATIOS

PREMIUM TO SURPLUS RATIO

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

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

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

* Not available

While there is no statutory requirement regarding a permissible premium to
policyholders' surplus ratio, guidelines established by the National Association
of Insurance Commissioners provide that a property and casualty insurer's annual
statutory gross written premium should not exceed 900% and net written premium
should not exceed 300% of its policyholders' surplus. However, industry
standards and rating agency criteria place these ratios at 300% and 200%,
respectively. In the past, our property and casualty insurance companies have
maintained premium to surplus ratios generally lower than such guidelines and
below industry norms. The gross written premium ratio increased during 2000 with
the acquisition of The Centris Group, Inc.'s book of medical stop-loss business
in December, 1999 and the increasing use of our insurance companies as the
issuing company for business written by our underwriting agencies. This ratio is
expected to slowly decrease

19

from its current level as statutory policyholders' surplus increases due to the
retention of earnings and other increases in policyholders' surplus.

COMBINED RATIO IN ACCORDANCE WITH GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

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

COMBINED RATIO IN ACCORDANCE WITH STATUTORY ACCOUNTING PRINCIPLES

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

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

* Not available

The ratio data in accordance with statutory accounting principles is not
intended to be a substitute for results of operations in accordance with
generally accepted accounting principles. The differences between statutory
accounting principles and generally accepted accounting principles are described
in Note (15) of our consolidated financial statements included in this report.
Including this information on the basis of statutory accounting principles is
meaningful and useful to allow a comparison of our operating results with those
of other companies in the insurance industry. The source of the industry average
is A.M. Best Company Inc. A.M. Best Company Inc. reports on insurer performance
on the basis of statutory accounting principles to provide for more standardized
comparisons among individual companies, as well as overall industry performance.

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RESERVES

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

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

- jurisdiction of the occurrence;

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

- our knowledge of the circumstances surrounding the claim;

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

- the potential for ultimate exposure;

- the severity of injury or damage; and

- the type of loss.

We establish loss reserves for incurred but not reported losses based in
part on statistical information and in part on industry experience with respect
to the probable number and nature of claims arising from occurrences that have
not been reported. We also establish our reserves based on predictions of future
events, our estimates of future trends in claims severity, and other subjective
factors. Insurance companies are not permitted to reserve for a catastrophe
until it has occurred. Reserves are recorded on an undiscounted basis, except
for an immaterial amount of reserves acquired in a transaction recorded using
the purchase method of accounting. The net reserves of each of our insurance
companies are established in conjunction with and reviewed by our in-house
actuarial staff, and our reserves in accordance with statutory accounting
principles are certified annually by our independent actuaries.
PricewaterhouseCoopers LLP certified the reserves of our insurance companies in
accordance with statutory accounting principles as of December 31, 2001.

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

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

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

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

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

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

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

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

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

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

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

23

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

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

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The following table provides a reconciliation of the gross liability of
loss and loss adjustment expenses on the basis of generally accepted accounting
principles for the three years ended December 31, 2001 (in thousands):

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

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

This table provides a reconciliation of the liability for loss and loss
adjustment expense, net of reinsurance ceded, on the basis of generally accepted
accounting principles for the three years ended December 31, 2001 (in
thousands):

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

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

Although we experienced gross loss deficiencies during 2001 and 1999, the
business was substantially reinsured and, therefore, there was no material
effect to our insurance companies on a net loss basis.

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During 2001, we had net loss and loss adjustment expense redundancy of
$10.7 million relating to prior year losses compared to a redundancy of $9.6
million in 2000 and a deficiency of $4.6 million in 1999. The deficiencies and
redundancies in the net reserves result from our continued review with our
actuaries of our loss reserves and the increase or reduction of reserves as
losses are finally settled and claims exposures are reduced. We believe we have
provided for all material net incurred losses.

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

INVESTMENTS

Insurance company investments must comply with applicable regulations which
prescribe the type, quality and concentration of investments. These regulations
permit investments, within specified limits and subject to certain
qualifications, in federal, state and municipal obligations, corporate bonds,
and preferred and common equity securities. As of December 31, 2001, we had
$888.5 million of investment assets. The majority of our investment assets are
held by our insurance companies. All of our securities are classified as
available for sale and are recorded at market value.

Our investment policy is determined by our Board of Directors and our
Investment and Finance Committee and is reviewed on a regular basis. We continue
to engage a nationally prominent investment advisor, New England Asset
Management, a subsidiary of Berkshire Hathaway, Inc., to oversee our investments
and to make recommendations to our Board's Investment and Finance Committee.
Although we generally intend to hold fixed income securities to maturity, we
regularly re-evaluate our position based upon market conditions. As of December
31, 2001, our fixed income securities have a weighted average maturity of five
years and a weighted average duration of four years. Our financial statements
reflect an unrealized gain on fixed income securities available for sale as of
December 31, 2001, of $11.8 million.

We have maintained a substantial level of cash and liquid short-term
instruments in our insurance companies in order to maintain the ability to fund
losses of our insureds. Our underwriting agencies and intermediaries typically
have short-term investments, which are fiduciary funds held on behalf of others.
As of December 31, 2001, we had cash and short-term investments of approximately
$355.8 million, of which $220.6 million were in our agencies and intermediaries.

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

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

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

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This table summarizes, by type, the estimated market value of our
investments as of December 31, 2001 (dollars in thousands):

This table summarizes, by rating, the market value of our investments in
fixed income securities as of December 31, 2001 (dollars in thousands):