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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
/X/ Annual Report pursuant to Section 13 or 15(d)of the Securities Exchange Act
of 1934 (Fee required).
/ / Transaction report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 (No fee required).
For the fiscal year ended _______December 31, 1997________________________
Commission file number _______0-20766_____________________________________
HCC Insurance Holdings, Inc.
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(Exact name of registrant as specified in its charter)
Delaware 76-0336636
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(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
13403 Northwest Freeway, Houston, Texas 77040-6094
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(Address of principal executive offices) (Zip Code)
(713) 690-7300
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(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12 (b) of the Act:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE OF WHICH REGISTERED:
COMMON STOCK, $1.00 PAR VALUE New York Stock Exchange
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 (Section229.405 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 13, 1998, of the voting stock held by
non-affiliates of the registrant was approximately $869.2 million. 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 13, 1998 was 47,827,789.
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.
TABLE OF CONTENTS
HCC INSURANCE HOLDINGS, INC.
PAGE
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PART I.
ITEM 1. Business........................................................................ 3
ITEM 2. Properties...................................................................... 24
ITEM 3. Legal Proceedings............................................................... 24
ITEM 4. Submission of Matters to a Vote of Security Holders............................. 24
PART II.
ITEM 5. Market for the Registrant's Common Equity and Related Stockholder Matters....... 25
ITEM 6. Selected Financial Data......................................................... 26
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of
Operations...................................................................... 28
ITEM 7A. Quantitative and Qualitative Disclosure About Market Risk....................... 35
ITEM 8. Financial Statements and Supplementary Data..................................... 35
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosures..................................................................... 35
PART III.
ITEM 10. Directors and Executive Officers of the Registrant.............................. 36
ITEM 11. Executive Compensation.......................................................... 36
ITEM 12. Security Ownership of Certain Beneficial Owners and Management.................. 36
ITEM 13. Certain Relationships and Related Transactions.................................. 36
PART IV.
ITEM 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K................. 36
SIGNATURES.............................................................................................. 37
This report on Form 10-K (this "Report") contains certain forward-looking
statements within the meaning of Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as amended,
which are intended to be covered by the safe harbors created thereby. Investors
are cautioned that all forward-looking statements necessarily involve risks and
uncertainty, including, without limitation, the risk of a significant natural
disaster, the inability of the Company to reinsure certain risks, the adequacy
of its loss reserves, the financial viability of reinsurers, the expansion or
contraction in its various lines of business, the impact of inflation, changing
licensing requirements and regulations in the United States and in foreign
countries, the ability of the Company to integrate its recently acquired
businesses, the effect of pending or future acquisitions as well as acquisitions
which have recently been consummated, general market conditions, competition,
licensing and pricing. All statements, other than statements of historical
facts, included or incorporated by reference in this Report that address
activities, events or developments that the Company expects or anticipates will
or may occur in the future, including, without limitation, such things as future
capital expenditures (including the amount and nature thereof), business
strategy and measures to implement such strategy, competitive strengths, goals,
expansion and growth of the Company's businesses and operations, plans,
references to future success, as well as other statements which includes words
such as "anticipate", "believe", "plan", "estimate", "expect", and "intend" and
other similar expressions, constitute forward-looking statements. Although the
Company believes that the assumptions underlying the forward-looking statements
contained herein are reasonable, any of the assumptions could over time prove to
be inaccurate and therefore, there can be no assurance that the forward-looking
statements included in this Report will themselves prove to be accurate. In
light of the significant uncertainties inherent in the forward-looking
statements included herein, the inclusion of such information should not be
regarded as a representation by the Company or any other person that the
objectives and plans of the Company will be achieved.
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PART I
In accordance with the pooling-of-interests method of accounting, the
financial information of HCC Insurance Holdings, Inc. and its subsidiaries set
forth in this Form 10-K has been restated to include the accounts and operations
of AVEMCO Corporation and LDG Management Company Incorporated.
ITEM 1. BUSINESS
GENERAL
HCC Insurance Holdings, Inc. ("HCC") is a Delaware corporation with
principal and executive offices located at 13403 Northwest Freeway, Houston,
Texas 77040. HCC and its consolidated subsidiaries are collectively referred to
herein as the "Company" unless the context otherwise requires. HCC, through its
subsidiaries, provides specialized property and casualty insurance coverages,
managing general agency services and insurance related services both to
commercial customers and individuals. The Company's insurance products are
underwritten on both a direct and reinsurance basis and are marketed by the
Company itself and through a network of independent and affiliated agents and
brokers. The Company's principal insurance company subsidiaries are Houston
Casualty Company ("HC"), U.S. Specialty Insurance Company ("USSIC") and
Trafalgar Insurance Company ("TIC") in Houston, Texas; and AVEMCO Insurance
Company ("AIC") in Frederick, Maryland. Until recently, the Company operated IMG
Insurance Company Ltd. ("IMG") as a separate company in Amman, Jordan and
London, England. The Company is in the process of consolidating IMG's operations
with those of HC and on a going forward basis, IMG will be operated as a branch
of HC in the same locations. The Company's principal agency subsidiaries are LDG
Management Company Incorporated ("LDG") in Wakefield, Massachusetts; HCC
Underwriters, A Texas Corporation ("HCCU") in Houston, Texas; The Kachler
Corporation ("Kachler") in Houston, Texas; North American Special Risk
Associates, Inc. ("NASRA") in Northbrook, Illinois; Aviation & Marine Insurance
Group, Inc. ("AMIG") in Dallas, Texas; and Guarantee Insurance Resources, Inc.
("GIR") in Marietta, Georgia.
Since its founding in 1974, the Company and its predecessor companies have
been consistently profitable, generally reporting annual increases in gross
written premium ("GWP"), net written premium ("NWP"), management fee and
commission income and total revenue. During the period 1995 through 1997, the
Company's insurance company subsidiaries had an average combined ratio of 82.3%
versus the less favorable 106.1% recorded by the U.S. property and casualty
insurance industry overall (1995-1996). During the same period, the Company's
GWP increased from $283.5 million to $346.4 million, an increase of 22%,
although growth has slowed recently; management fee and commission income
increased from $35.9 million to $75.9 million an increase of 112%; and net
earnings increased from $26.1 million to $49.8 million, an increase of 91%.
The Company's insurance companies' underwriting activities are focused on
providing aviation, marine, offshore energy, property, accident and health, and
lenders single interest insurance and reinsurance on a worldwide basis. As an
insurer, the Company operates on a surplus lines or a non-admitted basis through
HC and TIC and on an admitted basis through AIC and USSIC.
The Company's domestic insurance company subsidiaries are rated "A+"
(Superior) by A.M. Best Company ("A.M. Best"). HC is rated "Aq" and AIC is rated
"AAq" by Standard & Poor's Corporation ("S&P"). An A.M. Best or S&P rating is
intended to provide an independent opinion of an insurer's ability to meet its
obligations to policyholders and should not be considered as an investment
recommendation.
The Company also underwrites on behalf of non-affiliiated insurance
companies through its managing general agency operations. These agency
operations specialize in domestic general aviation insurance, medical stop-loss
coverage for employee sponsored self-insured health plans, occupational accident
coverage for self-insured truckers, and a variety of accident and health related
insurance and reinsurance products. Beginning in 1996, in an effort to further
diversify its operations to enhance the Company's
3
ability to anticipate and capitalize on opportunities resulting from changing
market conditions in the insurance industry, the Company commenced a strategy of
acquiring through merger or purchase, a number of privately held companies whose
business was managing general agency activities, primarily in the medical
stop-loss and domestic general aviation insurance businesses. As a result of
these acquisitions and internal growth, since 1995, the Company's management fee
and commission income has increased from $5.9 million (prior to both
poolings-of-interests restatements) to $75.9 million. The managing general
agency operations generated $518.2 million in premium during 1997, an increase
of 55% since 1995. The Company will continue to review possible acquisition
candidates in the insurance agency and services sectors in order to further the
Company's growth in this area.
STRATEGY
The Company's operating philosophy as an insurer is to maximize underwriting
profit while preserving the integrity of shareholders' equity. The Company
concentrates its writings in selected, narrowly defined lines of business in
which it believes there is a substantial opportunity to achieve underwriting
profits. The Company primarily underwrites first party coverages and lines of
business which have relatively short lead times between the occurrence of an
insured event and the reporting of claims to the Company. The Company's
insurance products are marketed both directly by the Company and through
independent and affiliated agents. With respect to the underwriting management,
marketing and related services, the Company seeks to offer quality underwriting,
decision-making, support and reinsurance capacity and financial and other
resources to take advantage of market opportunities for the development of new
products.
The property and casualty insurance underwriting business has historically
been cyclical (though not seasonal) and within the overall cycle of the
industry, particular lines of business experience their own cycles. These cycles
are characterized by periods of excess capital and significant competition in
policy pricing, terms and conditions, followed by periods of capital shortages,
typically resulting from adverse loss experience, which leads to decreased
competition, higher premium rates and stricter underwriting standards.
The position of a particular line of business in its respective underwriting
cycle depends on prevailing premium rates, availability and cost of reinsurance,
and other market conditions. The Company considers each of these factors in
determining when to increase or decrease premium volume in each line. With this
approach, the Company focuses on increasing net earnings rather than premium
volume or market share.
The Company purchases a substantial amount of reinsurance to limit its net
loss from both individual and catastrophic risks. The degree to which the
Company reinsures varies by, among other things, the particular risks inherent
in the policies underwritten, pricing of available reinsurance and competitive
conditions within the relevant line of business.
In its insurance company operations, the Company believes its operational
flexibility, experienced underwriting personnel, and access to and expertise in
the reinsurance marketplace allow the Company to implement its 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, through its acquisition and
ownership of insurance agency businesses, the Company believes that it has
demonstrated that those service based businesses can both complement the
Company's underwriting activities and serve as a source of revenue which may not
be subject to the same level of volatility as traditional underwriting revenues.
Many of the Company's insurance agency and services subsidiaries act as an agent
on behalf of, or provide services to, the Company's insurance company
subsidiaries as well as to non-affiliated insurers. The ability of the Company's
insurance company subsidiaries to utilize an affiliated insurance agency or
services provider, and the corollary ability of such insurance agency and
services subsidiaries to place business with, or provide other services to, an
affiliated
4
insurer, permits the Company to capture a greater portion of the total income
derived from generated premium.
The Company's business plan is to expand its underwriting activities and
continue the growth of its insurance agency and services operations. However,
the Company's business plan is shaped by its underlying operating philosophy,
which is to maximize underwriting profit opportunities, while preserving the
integrity of shareholders' equity. The Company expects to continue to seek to
acquire complementary businesses with established management and reputation in
the insurance industry, whose business, the Company believes, can be enhanced
through the synergism created by the Company's underwriting capabilities and its
other owned insurance related businesses. As a result, the Company's primary
interests are not necessarily in expanding market share or GWP, but rather in
increasing net earnings. To accomplish this objective, the Company: (i) has been
and is prepared to emphasize or reduce underwritings in certain lines of
business as premium rates, the availability and cost of reinsurance and other
market conditions warrant; (ii) will continue to attempt to limit its downside
net loss exposure through the effective, prudent and conservative use of
reinsurance; (iii) will, as conditions warrant, continue to emphasize the growth
of its insurance agency and services operations, which can be expected to result
in continuing growth of management fee and commission income as a portion of
total revenues; and (iv) will continue to review the possible acquisition of
other specialty insurance companies.
INDUSTRY SEGMENT INFORMATION
Financial information concerning the Company's operations by industry
segments is set forth in the Consolidated Financial Statements and the Notes
thereto.
RECENT ACQUISITIONS
On May 24, 1996, the Company issued 6,250,000 shares of its Common Stock to
acquire all of the outstanding shares of LDG. LDG underwrites on behalf of
insurance and reinsurance companies and conducts its business in two areas: (i)
insurance underwriting management and (ii) reinsurance underwriting management
and intermediary services. LDG underwrites insurance and/or reinsurance in the
following lines of business: medical stop-loss insurance for employer sponsored
self-insured health plans, accident and health special risks, workers'
compensation and alternative workers' compensation. LDG generally concentrates
on lines of business that have relatively short lead times between the
occurrence of an insured event and the reporting of claims.
On November 27, 1996, the Company issued 1,136,400 shares of its Common
Stock and paid $1.7 million in cash to acquire all of the outstanding shares of
NASRA. NASRA provides underwriting management and claims administration services
to insurance and reinsurance companies primarily for occupational accident
insurance for self-employed truckers and alternative workers' compensation
insurance.
On January 24, 1997, the Company issued 266,667 shares of its Common Stock
and paid $6.6 million in cash to acquire all of the occupational accident
business of TRM International, Inc. This acquired business was consolidated with
the operations of NASRA and effectively doubled NASRA's business.
On April 30, 1997, the Company issued 725,000 shares of its Common Stock to
acquire all of the outstanding shares of Interworld Corporation ("Interworld"),
the parent corporation of AMIG. AMIG provides underwriting management services
for general aviation risks, with special emphasis on private and corporate
aircraft and small to medium size airports and commercial operators.
On June 17, 1997, the Company issued 8,511,625 shares of its Common Stock
and 604,575 options to purchase its Common Stock in order to acquire all of the
outstanding shares and options to purchase shares of AVEMCO Corporation
("AVEMCO"), the parent corporation of a group of insurance and insurance
services companies. AVEMCO, through its insurance company subsidiaries, provides
property
5
and casualty insurance in the general aviation, lenders single interest,
short-term health and pleasure-craft marine lines of business. AVEMCO's primary
insurance company subsidiaries were AIC and USSIC. Following the acquisition,
the operations of USSIC have been relocated to Houston, Texas and it has become
a subsidiary of HC. AIC and USSIC operate on an admitted basis throughout the
United States and AIC also operates as an admitted insurer in Canada (except
Quebec).
AVEMCO's principal insurance agency and services operations are focused in
five areas: (i) underwriting management services for lenders single interest
coverage for banks and other financial institutions; (ii) underwriting
management services for short-term health and travel insurance marketed to
foreign students resident in the United States; (iii) claims management services
primarily on behalf of AIC; (iv) worldwide multilingual emergency assistance and
evacuation arrangement services for individuals traveling abroad; and (v)
insurance related computer products, software and services for property and
casualty insurance companies throughout the United States.
On June 26, 1997, the Company issued 98,003 shares of its Common Stock and
paid $3.6 million in cash to acquire all of the outstanding shares of Managed
Group Underwriting, Inc. ("MGU"). MGU provides underwriting management services
for medical stop-loss insurance for employer sponsored self-insured health
plans.
On July 31, 1997, the Company issued 17,354 shares of its Common Stock and
paid $2.8 million in cash to acquire all of the outstanding shares of
Continental Aviation Underwriters, Inc. ("Continental"). Continental provides
underwriting management services for general aviation risks, with special
emphasis on commercial agricultural operators.
On August 8, 1997, the Company issued 225,000 shares of its Common Stock to
acquire all of the outstanding shares of Southern Aviation Insurance
Underwriters, Inc. and Aviation Claims Administrators, Inc. (collectively,
"Southern"). Southern provides underwriting management and claims administration
services for general aviation risks, specializing in antique and vintage
military aircraft.
The operations of each of Continental and Southern have been consolidated
with those of AMIG in Dallas, Texas, which exercises overall responsibility for
underwriting management and claims administration services for the Company's
agency produced, domestic general aviation business.
On February 27, 1998, the Company issued 1,600,000 shares of its Common
Stock to acquire all of the outstanding shares of The Kachler Corporation
("Kachler"). Kachler is a retail insurance agency specializing in life, accident
and health insurance for employee benefit plans of large commercial customers
throughout the United States.
Effective as of February 28, 1998, the Company issued 29,029 shares of its
Common Stock and paid $21.4 million in cash to acquire all of the outstanding
shares of Insurance Alternatives, Inc. and the assets and liabilities of
Guarantee Insurance Resources, a general partnership (collectively, "GIR"). GIR
provides underwriting management services for medical stop-loss insurance for
employer sponsored self-insured health plans.
PENDING ACQUISITIONS
There are currently no acquisitions pending; however, the Company is
evaluating a number of possible acquisition candidates and expects to complete
one or more acquisitions during the remainder of 1998. The Company believes
these future acquisitions will expand and strengthen its existing lines of
business and perhaps provide access to additional specialty sectors, which
management expects will contribute to the growth of the Company.
6
INSURANCE COMPANY OPERATIONS
The Company's property and casualty insurance company businesses specialize
in the direct underwriting, including facultative (individual policy)
reinsurance of aviation, marine, offshore energy, property, accident and health,
and lenders single interest risks and to a lesser extent, treaty reinsurance
(contractual arrangements relating to specific types of risks) on both a
proportional (where the reinsurer shares proportionately in premiums and losses)
and an excess of loss (where only losses above a fixed point or percentage are
reinsured) basis in these same lines of business.
LINES OF BUSINESS
The following table sets forth the Company's insurance company subsidiaries'
GWP by line of business and the percent to total GWP for the periods indicated:
FOR THE YEARS ENDED DECEMBER 31,
(DOLLARS IN THOUSANDS)
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1997 1996 1995
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Aviation................................................. $ 164,519 47% $ 140,725 42% $ 132,690 39%
Property................................................. 85,379 25 118,154 35 124,336 37
Accident and health...................................... 43,232 12 13,004 4 10,897 3
Marine................................................... 22,847 7 32,433 10 37,321 11
Lenders single interest.................................. 21,878 7 22,870 7 16,646 5
Offshore energy.......................................... 7,469 2 8,496 2 14,893 4
Excess of loss........................................... 386 -- 734 -- 1,877 1
Miscellaneous............................................ 689 -- 862 -- 445 --
---------- --- ---------- --- ---------- ---
Total GWP.............................................. $ 346,399 100% $ 337,278 100% $ 339,105 100%
---------- --- ---------- --- ---------- ---
---------- --- ---------- --- ---------- ---
The following table sets forth the Company's insurance company subsidiaries'
NWP by line of business and the percent to total NWP for the periods indicated:
FOR THE YEARS ENDED DECEMBER 31,
(DOLLARS IN THOUSANDS)
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1997 1996 1995
----------------------- --------------------- ---------------------
Aviation................................................. $ 75,518 53% $ 104,964 56% $ 95,488 52%
Accident and health...................................... 28,165 20 12,851 7 10,794 6
Marine................................................... 17,271 12 25,918 14 32,855 18
Lenders single interest.................................. 11,097 8 19,726 10 14,600 8
Property................................................. 8,838 6 21,534 11 24,186 13
Offshore energy.......................................... 1,495 1 3,472 2 5,115 3
Excess of loss........................................... 300 -- (1,047) -- 833 --
Miscellaneous............................................ 688 -- 857 -- 454 --
---------- --- ---------- --- ---------- ---
Total NWP.............................................. $ 143,372 100% $ 188,275 100% $ 184,325 100%
---------- --- ---------- --- ---------- ---
---------- --- ---------- --- ---------- ---
UNDERWRITING
DIRECT--The Company underwrites direct business produced through independent
agents and brokers, affiliated intermediaries, and by direct marketing efforts,
particularly in small general aviation business.
REINSURANCE--The Company engages in reinsurance underwriting on a periodic
basis when market rates and other conditions make it profitable to do so, to
access business not readily available to the Company on a direct basis and to
provide reciprocity to non-affiliated insurance companies. The Company
7
began writing treaty reinsurance in 1984, but had dramatically reduced its book
of business by 1992, due to the deterioration in market conditions.
The Company's current reinsurance underwriting activities are primarily in
accident and health lines of business where the Company's insurance company
subsidiaries participate in various insurance and reinsurance underwriting pools
managed by one of its subsidiaries and facultative reinsurance, particularly in
the aviation and property lines of business.
The Company previously wrote excess of loss reinsurance, typically aviation,
marine and non-marine catastrophe exposures. In 1992, due to a general market
contraction of available reinsurance for excess of loss business, the Company
was unable to purchase adequate protection at a reasonable cost and, therefore,
elected not to continue writing this class other than selectively on a net
basis. The run-off of this line of business continues profitably on a net basis.
The Company underwrites proportional treaty reinsurance on a selective
basis. The exposures reinsured are typically the same type of risks that the
Company underwrites on a direct basis.
The Company underwrites facultative reinsurance in most of its lines of
business. Typically, this is on international business in order to comply with
local licensing requirements or as reinsurance of captives, and usually can be
considered direct business, as the Company maintains underwriting and claims
control. However, all of this business is recorded under the caption of
"Reinsurance Assumed".
AVIATION--Aviation underwriting presently represents the Company's largest
overall line of business and in recent years the Company has grown into a market
leader in the aviation insurance industry. The Company insures, on both a direct
marketed and independent agency produced basis, general aviation risks,
including private aircraft owners and pilots, fixed base operations, rotor wing
aircraft, corporate aircraft, cargo operations, commuter airlines and similar
operations, many on both a domestic and international basis. At this time, the
Company does not generally insure major domestic trunk airlines, major
manufacturers or satellites. The coverages underwritten include hull (including
engines, avionics and other systems), liabilities, war, cargo and various
ancillary coverages.
The Company has been underwriting aviation risks since 1981 through HC. AIC
has been insuring aviation risks since 1959. GWP has risen consistently since
1995, increasing from $132.7 million to $164.5 million in 1997. This growth has
occurred due to internal growth, particularly internationally. Although, due to
market conditions, domestic risks had not been a focus for the Company since the
early 1990's, HC resumed writing domestic general aviation risks late in 1996
and with the acquisition of AIC and USSIC in mid-1997, the Company assumed the
role of a major participant in the domestic general aviation insurance market.
The Company's position in the domestic general aviation market is further
enhanced by its aviation managing general agency operations and the Company
estimates that it presently underwrites on behalf of affiliated and
non-affiliated insurance companies approximately 25% of the overall domestic
general aviation market. The Company expects that general aviation insurance
will continue to play a key role in the Company's near-term operations. In 1997,
the Company experienced a decline in NWP due to the implementation of the
Company's reinsurance program at AIC. The Company expects its overall increases
in GWP and NWP to slow during 1998 as a result of the Company's already
substantial market share and increased competition.
Treaty reinsurance is maintained on both a proportional and an excess of
loss basis to protect the Company against individual risk severity of loss and
catastrophe exposure. Management believes that the aviation risks underwritten
by the Company carry a relatively low level of catastrophe exposure.
MARINE--The Company underwrites marine risks for ocean going vessels ("Blue
Water"), inland and coastal trading vessels ("Brown Water"), fishing vessels and
to a limited extent, pleasure-crafts. The coverages written include hull and
machinery, liabilities (including protection and indemnity), marine cargo and
various ancillary coverages.
8
The Company has underwritten marine risks since 1984. Premium rates were
adequate during 1995 and 1996 but competition has created downward pressure on
these rates causing a reduction in the Company's GWP from $37.3 million in 1995
to $22.8 million in 1997 and a corresponding decrease in NWP from $32.9 million
to $17.3 million for the same period. The Company believes these rates will
remain soft during 1998.
Treaty reinsurance is maintained on an excess of loss basis to protect the
Company against individual risk severity of loss and catastrophe exposure.
Management believes that the marine risks underwritten by the Company carry a
relatively low level of catastrophe exposure.
OFFSHORE ENERGY--The Company has been underwriting offshore energy risks
since 1988. Offshore energy risks include drilling rigs, production and
gathering platforms, and pipelines. Coverages underwritten include physical
damage, liabilities, business interruption and various ancillary coverages.
Rates have declined significantly during the past few years to levels where
profitability is unlikely. Underwriting has been on a very selective basis,
striving for quality rather than quantity, which has resulted in a continued
reduction in GWP from $14.9 million in 1995 to $7.5 million in 1997. The Company
anticipates little growth in GWP and NWP during 1998 as severe competition is
expected to continue.
Treaty reinsurance is maintained on both a proportional and an excess of
loss basis to protect the Company against individual risk severity of loss and
the catastrophic exposure that exists, for example, from a hurricane in the Gulf
of Mexico.
PROPERTY--The Company specializes in writing catastrophe exposed risks in
general and the property risks of large multinational corporations, covering
such commercial risks as hotels, office buildings, retail locations, factories,
industrial plants, utilities, refineries, natural gas facilities and
petrochemical plants. Coverage includes business interruption and physical
damage, including flood and earthquake.
The Company has written property business since 1986. GWP grew to $124.3
million in 1995 as premium rates increased following the Northridge earthquake
in 1994. During 1996, premium rates began to soften and this trend has continued
throughout 1997 due in a large part to excess capacity and the absence of
significant catastrophe losses. GWP has declined from $124.3 million in 1995 to
$85.4 million in 1997. NWP also declined from $24.2 million to $8.8 million in
the same period. Property NWP will always be substantially less than GWP due to
the amount of reinsurance purchased to protect the Company's catastrophe
exposure. In the absence of a major catastrophe loss, which could be expected to
have a positive impact on pricing in the sector, the Company expects both GWP
and NWP to decline further during 1998 as premium rates continue to soften.
Considerable treaty reinsurance is maintained on both a proportional and an
excess of loss basis to ensure adequate protection, particularly against
catastrophic exposures. The Company conservatively estimates its aggregate
exposure in any individual catastrophe zone and maintains catastrophe
reinsurance to cover its exposure to any one occurrence.
ACCIDENT AND HEALTH--The Company began underwriting accident and health
risks through HC during 1996. These risks are produced primarily by the managing
general agencies which were acquired by the Company during that year. The risks
underwritten include medical stop-loss insurance for employer sponsored
self-insured health plans; reinsurance in the medical, accident and health
special risks, workers' compensation and alternative workers' compensation
areas; and occupational accident insurance for self-employed truckers. The
Company underwrites in this area on both a direct and reinsurance basis. The
Company's GWP increased from $13.0 million in 1996 to $43.2 million in 1997. The
Company expects its overall GWP and NWP to continue to increase significantly
during 1998, primarily due to the Company's anticipated utilization of AIC as a
primary insurer of medical stop-loss products underwritten by the Company's
accident and health agency operations.
9
Management believes that its accident and health business carries a
relatively low level of catastrophe exposure.
LENDERS SINGLE INTEREST--USSIC began writing lenders single interest risks
in 1984. GWP increased from $16.6 million in 1995 to $21.9 million in 1997,
however, due to the implementation of a reinsurance program when USSIC was
acquired in June, 1997, NWP decreased from $14.6 million in 1995 to $11.1
million in 1997. This coverage is marketed to banks and other financial
institutions and addresses risks of physical loss or damage to the property
securing installment loans (primarily automobiles). All of the lenders single
interest risks underwritten by the Company are produced by the Company's
subsidiary, Matterhorn Bank Programs, Inc. ("Matterhorn"). GWP is expected to
grow during 1998 but NWP will remain unchanged as the new reinsurance program
will be in effect for the entire year.
Treaty reinsurance is maintained on a proportional basis to protect against
frequency of loss. Management believes that its lenders single interest business
carries a relatively low level of catastrophe exposure.
INSURANCE COMPANY SUBSIDIARIES
HOUSTON CASUALTY COMPANY--HC, the Company's principal insurance company
subsidiary, is rated A+, VIII by A.M. Best and operates worldwide in all of the
lines of business in which the Company specializes (except lenders single
interest). HC's business is produced by independent agents and brokers, the
group's agency subsidiaries, AIC, USSIC, TIC, and other insurance and
reinsurance companies worldwide. HC 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 the Company specializes. As
of December 31, 1997, HC had statutory policyholders' surplus of $233.0 million.
TRAFALGAR INSURANCE COMPANY--TIC, which was organized in 1993, is a wholly
owned subsidiary of HC. TIC is an Oklahoma domiciled property and casualty
insurance company, is rated A+, VI by A.M. Best and currently underwrites
domestic property risks and allows HC to offer insurance on a surplus lines
basis in certain jurisdictions where HC is not otherwise permitted to do so.
Applications for surplus lines approval are pending in many additional states
and TIC will expand its operations as approvals are received. As of December 31,
1997, TIC had statutory policyholders' surplus of $30.9 million.
U.S. SPECIALTY INSURANCE COMPANY--USSIC is a Maryland domiciled property and
casualty insurance company and former subsidiary of AIC which became a
subsidiary of HC in December, 1997. The Company is in the process of effecting
the re-domestication of USSIC from Maryland to Texas, which, pending regulatory
approval, is expected to be completed during the second quarter of 1998. USSIC
is rated A+, VII by A.M. Best and has historically been an underwriter of
general aviation, pleasure-craft marine and lenders single interest risks
through a network of independent agents. USSIC operates on an admitted basis
throughout the United States (except Hawaii). The Company expects to continue
USSIC's operation primarily as a general aviation and lenders single interest
underwriter. During December, 1997, the Company increased the policyholders'
surplus of USSIC by $38.4 million and as of December 31, 1997, USSIC had
statutory policyholders' surplus of $50.1 million.
IMG INSURANCE COMPANY LTD.--Organized in September, 1991, as a Jordanian
Exempt Company ("JEC"), IMG conducts substantially all of its business outside
of Jordan and has been principally engaged in insuring and reinsuring large
commercial risks in substantially the same lines of business as HC. In
connection with IMG's business, the Company has agreed to unconditionally
guarantee certain of the insurance and reinsurance business of IMG. As of
December 31, 1997, IMG had policyholders' surplus of $28.5 million. During 1998,
the operations of IMG, through its Amman, Jordan and London, England offices,
were consolidated with the operations of HC and HC is in the process of assuming
all of IMG's existing insurance obligations. On a going forward basis, IMG will
operate as a branch of HC. Management believes that this action can be expected
to enhance the direct presence of HC in the Middle Eastern,
10
African and London insurance markets and is expected to lead to increased
underwriting opportunities for the Company in those and other international
markets.
AVEMCO INSURANCE COMPANY--AIC was organized in 1959 and became a subsidiary
of the Company in June, 1997. AIC is a Maryland domiciled property and casualty
insurer, is rated A+, VII by A.M. Best and operates primarily as a direct market
writer of general aviation and pleasure-craft marine business on an admitted
basis throughout the United States and Canada (except Quebec). In addition, as a
part of the Company's overall operations, it is anticipated that AIC will become
a primary insurer of medical stop-loss products underwritten by the Company's
accident and health managing general agency subsidiaries and of lenders single
interest risks underwritten by another subsidiary of the Company. At December
31, 1997, AIC had statutory policyholders' surplus of $67.9 million.
INSURANCE AGENCY AND SERVICES OPERATIONS
The Company's insurance agency subsidiaries act on behalf of insurance and
reinsurance companies, conducting business in the areas of insurance and
reinsurance underwriting management and claims administration. The insurance
services operations provide insurance related services including intermediary
services. The insurance agency and services subsidiaries do not assume any
insurance or reinsurance risk themselves and the revenues generated are based
entirely on management fees, commissions and profit commissions. As a result of
their operations, these subsidiaries are in a position to direct and control
such insurance premiums.
LDG, GIR and MGU act as underwriting managers providing medical stop-loss
and excess coverage insurance products principally to employer sponsored
self-insured health plans. Other areas of business include medical, accident and
health special risks, workers' compensation and alternative workers'
compensation insurance. In 1997, these operations generated approximately $442.0
million in premium, the majority of which was underwritten on behalf of
non-affiliated insurance companies.
AMIG, acquired by the Company in April, 1997, has provided the base, along
with the Company's insurance company subsidiary AIC, around which the Company
has rapidly developed a significant presence in the domestic general aviation
market. The underwriting management operations of AMIG have been consolidated
with those of Continental, acquired in July, 1997, Southern, acquired in August,
1997 and certain operations of USSIC, acquired in June, 1997. This combined
operation provides underwriting management services on behalf of affiliated and
non-affiliated insurance companies in the areas of private and corporate
aircraft, commercial agricultural aircraft, antique and vintage military
aircraft, small to medium sized airports, and commercial operators. During 1997,
the combined AMIG operation generated approximately $87.5 million in premium,
the majority of which was underwritten on behalf of non-affiliated insurance
companies.
NASRA acts as an underwriting manager providing occupational accident
(similar to workers' compensation) insurance to self-employed truckers and
generated approximately $46.9 million in premium in 1997, the majority of which
was underwritten on behalf of non-affiliated insurance companies.
Matterhorn acts as an underwriting manager providing lenders single interest
coverage to banks and other financial institutions. During 1997, Matterhorn
generated approximately $21.9 million in premium, all on behalf of affiliated
insurance companies, primarily USSIC.
Kachler, which was acquired in February, 1998, is a retail insurance agency
specializing in life, accident and health insurance for employee benefit plans
of large commercial customers throughout the United States. The Company intends
to increase Kachler's revenues substantially through the acquisition of similar
businesses during 1998 and 1999.
11
HCCU is an intermediary specializing in marketing and servicing large,
complicated insurance and reinsurance programs placed on behalf of multinational
clients operating in the same lines of business that the Company underwrites.
This business is placed with domestic and international insurance companies,
including affiliated insurance companies, on a direct basis and through other
intermediaries. In addition, HCCU acts as a reinsurance intermediary on behalf
of affiliated and non-affiliated insurance companies.
The Company's overall revenue from insurance agency and services operations
is composed of management fee and commission income which increased 77% to $75.9
million in 1997 from $42.8 million in 1995. The Company's premium from managing
general agency operations was $518.2 million in 1997 an increase of 55% from
$334.7 million in 1995. Management expects continued growth in management fee
and commission revenue in 1998, both from existing operations and additional
acquisitions in this sector.
COMBINED INSURANCE COMPANY AND INSURANCE AGENCY OPERATIONS
The Company's combined GWP was over $850.0 million in 1997, with its
insurance company operations underwriting $346.4 million and its managing
general agency operations underwriting $518.2 million, primarily on behalf of
non-affiliated insurance companies. The substantial premium base underwritten
and controlled by the Company's managing general agency operations is expected
to increase both internally and by acquisition during 1998 and will provide a
basis for significant growth for the Company's insurance company operations as
business is transferred from non-affiliated insurance companies.
REINSURANCE CEDED
The Company principally utilizes reinsurance to reduce its net liability on
individual risks, to protect against catastrophic losses and to achieve a
desired ratio of NWP to policyholders' surplus. Various intermediaries,
including HCCU, facilitate the placement of this reinsurance coverage on behalf
of the Company and are compensated, directly or indirectly, by the reinsurers.
Reinsurance is ceded under reinsurance treaties on both a proportional and
an excess of loss basis. The Company also reinsures large individual risks on a
facultative basis. Management believes that the Company reinsures its risks to a
greater extent than most of its competitors and most other insurance companies.
This strategy greatly reduces the likelihood of a significant net loss from
insurance company operations and protects the integrity of the Company's
shareholders' equity. Under its current reinsurance protections, the Company has
limited its net retained loss, across any single line of business, to a maximum
of approximately $500,000 for any one risk, but significantly less on most
risks.
The type, cost and limits of reinsurance purchased can vary from year to
year based upon the Company's desired retention levels and the availability of
adequate reinsurance at a reasonable price. The majority of the Company's
reinsurance programs are renewed on a calendar year basis. For 1998, the Company
has been successful in renewing its reinsurance protections at reduced costs to
1997.
The Company structures a specific reinsurance program for each line of
business it underwrites. This reinsurance is placed in order to protect the
Company from unreasonable exposure to foreseeable events. The Company places
reinsurance proportionally to cover loss frequency and for catastrophe coverage,
on an excess of loss basis to cover individual risk severity of loss and on a
catastrophe basis to cover losses involving multiple risks, such as those
resulting from a hurricane or an earthquake. The Company does not intend to
expose itself to a net loss from an individual risk in excess of its reinsurance
protection.
The Company writes business in areas exposed to catastrophic losses and has
significant exposures to this type of loss in California, the Atlantic Coast of
the United States, certain United States Gulf Coast states, particularly in
Florida and Texas, the Caribbean and Mexico. The Company carefully assesses its
overall exposures to a single catastrophic event and applies procedures that it
believes are more conservative than are typically used by the industry to
ascertain the Company's probable maximum loss ("PML") from any
12
single event. The Company maintains reinsurance protection which it believes is
sufficient to cover any foreseeable event.
The Company receives an overriding (ceding) commission on the premium ceded
to reinsurers which compensates the Company for the direct costs associated with
the production of the premium, 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 the Company's reinsurance treaties allow
for a sharing with the Company, by the reinsurers, of the net profits generated
under such treaties.
The ceding of reinsurance does not discharge the Company from liability to
its policyholders. The Company is required to pay losses even if the reinsurer
fails to meet its obligations under the reinsurance contract. To minimize its
exposure to reinsurance credit risk, the Company places its reinsurance with a
diverse group of financially sound reinsurers. The Company's 1998 treaty
reinsurance program was placed with more than 57 domestic and foreign
reinsurers. As of December 31, 1997, the total amount recoverable from
reinsurers was approximately $203.3 million, of which $50.5 million represents
paid losses recoverable (in the ordinary course of business) and $155.4 million
represents outstanding losses recoverable, less a $2.5 million reserve for
uncollectible reinsurance. In addition, ceded unearned premium was $84.6
million. The Company held $93.9 million of irrevocable letters of credit and
$8.6 million in cash to collateralize a portion of the total amount recoverable
and had other payable balances due to its reinsurers of $116.6 million as
potential offsets against reinsurance recoverables. The estimated duration for
the Company's outstanding losses is 2 years, as the majority of the Company's
business has historically had shorter lead times between the occurrence of an
insured event and final settlements.
Prior to the Company's acquisition of AVEMCO, AIC retained a greater
percentage of overall premiums written than HC and TIC. Following the
acquisition, the Company implemented a program of reinsurance for AIC which is
more consistent with the reinsurance programs utilized by the Company's other
insurance company subsidiaries. The effect of this change was to limit the net
retained exposure of AIC and to reduce the effect on net earnings of large
losses and high frequency of losses.
Due to the Company's financial analysis of active and potential reinsurers
and its conservative strategy of diversifying its reinsurers, the Company has
never incurred a significant loss on recoverables from reinsurers. The Company
has established a reserve of $2.5 million as of December 31, 1997, to reduce the
effects of any recoverable problem.
OPERATING RATIOS
PREMIUM TO SURPLUS RATIO
The following table shows, for the periods indicated, the ratio of statutory
GWP and NWP to statutory policyholders' surplus for the Company's property and
casualty insurance company subsidiaries:
FOR THE YEARS ENDED DECEMBER 31,
(DOLLARS IN THOUSANDS)
----------------------------------------------------------
1997 1996 1995 1994 1993
---------- ---------- ---------- ---------- ----------
GWP.................................................. $ 346,094 $ 340,367 $ 338,753 $ 283,530 $ 205,905
NWP.................................................. 143,068 189,022 184,028 133,143 101,015
Policyholders' surplus............................... 331,922 288,863 251,125 206,596 175,637
GWP ratio............................................ 104.3% 117.8% 134.9% 137.2% 117.2%
GWP industry average (1)............................. * 179.9 194.0 221.8 224.4
NWP ratio............................................ 43.1% 65.4% 73.3% 64.4% 57.5%
NWP industry average (1)............................. * 105.2 113.0 129.7 132.6
- ------------------------
* Not available
(1) Source: A.M. Best.
13
While there is no statutory requirement regarding a permissible premium to
surplus ratio, guidelines established by the National Association of Insurance
Commissioners ("NAIC") provide that a property and casualty insurer's annual
statutory GWP should not exceed 900% and NWP should not exceed 300% of its
policyholders' surplus. In keeping with its philosophy of protecting its
shareholders' equity and limiting its aggregate loss exposure, the Company
maintains premium to surplus ratios significantly lower than such guidelines,
and, as indicated above, below industry norms.
COMBINED RATIO
The underwriting experience of a property and casualty insurance company is
indicated by its combined ratio. The Company's insurance subsidiaries' loss
ratio, expense ratio and combined ratio, determined on the basis of statutory
accounting principles ("SAP"), are shown in the following table:
1997 1996 1995 1994 1993
--------- --------- --------- --------- ---------
Loss ratio............................................................. 61.6% 64.4% 66.4% 62.5% 66.3%
Expense ratio.......................................................... 17.2 19.2 18.1 20.4 23.7
--------- --------- --------- --------- ---------
Combined ratio......................................................... 78.8% 83.6% 84.5% 82.9% 90.0%
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
Industry average (1)................................................... * 105.8% 106.4% 108.4% 106.9%
- ------------------------
* Not available
(1) Source: A.M. Best.
The SAP basis ratio data is not intended to be a substitute for results of
operations on the basis of generally accepted accounting principles ("GAAP").
The difference between SAP and GAAP are shown in Note (15) of the Company's
consolidated financial statements. Including this information on a SAP basis is
meaningful and useful to allow a comparison of the Company's operating results
with those of other companies in the insurance industry. A.M. Best reports on
insurer performance on a SAP basis to provide for more standardized comparisons
among individual companies, as well as overall industry performance.
RESERVES
Applicable insurance laws and regulations require that reserves be
maintained for the payment of loss and loss adjustment expense ("LAE") with
respect to both reported and incurred but not reported ("IBNR") claims under
insurance and reinsurance policies issued by the Company. In most cases, the
Company establishes reserves through an evaluation of individual claims. In some
types of aviation claims, an average reserving method is utilized until more
information becomes available which will permit a more specific individual
evaluation of claims. In the case of direct and facultative reinsurance
business, loss reserves are determined by evaluating reported claims on the
basis of the type of loss, jurisdiction of the occurrence, knowledge of the
circumstances surrounding the claim, severity of injury or damage, potential for
ultimate exposure, experience with the insured and the line of business and
policy provisions relating to the particular type of claim. The Company
establishes loss reserves for excess of loss and proportional reinsurance claims
based on information and reports received from ceding companies. Loss reserves
for IBNR losses are determined in part on the basis of statistical information
and in part on industry experience with respect to the probable number and
nature of claims arising from occurrences which have not been reported. The
Company does not discount any of its loss reserves.
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 insurance underwritten by the Company have historically had longer lead
times between the occurrence of an insured event, reporting of the claim to the
Company, and final settlement. In such cases, the Company is forced to estimate
reserves over long periods of time, with the possibility of several adjustments
to
14
reserves. Other classes of insurance, such as most aviation, property and
accident and health business the Company underwrites, historically have shorter
lead times between the occurrence of an insured event, reporting of the claim to
the Company, and final settlement. The reserves with respect to such classes
are, therefore, less likely to be adjusted. The classes of insurance with
shorter lead times currently represent the majority of the risks underwritten by
the Company's insurance company operations.
The reserving process is intended to provide implicit recognition of the
impact of inflation and other factors affecting loss payments by taking into
account changes in historical payment patterns and perceived probable 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, some of which are interdependent.
The Company underwrites, directly and through reinsurance, risks which are
denominated in a number of foreign currencies, and therefore establishes and
maintains 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 the Company's earnings. From time to time, the Company may
attempt to limit its exposure to future currency fluctuations through the use of
foreign currency forward contracts.
The following loss development triangles show changes in reserves in
subsequent years from the prior loss estimates based on experience as of the end
of each succeeding year on the basis of GAAP. 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 each of the
years indicated, the gross reserve liability including the reserve for IBNR
losses. The first section of each table shows, by year, the cumulative amounts
of loss and LAE 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 December 31, 1997, the difference between the latest
re-estimated liability and the reserves as originally estimated.
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15
The following loss development triangle shows development in loss reserves
on a gross basis:
FOR THE YEARS ENDED DECEMBER 31,
(DOLLARS IN THOUSANDS)
----------------------------------------------------------------------
1997 1996 1995 1994 1993 1992
---------- ---------- ---------- ---------- ---------- ----------
Balance sheet reserves:.......................... $ 275,008 $ 229,049 $ 200,756 $ 170,957 $ 144,178 $ 129,503
Cumulative paid as of:
One year later................................. 119,453 118,656 97,580 82,538 83,574
Two years later................................ 167,459 143,114 126,290 130,379
Three years later.............................. 166,541 157,509 158,973
Four years later............................... 176,472 182,193
Five years later............................... 192,512
Re-estimated liability as of:
End of year.................................... 275,008 229,049 200,756 170,957 144,178 129,503
One year later................................. 252,236 243,259 186,898 163,967 162,827
Two years later................................ 248,372 207,511 183,015 176,817
Three years later.............................. 214,738 203,137 194,419
Four years later............................... 211,546 215,531
Five years later............................... 222,746
Cumulative redundancy (deficiency)............... $ (23,187) $ (47,616) $ (43,781) $ (67,368) $ (93,243)
During 1997, the Company had gross loss and LAE deficiency of $23.2 million
compared to deficiencies of $42.5 million in 1996 and $15.9 million in 1995. The
gross deficiency comes from two primary sources. Firstly, the development of
several large claims on individual policies which were either reported late or
reserves were increased as subsequent information became available, however, as
most of these policies were substantially reinsured, there was no material
effect to the Company's net earnings. Secondly, the run-off of the
retrocessional excess of loss business which the Company underwrote between 1988
and 1991. This development, $1.6 million in 1997 compared to $11.3 million in
1996 and $9.8 million in 1995, is due primarily to the delay in reporting of
catastrophe losses by the London insurance market, coupled with the
unprecedented number of catastrophes during the period in which the Company
underwrote this business. This business is also substantially reinsured, thereby
not having a material effect on the Company's net earnings.
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16
The following loss development triangle shows development in loss reserves
on a net basis:
FOR THE YEARS ENDED DECEMBER 31,
(DOLLARS IN THOUSANDS)
---------------------------------------------------------------------------
1997 1996 1995 1994 1993 1992 1991
--------- --------- --------- --------- --------- --------- ---------
Gross reserves for loss and LAE.................. $ 275,008 $ 229,049 $ 200,756 $ 170,957 $ 144,178 $ 129,503 $ 123,248
Less reinsurance recoverables.................... 155,374 111,766 101,497 95,279 82,289 81,075 83,727
--------- --------- --------- --------- --------- --------- ---------
Reserves for loss and LAE, net of reinsurance.... 119,634 117,283 99,259 75,678 61,889 48,428 39,521
Cumulative paid, net of reinsurance as of
One year later................................. 47,874 41,947 36,500 29,258 18,978 18,416
Two years later................................ 56,803 49,283 41,207 32,733 23,057
Three years later.............................. 56,919 46,576 36,536 31,903
Four years later............................... 51,536 38,480 33,875
Five years later............................... 40,327 34,970
Six years later................................ 36,203
Seven years later..............................
Eight years later..............................
Nine years later...............................
Ten years later................................
Re-estimated liability, net of reinsurance as of
End of year.................................... 119,634 117,283 99,259 75,678 61,889 48,428 39,521
One year later................................. 113,509 94,322 72,912 59,659 45,812 38,575
Two years later................................ 93,550 74,836 60,079 44,964 38,656
Three years later.............................. 76,423 62,224 46,129 39,176
Four years later............................... 64,377 48,993 40,407
Five years later............................... 50,785 43,418
Six years later................................ 45,142
Seven years later..............................
Eight years later..............................
Nine years later...............................
Ten years later................................
Cumulative redundancy (deficiency)............... $ 3,774 $ 5,709 $ (745) $ (2,488) $ (2,357) $ (5,621)
1990 1989 1988 1987
--------- --------- --------- ---------
Gross reserves for loss and LAE.................. $ 108,027 $ 96,477 $ 76,754 $ 86,101
Less reinsurance recoverables.................... 60,194 45,160 30,481 37,971
--------- --------- --------- ---------
Reserves for loss and LAE, net of reinsurance.... 47,833 51,317 46,273 48,130
Cumulative paid, net of reinsurance as of
One year later................................. 23,450 22,660 18,414 23,476
Two years later................................ 33,815 34,300 27,698 29,440
Three years later.............................. 35,912 40,806 33,601 32,820
Four years later............................... 42,465 41,878 36,256 35,713
Five years later............................... 43,422 46,734 36,045 36,992
Six years later................................ 43,690 47,164 37,718 36,490
Seven years later.............................. 44,611 47,229 38,338 37,567
Eight years later.............................. 47,928 38,415 38,074
Nine years later............................... 39,006 38,180
Ten years later................................ 38,750
Re-estimated liability, net of reinsurance as of
End of year.................................... 47,833 51,317 46,273 48,130
One year later................................. 44,887 49,475 43,362 45,267
Two years later................................ 45,435 47,313 42,463 42,526
Three years later.............................. 44,689 48,085 40,352 40,699
Four years later............................... 45,507 47,884 40,937 39,688
Five years later............................... 46,805 47,933 40,384 40,207
Six years later................................ 48,932 48,086 40,071 39,737
Seven years later.............................. 50,190 49,392 39,880 39,341
Eight years later.............................. 50,324 40,587 39,217
Nine years later............................... 41,014 39,983
Ten years later................................ 40,360
Cumulative redundancy (deficiency)............... $ (2,357) $ 993 $ 5,259 $ 7,770
17
The following table provides a reconciliation of the gross liability of loss
and LAE on a GAAP basis for the three years ended December 31, 1997 (dollars in
thousands):
1997 1996 1995
---------- ---------- ----------
Reserves for loss and LAE at beginning of year............................... $ 229,049 $ 200,756 $ 170,957
Reserves acquired with purchase of subsidiary................................ 1,919 -- --
Provision for loss and LAE for claims occurring in the current year.......... 269,505 185,502 195,019
Increase in estimated loss and LAE for claims occurring in prior years (1)... 23,187 42,503 15,941
---------- ---------- ----------
Incurred loss and LAE........................................................ 292,692 228,005 210,960
---------- ---------- ----------
Loss and LAE payments for claims occurring during:
Current year............................................................... 129,199 81,056 83,579
Prior years................................................................ 119,453 118,656 97,582
---------- ---------- ----------
Loss and LAE payments........................................................ 248,652 199,712 181,161
---------- ---------- ----------
Reserves for loss and LAE at end of the year................................. $ 275,008 $ 229,049 $ 200,756
---------- ---------- ----------
---------- ---------- ----------
- ------------------------
(1) Changes in loss and LAE reserves on a GAAP basis, 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.
The following table provides a reconciliation of the liability for loss and
LAE, net of reinsurance ceded, on a GAAP basis for the three years ended
December 31, 1997 (dollars in thousands):
1997 1996 1995
---------- ---------- ---------
Reserves for loss and LAE at beginning of year................................. $ 117,283 $ 99,259 $ 75,678
Reserves acquired with purchase of subsidiary.................................. 1,919 -- --
Provision for loss and LAE for claims occurring in the current year............ 100,288 119,401 108,140
Decrease in estimated loss and LAE for claims occurring in prior years (2)..... (3,774) (4,937) (2,766)
---------- ---------- ---------
Incurred loss and LAE.......................................................... 96,514 114,464 105,374
---------- ---------- ---------
Loss and LAE payments for claims occurring during:
Current year................................................................... 48,208 54,493 45,291
Prior years.................................................................... 47,874 41,947 36,502
---------- ---------- ---------
Loss and LAE payments.......................................................... 96,082 96,440 81,793
---------- ---------- ---------
Reserves for loss and LAE at end of the year................................... $ 119,634 $ 117,283 $ 99,259
---------- ---------- ---------
---------- ---------- ---------
- ------------------------
(2) Changes in loss and LAE reserves on a GAAP basis, 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 the Company experienced a gross loss deficiency during 1997, 1996
and 1995, because the business is substantially reinsured in the lines where
adverse development has occurred, there is no material adverse effect on a net
loss basis.
During 1997, the Company had net loss and LAE redundancy of $3.8 million
relating to prior year losses compared to redundancies of $4.9 million in 1996
and $2.8 million in 1995. The Company believes it has materially provided for
all net incurred losses.
18
AIC, acquired in June, 1997, recorded a $10.0 million increase in loss and
LAE reserves during December, 1997, predominately related to 1995 and 1996
claims incurred prior to the Company's acquisition of AIC. This deficiency is
included in the net redundancy recorded for 1997. This increase in reserves was
made in an effort to bring AIC's reserving practices consistent with the more
conservative method used by the Company's other insurance company operations.
The Company expects the increase in loss reserves to be adequate to cover any
subsequent adverse development of AIC's prior losses.
The Company has no material exposure to environmental pollution losses, as
HC only began writing business in 1981 and policies issued by HC 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 AIC and USSIC, because of the types of risks insured,
principally general aviation, are not considered to have significant
environmental exposures. Therefore, the Company should not experience any
material development in reserves from environmental pollution claims.
INVESTMENTS
Insurance company investments must comply with applicable laws and
regulations which prescribe the type, quality and concentration of investments.
In general, these laws and regulations permit investments, within specified
limits and subject to certain qualifications, in Federal, state and municipal
obligations, corporate bonds, preferred and common equity securities. As of
December 31, 1997, the Company had $523.3 million of investment assets, the
majority of which were held by insurance company subsidiaries.
The Company's investment policy is determined by the Company's Board of
Directors and is reviewed on a regular basis. Pursuant to its investment policy,
the Company concentrates its investments in obligations of states,
municipalities and political subdivisions, the interest income from which is
predomi-
nantly exempt from Federal income tax. The interest rates on these securities
are normally lower than rates on comparable taxable securities. The Company's
portfolio of fixed income securities available for sale principally consists of
intermediate term, tax-exempt securities. The Company generally intends to hold
such securities to maturity. However, the Company regularly re-evaluates its
position based upon market conditions, which may cause the Company to
restructure its portfolio and realize gains or losses in order to maximize its
total return on investments. Accordingly, all fixed income securities are
classified as available for sale and are recorded at market value.
The Company's financial statements reflect an unrealized ("mark-to-market")
gain on fixed income securities available for sale as of December 31, 1997, of
$14.6 million. Since the Company's intention is to hold these securities until
maturity, it does not currently expect to realize any significant gain or loss
on these investments.
The Company has maintained a substantial level of cash and liquid short-term
instruments in order to maintain the ability to fund large physical damage
losses of the Company's insureds, should they occur. As of December 31, 1997,
the Company had cash and short-term investments of approximately $112.6 million.
The following tables reflect the investments of the Company (dollars are
expressed in thousands). The table set forth below reflects the average amount
of investments, income earned, and the yield thereon for the three years ended
December 31, 1997:
1997 1996 1995
---------- ---------- ----------
Average investments.......................................................... $ 496,010 $ 461,778 $ 401,545
Net investment income........................................................ 27,718 23,595 21,748
Average yield (1)............................................................ 5.6% 5.1% 5.4%
Average tax equivalent yield (1)............................................. 7.3 6.9 7.1
- ------------------------
(1) Excluding realized and unrealized capital gains and losses.
19
The table set forth below summarizes, by type, the investments of the
Company as of December 31, 1997:
AMOUNT PERCENT OF TOTAL
---------- -----------------
Short-term investments................................................................ $ 105,255 20%
U.S. Treasury securities.............................................................. 12,214 2
Obligations of states, municipalities and political subdivisions...................... 180,028 35
Special revenue....................................................................... 216,259 41
Other fixed income securities......................................................... 1,200 --
Marketable equity securities.......................................................... 8,339 2
---------- ---
Total investments................................................................... $ 523,295 100%
---------- ---
---------- ---
The table set forth below indicates the expected maturity distribution of
the Company's fixed income securities as of December 31, 1997:
AMOUNT PERCENT OF TOTAL
---------- -----------------
One year or less...................................................................... $ 13,151 3%
One year to five years................................................................ 126,691 31
Five years to ten years............................................................... 132,278 32
Ten years to fifteen years............................................................ 102,064 25
More than fifteen years............................................................... 35,517 9
---------- ---
Total fixed income securities....................................................... $ 409,701 100%
---------- ---
---------- ---
BANK LOAN
Effective as of December 30, 1997, the Company entered into a $120.0 million
revolving credit facility (the "Facility") with a group of banks. Borrowings
under the Facility may be made by the Company until the expiration of the
Facility on December 30, 1999, at which time all principal is due. The Facility
is collateralized by the stock of HC and AIC. The Facility agreement contains
certain restrictive covenants, including, without limitation, minimum net worth
requirements for the Company and certain subsidiaries, restrictions on certain
extraordinary corporate actions, notice requirements for certain material
occurrences, and required maintenance of specified financial ratios. Management
believes that the restrictive covenants and other obligations of the Company
which are contained in the Facility agreement are typical for financing
arrangements comparable to the Facility. The initial funding was used, among
other things, to refinance existing indebtedness of the Company. As of March 13,
1998, the Company had outstanding indebtedness under the Facility in the amount
of $102.0 million.
FOREIGN EXCHANGE
From time to time, the Company enters into foreign currency forward
contracts as a hedge against foreign currency fluctuations, primarily British
Pound Sterling ("GBP"). The Company's balances denominated in foreign currency
fluctuate as transactions are recorded and settled. During 1997, the average GBP
liability, for subsidiaries whose functional currency was the United States
dollar, was approximately L793,000 ($1.3 million at December 31, 1997, rate of
exchange) which was hedged by an average open forward contract balance of
approximately L125,000 ($206,000 at the December 31, 1997, rate of exchange).
There are no open foreign currency forward contracts as of December 31, 1997.
The Company may continue to limit its exposure to currency fluctuations through
the use of foreign currency forward contracts.
The Company utilizes these foreign currency forward contracts strictly as a
hedge against existing exposure to foreign currency fluctuations and it does not
do so as any form of speculative or trading investment.
20
COMPETITION
The insurance business is generally highly competitive. The Company faces
competition from domestic and foreign insurers and agency operations, many of
whom are larger and have greater financial, marketing and management resources
than the Company. The Company's profitability is affected by many other factors,
including rate competition, severity and frequency of claims, interest rates,
state regulations, court decisions, the judicial climate and general business
conditions, all of which are outside the control of the Company. Although as an
insurer, the Company's underwriting strategy is to concentrate its writings in
selected, narrowly defined lines of business, the Company faces competition in
these selected lines of business both from other specialty insurance companies
as well as larger, more diversified insurance companies which underwrite
multiple lines of business, including the lines of business underwritten by the
Company. The Company's medical stop-loss business involves a diversified field
of participants from small, start-up operations to large, well-established
organizations. Significant growth in the number of medical stop-loss insurance
underwriters and underwriting managers in the past several years has increased
the level of competition in this area of the Company's business. The Company
also faces intense and growing pressure in this area from alternatives to
employer sponsored self-insured health plans, such as fully-insured plans, HMOs
and Point of Service plans, as well as from large well established direct
insurers and competing underwriting managers providing similar medical stop-loss
products to those offered by the Company to employer sponsored self-insured
health plans.
Competition in the reinsurance marketplace is primarily due to an increase
in the number of reinsurers participating in the market as well as a tendency by
reinsureds to retain a greater percentage of their own risk. The Company
competes with other reinsurance underwriting managers and domestic and
international reinsurance companies. The Company's results of operations may
also be affected by the competition for reinsurance business between broker
reinsurance markets and direct marketing reinsurance companies. The Company also
competes with many reinsurance intermediaries in the broker reinsurance market,
some of which are affiliated with primary insurance brokers with substantial
financial resources. In its insurance agency and services operations, the
Company competes with a large number of publicly traded and private firms which
operate as independent insurance agencies or insurance services providers as
well as with insurance companies which market insurance products directly
through their employees or affiliated insurance agencies. In each of the
business areas in which the Company is engaged, a significant number of the
Company's competitors have financial resources, employees, facilities, market
recognition, marketing, management, experience, and other resources
substantially greater than those of the Company. In addition to competition in
the operation of its business, the Company faces competition from a variety of
sources in attracting and retaining qualified employees.
REGULATION
The activities of the Company are subject to licensing requirements and
extensive regulation under the laws of the United States and its various states,
territories and possessions, as well as the laws of other countries in which the
Company's subsidiaries operate. Currently insurance companies are generally not
subject to any Federal regulation of their insurance business because of the
existence of a Federal law commonly known as the McCarran-Ferguson Act, which
provides the insurance industry with immunity from certain aspects of the
Federal anti-trust law and exempts the business of insurance from Federal
regulation. Therefore, in the United States, the Company's operations are
regulated primarily at the state level. The Company's business depends on the
validity of, and continued good standing under, the licenses and approvals
pursuant to which it operates, as well as compliance with pertinent regulations.
The Company therefore devotes significant efforts toward obtaining and
maintaining its licenses and compliance with a diverse and complex regulatory
structure.
The Company's insurance subsidiaries, in common with other insurers, are
subject to regulation and supervision by the states and by other jurisdictions
in which they do business. Within the states, the method of such regulation
varies but generally has its source in statutes that delegate regulatory and
supervisory
21
powers to an insurance official. The regulation and supervision relates
primarily to approval of policy forms and rates, the standards of solvency that
must be met and maintained, including risk based capital measurements, the
licensing of insurers and their agents, the nature of and limitations of
investments, restrictions of the size of risks which may be insured under a
single policy, deposits of securities for the benefit of policyholders, methods
of accounting, periodic examinations of the affairs of insurance companies, the
form and content of records of financial condition required to be filed, and
reserves for unearned premiums, losses and other purposes. In general, such
regulations are intended primarily for the protection of policyholders rather
than shareholders. Compliance is monitored by the state insurance departments
through periodic regulatory reporting procedures and periodic examinations. The
quarterly and annual financial reports to the regulators in the United States
utilize accounting principles which are different from the GAAP used by the
Company in its reports to shareholders. The SAP, in keeping with the intent to
assure the protection of policyholders, are generally based on a liquidation
concept while GAAP is based on a going-concern concept.
In addition to the regulatory supervision of the insurance company
subsidiaries of the Company, as an insurance holding company, the Company is
subject to regulation under the insurance holding company system regulatory acts
in the states of California, Maryland, Missouri, Oklahoma and Texas, which
contain certain reporting requirements including registration and the filing of
annual reports. In such registration and annual reports, the Company is required
to provide current information regarding its capital structure, general
financial condition, ownership, management, and the identity of each member of
its insurance holding company system. The Company is also required to provide
prior notice to insurance regulatory authorities of certain agreements and
transactions between the Company and its affiliates. These agreements and
transactions must satisfy certain standards set forth in the insurance laws and
regulations of such states. Insurance holding company laws also regulate the
payment of dividends and other distributions by insurance companies to their
shareholders.
Additionally, the insurance agency and services operations of the Company
are subject to state insurance laws and regulations which require the licensing
of insurance agents, brokers, reinsurance intermediaries, reinsurance
underwriting managers, third party administrators and managing general agents
and which regulate certain aspects of their business. These laws and regulations
may include requirements for certain provisions in contracts entered into
between the Company and various insurers or reinsurers, record keeping and
reporting requirements, limitations on authority, advertising and business
practice rules, and other matters. The manner of operating the Company's agency
activities in particular states may vary according to the licensing requirements
of the particular state, which may require, among other things, that a firm
operate in the state through a local corporation. In a few states, licenses are
issued only to individual residents or locally-owned business entities. In such
cases, the Company has arrangements with residents or business entities licensed
to act in the state.
There can be no assurance given that the Company has all such required
licenses, approvals or complying contracts or that such licenses, approvals or
complying contracts can always be obtained or continued. In all jurisdictions,
the applicable laws and regulations are subject to amendment or interpretation
by regulatory authorities. Generally, such authorities are vested with
relatively broad discretion to grant, renew and revoke licenses and approvals,
and to implement regulations, and licenses may be denied or revoked for various
reasons, including the violations of such regulations, conviction of crimes and
the like. In some instances, the Company follows practices based on its
interpretations, or those that it believes may be generally followed by the
industry, of laws and regulations, which may be different from the requirements
or interpretations of regulatory authorities. Accordingly, the possibility
exists that the Company may be precluded or temporarily suspended from carrying
on some or all of its activities or otherwise penalized in a given jurisdiction.
Such preclusion or suspension could have a materially adverse effect on the
business and results of operations of the Company.
HC is domiciled and licensed as an admitted insurer in Texas, is an
accredited reinsurer in 30 states (including Texas), and is an approved surplus
lines insurer or is otherwise permitted to write surplus lines
22
insurance in 46 states, three U.S. territories and the District of Columbia.
When a reinsurer obtains accreditation from a particular state, insurers within
that state are permitted to obtain statutory credit for risks ceded to the
reinsurer. Surplus lines insurance is offered by non-admitted (unlicensed)
companies on risks which are not insured by admitted (licensed) companies. All
surplus lines insurance is written through licensed surplus lines insurance
brokers, who are required to ensure that no licensed admitted insurer will write
a particular risk prior to placing that risk with a surplus lines insurer.
Additionally, HC through its operations in Amman, Jordan (formerly IMG), is able
under Jordanian law to directly underwrite non-Jordanian risks and reinsure
Jordanian risks. HC is in the process of seeking regulatory approval with the
appropriate English authorities to operate a formal branch office in London,
England. Such approval, if granted, will impose additional regulatory
requirements on HC, but management expects that such approval will also permit
HC to take advantage of increased opportunities in the London insurance market,
a historical focal point for specialty property and casualty risks. TIC is
domiciled and licensed as an admitted insurer in Oklahoma, is an accredited
reinsurer in three states (including Oklahoma), and is an approved surplus lines
insurer or is otherwise permitted to write surplus lines insurance in 28 states
and the District of Columbia. AIC is domiciled and licensed as an admitted
insurer in Maryland and operates as a licensed admitted insurer in 49 other
states, the District of Columbia, and all Canadian provinces (except Quebec).
USSIC is domiciled and licensed as an admitted insurer in Maryland and operates
as a licensed admitted insurer in 48 other states and the District of Columbia.
The Company expects, pending regulatory approval, to re-domesticate USSIC from
Maryland to Texas in 1998.
Under the laws of the State of Texas, HC must maintain minimum statutory
capital of $1.0 million and minimum statutory surplus of $1.0 million and may
only pay dividends out of its statutory earned surplus. The maximum amount of
dividends that HC may pay without prior regulatory approval in any 12 month
period is the greater of its statutory net investment income for the prior year,
or 10% of its statutory policyholders' surplus as of the prior year end, which
at December 31, 1997, was $23.3 million. Under the laws of the State of
Maryland, AIC and USSIC may only pay dividends out of its statutory earned
surplus. The maximum amount of dividends that AIC and USSIC may pay without
prior regulatory approval in any 12 month period is the greater of its statutory
net income or 10% of its statutory policyholders' surplus, which at December 31,
1997 was $6.8 million for AIC. However, on December 30, 1997, AIC paid an
extraordinary dividend of $13.7 million, which was approved by the Maryland
Insurance Administration and which represented a dividend of USSIC to AIC's
parent, the result of which is that USSIC has become a wholly owned subsidiary
of HC. As a result of this transaction, any dividends by AIC during the period
ending December 30, 1998 would require the prior approval of the Maryland
Insurance Administration. The maximum amount of dividends USSIC may pay HC
during 1998 is $5.0 million. Under the laws of the State of Oklahoma, TIC may
only pay dividends out of surplus funds. The maximum amount TIC may pay HC
without prior regulatory approval is the greater of statutory net income
excluding realized capital gains or 10% of statutory capital and surplus, which
at December 31, 1997 was $3.1 million.
The NAIC has developed a formula for analyzing insurance companies called
risk-based capital. The risk-based capital formula is intended to establish
"minimum" capital threshold levels that vary with the size and mix of a
company's business. It is designed to identify companies with the capital levels
that may require regulatory attention. As of December 31, 1997, each of the
Company's domestic insurance company subsidiaries' total adjusted capital is
significantly in excess of the NAIC authorized control level risk-based capital.
PENDING LEGISLATION
In recent years, state legislatures have considered or enacted laws that
modify and, in many cases, increase state authority to regulate insurance
companies and insurance holding company systems. The majority of state insurance
regulators are members of the NAIC, which seeks to promote uniformity of, and to
enhance the state regulation of, insurance. In addition, the NAIC and state
insurance regulators, as part of the NAIC's state insurance department
accreditation program, have re-examined existing laws and
23
regulations, specifically focusing on insurance company investments, issues
relating to the solvency of insurance companies, licensing and market conduct
issues, interpretations of existing laws, the development of new laws, and the
definition of extraordinary dividends. Also, Congress and certain Federal
agencies have conducted investigations of the current condition of the insurance
industry in the United States to determine whether to impose Federal regulation
of insurers and reinsurers. In the past several years there have been a number
of recommendations that the McCarran-Ferguson Act (which generally exempts the
insurance business from Federal regulation) be repealed entirely or modified to
remove the industry's anti-trust exemption and subject it to Federal regulation.
The Company is not aware of any such legislation that is currently pending. If
the McCarran-Ferguson Act were to be repealed or modified, state regulation of
the insurance business would continue. This could result in an additional layer
of Federal regulation. Also from time to time, Congress and certain states have
considered various legislative proposals which would provide for governmental
earthquake insurance coverage. The Company does not know at this time the extent
to which any or all such Federal or state legislative or regulatory initiatives
will or may be adopted, and no assurance can be given that they would not, if
adopted, have a material adverse effect on the Company.
EMPLOYEES
As of December 31, 1997, the Company had 929 employees, which included five
executive officers, 46 senior management, 94 management and 784 other personnel.
Of this number, 306 were employed by the Company's insurance subsidiaries, 499
were employed by the Company's insurance agency subsidiaries and 124 were
employed by the Company's insurance services subsidiaries. The Company is not a
party to any collective bargaining agreement and has not experienced work
stoppages or strikes as a result of labor disputes. The Company considers
relations with its employees to be good.
ITEM 2. PROPERTIES
The Company's principal and executive offices are located in Houston, Texas,
in an approximately 54,000 square foot building owned by HC. LDG's principal
facility is leased office space in Wakefield, Massachusetts consisting of
approximately 34,000 square feet, which lease terminates on October 31, 2001.
AIC's principal facility is an approximately 40,000 square foot office building
owned by an AVEMCO subsidiary and located in Frederick, Maryland. AMIG's
principal facility is leased office space in Dallas, Texas consisting of
approximately 36,000 square feet, which lease terminates on August 31, 2002. The
Company owns a 48,200 square foot office building and storage complex in St.
Peters, Missouri. The Company also maintains sales and administration offices or
other facilities in over 30 locations elsewhere in the United States and in
England, Turkey and China. The majority of these additional locations are in
leased facilities.
ITEM 3. LEGAL PROCEEDINGS
The Company is a party to numerous claims and lawsuits which arise in the
normal course of its business. Many of the pending lawsuits involve claims under
policies underwritten or reinsured by the Company, the liabilities for which
management believes have been adequately included in its established loss
reserves. The Company believes the resolution of these lawsuits will not have a
material adverse effect on its financial condition, results of operations or
cash flows.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the
fourth quarter of 1997.
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24
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS
MARKET INFORMATION
The Company's Common Stock trades on the New York Stock Exchange ("NYSE")
under the symbol "HCC".
The high and low closing sales prices for quarterly periods during the
period January 1, 1996 through December 31, 1997, as reported by the NYSE were
as follows:
1997 1996(1)
--------------------- --------------------
HIGH LOW HIGH LOW
---------- --------- --------- ---------
First quarter......................................................... $ 29 1/2 $ 22 1/2 $ 23 1/4 $ 14 1/2
Second quarter........................................................ 28 5/8 21 1/2 25 1/2 19 1/8
Third quarter......................................................... 32 11/16 23 1/4 32 3/4 22 1/8
Fourth quarter........................................................ 29 3/8 18 1/8 29 1/4 23 1/8
- ------------------------
(1) The above prices have been retroactively adjusted to reflect the effects of
the five-for-two stock split, payable as a 150% stock dividend to
shareholders of record April 30, 1996. On March 13, 1998, the closing sales
price of one share of the Company's Common Stock as reported by the NYSE was
$22 1/8.
SHAREHOLDERS
The Company has one class of authorized capital stock: 100,000,000 shares of
Common Stock, par value $1.00 per share. As of March 13, 1998, there were
47,827,789 shares of issued and outstanding Common Stock held by 1,158
shareholders of record; however, the Company believes there are in excess of
15,000 beneficial owners.
DIVIDENDS
On April 19, 1996, the Company announced that the Board of Directors had
declared a five-for-two stock split in the form of a 150% stock dividend,
payable to shareholders of record as of April 30, 1996 and that it would
purchase, for cash, any fractional shares issued in connection with this split.
Beginning in June, 1996, the Company announced a planned quarterly program
of paying cash dividends to shareholders. The Company paid a cash dividend in
July, 1996 of $0.02 per share and in each succeeding quarter until the first
quarter of 1997. The Company increased the cash dividend to $0.03 per share in
April, 1997 and to $0.04 per share beginning in April, 1998. The Company
presently plans to continue to pay a $0.04 per share dividend in future
quarters. The Board of Directors may review the Company's dividend policy from
time to time, and any determination with respect thereto will be made in light
of regulatory and other conditions then existing, including the Company's
earnings, financial condition, capital requirements, loan covenants, and other
related factors. Under the terms of the Company's December 30, 1997 Facility,
the Company is prohibited from paying dividends in excess of an agreed upon
maximum amount in any fiscal year. Such limitation will not affect the ability
of the Company to pay dividends in a manner consistent with its past practice
and current expectations.
25
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial data set forth below has been derived
from the Consolidated Financial Statements. All information contained herein
should be read in conjunction with the Consolidated Financial Statements, the
related notes thereto and Management's Discussion and Analysis of Financial
Condition and Results of Operations included elsewhere in this Report.
FOR THE YEARS ENDED DECEMBER 31,
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)(1)(2)
----------------------------------------------------------
1997 1996 1995 1994 1993
---------- ---------- ---------- ---------- ----------
STATEMENT OF EARNINGS DATA
Revenue
Net earned premium................................ $ 163,090 $ 175,309 $ 159,588 $ 122,352 $ 95,365
Management fee and commission income.............. 75,867 51,356 42,786 35,722 30,900
Net investment income............................. 27,718 23,595 21,748 17,778 14,458
Computer products and services.................... 7,064 8,471 8,227 8,153 7,453
Net realized investment gain (loss)............... (329) 8,341 1,636 434 10,583
Gain on sale of subsidiary........................ -- 3,307 -- -- --
---------- ---------- ---------- ---------- ----------
Total revenue................................. 273,410 270,379 233,985 184,439 158,759
Expense
Loss and LAE...................................... 96,514 114,464 105,374 75,898 62,712
Operating expense
Policy acquisition costs........................ 59,110 47,512 42,357 35,234 24,056
Compensation expense............................ 44,634 37,102 43,110 38,142 29,823
Other operating expense......................... 31,042 25,797 25,868 20,922 19,944
Merger expense.................................. 8,069 26,160 -- -- --
Ceding commissions.............................. (45,011) (34,053) (30,767) (24,834) (15,771)
---------- ---------- ---------- ---------- ----------
Net operating expense......................... 97,844 102,518 80,568 69,464 58,052
Interest expense.................................. 6,004 4,993 6,471 5,697 3,513
---------- ---------- ---------- ---------- ----------
Total expense................................. 200,362 221,975 192,413 151,059 124,277
---------- ---------- ---------- ---------- ----------
Earnings before income tax provision.............. 73,048 48,404 41,572 33,380 34,482
Income tax provision.............................. 23,297 9,874 9,884 7,328 6,269
---------- ---------- ---------- ---------- ----------
Net earnings.................................. $ 49,751 $ 38,530 $ 31,688 $ 26,052 $ 28,213
---------- ---------- ---------- ---------- ----------
---------- ---------- ---------- ---------- ----------
BASIC EARNINGS PER SHARE DATA:
Earnings per share (3)............................ $ 1.10 $ 0.89 $ 0.77 $ 0.72 $ 0.83
---------- ---------- ---------- ---------- ----------
---------- ---------- ---------- ---------- ----------
Weighted average shares outstanding (3)........... 45,395 43,195 40,977 36,370 34,138
---------- ---------- ---------- ---------- ----------
---------- ---------- ---------- ---------- ----------
DILUTED EARNINGS PER SHARE DATA:
Earnings per share (3)............................ $ 1.07 $ 0.87 $ 0.76 $ 0.71 $ 0.81
---------- ---------- ---------- ---------- ----------
---------- ---------- ---------- ---------- ----------
Weighted average shares outstanding (3)........... 46,609 44,443 41,513 36,929 35,040
---------- ---------- ---------- ---------- ----------
---------- ---------- ---------- ---------- ----------
Cash dividends declared, per share.................. $ 0.12 $ 0.06
---------- ----------
---------- ----------
26
FOR THE YEARS ENDED DECEMBER 31,
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)(1)(2)
----------------------------------------------------------
1997 1996 1995 1994 1993
---------- ---------- ---------- ---------- ----------
BALANCE SHEET DATA:
Total investments................................... $ 523,295 $ 468,725 $ 454,831 $ 348,259 $ 312,297
Reinsurance recoverables............................ 203,300 132,328 117,700 116,365 96,944
Premium, claims and other receivables............... 251,477 167,168 154,084 132,799 76,063
Ceded unearned premium.............................. 84,610 71,758 78,460 65,595 32,727
Total assets........................................ 1,222,763 964,099 894,834 751,213 563,819
Loss and LAE payable................................ 275,008 229,049 200,756 170,957 144,178
Unearned premium.................................... 152,094 156,268 151,976 114,347 68,120
Total debt.......................................... 80,750 72,917 71,628 99,508 83,444
Shareholders' equity................................ 365,480 296,413 255,425 168,758 146,204
Net tangible book value per share (3) (4)........... $ 7.16 $ 6.43 $ 5.59 $ 4.04 $ 4.05
Book value per share (3) (4)........................ $ 7.92 $ 6.72 $ 5.91 $ 4.41 $ 4.08
- ------------------------
(1) On May 24, 1996, the Company acquired 100% of the outstanding common stock
of LDG and on June 17, 1997 the Company acquired 100% of the outstanding
common stock and options of AVEMCO. These business combinations have been
accounted for as poolings-of-interests and, accordingly, the consolidated
financial data shown in this table has been restated to include the accounts
and operations of LDG and AVEMCO for all periods presented.
On November 27, 1996, the Company acquired 100% of the outstanding shares of
NASRA, on April 30, 1997, the Company acquired 100% of the outstanding
shares of Interworld Corporation and on August 8, 1997, the Company acquired
all of the outstanding shares of Southern and Aviation Claims
Administrators, Inc. These combinations have been accounted for as
poolings-of-interests. However, the Company's consolidated financial
statements have not been restated due to immateriality.
(2) The 1996 and prior financial statements of AVEMCO, which was acquired in
1997, have been restated prior to their inclusion in the Company's
historical consolidated financial statements to reflect certain prior period
adjustments discovered in 1997. The selected financial data in this table
has been restated to reflect these adjustments. The adjustments were for
periods prior to HCC's ownership and relate to a restatement of the method
of accounting for certain short-duration insurance contracts and to the
correction of accounting errors. The adjusted consolidated financial
statements of AVEMCO and its subsidiaries were utilized to restate the
Company's financial statements for AVEMCO's acquisition in a
pooling-of-interests transaction. (See Note 1 above and Note 1 of the Notes
to Consolidated Financial Statements.)
(3) These amounts have been adjusted to reflect the effects of the three-for-two
stock split payable as a 50% stock dividend to shareholders of record March
15, 1994, and the five-for-two stock split payable as a 150% stock dividend
to shareholders of record April 30, 1996.
(4) Book value per share is calculated by dividing shares outstanding into total
shareholders' equity. Net tangible book value per share uses total
shareholders' equity less goodwill as the numerator.
27
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
THIS REPORT CONTAINS CERTAIN FORWARD-LOOKING STATEMENTS WITHIN THE MEANING
OF SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED, AND SECTION 21E OF THE
SECURITIES EXCHANGE ACT OF 1934, AS AMENDED, WHICH ARE INTENDED TO BE COVERED BY
THE SAFE HARBORS CREATED THEREBY. INVESTORS ARE CAUTIONED THAT ALL FORWARD-
LOOKING STATEMENTS NECESSARILY INVOLVE RISKS AND UNCERTAINTY, INCLUDING, WITHOUT
LIMITATION, THE RISK OF A SIGNIFICANT NATURAL DISASTER, THE INABILITY OF THE
COMPANY TO REINSURE CERTAIN RISKS, THE ADEQUACY OF ITS LOSS RESERVES, THE
FINANCIAL VIABILITY OF REINSURERS, THE EXPANSION OR CONTRACTION IN ITS VARIOUS
LINES OF BUSINESS, THE IMPACT OF INFLATION, CHANGING REGULATIONS IN FOREIGN
COUNTRIES, THE ABILITY OF THE COMPANY TO INTEGRATE ITS RECENTLY ACQUIRED
BUSINESSES, EFFECT OF PENDING OR FUTURE ACQUISITIONS AS WELL AS ACQUISITIONS
WHICH HAVE RECENTLY BEEN CONSUMMATED, GENERAL MARKET CONDITIONS, COMPETITION,
LICENSING AND PRICING. ALL STATEMENTS, OTHER THAN STATEMENTS OF HISTORICAL
FACTS, INCLUDED OR INCORPORATED BY REFERENCE IN THIS REPORT THAT ADDRESS
ACTIVITIES, EVENTS OR DEVELOPMENTS THAT THE COMPANY EXPECTS OR ANTICIPATES WILL
OR MAY OCCUR IN THE FUTURE, INCLUDING, WITHOUT LIMITATION, SUCH THINGS AS FUTURE
CAPITAL EXPENDITURES (INCLUDING THE AMOUNT AND NATURE THEREOF), BUSINESS
STRATEGY AND MEASURES TO IMPLEMENT SUCH STRATEGY, COMPETITIVE STRENGTHS, GOALS,
EXPANSION AND GROWTH OF THE COMPANY'S BUSINESSES AND OPERATIONS, PLANS,
REFERENCES TO FUTURE SUCCESS, AS WELL AS OTHER STATEMENTS WHICH INCLUDES WORDS
SUCH AS "ANTICIPATE", "BELIEVE", "PLAN", "ESTIMATE", "EXPECT", AND "INTEND" AND
OTHER SIMILAR EXPRESSIONS, CONSTITUTE FORWARD-LOOKING STATEMENTS. ALTHOUGH THE
COMPANY BELIEVES THAT THE ASSUMPTIONS UNDERLYING THE FORWARD-LOOKING STATEMENTS
CONTAINED HEREIN ARE REASONABLE, ANY OF THE ASSUMPTIONS COULD OVER TIME PROVE TO
BE INACCURATE AND THEREFORE, THERE CAN BE NO ASSURANCE THAT THE FORWARD-LOOKING
STATEMENTS INCLUDED IN THIS REPORT WILL THEMSELVES PROVE TO BE ACCURATE. IN
LIGHT OF THE SIGNIFICANT UNCERTAINTIES INHERENT IN THE FORWARD-LOOKING
STATEMENTS INCLUDED HEREIN, THE INCLUSION OF SUCH INFORMATION SHOULD NOT BE
REGARDED AS A REPRESENTATION BY THE COMPANY OR ANY OTHER PERSON THAT THE
OBJECTIVES AND PLANS OF THE COMPANY WILL BE ACHIEVED.
GENERAL
The Company's primary sources of revenue are earned premium and investment
income derived from its insurance company operations, and management fee and
commission income generated from its insurance agency and services operations.
The Company's core underwriting activities involve providing aviation, marine,
offshore energy, property, accident and health, and lenders single interest
insurance, which is underwritten on both a direct and a reinsurance basis,
marketed directly by the Company and produced by independent agents. The Company
concentrates on first party, physical damage coverages and lines of business
which have relatively short lead times between the occurrence of an insured
event and the reporting of claims to the Company.
During recent years, the Company has substantially increased its capital and
surplus through the issuance of equity securities, incurrence of debt, and
earnings, thereby enabling it to increase the underwriting capacity of its
insurance company subsidiaries. The Company has utilized this additional capital
by increasing underwriting activity across many of its core lines of business,
emphasizing lines of business and individual opportunities with the most
favorable underwriting characteristics at a particular point in time. In each
line of business, the Company also cedes premium through the purchase of
reinsurance in types and amounts appropriate to the line of business, market
conditions and the Company's desired net risk retention profile.
The Company's insurance agency operations underwrite and service domestic
general aviation, medical stop-loss, lenders single interest, occupational
accident, and accident and health insurance and reinsurance business. They also
place reinsurance for the Company's insurance company operations and other
non-affiliated insurance companies.
28
Since 1996, the Company has focused its acquisition activities on expanding
its insurance agency and services operations for three principal reasons.
Firstly, is an attempt to increase the management fee and commission income
revenue component of the Company's total revenue, which management believes to
be a more predictable and more stable source of revenue than the potential
underwriting gain from insurance company operations. Secondly, is an effort to
insulate the Company from a decline in its net earnings growth rate as insurance
premium rates become more competitive in the lines of business in which the
Company specializes in and the Company becomes more selective in its
underwriting approach, resulting in reduced written premium. Thirdly, is to
provide a future source of premium revenue to the Company's insurance company
subsidiaries.
RESULTS OF OPERATIONS
The following table sets forth certain premium revenue information for the
three years ended December 31, 1997 (dollars in thousands):
1997 1996 1995
----------- ----------- -----------
Direct..................................................................... $ 177,728 $ 178,969 $ 191,068
Reinsurance assumed(1)..................................................... 168,671 158,309 148,037
----------- ----------- -----------
Gross written premium.................................................... 346,399 337,278 339,105
Reinsurance ceded.......................................................... (203,027) (149,003) (154,780)
----------- ----------- -----------
Net written premium...................................................... 143,372 188,275 184,325
Change in unearned premium................................................. 19,718 (12,966) (24,737)
----------- ----------- -----------
Net earned premium......................................................... $ 163,090 $ 175,309 $ 159,588
----------- ----------- -----------
----------- ----------- -----------
The following table sets forth the relationships of certain income statement
items as a percent of total revenue for the three years ended December 31, 1997:
1997 1996 1995
----------- ----------- -----------
Net earned premium................................................................ 59.7% 64.8% 68.2%
Management fee and commission income.............................................. 27.7 19.0 18.3
Net investment income............................................................. 10.1 8.7 9.3
All other income.................................................................. 2.5 7.5 4.2
----- ----- -----
Total revenue................................................................... 100.0 100.0 100.0
Loss and LAE...................................................................... 35.3 42.3 45.0
Net operating expense............................................................. 35.8 37.9 34.4
Interest expense.................................................................. 2.2 1.8 2.8
----- ----- -----
Earnings before taxes........................................................... 26.7 18.0 17.8
Income taxes...................................................................... 8.5 3.7 4.3
----- ----- -----
Net earnings.................................................................... 18.2% 14.3% 13.5%
----- ----- -----
----- ----- -----
- ------------------------
(1) Reinsurance assumed includes all reinsurance business written, including
facultative reinsurance.
YEAR ENDED DECEMBER 31, 1997 VERSUS YEAR ENDED DECEMBER 31, 1996
Total revenue increased to $273.4 million in 1997 from $270.4 million in
1996. GWP increased to $346.4 million in 1997 from $337.3 million in 1996, due
primarily to increased aviation and accident and health premiums offset by
decreased property and marine premium. NWP for 1997 decreased to $143.4 million
from $188.3 million in 1996, due to an increase in the amount of ceded
reinsurance. Net earned premium decreased to $163.1 million in 1997 compared to
$175.3 million in 1996 reflecting the
29
reduction in NWP and the reduced retentions of the Company. The Company expects
GWP to increase during 1998 primarily due to internal growth as the Company's
managing general agency subsidiaries transfer business from non-affiliated
insurance companies to the Company's insurance company operations. However, NWP
and net earned premium will be unchanged as the Company does not intend to
increase its retentions at this time.
Management fee and commission income in 1997 increased 48% to $75.9 million
from $51.4 million in 1996, reflecting internal growth and the acquisition of
several agencies in 1997. The Company expects management fee and commission
income to continue to increase due to the effect of recent and future
acquisitions and internal growth. Net investment income increased 17% to $27.7
million in 1997 from $23.6 million in 1996 reflecting a higher level of
investment assets.
Net realized investment losses from sales of equity securities were $155,000
during 1997, compared to gains of $8.3 million in 1996. During 1996, the Company
systematically liquidated the majority of its equity portfolio. Net realized
investment losses from disposition of fixed income securities were $174,000
during 1997, compared to gains of $29,000 in 1996. During 1996, AVEMCO
consummated the sale of National Assurance Underwriters, Inc., which was a
subsidiary of AVEMCO prior to the pooling-of-interests combination with the
Company. This sale generated an after tax gain of $2.2 million or $0.05 per
share.
AIC, acquired in June, 1997, recorded a $10.0 million increase in loss and
LAE reserves during December, 1997, predominately relating to 1995 and 1996
claims incurred prior to the Company's acquisition of AIC. This increase in
reserves was made to bring AIC's reserving practices consistent with the more
conservative method used by the Company's other insurance company operations.
The Company expects the increase in loss reserves to be adequate to cover any
subsequent adverse development of AIC's prior losses.
Loss and LAE decreased $18.0 million in 1997, to $96.5 million, reflecting
the increased use of reinsurance, despite the $10.0 million reserve
strengthening charge taken by AIC. During 1997, the Company had net loss and LAE
redundancy of $3.8 million relating to prior year losses compared to a
redundancy of $4.9 million in 1996. During 1997, the Company had gross loss and
LAE deficiency of $23.2 million compared to a deficiency of $42.5 million in
1996. The gross deficiency comes from two primary sources. Firstly, the
development of several large claims on individual policies which were either
reported late or reserves were increased as subsequent information became
available, however, as most of these policies were substantially reinsured,
there is no material effect to the Company's net earnings. Secondly, is the
run-off of the retrocessional excess of loss business which the Company
underwrote between 1988 and 1991. This development, $1.6 million in 1997
compared to $11.3 million in 1996, is primarily due to the delay in reporting of
catastrophe losses by the London insurance market, coupled with the
unprecedented number of catastrophes during the period in which the Company
underwrote this business. This business is also substantially reinsured, thereby
not having a material effect on the Company's net earnings. The Company
continues to believe it has materially provided for all net incurred losses.
Compensation expense increased $7.5 million or 20% in 1997, to $44.6 million
due to the increase in personnel resulting from acquisitions completed during
1997, along with an increase in management personnel hired to oversee the
integration of the Company's many acquisitions.
Other operating expense increased 20% to $31.0 million in 1997. These
expenses reflect increased expenditures required to meet the overall growth in
business and from acquisitions. Currency conversion losses amounted to $884,000
in 1997, compared to losses of $181,000 in 1996.
Merger expense represents non-recurring items incurred to consummate the
acquisitions and mergers which are accounted for as poolings-of interests. The
amounts incurred during 1996 were due to the combination with LDG and included a
compensatory stock grant of $24.0 million to certain key LDG
30
employees immediately prior to the merger. The amounts incurred during 1997 were
due to the combinations with AVEMCO, Interworld and Southern.
The 1996 and prior financial statements of AVEMCO were restated prior to
their combinations with those of the Company. See Note 1 to the Consolidated
Financial Statements for the reasons for and the effects of this restatement.
Interest expense during 1997 increased 20% to $6.0 million from $5.0 million
during 1996 due to the increased level of indebtedness primarily to fund the
cash portion of acquisitions.
Income tax expense was $23.3 million in 1997, compared to $9.9 million in
1996. The 1996 amount included a deferred tax benefit of $9.6 million which was
recorded in connection with the compensatory stock grant to certain key LDG
employees. The compensation expense was a non-cash item; however, $9.6 million
of actual cash tax savings will be recognized beginning from the grant date.
Most of the other merger expenses are not deductible for income tax purposes.
Also, as an S Corporation, LDG was exempt from Federal income taxes through May
21, 1996. Had LDG been subject to Federal income tax during the period January
1, 1996 to May 21, 1996, additional income tax expense of $2.3 million would
have been recorded in 1996.
Net earnings increased 29% to $49.8 million in 1997 from $38.5 million in
1996. Diluted earnings per share increased 23% to $1.07 in 1997 from $0.87 in
1996.
The Company's insurance company subsidiaries' statutory combined ratio was
78.8% for 1997 compared to 83.6% in 1996. The Company's combined ratio remains
significantly better than the industry average.
YEAR ENDED DECEMBER 31, 1996 VERSUS YEAR ENDED DECEMBER 31, 1995
Total revenue during 1996 increased 16% to $270.4 million from $234.0
million in 1995. 1996 GWP decreased to $337.3 million from $339.1 million in
1995, while NWP increased from $184.3 million in 1995 to $188.3 million in 1996.
The decrease in written premium was a result of the planned exit from the
offshore energy business as a result of increased competition that has driven
rates below acceptable levels, as well as the softening in marine rates and,
more recently, property rates. Net earned premium in 1996 increased from $159.6
million to $175.3 million, reflecting the large increase in written premium
during 1995.
Management fee and commission income in 1996 increased 20% to $51.4 million
from $42.8 million in 1995, reflecting internal growth. Net investment income
increased 8% to $23.6 million in 1996 from $21.7 million in 1995 reflecting a
higher level of investment assets.
Realized investment gains from sales of marketable equity securities were
$8.3 million during 1996 compared to $1.3 million during 1995. Realized
investment gains from dispositions of fixed income securities were $29,000
during 1996, compared to gains of $371,000 during 1995. During 1996, the Company
liquidated most of its equity security portfolio and re-deployed those
investment assets into fixed income securities. During 1996, AVEMCO consummated
the sale of National Assurance Underwriters, Inc., which was a subsidiary of
AVEMCO prior to the pooling-of-interests combination with the Company. This sale
generated an after tax gain of $2.2 million or $0.05 per share.
Loss and LAE increased $9.1 million in 1996, to $114.5 million, reflecting
the overall increase in business. During 1996, the Company had net loss and LAE
redundancy of $4.9 million relating to prior year losses compared to a
redundancy of $2.8 million in 1995. During 1996, the Company had gross loss and
LAE deficiency of $42.5 million compared to a deficiency of $15.9 million in
1995. The gross deficiency comes from two primary sources. Firstly, the
development of several large claims on individual policies which were either
reported late or reserves were increased as subsequent information became
available, however, as most of these policies were substantially reinsured,
there is no material effect to the
31
Company's net earnings. Secondly, is the run-off of the retrocessional excess of
loss business which the Company underwrote between 1988 and 1991. This
development, $11.3 million in 1996 compared to $9.8 million in 1995, is due to
the delay in reporting of catastrophe losses by the London insurance market,
coupled with the unprecedented number of catastrophes during the period in which
the Company underwrote this business. This business is also substantially
reinsured, thereby not having a material effect on the Company's net earnings.
The Company continues to believe it has materially provided for all net incurred
losses.
Compensation expense decreased $6.0 million or 14% in 1996, to $37.1 million
due primarily to changes in compensation to LDG's previous principal
shareholders.
Merger expense represents non-recurring items incurred to consummate the
acquisitions and mergers which are accounted for as poolings-of-interests. The
amounts incurred during 1996 were due to the combination with LDG and included a
compensatory stock grant of $24.0 million to certain key LDG employees
immediately prior to the Company's May, 1996 merger with LDG.
The 1996 and prior financial statements of AVEMCO were restated prior to
their combinations with those of the Company. See Note 1 to the Consolidated
Financial Statements for the reasons for and the effects of this restatement.
Interest expense during 1996 decreased 23% to $5.0 million from $6.5 million
during 1995 due to the reduced level of indebtedness as a portion of the
proceeds of a June, 1995, public offering of Common Stock which was used to
retire debt.
Income tax expense remained unchanged at $9.9 million in 1996, compared to
1995 despite higher pretax income in 1996. This was a result of a deferred tax
benefit of $9.6 million which was recorded in connection with the compensatory
stock grant to certain LDG employees. The compensation expense was a non-cash
item; however, $9.6 million of actual cash tax savings will be recognized
beginning from the grant date. Also, as an S corporation, LDG was exempt from
Federal income taxes through May 21, 1996. Had LDG been subject to Federal
income taxes for both years, additional income tax expense of $2.3 million and
$722,000 would have been recorded during the years ended December 31, 1996 and
1995, respectively.
Net earnings increased 22% to $38.5 million in 1996 from $31.7 million in
1995. Diluted earnings per share increased 14% to $0.87 in 1996 from $0.76 in
1995.
The Company's insurance company subsidiaries' statutory combined ratio was
83.6% for 1996 compared to 84.5% in 1995. The Company's combined ratio remains
significantly better than the industry average.
LIQUIDITY AND CAPITAL RESOURCES
HCC completed an initial public offering of 1,437,500 shares of Common Stock
during October, 1992 and secondary public offerings of 1,254,200 shares of
Common Stock in September, 1993 and 2,012,500 shares of Common Stock in June,
1995. The offerings significantly improved the capital resources of the Company.
The net proceeds of the offerings have been used to reduce the Company's
indebtedness and to contribute capital to its insurance company subsidiaries. HC
now has more than $233.0 million in policyholders' surplus. This additional
capital enables HC to write significantly more premium and to have sufficient
financial size and strength to operate in the current insurance industry
environment.
The Company receives substantial cash from premiums and reinsurance
recoverables, and, to a lesser extent, investment income, proceeds from sales
and redemptions of investment assets and management fee and commission income.
The principal cash outflows are for the payment of claims and LAE, payment of
premiums to reinsurers, purchase of investments, debt service, policy
acquisition costs, operating expenses, income and other taxes and dividends.
32
During 1997, HC renewed its existing credit facility (the "HC Facility")
which provides for a $12.0 million bank line of credit for the issuance of
letters of credit and for short-term borrowings at the prime rate of interest.
The HC Facility is collateralized by securities with a market value equal to
125% of the total sum of the letters of credit issued and cash advances
outstanding. The HC Facility matures on April 30, 1998. As of December 31, 1997,
letters of credit in the amount of $10.3 million were issued on behalf of HC to
collateralize certain reinsurance obligations.
Effective December 30, 1997, the Company executed a $120.0 million revolving
credit facility (the "Facility") with a group of banks. Borrowings under the
Facility may be made by the Company until the expiration of the Facility on
December 30, 1999, at which time all principal is due. Outstanding loans under
the Facility bear interest at the Company's option at either the prime rate
(8 1/2% at December 31, 1997) or at the current London Interbank Offering Rate
("LIBOR") (5.72% at December 31, 1997) plus 1%. The Facility is collateralized
by the common stock of HC and AIC. The agreement contains restrictive covenants,
including without limitation, minimum net worth requirements for the Company and
certain subsidiaries, restrictions on certain extraordinary corporate actions,
notice requirements for certain material occurences and required maintenance of
specified financial ratios. The initial funding from the Facility was used,
among other things, to refinance HCC's then existing outstanding loans.
The Company maintains a substantial level of cash and liquid short-term
investments which are used to meet anticipated payment obligations. As of
December 31, 1997, the Company had cash and short-term investments of
approximately $112.6 million. The Company's consolidated investment portfolio of
$523.3 million as of December 31, 1997 (of which $105.3 million is short-term
investments), is available to provide additional liquidity and cash for
operations.
Property and casualty insurance companies domiciled in the State of Texas
are limited in the payment of dividends to their shareholders in any 12 month
period, without the prior written consent of the Commissioner of Insurance, to
the greater of net investment income or 10% of statutory policyholders' surplus.
HC paid no dividends in 1997 to HCC. During 1998, HC's ordinary dividend
capacity will be approximately $23.3 million.
The Company believes that its operating cash flows, short-term investments
and the bank lines of credit will provide sufficient sources of liquidity to
meet its anticipated needs for the foreseeable future.
At December 31, 1997, the Company had a net deferred tax asset of $6.6
million compared to $12.6 million at December 31, 1996. Due to the Company's
history of consistent earnings, strong operating cash flows and expectations for
the future, it is more likely than not that the Company will be able to realize
the benefit of its deferred tax asset.
As of December 31, 1997, the domestic insurance company subsidiaries' total
adjusted capital is significantly in excess of the NAIC authorized control level
risk-based capital.
Industry and regulatory guidelines suggest that a property and casualty
insurer's annual statutory GWP should not exceed 900% of its statutory
policyholders' surplus and NWP should not exceed 300% of its statutory
policyholders' surplus. The Company's insurance company subsidiaries maintain a
premium to surplus ratio significantly lower than such guidelines, and for the
year ended December 31, 1997, their annual statutory GWP was 104.3% of their
statutory policyholders' surplus and their NWP was 43.1% of their statutory
policyholders' surplus.
IMPACT OF INFLATION
The Company's operations, like those of other property and casualty
insurers, are susceptible to the effects of inflation, as premiums are
established before the ultimate amounts of loss and LAE are known. Although
management considers the potential effects of inflation when setting premium
rates for competitive reasons, such premiums may not adequately compensate the
Company for the effects of inflation. However, as the majority of the Company's
business is comprised of lines which have short lead times
33
between the occurrence of an insured event, reporting of the claims to the
Company and the final settlement of the claims, the effects of inflation are
minimized.
A significant portion of the Company's revenue is related to healthcare
insurance and reinsurance products which are subject to the effects of the
underlying inflation of medical costs. Such inflation in the costs of healthcare
tends to generate increases in premiums for medical stop-loss coverage,
resulting in greater revenue, but also higher claim payments. Inflation may have
a negative impact on insurance and reinsurance operations by causing higher
claim settlements than may originally have been estimated without an immediate
increase in premiums to a level necessary to maintain profit margins. No express
provision for inflation is made, although trends are considered when setting
underwriting terms and claim reserves. Claim reserves are subject to a
continuing review process to assess their adequacy and are adjusted as deemed
appropriate. In addition, the market value of the investments held by the
Company varies depending on economic and market conditions and interest rates,
which are highly sensitive to the policies of governmental and regulatory
authorities. Any significant increase in interest rates could therefore have a
material adverse effect on the market value of the Company's investments.
EXCHANGE RATE FLUCTUATIONS
The Company underwrites risks which are denominated in a number of foreign
currencies. It establishes and maintains loss reserves with respect to these
policies in their respective currencies. These reserves are subject to exchange
rate fluctuations which can have an effect on the Company's net earnings. The
Company's principal area of exposure is with respect to fluctuation in the
exchange rate between the major European currencies and the United States
Dollar. For the years ended December 31, 1997, 1996 and 1995, the loss from
currency conversion was $884,000, $181,000 and $209,000, respectively.
From time to time the Company enters into foreign currency forward contracts
as a hedge against foreign currency fluctuations, primarily GBP. The Company's
balances denominated in foreign currencies fluctuate as transactions are
recorded and settled. During 1997, the average GBP liability, for subsidiaries
whose functional currency was the United States dollar, was approximately
L793,000 ($1.3 million at the December 31, 1997, rate of exchange) which was
hedged by an average open forward contract balance of approximately L125,000
($206,000 at the December 31, 1997, rate of exchange). There were no open
foreign currency forward contracts as of December 31, 1997. The Company may
continue to limit its exposure to currency fluctuations through the use of
foreign currency forward contracts.
The Company utilizes these foreign currency forward contracts strictly as a
hedge against existing exposure to foreign currency fluctuations and it does not
do so as any form of speculative or trading investment.
EFFECTS OF RECENT ACCOUNTING PRONOUNCEMENTS
In June, 1997, the Financial Accounting Standards Board issued SFAS No. 130
"Reporting Comprehensive Income" and SFAS No. 131 "Disclosures about Segments of
an Enterprise and Related Information". Both statements are effective for fiscal
years beginning after December 15, 1997. These SFAS's require that additional
information be included in a complete set of financial statements, but will have
no effect on the Company's net earnings, shareholders' equity or cash flows. The
Company does not expect to change its definition of segments when SFAS No. 131
is adopted.
YEAR 2000
The Year 2000 issue is the result of computer programs being written using
two digits rather than four digits to define the applicable year. If not
corrected, computer applications could fail or create erroneous results by or at
the Year 2000.
The Company, together with outside vendors engaged by the Company, has made
assessments of the Company's potential Year 2000 exposure. The Company believes
that with modifications to existing
34
software and in connection with planned conversions to new software, the Year
2000 issue will be mitigated. The Company has implemented a plan to mitigate its
Year 2000 exposure, including the identification, selection and implementation
of a new Year 2000 compliant software system at an insurance company subsidiary.
Management believes that the plan is progressing such that Year 2000 exposures
will be mitigated prior to any critical date and by October, 1998 with respect
to the insurance company subsidiary where the Company's major Year 2000 risk
exists.
The Company is utilizing and will continue to utilize both internal and
external resources to reprogram or replace its computer systems such that the
reprogrammed or new systems will cause the Company to be Year 2000 compliant in
advance of respective critical dates. The total estimated remaining cost of
modification of existing software and new Year 2000 compliant systems is
$4,600,000 which includes, $4,400,000 attributable to the planned purchase and
implementation of new systems, principally to replace the above mentioned
insurance company subsidiary's system. The cost of this new software will be
capitalized. The remaining estimated cost of $200,000 will be expensed as
incurred over the next two years. The level of expense is not expected to have a
material effect on results of operations. The cost of modification of existing
systems to become Year 2000 compliant and of the new Year 2000 compliant
software is to be funded out of operating cash flow, which is sufficient to
provide the funding. The cost estimates are management's best estimates based
upon assumed future events which could change.
In 1997, the Company expensed $11,000 with respect to Year 2000 compliance
and capitalized $550,000 with respect to new Year 2000 compliant software
purchases and installations. The Company does not believe that it has
significant Year 2000 exposure with respect to its vendors and the Company's
software vendor subsidiary's products are Year 2000 compliant.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
The information required by the Item is set forth under the heading
"Business--Foreign Exchange" and in Note 1 of the Notes to Consolidated
Financial Statements.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements required in response to this section
are submitted as part of Item 14 of this report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURES
None.
35
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
For information regarding Directors and Executive Officers of the
Registrant, reference is made to the Registrant's definitive proxy statement for
its Annual Meeting of Shareholders, which will be filed with the Securities and
Exchange Commission within 120 days after December 31, 1997, and which is
incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
For information regarding Executive Compensation, reference is made to the
Registrant's definitive proxy statement for its Annual Meeting of Shareholders,
which will be filed with the Securities and Exchange Commission within 120 days
after December 31, 1997, and which is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
For information regarding Security Ownership of Certain Beneficial Owners
and Management, reference is made to the Registrant's definitive proxy statement
for its Annual Meeting of Shareholders, which will be filed with the Securities
and Exchange Commission within 120 days after December 31, 1997, and which is
incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
For information regarding Certain Relationships and Related Transactions,
reference is made to the Registrant's definitive proxy statement for its Annual
Meeting of Shareholders, which will be filed with the Securities and Exchange
Commission within 120 days after December 31, 1997, and which is incorporated
herein by reference.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) EXHIBITS
The exhibits listed on the accompanying Index to Exhibits are filed as part
of this Report.
(b) FINANCIAL STATEMENT SCHEDULES
The financial statements and financial statement schedules listed in the
accompanying index are filed as part of this Report.
(c) REPORTS ON FORM 8-K
No reports on Form 8-K were filed by the Company during the fourth quarter
of 1997.
36
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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)
By: /s/ STEPHEN L. WAY
------------------------------------------
(Stephen L. Way)
CHAIRMAN OF THE BOARD
Dated: March 27, 1998 AND CHIEF EXECUTIVE OFFICER
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
NAME TITLE DATE
- ------------------------------ --------------------------- -------------------
Chairman of the Board of
/s/ STEPHEN L. WAY Directors and Chief
- ------------------------------ Executive Officer March 27, 1998
(Stephen L. Way) (Principal Executive
Officer)
/s/ JAMES M. BERRY*
- ------------------------------ Director March 27, 1998
(James M. Berry)
/s/ FRANK J. BRAMANTI
- ------------------------------ Director and Executive Vice March 27, 1998
(Frank J. Bramanti) President
/s/ PATRICK B. COLLINS*
- ------------------------------ Director March 27, 1998
(Patrick B. Collins)
/s/ J. ROBERT DICKERSON*
- ------------------------------ Director March 27, 1998
(J. Robert Dickerson)
Senior Vice President and
/s/ EDWARD H. ELLIS, JR. Chief Financial Officer
- ------------------------------ (Chief Accounting March 27, 1998
(Edward H. Ellis, Jr.) Officer)
/s/ EDWIN H. FRANK, III*
- ------------------------------ Director March 27, 1998
(Edwin H. Frank, III)
/s/ ALAN W. FULKERSON*
- ------------------------------ Director March 27, 1998
(Alan W. Fulkerson)
/s/ WALTER J. LACK*
- ------------------------------ Director March 27, 1998
(Walter J. Lack)
37
/s/ STEPHEN J. LOCKWOOD*
- ------------------------------ Director and Vice Chairman March 27, 1998
(Stephen J. Lockwood)
/s/ JOHN N. MOLBECK, JR.*
- ------------------------------ Director and President March 27, 1998
(John N. Molbeck, Jr.)
/s/ PETER B. SMITH, JR.*
- ------------------------------ Director and Executive Vice March 27, 1998
(Peter B. Smith, Jr.) President
/s/ HUGH T. WILSON*
- ------------------------------ Director March 27, 1998
(Hugh T. Wilson)
*By: /s/ FRANK J. BRAMANTI
-------------------------
Frank J. Bramanti, March 27, 1998
ATTORNEY-IN-FACT
38
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES
Reports of Independent Accountants................................................... F-1
Consolidated Balance Sheets at December 31, 1997 and 1996............................ F-3
Consolidated Statements of Earnings for the three years ended December 31, 1997...... F-4
Consolidated Statements of Changes in Shareholders' Equity for the three years ended
December 31, 1997.................................................................. F-5
Consolidated Statements of Cash Flows for the three years ended December 31, 1997.... F-8
Notes to Consolidated Financial Statements........................................... F-9
SCHEDULES:
Reports of Independent Accountants........................................ S-1
Schedule 1 Summary of Investments other than Investments in Related Parties........ S-3
Schedule 2 Condensed Financial Information of Registrant........................... S-4
Schedule 3 Supplementary Insurance Information..................................... S-8
Schedule 4 Reinsurance............................................................. S-9
Schedules other than those listed above have been omitted because they are
either not required, not applicable, or the required information is shown in the
Consolidated Financial Statements and related notes thereto.
39
INDEX TO EXHIBITS
(ITEMS DENOTED BY A LETTER ARE INCORPORATED BY REFERENCE TO OTHER DOCUMENTS
PREVIOUSLY FILED WITH THE SECURITIES AND EXCHANGE COMMISSION AS SET FORTH AT THE
END OF THIS INDEX. ITEMS NOT DENOTED BY A LETTER ARE BEING FILED HEREWITH.)
EXHIBIT
NUMBER
- ------------
(A)3.4 --Bylaws of HCC Insurance Holdings, Inc., as amended.
(J)3.7 --Restated Certificate of Incorporation of HCC Holdings, Inc., filed with the Delaware Secretary of
State on July 23, 1996.
(A)4.1 --Specimen of Common Stock Certificate, $1.00 par value, of HCC Insurance Holdings, Inc.
(A)10.17 --Cost Allocation Agreement dated September 1, 1991, by and among HCC Holdings, A Texas Corporation,
Houston Casualty Company, Trafalgar Reinsurance Company Ltd., Houston Re Corporation and HCC
Underwriters, A Texas Corporation
(A)10.19 --Agreement for Allocation of Federal Income Tax dated November 29, 1991, by and among HCC Holdings,
Inc., Houston Casualty Company, SBS Insurance Holdings, Trafalgar Reinsurance Company, Ltd., HCC
Underwriters and Houston Re Corporation
(A)10.23 --HCC Insurance Holdings, Inc. 1992 Incentive Stock Option Plan
(A)10.24 --Program License Agreement dated April 29, 1992, by and between EPG America, Inc., and HCC Holdings,
Inc. pertaining to license for the computer services described therein
(B)10.227 --Loan Agreement dated August 24, 1993 in the original principal amount of $29,250,000 executed by HCC
Insurance Holdings, Inc., payable to First Interstate Bank of Texas, N.A. together with Promissory
Note and Commercial Pledge Agreement relating thereto.
(B)10.227.1 --Change in Loan Agreement dated February 7, 1994 between HCC Insurance Holdings, Inc. and First
Interstate Bank of Texas, N.A. relating to the $29,250,000 loan.
(B)10.228 --Promissory Note dated February 25, 1994 in the original principal amount of $12,000,000 executed by
Houston Casualty Company, payable to First Interstate Bank of Texas, N.A. together with Commercial
Pledge Agreement relating thereto.
(C)10.302 --Aircraft Dry Lease Agreement effective January 4, 1995 between SLW Aviation, Inc. and HCC Insurance
Holdings, Inc.
(C)10.303 --Stock Purchase Agreement effective January 1, 1994 between River Investments Limited and HCC
Underwriters, A Texas Corporation related to the acquisition of 25% of Middle East Insurance Brokers
Ltd.
(C)10.304 --Stock Purchase Agreement effective October 1, 1994 between various shareholders of Middle East
Insurance Brokers Ltd. and HCC Insurance Holdings, Inc. related to the acquisition of 75% of Middle
East Insurance Brokers Ltd.
(C)10.305 --Stock Purchase Agreement effective October 1, 1994 between various shareholders of International
Marine & General Insurance Company Ltd. and HCC Insurance Holdings, Inc. related to the acquisition
of 100% of International Marine & General Insurance Company Ltd.
(C)10.306 --Loan Agreement dated November 29, 1994 in the original principal amount of $20,000,000 executed by
HCC Insurance Holdings, Inc., payable to First Interstate Bank of Texas, N.A. together with the
Promissory Note.
40
EXHIBIT
NUMBER
- ------------
(D)10.320 --Promissory note dated April 30, 1995, in the original principal amount of $12,000,000 executed by
Houston Casualty Company, payable to First Interstate Bank of Texas, N.A.
(E)10.324 --HCC Insurance Holdings, Inc. 1994 Non-employee Director Stock Option Plan.
(F)10.325 --HCC Insurance Holdings, Inc. 1995 Flexible Incentive Plan.
(H)10.326 --Agreement and Plan of Reorganization dated February 22, 1996 between various shareholders of LDG
Management Company Incorporated and affiliated companies and HCC Insurance Holdings, Inc. related to
the acquisition of 100% of the common stock of LDG Management Company Incorporated and affiliated
companies.
(I)10.327 --Agreement and Plan of Reorganization dated February 28, 1997 between AVEMCO Corporation and HCC
Insurance Holdings, Inc. related to the intent to merge in a stock for stock transaction.
(J)10.328 --HCC Insurance Holdings, Inc. 1996 Non-employee Director Stock Option Plan.
(K)10.329 --HCC Insurance Holdings, Inc. 1995 Flexible Incentive Plan.
(L)10.330 --Agreement and Plan of Reorganization dated November 27, 1996 between various shareholders of North
American Special Risk Associates and affiliated companies and HCC Insurance Holdings, Inc. related to
the acquisition of 100% of the common stock of North American Special Risk Associates, Inc. and
affiliated companies.
(L)10.331 --Agreement of Purchase and Sale dated January 23, 1997, between TRM International, Inc., Unicover
Manager, Inc., North American Special Risk Associates, Inc. and HCC Insurance Holdings, Inc.
(L)10.332 --Revolving Line of Credit Note dated October 7, 1996, in the original principal amount of $12,000,000
executed by Houston Casualty Company, payable to Wells Fargo Bank (Texas), National Association
together with Credit Agreement and General Pledge Agreement and Amendment relating thereto.
(L)10.333 --Revolving Line of Credit Note dated January 10, 1997, in the original principal amount of $10,000,000
executed by HCC Insurance Holdings, Inc., payable to Wells Fargo Bank (Texas), National Association
together with Credit Agreement and General Pledge Agreement relating thereto.
(N)10.334 --Agreement and Plan of Reorganization dated April 30, 1997 among Interworld Corporation, Aviation &
Marine Insurance Group, Inc., various shareholders of those companies and HCC Insurance Holdings,
Inc. related to the acquisition of 100% of the common stock of Interworld Corporation.
(O)10.335 --Stock Purchase Agreement dated June 27, 1997 between Sandra L. Ruder and HCC Insurance Holdings, Inc.
related to the purchase of 100% of the common stock of Managed Group Underwriting, Inc.
(P)10.336 --Stock Purchase Agreement dated July 31, 1997 between Continental Aviation Underwriters, Inc., the
shareholders thereof, and HCC Insurance Holdings, Inc. related to the purchase of 100% of the common
stock of Continental Aviation Underwriters, Inc.
(P)10.337 --Acquisition Agreement dated August 8, 1997 between Southern Aviation Insurance Underwriters, Inc.,
Aviation Claims Administrators, Inc., the shareholders thereof, and HCC Insurance Holdings, Inc.
related to the acquisition of 100% of the common stock of Southern Aviation Insurance Underwriters,
Inc. and Aviation Claims Administrators, Inc.
41
EXHIBIT
NUMBER
- ------------
(P)10.338 --Line of Credit Agreements payable to Wells Fargo Bank (Texas), National Association executed by HCC
Insurance Holdings, Inc., Houston Casualty Company and IMG Insurance Company, Ltd. together with the
Credit Agreements and Security Agreements related thereto.
(Q)10.339 --Loan Agreement ($120,000,000 Revolving Loan Facility) dated as of December 19, 1997 among HCC
Insurance Holdings, Inc. as Borrower, Wells Fargo Bank (Texas), National Association, as Agent and as
a Lender, NationsBank of Texas, N.A. as Documentation Agent and as a Lender, and the Other Lenders
Now or Hereafter Parties Thereto.
10.340 --Agreement and Plan of Reorganization dated as of February 27, 1998 among HCC Insurance Holdings, Inc.
and various shareholders of The Kachler Corporation related to the acquisition of 100% of the common
stock of The Kachler Corporation.
10.341 --Purchase Agreement dated as of February 28, 1998, among HCC Insurance Holdings, Inc., Bethany A.
Belanger, the partners of Guarantee Insurance Resources and others related to the acquisition of 100%
of the partnership assets and liabilities of Guarantee Insurance Resources and 100% of the common
stock of Insurance Alternatives, Inc.
(M)10.342 --HCC Insurance Holdings, Inc. 1997 Flexible Incentive Plan.
12 --Statement Regarding Computation of Ratios
21 --Subsidiaries of HCC Insurance Holdings, Inc.
23 --Consent of Independent Accountants--Coopers & Lybrand L.L.P. dated March 27, 1998.
23.1 --Consent of Independent Accountants--KPMG Peat Marwick L.L.P. dated March 26, 1998-- included at page
S-2.
24 --Powers of Attorney
27 --EDGAR Financial Data Schedule--December 31, 1997
27.1 --EDGAR Financial Data Schedule--Restated December 31, 1996
27.2 --EDGAR Financial Data Schedule--Restated September 30, 1997, June 30, 1997, September 30, 1996 and
June 30, 1996
27.3 --EDGAR Financial Data Schedule--Restated March 31, 1997 and March 31, 1996
- ------------------------
(A)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Registration Statement (Registration No. 33-48737) filed October 27, 1992.
(B)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Form 10-K for the fiscal year ended December 31, 1993.
(C)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Form 10-K for the fiscal year ended December 31, 1994.
(D)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Form 10-Q for the fiscal quarter ended March 31, 1995.
(E)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Registration Statement on Form S-8 (Registration No. 33-94472) filed July 11,
1995.
(F)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Registration Statement on Form S-8 (Registration No. 33-94468) filed July 11,
1995.
42
(G)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Form 10-K for fiscal year ended December 31, 1995.
(H)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Registration Statement (Registration No. 333-3652) filed April 15, 1996.
(I)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.
Preliminary Registration Statement filed March 7, 1997.
(J)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Registration Statement on Form S-8 (Registration No. 333-14479) filed October
18, 1996.
(K)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Registration Statement on Form S-8 (Registration No. 333-14471) filed October
18, 1996.
(L)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Form 10-K for fiscal year ended December 31, 1996.
(M)Incorporated by reference to Exhibit A to the HCC Insurance Holdings, Inc.
Proxy Statement for the May 22, 1997 Annual Meeting of Shareholders filed
April 30, 1997.
(N)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Form 10-Q for the fiscal quarter ended March 31, 1997.
(O)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Form 10-Q for the fiscal quarter ended June 30, 1997.
(P)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Form 10-Q for the fiscal quarter ended September 30, 1997.
(Q)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Form 8-K filed January 6, 1998.
43
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders
HCC Insurance Holdings, Inc.
We have audited the accompanying consolidated balance sheets of HCC
Insurance Holdings, Inc. and Subsidiaries as of December 31, 1997 and 1996, and
the related consolidated statements of earnings, changes in shareholders'
equity, and cash flows for each of the three years in the period ended December
31, 1997. These financial statements are the responsibility of HCC Insurance
Holdings, Inc.'s management. Our responsibility is to express an opinion on
these financial statements based on our audits. We did not audit the 1996 and
1995 consolidated financial statements of AVEMCO Corporation, which statements
reflect total revenues constituting 43.7 percent and 45.6 percent and net
earnings constituting 24.0 percent and 23.2 percent of the related consolidated
financial statements totals for the years ended December 31, 1996 and 1995,
respectively. Those statements were audited by other auditors whose report dated
January 31, 1997 except for Note 12 of which the date is February 28, 1997 and
except for Note 14 of which the date is February 18, 1998, has been furnished to
us, and our opinion, insofar as it related to data included for 1996 and 1995 is
based solely on the report of the other auditors.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits and the report of the other auditors provide a
reasonable basis for our opinion.
In our opinion, based on our audits and the report of the other auditors,
the consolidated financial statements referred to above present fairly, in all
material respects, the consolidated financial position of HCC Insurance
Holdings, Inc. and Subsidiaries as of December 31, 1997 and 1996, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 1997, in conformity with generally
accepted accounting principles.
COOPERS & LYBRAND L.L.P.
Houston, Texas
March 26, 1998
F-1
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Shareholder
AVEMCO Corporation:
We have audited the consolidated balance sheet of AVEMCO Corporation and
subsidiaries as of December 31, 1996, and the related consolidated statements of
income, stockholders' equity and cash flows for each of the years in the
two-year period ended December 31, 1996 (not included separately herein). These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of AVMECO
Corporation and subsidiaries as of December 31, 1996, and the results of their
operations and their cash flows for each of the years in the two-year period
ended December 31, 1996, in conformity with generally accepted accounting
principles.
KPMG Peat Marwick LLP
Washington, D.C.
January 31, 1997
(February 28, 1997, as to note 12
and February 18, 1998, as to note 14)
F-2
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31,
--------------------------------
1997 1996
---------------- --------------
ASSETS
Investments:
Fixed income securities, at market
(cost: 1997 $395,121,000; 1996 $371,844,000)............................... $ 409,701,000 $ 377,555,000
Marketable equity securities, at market
(cost: 1997 $10,221,000; 1996 $12,661,000)................................. 8,339,000 12,477,000
Short-term investments, at cost, which approximates market................... 105,255,000 78,693,000
---------------- --------------
Total investments........................................................ 523,295,000 468,725,000
Cash........................................................................... 7,324,000 9,171,000
Restricted cash and cash investments........................................... 60,063,000 44,363,000
Reinsurance recoverables....................................................... 203,300,000 132,328,000
Premium, claims and other receivables.......................................... 251,477,000 167,168,000
Ceded unearned premium......................................................... 84,610,000 71,758,000
Deferred policy acquisition costs.............................................. 21,604,000 24,809,000
Property and equipment, net.................................................... 19,842,000 16,665,000
Deferred income tax............................................................ 6,639,000 12,636,000
Other assets, net.............................................................. 44,609,000 16,476,000
---------------- --------------
Total assets............................................................. $ 1,222,763,000 $ 964,099,000
---------------- --------------
---------------- --------------
LIABILITIES
Loss and loss adjustment expense payable....................................... $ 275,008,000 $ 229,049,000
Reinsurance balances payable................................................... 70,249,000 45,449,000
Unearned premium............................................................... 152,094,000 156,268,000
Deferred ceding commissions.................................................... 19,553,000 16,901,000
Premium and claims payable..................................................... 237,770,000 123,118,000
Notes payable.................................................................. 80,750,000 72,917,000
Accounts payable and accrued liabilities....................................... 21,859,000 23,984,000
---------------- --------------
Total liabilities........................................................ 857,283,000 667,686,000
SHAREHOLDERS' EQUITY
Common Stock, $1.00 par value; 100,000,000 shares authorized;
(issued: 1997 46,158,929 shares; 1996 47,416,643 shares)..................... 46,159,000 47,417,000
Additional paid-in capital..................................................... 156,089,000 139,971,000
Retained earnings.............................................................. 155,232,000 162,163,000
Unrealized investment gain, net................................................ 8,306,000 3,623,000
Foreign currency translation adjustment........................................ (306,000) (91,000)
Treasury stock, at cost (1996 3,301,741 shares)................................ -- (56,670,000)
---------------- --------------
Total shareholders' equity............................................... 365,480,000 296,413,000
---------------- --------------
Total liabilities and shareholders' equity............................... $ 1,222,763,000 $ 964,099,000
---------------- --------------
---------------- --------------
See Notes to Consolidated Financial Statements.
F-3
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF EARNINGS
FOR THE YEARS ENDED DECEMBER 31,
----------------------------------------------
1997 1996 1995
-------------- -------------- --------------
REVENUE
Net earned premium.............................................. $ 163,090,000 $ 175,309,000 $ 159,588,000
Management fee and commission income............................ 75,867,000 51,356,000 42,786,000
Net investment income........................................... 27,718,000 23,595,000 21,748,000
Computer products and services.................................. 7,064,000 8,471,000 8,227,000
Net realized investment gain (loss)............................. (329,000) 8,341,000 1,636,000
Gain on sale of subsidiary...................................... -- 3,307,000 --
-------------- -------------- --------------
Total revenue............................................. 273,410,000 270,379,000 233,985,000
EXPENSE
Loss and loss adjustment expense................................ 96,514,000 114,464,000 105,374,000
Operating expense:
Policy acquisition costs...................................... 59,110,000 47,512,000 42,357,000
Compensation expense.......................................... 44,634,000 37,102,000 43,110,000
Other operating expense....................................... 31,042,000 25,797,000 25,868,000
Merger expense................................................ 8,069,000 26,160,000 --
Ceding commissions............................................ (45,011,000) (34,053,000) (30,767,000)
-------------- -------------- --------------
Net operating expense..................................... 97,844,000 102,518,000 80,568,000
Interest expense................................................ 6,004,000 4,993,000 6,471,000
-------------- -------------- --------------
Total expense............................................. 200,362,000 221,975,000 192,413,000
-------------- -------------- --------------
Earnings before income tax provision...................... 73,048,000 48,404,000 41,572,000
Income tax provision............................................ 23,297,000 9,874,000 9,884,000
-------------- -------------- --------------
Net earnings.............................................. $ 49,751,000 $ 38,530,000 $ 31,688,000
-------------- -------------- --------------
-------------- -------------- --------------
BASIC EARNINGS PER SHARE DATA:
Earnings per share.............................................. $ 1.10 $ 0.89 $ 0.77
-------------- -------------- --------------
-------------- -------------- --------------
Weighted average shares outstanding............................. 45,395,000 43,195,000 40,977,000
-------------- -------------- --------------
-------------- -------------- --------------
DILUTED EARNINGS PER SHARE DATA:
Earnings per share.............................................. $ 1.07 $ 0.87 $ 0.76
-------------- -------------- --------------
-------------- -------------- --------------
Weighted average shares outstanding............................. 46,609,000 44,443,000 41,513,000
-------------- -------------- --------------
-------------- -------------- --------------
See Notes to Consolidated Financial Statements.
F-4
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
FOREIGN
ADDITIONAL UNREALIZED CURRENCY
COMMON PAID-IN RETAINED INVESTMENT TRANSLATION
STOCK CAPITAL EARNINGS GAIN (LOSS) ADJUSTMENT
------------- -------------- -------------- ------------- -----------
BALANCE AS OF DECEMBER 31, 1994............. $ 16,385,000 $ 91,222,000 $ 114,501,000 $ (6,143,000) $ (219,000)
61,996 shares of Common Stock issued for
exercise of options, including tax benefit
of $252,000................................ 62,000 855,000 -- -- --
Net earnings................................ -- -- 31,688,000 -- --
2,012,500 shares of Common Stock issued in
public offering, net of costs.............. 2,013,000 45,957,000 -- -- --
Dividends to shareholders of pooled
companies prior to merger.................. -- -- (5,848,000) -- --
Repurchase of 83,480 shares of common stock
by pooled company prior to merger.......... -- -- -- -- --
Unrealized investment gain on fixed income
securities net of deferred tax charge of
$6,055,000................................. -- -- -- 11,391,000 --
Unrealized investment gain on marketable
equity securities, net of deferred tax
charge of $2,120,000....................... -- -- -- 4,048,000 --
Other....................................... -- 50,000 -- -- 33,000
------------- -------------- -------------- ------------- -----------
BALANCE AS OF DECEMBER 31, 1995......... $ 18,460,000 $ 138,084,000 $ 140,341,000 $ 9,296,000 $ (186,000)
TOTAL
TREASURY SHAREHOLDERS'
STOCK EQUITY
-------------- --------------
BALANCE AS OF DECEMBER 31, 1994............. $ (46,988,000) $ 168,758,000
61,996 shares of Common Stock issued for
exercise of options, including tax benefit
of $252,000................................ -- 917,000
Net earnings................................ -- 31,688,000
2,012,500 shares of Common Stock issued in
public offering, net of costs.............. -- 47,970,000
Dividends to shareholders of pooled
companies prior to merger.................. -- (5,848,000)
Repurchase of 83,480 shares of common stock
by pooled company prior to merger.......... (3,582,000) (3,582,000)
Unrealized investment gain on fixed income
securities net of deferred tax charge of
$6,055,000................................. -- 11,391,000
Unrealized investment gain on marketable
equity securities, net of deferred tax
charge of $2,120,000....................... -- 4,048,000
Other....................................... -- 83,000
-------------- --------------
BALANCE AS OF DECEMBER 31, 1995......... $ (50,570,000) $ 255,425,000
See Notes to Consolidated Financial Statements.
F-5
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY--(CONTINUED)
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
FOREIGN
ADDITIONAL UNREALIZED CURRENCY
COMMON PAID-IN RETAINED INVESTMENT TRANSLATION
STOCK CAPITAL EARNINGS GAIN (LOSS) ADJUSTMENT
------------ ------------- ------------- ----------- -----------
BALANCE AS OF DECEMBER 31, 1995..................... $ 18,460,000 $ 138,084,000 $ 140,341,000 $ 9,296,000 $(186,000)
27,688,869 shares of Common Stock issued for 150%
stock dividend..................................... 27,689,000 (27,689,000) -- -- --
132,108 shares of Common Stock issued for exercise
of options, including tax benefit of $366,000...... 132,000 837,000 -- -- --
Net earnings........................................ -- -- 38,530,000 -- --
Cash dividends declared, $0.06 per share............ -- -- (2,104,000) -- --
Compensatory grant of pooled company stock prior to
merger............................................. -- 23,682,000 -- -- --
Dividends to shareholders of pooled companies prior
to merger.......................................... -- -- (7,705,000) -- --
Capitalize undistributed earnings of pooled company
upon conversion from S Corporation................. -- 3,840,000 (3,840,000) -- --
1,136,400 shares of Common Stock issued for NASRA
combination........................................ 1,136,000 -- (1,452,000) -- --
Repurchase of 520,000 shares of common stock by
pooled company prior to merger..................... -- -- -- -- --
Unrealized investment loss on fixed income
securities, net of deferred tax benefit of
$857,000........................................... -- -- -- (1,594,000) --
Unrealized investment loss on marketable equity
securities, net of deferred tax benefit of
$2,144,000......................................... -- -- -- (4,079,000) --
Other............................................... -- 1,217,000 (1,607,000) -- 95,000
------------ ------------- ------------- ----------- -----------
BALANCE AS OF DECEMBER 31, 1996................. $ 47,417,000 $ 139,971,000 $ 162,163,000 $ 3,623,000 $ (91,000)
TOTAL
TREASURY SHAREHOLDERS'
STOCK EQUITY
------------- -------------
BALANCE AS OF DECEMBER 31, 1995..................... $ (50,570,000) $ 255,425,000
27,688,869 shares of Common Stock issued for 150%
stock dividend..................................... -- --
132,108 shares of Common Stock issued for exercise
of options, including tax benefit of $366,000...... -- 969,000
Net earnings........................................ -- 38,530,000
Cash dividends declared, $0.06 per share............ -- (2,104,000)
Compensatory grant of pooled company stock prior to
merger............................................. -- 23,682,000
Dividends to shareholders of pooled companies prior
to merger.......................................... -- (7,705,000)
Capitalize undistributed earnings of pooled company
upon conversion from S Corporation................. -- --
1,136,400 shares of Common Stock issued for NASRA
combination........................................ -- (316,000)
Repurchase of 520,000 shares of common stock by
pooled company prior to merger..................... (7,909,000) (7,909,000)
Unrealized investment loss on fixed income
securities, net of deferred tax benefit of
$857,000........................................... -- (1,594,000)
Unrealized investment loss on marketable equity
securities, net of deferred tax benefit of
$2,144,000......................................... -- (4,079,000)
Other............................................... 1,809,000 1,514,000
------------- -------------
BALANCE AS OF DECEMBER 31, 1996................. $ (56,670,000) $ 296,413,000
See Notes to Consolidated Financial Statements.
F-6
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY--(CONTINUED)
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
FOREIGN
ADDITIONAL UNREALIZED CURRENCY
COMMON PAID-IN RETAINED INVESTMENT TRANSLATION
STOCK CAPITAL EARNINGS GAIN (LOSS) ADJUSTMENT
------------- -------------- -------------- ------------- -----------
BALANCE AS OF DECEMBER 31, 1996............. $ 47,417,000 $ 139,971,000 $ 162,163,000 $ 3,623,000 $ (91,000)
726,898 shares of Common Stock issued for
exercise of options, including tax benefit
of $1,725,000.............................. 727,000 9,743,000 -- -- --
382,024 shares of Common Stock issued for
purchased companies........................ 382,000 9,805,000 -- -- --
950,000 shares of Common Stock issued for
Southern and Interworld combinations....... 950,000 -- (1,507,000) -- --
Net earnings................................ -- -- 49,751,000 -- --
Cash dividends declared, $0.12 per share.... -- -- (5,219,000) -- --
Repurchase of 14,895 shares of common stock
by pooled company prior to combination..... -- -- -- -- --
Retirement of 3,316,636 shares of treasury
stock...................................... (3,317,000) (3,430,000) (50,247,000) -- --
Unrealized investment gain on fixed income
securities, net of deferred tax charge of
$3,104,000................................. -- -- -- 5,765,000 --
Unrealized investment loss on marketable
equity securities, net of deferred tax
benefit of $616,000........................ -- -- -- (1,082,000) --
Other....................................... -- -- 291,000 -- (215,000)
------------- -------------- -------------- ------------- -----------
BALANCE AS OF DECEMBER 31, 1997......... $ 46,159,000 $ 156,089,000 $ 155,232,000 $ 8,306,000 $ (306,000)
------------- -------------- -------------- ------------- -----------
------------- -------------- -------------- ------------- -----------
TOTAL
TREASURY SHAREHOLDERS'
STOCK EQUITY
-------------- --------------
BALANCE AS OF DECEMBER 31, 1996............. $ (56,670,000) $ 296,413,000
726,898 shares of Common Stock issued for
exercise of options, including tax benefit
of $1,725,000.............................. -- 10,470,000
382,024 shares of Common Stock issued for
purchased companies........................ -- 10,187,000
950,000 shares of Common Stock issued for
Southern and Interworld combinations....... -- (557,000)
Net earnings................................ -- 49,751,000
Cash dividends declared, $0.12 per share.... -- (5,219,000)
Repurchase of 14,895 shares of common stock
by pooled company prior to combination..... (324,000) (324,000)
Retirement of 3,316,636 shares of treasury
stock...................................... 56,994,000 --
Unrealized investment gain on fixed income
securities, net of deferred tax charge of
$3,104,000................................. -- 5,765,000
Unrealized investment loss on marketable
equity securities, net of deferred tax
benefit of $616,000........................ -- (1,082,000)
Other....................................... -- 76,000
-------------- --------------
BALANCE AS OF DECEMBER 31, 1997......... $ -- $ 365,480,000
-------------- --------------
-------------- --------------
See Notes to Consolidated Financial Statements.
F-7
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31,
-----------------------------------------------
1997 1996 1995
-------------- -------------- ---------------
Cash flows from operating activities:
Net earnings...................................................... $ 49,751,000 $ 38,530,000 $ 31,688,000
Adjustments to reconcile net earnings to net cash provided by
operating activities:
Change in reinsurance recoverables.............................. (70,972,000) (14,628,000) (1,335,000)
Change in premium, claims and other receivables................. (84,309,000) (13,084,000) (21,285,000)
Change in ceded unearned premium................................ (12,852,000) 6,702,000 (12,865,000)
Change in deferred policy acquisition costs, net................ 5,857,000 (3,379,000) (1,092,000)
Change in deferred income tax, net of tax effect of unrealized
gain or loss.................................................. 3,475,000 (7,430,000) (1,955,000)
Change in loss and loss adjustment expense payable.............. 45,959,000 28,293,000 29,799,000
Change in reinsurance balances payable.......................... 24,800,000 (28,061,000) (81,000)
Change in unearned premium...................................... (4,174,000) 4,292,000 37,629,000
Change in premium and claims payable, net of restricted cash.... 98,952,000 2,483,000 7,711,000
Change in accounts payable and accrued liabilities.............. (2,794,000) 248,000 2,546,000
Net realized investment (gain) loss............................. 329,000 (8,341,000) (1,636,000)
Gain on sale of subsidiary...................................... -- (3,307,000) --
Non-cash compensation expense................................... -- 24,176,000 --
Depreciation and amortization expense........................... 5,163,000 4,029,000 3,343,000
Other, net...................................................... (5,068,000) (1,060,000) 864,000
-------------- -------------- ---------------
Cash provided by operating activities......................... 54,117,000 29,463,000 73,331,000
Cash flows from investing activities:
Sales of fixed income securities.................................. 27,090,000 24,399,000 44,706,000
Maturity or call of fixed income securities....................... 19,173,000 17,573,000 21,389,000
Sales of equity securities........................................ 17,656,000 41,202,000 24,150,000
Proceeds from sale of subsidiary.................................. -- 13,957,000 --
Change in short-term investments.................................. (26,562,000) (7,296,000) (15,413,000)
Cash paid for companies acquired.................................. (12,948,000) (1,753,000) --
Cost of investments acquired...................................... (87,084,000) (97,909,000) (156,898,000)
Other, net........................................................ (6,718,000) (2,762,000) (4,683,000)
-------------- -------------- ---------------
Cash used by investing activities............................. (69,393,000) (12,589,000) (86,749,000)
Cash flows from financing activities:
Proceeds from notes payable....................................... 97,500,000 44,000,000 11,700,000
Sale of Common Stock, net of costs................................ 10,470,000 969,000 48,887,000
Payments on notes payable......................................... (89,667,000) (42,711,000) (39,580,000)
Dividends paid.................................................... (4,550,000) (9,092,000) (5,526,000)
Repurchase common stock........................................... (324,000) (7,909,000) (3,582,000)
-------------- -------------- ---------------
Cash provided (used) by financing activities.................. 13,429,000 (14,743,000) 11,899,000
-------------- -------------- ---------------
Net change in cash............................................ (1,847,000) 2,131,000 (1,519,000)
Cash at beginning of year..................................... 9,171,000 7,040,000 8,559,000
-------------- -------------- ---------------
Cash at end of year........................................... $ 7,324,000 $ 9,171,000 $ 7,040,000
-------------- -------------- ---------------
-------------- -------------- ---------------
See Notes to Consolidated Financial Statements.
F-8
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) GENERAL INFORMATION AND SIGNIFICANT ACCOUNTING AND REPORTING POLICIES
HCC Insurance Holdings, Inc. and its subsidiaries (collectively, "the
Company" or "HCC"), include domestic and foreign property and casualty insurance
companies and managing general agents, surplus lines insurance brokers and
wholesale insurance and reinsurance brokers. HCC, through its subsidiaries,
provides specialized property and casualty insurance to commercial customers
worldwide, underwritten on both a direct and reinsurance basis, in the areas of
aviation, marine, property, offshore energy, accident and health, and lenders
single interest. The principal insurance company subsidiaries are Houston
Casualty Company ("HC"), U.S. Specialty Insurance Company ("USSIC"), Trafalgar
Insurance Company ("TIC") in Houston, Texas and AVEMCO Insurance Company ("AIC")
in Frederick, Maryland. The agency subsidiaries provide underwriting management
and intermediary services for insurance and reinsurance companies, primarily in
the accident and health and aviation areas, but also in the same lines of
business that the insurance subsidiaries operate. The principal agency
subsidiaries are LDG Management Company Incorporated ("LDG") in Wakefield,
Massachusetts; Aviation and Marine Insurance Group ("AMIG" formerly Interworld
Corporation) in Dallas, Texas; HCC Underwriters, A Texas Corporation ("HCCU") in
Houston, Texas; North American Special Risk Associates, Inc. ("NASRA") in
Northbrook, Illinois and Middle East Insurance Brokers, Ltd. ("MEIB") in Amman,
Jordan.
The preparation of financial statements in conformity with generally
accepted accounting principles ("GAAP") requires management to make estimates
and assumptions. This affects amounts reported in the financial statements and
the disclosure of contingent assets and liabilities. Actual results could differ
from those estimates.
A description of the significant accounting and reporting policies utilized
by the Company in preparing the consolidated financial statements is as follows:
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries. All significant intercompany balances and
transactions have been eliminated in consolidation. The business combinations
with AVEMCO Corporation ("AVEMCO"), LDG, NASRA, Interworld and Southern Aviation
Insurance Underwriters, Inc. ("Southern") have been recorded as
poolings-of-interests. The Company's financial statements have been restated to
include the accounts and operations of AVEMCO and LDG for all periods presented.
The financial statements have not been restated to include Interworld, Southern
and NASRA due to immateriality. (See Note 2.)
INVESTMENTS
Fixed income securities and marketable equity securities are classified as
available for sale and are carried at quoted market value, if readily
marketable, or at management's estimated fair value, if not readily marketable.
The change in unrealized gain or loss with respect to these securities is
recorded as a direct increase or decrease to shareholders' equity, net of
related deferred income tax, if any. Fixed income securities available for sale
are purchased with the original intent to hold to maturity, but they may be
available for sale if market conditions warrant, or if the Company's investment
policies dictate, in order to maximize the Company's investment yield.
Short-term investments and restricted short-term investments are carried at cost
which approximates market value.
The realized gain or loss on investment transactions is determined on an
average cost basis and included in earnings on the trade date. When impairment
of the value of an investment is considered other
F-9
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(1) GENERAL INFORMATION AND SIGNIFICANT ACCOUNTING AND REPORTING POLICIES
(CONTINUED)
than temporary, the decrease in value is reported in earnings as a realized
investment loss and a new cost basis is established.
PROPERTY AND EQUIPMENT
Property and equipment are carried at cost, net of accumulated depreciation.
Depreciation expense is provided using the straight-line method over the
estimated useful lives of the related assets. Amortization of leasehold
improvements is provided using the straight-line method over the term of the
respective lease. Upon disposal of assets, the cost and related accumulated
depreciation are removed from the accounts and the resulting gain or loss is
included in earnings.
Costs incurred in developing or purchasing management information systems
are capitalized and included in property and equipment. These costs are
amortized over their estimated useful lives from the dates the systems are
placed in service.
EARNED PREMIUM, DEFERRED POLICY ACQUISITION COSTS AND CEDING COMMISSIONS OF
INSURANCE COMPANY SUBSIDIARIES
Written premium, net of reinsurance, is generally included in earnings on a
PRO RATA basis over the lives of the related policies. Policy acquisition costs,
including commissions, taxes, fees and other direct costs of underwriting
policies, and ceding commissions allowed by reinsurers, including expense
allowances, are deferred and charged or credited to earnings generally on a pro
rata basis as the premium is earned. Historical and current loss and loss
adjustment expense experience are considered in determining the recoverability
of deferred policy acquisition costs.
MANAGEMENT FEE AND COMMISSION INCOME
Management fee and commission income is recognized on the revenue
recognition date, which is the later of the effective date of the policy, the
date when the premium can be reasonably estimated, or the date when
substantially all required services relating to the insurance placement have
been rendered to the client. Commission income relating to additional or return
premiums or other policy adjustments is recognized when the events occur and the
amounts become known or can be estimated.
PREMIUM AND OTHER RECEIVABLES
The Company has adopted the gross method for reporting receivables and
payables on brokered transactions. Management reviews the collectibility of its
receivables on a current basis and provides an allowance for doubtful accounts
if it deems that there are accounts which are doubtful of collection. The amount
of the allowance at December 31, 1997 and 1996, is not material.
LOSS AND LOSS ADJUSTMENT EXPENSE PAYABLE OF INSURANCE COMPANY SUBSIDIARIES
Loss and loss adjustment expense payable is based on undiscounted estimates
of payments to be made for reported and incurred but not reported ("IBNR")
losses, net of reinsurance and anticipated salvage and subrogation receipts.
Estimates for reported losses are based on all available information, including
reports received from ceding companies on assumed business. Estimates for IBNR
are based both on the Company's and the industry's experience. While management
believes that amounts included in the
F-10
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(1) GENERAL INFORMATION AND SIGNIFICANT ACCOUNTING AND REPORTING POLICIES
(CONTINUED)
accompanying financial statements are adequate, such estimates may be more or
less than the amounts ultimately paid when the claims are settled. The estimates
are continually reviewed and any changes are reflected in current operations.
REINSURANCE
The Company records all reinsurance recoverables and ceded unearned premiums
as assets and deferred ceding commissions as a liability. All such amounts are
estimated and recorded in a manner consistent with the underlying reinsured
contracts. Management has recorded a reserve for uncollectible reinsurance based
on estimates of collectibility.
GOODWILL
In connection with the Company's acquisitions of subsidiaries accounted for
as purchases, the excess of cost over fair value of net assets acquired is being
amortized using the straight-line method principally over twenty years for
acquired agency operations and forty years for acquired insurance company
operations. Managements of the acquired businesses have successfully operated in
the Company's markets for a number of years and, with the additional capital
provided by the Company, will be positioned to take advantage of increased
opportunities.
The Company has no reason to expect major changes in the business conditions
in which the acquired companies operate which might affect the recoverability of
the recorded intangibles. However, in the event business conditions change, the
recoverability will be re-evaluated based upon revised projections of future
undiscounted operating income and cash flows and, if impaired, the balances will
be adjusted accordingly. Amortization charged to income for the years ended
December 31, 1997, 1996 and 1995, was $1.6 million, $684,000 and $672,000,
respectively.
CASH AND SHORT-TERM INVESTMENTS
Cash consists of cash in banks, generally in operating accounts. The Company
classifies certificates of deposit, corporate demand notes receivable,
commercial paper and money market funds as short-term investments. Short-term
investments are classified as investments in the consolidated balance sheets as
they relate principally to the Company's investment activities.
In 1997, in connection with the acquisition of AVEMCO in a transaction
accounted for as a pooling-of-interests, the Company conformed its accounting
policies between itself and AVEMCO such that changes in cash flows from
operating, investing and financing activities are reconciled to the change in
cash in the consolidated statements of cash flows. In prior years, the Company
reconciled to the change in cash and short-term investments. Management now
deems its consolidated short-term investing to be predominately an investing
activity, not a cash management activity. Accordingly, short-term investments
are now classified as investments in the consolidated balance sheets rather than
with cash. The conforming change was made retroactively and had the effect of
increasing (decreasing) cash utilized in investing activities and (increasing)
decreasing the change in cash by ($3.4 million) and $10.8 million in 1996 and
1995, respectively, in the consolidated statements of cash flows. The conformity
change had no effect on the results of operations or shareholders' equity.
F-11
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(1) GENERAL INFORMATION AND SIGNIFICANT ACCOUNTING AND REPORTING POLICIES
(CONTINUED)
The Company generally maintains its cash deposits in major banks and invests
its excess cash with major banks and in investment grade commercial papers and
repurchase agreements. These securities typically mature within 90 days and,
therefore, bear minimal risk. The Company has not experienced any losses on its
cash deposits or its short-term investments.
RESTRICTED CASH AND CASH INVESTMENTS
In conjunction with the management of reinsurance pools, the Company's
agency subsidiaries withhold premium funds for the payment of claims. These
funds are shown as restricted cash and cash investments on the consolidated
balance sheets. The corresponding liability is included within premium and
claims payable in the consolidated balance sheets. These amounts are considered
fiduciary funds, and interest earned on these funds accrues to the benefit of
the members of the reinsurance pools. Therefore, the Company does not include
these amounts as cash or cash equivalents in the consolidated statements of cash
flows.
FOREIGN CURRENCY TRANSLATION
The functional currency of most foreign subsidiaries is the United States
dollar. Assets and liabilities recorded in foreign currencies are translated
into United States dollars at exchange rates in effect at the balance sheet
date. Transactions in foreign currencies are translated at the rates of exchange
in effect on the date the transaction occurs. The Company's foreign currency
transactions are principally denominated in British Pound Sterling ("GBP") and
other European currencies. From time to time the Company enters into foreign
currency forward contracts as a hedge against foreign currency fluctuations.
Gains or losses in the market value of foreign currency forward contracts are
recognized in the statements of earnings concurrently with the gains and losses
on the hedged balances. For the years ended December 31, 1997, 1996 and 1995,
the loss from currency conversion was $884,000, $181,000 and $209,000,
respectively.
Some foreign subsidiaries or branches have a functional currency of either
the GBP or the Canadian Dollar ("CAD"). Cumulative translation adjustment,
representing the effect of translating these subsidiaries' or branches' assets
and liabilities into United States dollars is included in the foreign currency
translation adjustment within shareholders' equity.
COMPUTER PRODUCTS AND SERVICES
Revenue from custom software products is recognized using the percentage of
completion method of accounting. Other software contracts are recognized when
delivery has occurred, other remaining vendor obligations are no longer
significant, and collectibility is probable. Revenue from the sale of computer
hardware is recognized when delivery has occurred. Maintenance support is
recognized PRO RATA over the term of the maintenance agreement.
INCOME TAX
The domestic companies and the foreign insurance company subsidiaries (which
have all elected to be taxed as domestic companies) file a single consolidated
Federal income tax return and include the foreign subsidiaries' income to the
extent required by law. Deferred income tax is accounted for using the liability
method, which reflects the tax impact of temporary differences between the bases
of assets and liabilities
F-12
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(1) GENERAL INFORMATION AND SIGNIFICANT ACCOUNTING AND REPORTING POLICIES
(CONTINUED)
for financial reporting purposes and such bases as measured by tax laws and
regulations. LDG was an S Corporation prior to its reorganization and merger
with the Company. Therefore, Federal income tax expense was not provided for
LDG's earnings until the S Corporation election was terminated on May 22, 1996.
EARNINGS PER SHARE
In December, 1997, the Company adopted Statement of Financial Accounting
Standards ("SFAS") No. 128. Earnings per share have been restated for all
periods presented. Basic earnings per share are based on the weighted average
number of common shares outstanding during the year divided into net earnings.
Diluted earnings per share are based on the weighted average number of common
shares outstanding plus the potential common shares outstanding during the year
divided into net earnings. The shares issued in connection with the combinations
with AVEMCO and LDG are included in outstanding shares for all periods
presented. Outstanding common stock options, when dilutive, are considered to be
potential common stock for the purpose of the diluted calculation. The treasury
stock method is used to calculate potential common stock due to options.
STOCK SPLIT
In April, 1996, the Board of Directors declared a five-for-two stock split
in the form of a 150% stock dividend on the Company's $1.00 par value Common
Stock, payable to shareholders of record April 30, 1996. The par value of the
Company's Common Stock remains unchanged. All per share, weighted average shares
outstanding and option data presented in the consolidated financial statements
and the notes thereto have been retroactively adjusted to reflect the effect of
the split.
PRIOR PERIOD ADJUSTMENTS OF AVEMCO
The 1996 and prior financial statements of AVEMCO, which was acquired in
1997 in a transaction accounted for as a pooling-of-interests (See Note 2), have
been restated prior to their inclusion in the Company's historical consolidated
financial statements to reflect certain prior period adjustments discovered in
1997. The adjustments were for periods prior to HCC's ownership and relate to a
restatement of the method of accounting for certain short-duration insurance
contracts and to the correction of accounting errors. The adjustment had the
following effects with respect to amounts previously reported in AVEMCO's 1996
and prior consolidated financial statements for the years ended December 31,
1996 and 1995:
1996 1995
------------- ------------
Earnings before income tax provision as previously reported...... $ 15,962,000 $ 9,102,000
Effects of adjustments........................................... (4,185,000) (821,000)
------------- ------------
Earnings before income tax provisions, as restated........... $ 11,777,000 $ 8,281,000
------------- ------------
------------- ------------
Net earnings as previously reported.............................. $ 12,288,000 $ 7,918,000
Effects of adjustments........................................... (3,056,000) (567,000)
------------- ------------
Net earnings, as restated.................................... $ 9,232,000 $ 7,351,000
------------- ------------
------------- ------------
F-13
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(1) GENERAL INFORMATION AND SIGNIFICANT ACCOUNTING AND REPORTING POLICIES
(CONTINUED)
AVEMCO's retained earnings as of December 31, 1994 was decreased by
$1,226,000, net of a $233,000 tax effect, as a result of the adjustments. These
adjustments decreased the Company's basic and diluted earnings per share by
$0.07 and $0.01 for the years ended December 31, 1996 and 1995, respectively.
EFFECTS OF RECENT ACCOUNTING PRONOUNCEMENTS
In June, 1997, the Financial Accounting Standards Board issued SFAS No. 130
"Reporting Comprehensive Income" and SFAS No. 131 "Disclosures about Segments of
an Enterprise and Related Information". Both statements are effective for fiscal
years beginning after December 15, 1997. These SFAS's require that additional
information be included in a complete set of financial statements, but will have
no effect on the Company's net earnings, shareholders' equity or cash flows. The
Company does not expect to change its definition of segments when SFAS No. 131
is adopted.
RECLASSIFICATIONS
Certain amounts in the 1996 and 1995 consolidated financial statements have
been reclassified to conform with the 1997 presentation. Such reclassifications
had no effect on the Company's shareholders' equity, net earnings or cash flows,
except for the conforming change in cash and short-term investments which
affected the classification of cash flows.
(2) ACQUISITIONS
LDG
On May 24, 1996, the Company issued 6,250,000 shares of its Common Stock to
acquire all of the outstanding common stock of LDG. The former majority
shareholder of LDG is a director of the Company. This business combination has
been accounted for as a pooling-of-interests. The Company's consolidated
financial statements have been restated to include the accounts and operations
of LDG for all periods presented.
NASRA
On November 27, 1996, the Company acquired all of the outstanding shares of
NASRA by issuing 1,136,400 shares of its Common Stock and a payment of $1.7
million in cash to one dissenting shareholder. This combination has been
accounted for as a pooling-of-interests. However, the Company's consolidated
financial statements have not been restated due to immateriality.
TRM
On January 24, 1997, the Company acquired all of the occupational accident
business of the TRM International, Inc. group of companies in exchange for
266,667 shares of the Company's Common Stock and $6.6 million in cash. This
acquisition has been accounted for as a purchase and results of operations of
the business acquired have been included in the consolidated statements of
earnings beginning in January, 1997. Cost in excess of net assets acquired
(goodwill) of approximately $13.5 million was recorded from this acquisition.
Goodwill is being amortized over twenty years. The results of operations of TRM
for the periods prior to the acquisition are immaterial to the Company's
consolidated results of operations.
F-14
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(2) ACQUISITIONS (CONTINUED)
INTERWORLD
On April 30, 1997, the Company acquired all of the outstanding shares of
Interworld Corporation in exchange for 725,000 shares of the Company's Common
Stock. This combination has been accounted for as a pooling-of-interests.
However, the Company's consolidated financial statements have not been restated
due to immateriality.
AVEMCO
On June 17, 1997, the Company issued 8,511,625 shares of its Common Stock
and 604,575 options to purchase its Common Stock to acquire all of the
outstanding common stock and options of AVEMCO. This business combination has
been accounted for as a pooling-of-interests and, accordingly, the Company's
consolidated financial statements have been restated to include the accounts and
operations of AVEMCO for all periods presented.
Separate total revenue and net earnings amounts of the merged entities are
presented for the periods prior to the merger in the following table:
FOR THE YEARS ENDED DECEMBER
FOR THE SIX MONTHS 31,
ENDED JUNE 30, ------------------------------
1997 1996 1995
------------------ -------------- --------------
Total revenue:
HCC....................................................... $ 81,598,000 $ 152,245,000 $ 127,209,000
AVEMCO.................................................... 59,446,000 118,134,000 106,776,000
------------------ -------------- --------------
Total revenue........................................... $ 141,044,000 $ 270,379,000 $ 233,985,000
------------------ -------------- --------------
------------------ -------------- --------------
Net earnings:
HCC....................................................... $ 21,295,000 $ 29,298,000 $ 24,337,000
AVEMCO (See Note 1)....................................... 718,000 9,232,000 7,351,000
------------------ -------------- --------------
Net earnings............................................ $ 22,013,000 $ 38,530,000 $ 31,688,000
------------------ -------------- --------------
------------------ -------------- --------------
MGU
On June 26, 1997, the Company acquired all of the outstanding shares of MGU
in exchange for 98,003 shares of the Company's Common Stock and a cash payment
of $3.6 million. This acquisition has been accounted for as a purchase and the
results of operations have been included in the consolidated statements of
earnings beginning in July, 1997. Cost in excess of net assets acquired
(goodwill) of approximately $6.2 million was recorded from this acquisition.
Goodwill is being amortized over twenty years. The results of operations of MGU
for the periods prior to the acquisition are immaterial to the Company's
consolidated results of operations.
CONTINENTAL
On July 31, 1997, the Company acquired all of the outstanding shares of
Continental Aviation Underwriters, Inc. in exchange for 17,354 shares of the
Company's Common Stock and a cash payment of $2.8 million. This acquisition has
been accounted for as a purchase and the results of operations have been
included in the consolidated statements of earnings beginning in August, 1997.
Cost in excess of net assets acquired (goodwill) of approximately $3.4 million
was recorded from this acquisition. Goodwill is being
F-15
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(2) ACQUISITIONS (CONTINUED)
amortized over twenty years. The results of operations of Continental for the
periods prior to the acquisition are immaterial to the Company's consolidated
results of operations.
SOUTHERN
On August 8, 1997, the Company acquired all of the outstanding shares of
Southern and Aviation Claims Administrators, Inc. in exchange for 225,000 shares
of the Company's Common Stock. These business combinations have been accounted
for as poolings-of-interests. However, the Company's consolidated financial
statements have not been restated due to immateriality.
KACHLER
On February 27, 1998, the Company acquired all of the outstanding shares of
The Kachler Corporation ("Kachler") in exchange for 1,600,000 shares of the
Company's Common Stock. This business combination will be accounted for as a
pooling-of-interests. Total revenue and net earnings of Kachler are immaterial
to the Company's results of operations.
GIR
Effective February 28, 1998, the Company acquired all of the outstanding
shares of Insurance Alternatives, Inc. and all of the assets and liabilities of
Guarantee Insurance Resources (collectively, "GIR") in exchange for 29,029
shares of the Company's Common Stock and a cash payment of $21.4 million. This
acquisition has been accounted for as a purchase and the results of operations
will be included in the consolidated statements of earnings beginning in March,
1998.
F-16
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(3) INVESTMENTS
Substantially all of the Company's fixed income securities are investment
grade; most are A rated or better. No high-yield corporate bonds are owned or
contemplated. The amortized cost, gross unrealized gain or loss and estimated
market value of investments in fixed income and marketable equity securities,
all of which are classified as available for sale, are as follows:
GROSS GROSS ESTIMATED
AMORTIZED UNREALIZED UNREALIZED MARKET
COST GAIN LOSS VALUE
-------------- ------------- -------------- --------------
December 31, 1997:
Marketable equity securities................... $ 10,221,000 $ 140,000 $ (2,022,000) $ 8,339,000
Redeemable preferred stock..................... 788,000 7,000 -- 795,000
US Treasury securities......................... 11,807,000 410,000 (3,000) 12,214,000
Obligations of states, municipalities and
political subdivisions....................... 382,108,000 14,883,000 (704,000) 396,287,000
Other.......................................... 418,000 -- (13,000) 405,000
-------------- ------------- -------------- --------------
Total securities............................. $ 405,342,000 $ 15,440,000 $ (2,742,000) $ 418,040,000
-------------- ------------- -------------- --------------
-------------- ------------- -------------- --------------
December 31, 1996:
Marketable equity securities................... $ 12,661,000 $ 378,000 $ (562,000) $ 12,477,000
Redeemable preferred stock..................... 8,060,000 81,000 (31,000) 8,110,000
US Treasury securities......................... 11,808,000 234,000 (17,000) 12,025,000
Obligations of states, municipalities and
political subdivisions....................... 351,581,000 6,777,000 (1,393,000) 356,965,000
Other.......................................... 395,000 60,000 -- 455,000
-------------- ------------- -------------- --------------
Total securities............................. $ 384,505,000 $ 7,530,000 $ (2,003,000) $ 390,032,000
-------------- ------------- -------------- --------------
-------------- ------------- -------------- --------------
The amortized cost and estimated market value of fixed income securities at
December 31, 1997, by contractual maturity, are shown below. Expected maturities
may differ from contractual maturities because borrowers may have the right to
call or prepay obligations with or without call or prepayment penalties.
ESTIMATED
AMORTIZED MARKET
COST VALUE
-------------- --------------
Due in 1 year or less............................................................ $ 13,126,000 $ 13,151,000
Due after 1 year through 5 years................................................. 123,137,000 126,691,000
Due after 5 years through 10 years............................................... 127,270,000 132,278,000
Due after 10 years through 15 years.............................................. 97,341,000 102,064,000
Due after 15 years............................................................... 34,247,000 35,517,000
-------------- --------------
Total fixed income securities................................................ $ 395,121,000 $ 409,701,000
-------------- --------------
-------------- --------------
As of December 31, 1997, the Company's insurance company subsidiaries had
deposited fixed income securities with an amortized cost of approximately $16.7
million (market: $17.3 million) to meet the deposit requirements of various
insurance departments.
F-17
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(3) INVESTMENTS (CONTINUED)
The sources of net investment income for the three years ended December 31,
1997, are detailed below:
1997 1996 1995
------------- ------------- -------------
Fixed income securities............................................. $ 20,937,000 $ 19,140,000 $ 16,668,000
Short-term investments.............................................. 5,672,000 3,900,000 4,129,000
Equity securities................................................... 711,000 1,114,000 1,361,000
Other............................................................... 445,000 18,000 152,000
------------- ------------- -------------
Total investment income........................................... 27,765,000 24,172,000 22,310,000
Investment expense.................................................. (47,000) (577,000) (562,000)
------------- ------------- -------------
Net investment income............................................. $ 27,718,000 $ 23,595,000 $ 21,748,000
------------- ------------- -------------
------------- ------------- -------------
All investments in fixed income securities were income producing for the
twelve months preceding December 31, 1997.
Realized pre-tax gain (loss) on the sale of investments is as follows:
GAIN LOSS NET
------------ ------------- ------------
For the year ended December 31, 1997:
Fixed income......................................................... $ 68,000 $ (242,000) $ (174,000)
Equity securities.................................................... 113,000 (268,000) (155,000)
------------ ------------- ------------
Realized gain (loss)............................................... $ 181,000 $ (510,000) $ (329,000)
------------ ------------- ------------
------------ ------------- ------------
For the year ended December 31, 1996:
Fixed income securities.............................................. $ 543,000 $ (514,000) $ 29,000
Equity securities.................................................... 9,002,000 (690,000) 8,312,000
------------ ------------- ------------
Realized gain (loss)............................................... $ 9,545,000 $ (1,204,000) $ 8,341,000
------------ ------------- ------------
------------ ------------- ------------
For the year ended December 31, 1995:
Fixed income securities.............................................. $ 1,005,000 $ (634,000) $ 371,000
Equity securities.................................................... 2,257,000 (994,000) 1,263,000
Other................................................................ 2,000 -- 2,000
------------ ------------- ------------
Realized gain (loss)............................................... $ 3,264,000 $ (1,628,000) $ 1,636,000
------------ ------------- ------------
------------ ------------- ------------
F-18
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(4) PROPERTY AND EQUIPMENT
The following table summarizes property and equipment at December 31, 1997
and 1996:
ESTIMATED
1997 1996 USEFUL LIFE
------------- ------------- ----------------
Buildings and improvements....................................... $ 13,291,000 $ 12,733,000 30 to 45 years
Furniture, fixtures and equipment................................ 13,203,000 11,285,000 3 to 10 years
Management information systems................................... 13,684,000 9,665,000 3 to 7 years
------------- ------------- ----------------
Total property and equipment................................. 40,178,000 33,683,000
Less accumulated depreciation and amortization................... (20,336,000) (17,018,000)
------------- -------------
Property and equipment, net.................................. $ 19,842,000 $ 16,665,000
------------- -------------
------------- -------------
Depreciation and amortization expense on property and equipment was
approximately $3.5 million, $3.4 million and $2.7 million for the years ended
December 31, 1997, 1996 and 1995, respectively.
(5) NOTES PAYABLE
Notes payable at December 31, 1997 and 1996 are shown in the table below.
The estimated fair value of the notes payable at December 31, 1997 and 1996,
which is based on current rates offered to the Company for debt with similar
terms, approximates the carrying value.
1997 1996
------------- -------------
First note......................................................................... $ -- $ 16,250,000
Second note........................................................................ -- 3,667,000
Line of credit..................................................................... -- 53,000,000
Facility........................................................................... 80,750,000 --
------------- -------------
Total notes payable............................................................ $ 80,750,000 $ 72,917,000
------------- -------------
------------- -------------
The first note was payable to a bank in quarterly installments of $1.5
million plus interest increasing to quarterly installments of $1.8 million plus
interest as of October 1, 1997. Interest was payable quarterly at the prime
rate. During February, 1994, the first note was amended changing the interest
rate to a fixed rate of 6 1/2% until February 7, 1997. The rate reverted back to
the prime rate after such date or could be set at London Interbank Offering Rate
("LIBOR") plus 2 1/4% at the Company's discretion. The note was collateralized
by all of the Common Stock of HC. The loan agreement contained certain
restrictive covenants, including restrictions on certain transactions in the
Company's capital stock or the capital stock of HC and the maintenance of
required financial ratios.
The second note represented a $10.0 million unsecured five-year term loan
with a bank. The loan was being repaid in 60 monthly principal installments of
$166,667, plus interest. Interest was payable on a fluctuating basis equal to
LIBOR plus 1.65%.
The outstanding advance at December 31, 1996, on the line of credit, was
owed to a bank that allowed AVEMCO to borrow up to $60.0 million through April
30, 1997. Interest was payable at the lower of the bank's floating prime rate or
the daily LIBOR plus 1.45%. The Company also had the option, at any time, to
convert any portion of the outstanding principal balance of the loan into term
notes, which could be amortized over any period not to extend beyond December
31, 2000. The line of credit facility required AVEMCO to maintain a consolidated
net worth, as defined, of $48.9 million. Other covenants provided for
F-19
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(5) NOTES PAYABLE (CONTINUED)
certain limitations on AVEMCO's liability to net worth ratio, cash flow to
current portion of long term debt, the acquisition, disposition and pledging of
assets, incurring of indebtedness, and required its insurance subsidiary to
maintain a certain statutory policyholders' surplus and net premium written to
policyholders' surplus ratio.
All of the above notes were repaid during 1997. Effective December 30, 1997,
the Company executed a $120.0 million revolving credit facility ("Facility")
with a group of banks. Borrowing under the Facility may be made by the Company
until the expiration of the Facility on December 30, 1999, at which time all
principal is due. Outstanding loans under the Facility bear interest at the
Company's option of either the prime rate (8 1/2% at December 31, 1997) or at
the current London Interbank Offering Rate ("LIBOR") (5.72% at December 31,
1997) plus 1%. The loan is collateralized in part by the common stock of HC and
AIC. The agreement contains restrictive covenants, including minimum net worth
requirements for the Company and certain subsidiaries, restrictions on certain
extraordinary corporate actions, notice requirements for certain material
occurrences and the maintenance of required financial ratios. The initial
funding from the Facility was used, among other things, to refinance the then
existing outstanding loans.
At December 31, 1997, HC maintained a revolving line of credit with a bank
in the maximum amount of $12.0 million available through April 30, 1998.
Advances under the line of credit are limited to amounts required to fund draws,
if any, on letters of credit issued by the bank on behalf of HC and short-term
direct cash advances. The line of credit is collateralized by securities having
an aggregate market value of up to $15.0 million, the actual amount of
collateral at any one time being 125% of the aggregate amount outstanding.
Interest on the line is payable at the bank's prime rate of interest (8 1/2% at
December 31, 1997). At December 31, 1997, letters of credit totaling $10.3
million had been issued to insurance companies by the bank on behalf of HC, with
total securities collateralizing the line of $12.9 million.
(6) INCOME TAX
Several of the Company's foreign subsidiaries are not subject to foreign
income taxes and no material foreign income tax expense was incurred for the
three years ended December 31, 1997. United States Federal income taxes are
provided on all foreign earnings. As of December 31, 1997 and 1996, the Company
had income taxes receivable (payable) of $3.7 million and ($1.3 million),
respectively. For Federal income tax purposes, LDG has approximately $11.4
million of net operating loss carry forwards which will expire in the year 2010.
The components of the income tax provision for the three years ended December
31, 1997, are as follows:
1997 1996 1995
------------- ------------- -------------
Current............................................................. $ 19,367,000 $ 17,709,000 $ 11,769,000
Deferred:
Change in net deferred tax at current enacted tax rate............ 4,074,000 (7,835,000) (1,868,000)
Change in deferred tax valuation allowance........................ (144,000) -- (17,000)
------------- ------------- -------------
Total income tax provision...................................... $ 23,297,000 $ 9,874,000 $ 9,884,000
------------- ------------- -------------
------------- ------------- -------------
F-20
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(6) INCOME TAX (CONTINUED)
The composition of deferred tax assets and liabilities and the related tax
effects as of December 31, 1997 and 1996, are as follows:
1997 1996
------------ -------------
Tax net operating loss carry forward................................................. $ 4,806,000 $ 7,820,000
Excess of financial unearned premium over tax........................................ 4,944,000 7,472,000
Effect of loss reserve discounting and salvage and subrogation accrual for tax....... 4,398,000 4,144,000
Bad debt and accrued expenses, deducted for financial over tax....................... 3,258,000 2,313,000
------------ -------------
Total assets..................................................................... 17,406,000 21,749,000
Excess of financial over currently taxable earnings from foreign subsidiaries........ 821,000 421,000
Unrealized gain on increase in value of securities available for sale (shareholders'
equity)............................................................................ 4,455,000 1,903,000
Deferred policy acquisition costs, net of ceding commissions, deductible for tax..... 3,136,000 5,091,000
Property and equipment depreciation and other items.................................. 2,355,000 1,698,000
------------ -------------
Total liabilities................................................................ 10,767,000 9,113,000
------------ -------------
Net deferred tax asset........................................................... $ 6,639,000 $ 12,636,000
------------ -------------
------------ -------------
Changes in the valuation allowance account applicable to the net deferred
tax asset are as follows:
1997 1996 1995
---------- --------- ---------
Balance, beginning of year...................................................... $ 54,000 $ -- $ 17,000
Increase charged (decrease credited) to income.................................. (144,000) -- (17,000)
Valuation allowance acquired.................................................... 188,000 54,000 --
---------- --------- ---------
Balance, end of year........................................................ $ 98,000 $ 54,000 $ 0
---------- --------- ---------
---------- --------- ---------
The following table summarizes the differences between the Company's
effective tax rate for financial statement purposes and the Federal statutory
rate:
1997 1996 1995
------------- ------------- -------------
Statutory tax rate........................................... 35.0% 35.0% 35.0%
Federal tax at statutory rate................................ $ 25,567,000 $ 16,941,000 $ 14,550,000
Nontaxable municipal bond interest and dividends received
deduction.................................................. (6,065,000) (5,792,000) (4,672,000)
State income taxes........................................... 2,242,000 102,000 430,000
Tax exempt status of S Corporation........................... -- (1,617,000) (722,000)
Deferred taxes at date of S Corporation conversion........... -- (680,000) --
Other, net (primarily non deductible expenses)............... 1,553,000 920,000 298,000
------------- ------------- -------------
Income tax provision..................................... $ 23,297,000 $ 9,874,000 $ 9,884,000
------------- ------------- -------------
------------- ------------- -------------
Effective tax rate....................................... 31.9% 20.4% 23.8%
------------- ------------- -------------
------------- ------------- -------------
F-21
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(7) SEGMENT AND GEOGRAPHIC DATA
The Company classifies its activities into two core business segments: 1)
property and casualty insurance company operations and 2) insurance agency and
brokerage operations. Corporate includes general corporate items, other
operations and inter-segment eliminations. The following table shows information
by business segment and geographic location:
CORPORATE
COMPANY AGENCY AND OTHER TOTAL
-------------- ------------- -------------- --------------
For the year ended December 31, 1997:
Revenue:
Domestic....................................... $ 171,713,000 $ 74,411,000 $ 8,616,000 $ 254,740,000
Foreign........................................ 14,967,000 3,703,000 -- 18,670,000
Inter-segment.................................. 1,380,000 4,280,000 (5,660,000) --
-------------- ------------- -------------- --------------
Total revenue................................ $ 188,060,000 $ 82,394,000 $ 2,956,000 $ 273,410,000
-------------- ------------- -------------- --------------
-------------- ------------- -------------- --------------
Net earnings:
Domestic....................................... $ 34,367,000 $ 20,726,000 $ (12,081,000) $ 43,012,000
Foreign........................................ 6,333,000 406,000 -- 6,739,000
-------------- ------------- -------------- --------------
Total net earnings........................... $ 40,700,000 $ 21,132,000 $ (12,081,000) $ 49,751,000
-------------- ------------- -------------- --------------
-------------- ------------- -------------- --------------
Depreciation and amortization.................... $ 1,453,000 $ 2,815,000 $ 895,000 $ 5,163,000
-------------- ------------- -------------- --------------
-------------- ------------- -------------- --------------
Capital expenditures............................. $ 2,838,000 $ 3,416,000 $ 464,000 $ 6,718,000
-------------- ------------- -------------- --------------
-------------- ------------- -------------- --------------
For the year ended December 31, 1996:
Revenue:
Domestic....................................... $ 186,272,000 $ 46,388,000 $ 13,267,000 $ 245,927,000
Foreign........................................ 20,730,000 3,722,000 -- 24,452,000
Inter-segment.................................. 600,000 763,000 (1,363,000) --
-------------- ------------- -------------- --------------
Total revenue................................ $ 207,602,000 $ 50,873,000 $ 11,904,000 $ 270,379,000
-------------- ------------- -------------- --------------
-------------- ------------- -------------- --------------
For the year ended December 31, 1996:
Net earnings:
Domestic....................................... $ 35,610,000 $ 149,000 $ (2,422,000) $ 33,337,000
Foreign........................................ 6,151,000 (958,000) -- 5,193,000
-------------- ------------- -------------- --------------
Total net earnings........................... $ 41,761,000 $ (809,000) $ (2,422,000) $ 38,530,000
-------------- ------------- -------------- --------------
-------------- ------------- -------------- --------------
Depreciation and amortization.................... $ 1,583,000 $ 1,378,000 $ 1,067,000 $ 4,029,000
-------------- ------------- -------------- --------------
-------------- ------------- -------------- --------------
Capital expenditures............................. $ 617,000 $ 1,818,000 $ 468,000 $ 2,903,000
-------------- ------------- -------------- --------------
-------------- ------------- -------------- --------------
F-22
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(7) SEGMENT AND GEOGRAPHIC DATA (CONTINUED)
Non-recurring compensation expense of $24.0 million (pre-tax) caused a net
loss for the agency segment during 1996.
CORPORATE
COMPANY AGENCY AND OTHER TOTAL
-------------- ------------- ------------- --------------
For the year ended December 31, 1995:
Revenue:
Domestic........................................ $ 164,051,000 $ 38,185,000 $ 11,816,000 $ 214,052,000
Foreign......................................... 16,545,000 3,388,000 -- 19,933,000
Inter-segment................................... 474,000 383,000 (857,000) --
-------------- ------------- ------------- --------------
Total revenue................................. $ 181,070,000 $ 41,956,000 $ 10,959,000 $ 233,985,000
-------------- ------------- ------------- --------------
-------------- ------------- ------------- --------------
Net earnings:
Domestic........................................ $ 25,108,000 $ 4,367,000 $ (3,487,000) $ 25,988,000
Foreign......................................... 5,240,000 460,000 -- 5,700,000
-------------- ------------- ------------- --------------
Total net earnings............................ $ 30,348,000 $ 4,827,000 $ (3,487,000) $ 31,688,000
-------------- ------------- ------------- --------------
-------------- ------------- ------------- --------------
Depreciation and amortization..................... $ 1,072,000 $ 1,275,000 $ 996,000 $ 3,343,000
-------------- ------------- ------------- --------------
-------------- ------------- ------------- --------------
Capital expenditures.............................. $ 2,411,000 $ 1,306,000 $ 1,311,000 $ 5,028,000
-------------- ------------- ------------- --------------
-------------- ------------- ------------- --------------
Identifiable assets by business segment and geographic location are shown in
the following table:
CORPORATE
COMPANY AGENCY AND OTHER TOTAL
-------------- -------------- ------------- ----------------
December 31, 1997:
Domestic..................................... $ 811,462,000 $ 270,691,000 $ 42,874,000 $ 1,125,027,000
Foreign...................................... 66,572,000 31,164,000 -- 97,736,000
-------------- -------------- ------------- ----------------
Total identifiable assets.................. $ 878,034,000 $ 301,855,000 $ 42,874,000 $ 1,222,763,000
-------------- -------------- ------------- ----------------
-------------- -------------- ------------- ----------------
December 31, 1996:
Domestic..................................... $ 666,117,000 $ 136,553,000 $ 37,625,000 $ 840,295,000
Foreign...................................... 98,863,000 24,941,000 -- 123,804,000
-------------- -------------- ------------- ----------------
Total identifiable assets.................. $ 764,980,000 $ 161,494,000 $ 37,625,000 $ 964,099,000
-------------- -------------- ------------- ----------------
-------------- -------------- ------------- ----------------
During the years ended December 31, 1997, 1996 and 1995, one broker in
London, England, produced gross written premium ("GWP") to the Company of
approximately $42.8 million, $25.7 million and $31.2 million, respectively. This
represents 12%, 7% and 11% of the Company's total GWP for those years.
F-23
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(7) SEGMENT AND GEOGRAPHIC DATA (CONTINUED)
The Company has insureds and/or reinsureds in approximately 100 countries
world-wide. The following table shows the geographical distribution of GWP
written by the domestic insurance company subsidiaries based on location of the
insureds and reinsureds for the three years ended December 31, 1997:
1997 1996 1995
--------------------------- --------------------------- ---------------------------
GWP % GWP % GWP %
-------------- ----------- -------------- ----------- -------------- -----------
United States........................ $ 224,833,000 68% $ 194,546,000 62% $ 187,826,000 59%
Europe............................... 24,581,000 7 39,135,000 12 47,022,000 15
South America........................ 24,492,000 7 26,033,000 8 30,093,000 9
Central America...................... 15,109,000 5 19,253,000 6 22,241,000 7
Other................................ 42,316,000 13 36,525,000 12 33,269,000 10
-------------- --- -------------- --- -------------- ---
Total GWP........................ $ 331,331,000 100% $ 315,492,000 100% $ 320,451,000 100%
-------------- --- -------------- --- -------------- ---
-------------- --- -------------- --- -------------- ---
(8) REINSURANCE
In the normal course of business the Company's insurance company
subsidiaries cede a substantial portion of their premium to non-affiliated
domestic and foreign reinsurers through quota share, surplus, excess of loss and
facultative reinsurance agreements. Although the ceding of reinsurance does not
discharge the primary insurer from liability to its policyholder, the
subsidiaries participate in such agreements for the purpose of limiting their
loss exposure and diversifying their business. Substantially all of the
reinsurance assumed by the Company's insurance company subsidiaries was
underwritten directly by the Company but issued by other non-affiliated
companies in order to satisfy local licensing or other requirements. The
following table represents the effect of such reinsurance transactions on net
premium and loss and loss adjustment expense:
LOSS AND LOSS
ADJUSTMENT
WRITTEN PREMIUM EARNED PREMIUM EXPENSE
--------------- --------------- ---------------
For the year ended December 31, 1997:
Direct business............................................ $ 177,728,000 $ 174,533,000 $ 126,861,000
Reinsurance assumed........................................ 168,671,000 180,339,000 165,831,000
Reinsurance ceded.......................................... (203,027,000) (191,782,000) (196,178,000)
--------------- --------------- ---------------
Net amounts.............................................. $ 143,372,000 $ 163,090,000 $ 96,514,000
--------------- --------------- ---------------
--------------- --------------- ---------------
For the year ended December 31, 1996:
Direct business............................................ $ 178,969,000 $ 186,417,000 $ 122,940,000
Reinsurance assumed........................................ 158,309,000 146,606,000 105,085,000
Reinsurance ceded.......................................... (149,003,000) (157,714,000) (113,561,000)
--------------- --------------- ---------------
Net amounts.............................................. $ 188,275,000 $ 175,309,000 $ 114,464,000
--------------- --------------- ---------------
--------------- --------------- ---------------
For the year ended December 31, 1995:
Direct business............................................ $ 191,068,000 $ 173,012,000 $ 131,255,000
Reinsurance assumed........................................ 148,037,000 128,924,000 79,705,000
Reinsurance ceded.......................................... (154,780,000) (142,348,000) (105,586,000)
--------------- --------------- ---------------
Net amounts.............................................. $ 184,325,000 $ 159,588,000 $ 105,374,000
--------------- --------------- ---------------
--------------- --------------- ---------------
F-24
HCC INSURANCE HOLDINGS,INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(8) REINSURANCE (CONTINUED)
The table below represents the composition of reinsurance recoverables in
the accompanying consolidated balance sheets:
1997 1996
-------------- --------------
Reinsurance recoverable on paid losses....................... $ 50,461,000 $ 22,977,000
Reinsurance recoverable on outstanding losses................ 140,516,000 102,350,000
Reinsurance recoverable on IBNR.............................. 14,858,000 9,416,000
Reserve for uncollectible reinsurance........................ (2,535,000) (2,415,000)
-------------- --------------
Total reinsurance recoverables........................... $ 203,300,000 $ 132,328,000
-------------- --------------
-------------- --------------
The insurance company subsidiaries require reinsurers not authorized by
their respective states of domicile to collateralize their reinsurance
obligations to the Company with letters of credit or cash deposits. At December
31, 1997, the Company held letters of credit and cash deposits in the amounts of
$93.9 million and $8.6 million, respectively, to collateralize certain
reinsurance balances. The Company has established a reserve of $2.5 million as
of December 31, 1997, to reduce the effects of any recoverable problem.
In order to minimize its exposure to reinsurance credit risk, the Company
evaluates the financial condition of its reinsurers and places its reinsurance
with a diverse group of financially sound companies. The following table shows
reinsurance balances relating to the reinsurers with a total recoverable balance
greater than $10.0 million and the collateral and potential offsets held by the
Company as of each year end:
REINSURANCE LETTERS OF
RECOVERABLES AND CREDIT, CASH
CEDED UNEARNED DEPOSITS AND
REINSURER LOCATION PREMIUM OTHER PAYABLES
- -------------------------------------------------------- ------------------- ---------------- ----------------
December 31, 1997:
Underwriters at Lloyd's............................... London, England $ 31,687,000 $ 17,778,000
Underwriters Indemnity Company........................ Houston, TX 28,925,000 6,825,000
Reinsurance Australia Corporation, Ltd................ Sydney, Australia 28,921,000 31,965,000
SCOR Reinsurance Company.............................. New York, NY 23,625,000 10,707,000
AXA Reinsurance Company............................... Wilmington, DE 21,004,000 7,790,000
GIO Insurance Limited................................. Sydney, Australia 18,610,000 20,551,000
New Cap Reinsurance Corporation, Ltd.................. Sydney, Australia 18,496,000 16,295,000
Reliance Insurance Company............................ Philadelphia, PA 10,991,000 1,553,000
December 31, 1996:
Underwriters at Lloyd's............................... London, England $ 28,987,000 $ 18,446,000
GIO Insurance Limited................................. Sydney, Australia 25,204,000 26,106,000
Reinsurance Australia Corporation, Ltd................ Sydney, Australia 20,562,000 19,332,000
Underwriters Indemnity Company........................ Houston, TX 12,531,000 5,934,000
SCOR Reinsurance Company.............................. New York, NY 11,105,000 2,428,000
AXA Reinsurance Company............................... Wilmington, DE 10,402,000 2,759,000
Approximately $2.2 million in recoverables is due from reinsurers that are
either under regulatory supervision or insolvent. The Company holds letters of
credit and cash deposits totaling $2.0 million to collateralize these balances
plus other credits of $1.1 million available for potential offset. The Company
is
F-25
HCC INSURANCE HOLDINGS,INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(8) REINSURANCE (CONTINUED)
involved in a dispute with two reinsurers over coverage and other issues. The
Company believes the reinsurers' positions are without merit and all amounts due
from the reinsurers will be recovered. The total amount in dispute is
approximately $3.5 million.
(9) COMMITMENTS AND CONTINGENCIES
LITIGATION
The Company is a party to numerous lawsuits arising in the normal course of
business. Many of the pending lawsuits involve claims under policies
underwritten or reinsured by the Company, which management believes have been
adequately included in its established loss reserves. The Company believes the
resolution of these lawsuits will not have a material adverse effect on its
financial condition, results of operations or cash flows.
FOREIGN CURRENCY FORWARD CONTRACTS
From time to time the Company enters into foreign currency forward contracts
as a hedge against foreign currency fluctuations, primarily GBP. The Company's
balances denominated in foreign currency fluctuate as transactions are recorded
and settled. During 1997, the average GBP liability, for subsidiaries whose
functional currency was the United States dollar, was approximately L793,000
($1.3 million at the December 31, 1997, rate of exchange) which was hedged by an
average open forward contract balance of approximately L125,000 ($206,000 at the
December 31, 1997, rate of exchange). There are no open foreign currency forward
contracts as of December 31, 1997. The Company may continue to limit its
exposure to currency fluctuations through the use of foreign currency forward
contracts.
The Company utilizes these foreign currency forward contracts strictly as a
hedge against existing exposure to foreign currency fluctuations and it does not
do so as any form of speculative or trading investment.
LEASES
The Company leases administrative office facilities under long-term
non-cancelable operating lease agreements expiring at various dates through
November, 2005. The agreements generally require the payment of utilities, real
estate taxes, insurance and repairs. The Company has recognized rent expense on
a straight-line basis over the terms of these leases. In addition, the Company
leases computer equipment and automobiles under operating leases expiring at
various dates through the year 2002. Rent expense under these leases amounted to
$3.7 million, $2.5 million and $2.0 million for the years ended December 31,
1997, 1996 and 1995, respectively.
F-26
HCC INSURANCE HOLDINGS,INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(9) COMMITMENTS AND CONTINGENCIES (CONTINUED)
At December 31, 1997, future minimum annual rental payments required under
the long-term non-cancelable operating leases, excluding certain expenses
payable by the Company, are as follows:
FOR THE YEARS ENDED DECEMBER 31, AMOUNT DUE
- --------------------------------------------------------------------------------------------------- -------------
1998..................................................................................... $ 4,189,000
1999..................................................................................... 3,917,000
2000..................................................................................... 3,618,000
2001..................................................................................... 3,112,000
2002..................................................................................... 1,747,000
Thereafter......................................................................................... 1,212,000
-------------
Total future minimum annual rental payments due.................................................... $ 17,795,000
-------------
-------------
SYSTEMS SOFTWARE
The Company is committed to purchase and install major new systems software,
principally at its insurance company subsidiaries, in 1998. The approximate cost
of that software is $4.4 million.
CATASTROPHE EXPOSURE
The Company writes business in areas exposed to catastrophic losses and has
significant exposures to this type of loss in California, the Atlantic Coast of
the United States, certain United States Gulf Coast states, particularly Florida
and Texas, the Caribbean and Mexico. The Company carefully assesses its overall
exposures to a single catastrophic event and applies procedures that it believes
are more conservative than are typically used by the industry to ascertain the
Company's probable maximum loss ("PML") from any single event. The Company
maintains reinsurance protection which it believes is sufficient to cover any
foreseeable event.
(10) RELATED PARTY TRANSACTIONS
Certain of the Company's directors are officers, directors or owners of
business entities with which the Company transacts business. Balances with these
business entities and other related parties included in the accompanying
consolidated balance sheets are as follows:
1997 1996
------------- ------------
Reinsurance recoverables............................................................. $ 21,191,000 $ 3,472,000
Premiums, claims and other receivables............................................... 2,677,000 2,250,000
Ceded unearned premium............................................................... 7,734,000 9,059,000
Other assets, net.................................................................... 2,892,000 773,000
Loss and loss adjustment expense payable............................................. 661,000 663,000
Reinsurance balances payable......................................................... 5,564,000 3,780,000
Premium payable...................................................................... 1,754,000 1,532,000
Accounts payable and accrued liabilities............................................. 325,000 --
F-27
HCC INSURANCE HOLDINGS,INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(10) RELATED PARTY TRANSACTIONS (CONTINUED)
Transactions with these business entities and other related parties included
in the accompanying consolidated statements of earnings are as follows:
1997 1996 1995
------------ ------------ ----------
Gross earned premium..................................................... $ 672,000 $ 871,000 $ --
Ceded earned premium..................................................... 16,041,000 12,050,000 1,194,000
Commission income........................................................ 1,267,000 1,249,000 --
Investment income........................................................ 405,000 -- --
Gross loss and loss adjustment expense................................... 671,000 661,000 106,000
Ceded loss and loss adjustment expense................................... 17,868,000 5,852,000 185,000
Other operating expense.................................................. 807,000 1,011,000 758,000
During 1995, $63,000 was paid to a related party for construction management
services related to improvements to the Company's offices in Houston, Texas.
During 1997, the Company committed to invest $5.0 million in an investment
partnership managed by a related party. At December 31, 1997, no amount had been
invested under this commitment.
(11) EMPLOYEE BENEFIT PLANS
The Company has defined contribution retirement plans under Section 401(k)
of the Internal Revenue Code which cover substantially all of the domestic
employees who meet specified service requirements. The Company's contributions
of these plans are based on varying percentages of the employees' contributions,
up to varying maximum levels. The Company contributed $858,000, $997,000 and
$1,113,000 to the plans for the years ended December 31, 1997, 1996 and 1995,
respectively, which is included in compensation expense in the accompanying
consolidated statements of earnings.
AVEMCO had a non-contributory defined benefit retirement plan covering
substantially all of its employees who met specified age and service
requirements. Benefits were based on years of service and final average
compensation and were integrated with the provisions of the Federal Insurance
Compensation Act (Social Security), as provided for in the plan. Pension plan
assets are a diversified mix of stock and bond mutual funds. AVEMCO's funding
policy was to contribute amounts that met minimum funding requirements, but
which did not exceed the maximum funding limits as currently determined under
applicable tax regulations. This plan was terminated at December 31, 1997, at
which time the participants' accounts became fully vested. At December 31, 1997,
the vested benefits, calculated utilizing an interest rate of 7.25%, amounted to
$6.0 million and the fair value of the assets of the plan was $8.1 million. In
accordance with applicable regulations, the plan's assets will be distributed to
participants during 1998. The Company is not obligated for contributions to the
plan subsequent to December 31, 1997. It is expected that the assets of the plan
will be sufficient to cover the vested benefits which are to be paid to the
participants.
Total pension expense (credit) under the AVEMCO plan amounted to $0,
($590,000), and $512,000 for the years ended December 31, 1997, 1996 and 1995,
respectively. A curtailment gain of $1,044,000 was recognized in the 1996
pension credit as a result of AVEMCO's decision to eliminate certain future
service time credits.
F-28
HCC INSURANCE HOLDINGS,INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(12) SHAREHOLDERS' EQUITY
Under the Texas Insurance Code, HC must maintain minimum statutory capital
of $1,000,000 and minimum statutory surplus of $1,000,000, and can only pay
dividends out of surplus funds. In addition, HC is limited in the amount of
dividends which it may pay in any twelve month period, without prior regulatory
approval, to the greater of statutory net investment income for the prior
calendar year or ten percent (10%) of statutory capital and surplus as of the
prior calendar year end. During 1998, HC's ordinary dividend capacity will be
approximately $23.3 million.
AIC is limited by the state of Maryland in the amount of dividends which it
may pay in any twelve month period, without prior regulatory approval, to the
greater of statutory net income for the prior calendar year or ten percent (10%)
of statutory capital and surplus as of the prior year end. On December 30, 1997,
AIC paid an extraordinary dividend of $13.7 million, which was approved by the
Maryland Insurance Administration. AIC needs prior regulatory approval for all
dividends until December 30, 1998, at which time AIC's ordinary dividend
capacity will become approximately $6.8 million.
As of December 31, 1997, all of the domestic insurance company subsidiaries
total adjusted capital greatly exceeded the NAIC authorized control level
risk-based capital.
(13) STOCK OPTIONS
The Company has five option plans, the 1994 Non-employee Director Stock
Option Plan, the 1996 Non-employee Director Stock Option Plan, the 1992
Incentive Stock Option Plan, the 1995 Flexible Incentive Plan, and the 1997
Flexible Incentive Plan. All plans are administered by the Compensation
Committee of the Board of Directors. Each option may be used to purchase one
share of Common Stock of the Company. As of December 31, 1997, 5,987,251 shares
of Common Stock were reserved for the exercise of options, of which 3,508,226
shares were reserved for options previously granted and 2,479,025 shares were
reserved for future issuances of options.
Options generally vest over a one, three or five year period and expire ten
years after grant date. All options have been granted at fixed exercise prices,
generally at the market price of the Company's Common Stock on the grant date.
Any excess of the market price on the grant date over the exercise price is
recognized as compensation expense in the accompanying consolidated financial
statements. During 1996, such compensation expense amounted to $494,000. If the
fair value method of valuing compensation related to options would have been
used, pro forma net earnings and pro forma diluted earnings per share would have
been $43.8 million, or $0.94 per share for the year ended December 31, 1997, and
$37.5 million, or $0.84 per share, for the year ended December 31, 1996. The pro
forma compensation cost for the year ended December 31, 1995, is less than
$100,000. The fair value of each option grant was estimated on the grant date
using the Black-Scholes single option pricing model with the following weighted
average assumptions: a) risk free interest rate of 6.2% for 1997, 5.6% for 1996
and 6.6% for 1995, b) expected volatility factor of .3, c) dividend yield of
.56% for 1997, .3% for 1996 and 0% for 1995, and d) expected option life of five
years for 1997 and six years for 1996 and 1995.
F-29
HCC INSURANCE HOLDINGS,INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(13) STOCK OPTIONS (CONTINUED)
Stock option activity is shown below after adjustment for the effects of the
five-for-two stock split payable as a 150% stock dividend to shareholders of
record April 30, 1996 (See Note 1.)
1997 1996 1995
------------------------------------ ---------------------------------- -----------------------
AVERAGE AVERAGE AVERAGE AVERAGE
NUMBER OF EXERCISE AVERAGE NUMBER OF EXERCISE FAIR NUMBER OF EXERCISE
SHARES PRICE FAIR VALUE SHARES PRICE VALUE SHARES PRICE
---------- ----------- ----------- ---------- ----------- --------- ---------- -----------
Outstanding, beginning of
year......................... 3,124,793 $ 13.03 2,935,863 $ 11.71 2,076,212 $ 10.76
Granted at market value........ 1,301,500 22.88 $ 7.98 292,500 23.63 $ 9.87 1,078,751 12.29
Granted below market value..... -- -- -- 60,000 13.01 11.51 16,000 7.70
Cancelled...................... (123,700) 24.37 (12,250) 11.51 (77,184) 7.54
Exercised...................... (530,542) 12.80 (120,420) 4.52 (147,191) 3.92
AVEMCO option activity prior to
combination:
Granted at market value........ -- -- -- 45,600 15.25 4.69 9,000 16.44
Cancelled...................... (1,375) 15.84 (61,850) 20.02 (11,925) 20.10
Exercised...................... (262,450) 16.00 (14,650) 8.54 (7,800) 11.15
---------- ----------- ---------- ----------- ---------- -----------
Outstanding, end of year....... 3,508,226 $ 16.22 3,124,793 $ 13.03 2,935,863 $ 11.71
---------- ----------- ---------- ----------- ---------- -----------
---------- ----------- ---------- ----------- ---------- -----------
Exercisable, end of year....... 1,230,145 $ 11.60 1,491,792 $ 12.72 1,167,342 $ 12.29
---------- ----------- ---------- ----------- ---------- -----------
---------- ----------- ---------- ----------- ---------- -----------
AVERAGE
FAIR VALUE
-----------
Outstanding, beginning of
year.........................
Granted at market value........ $ 4.99
Granted below market value..... 5.70
Cancelled......................
Exercised......................
AVEMCO option activity prior to
combination:
Granted at market value........ 4.91
Cancelled......................
Exercised......................
Outstanding, end of year.......
Exercisable, end of year.......
Options outstanding at December 31, 1997, are shown on the following
schedule:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
----------------------------------------
AVERAGE -----------------------
REMAINING AVERAGE AVERAGE
NUMBER OF CONTRACTUAL EXERCISE NUMBER OF EXERCISE
RANGE OF EXERCISE PRICES SHARES LIFE PRICE SHARES PRICE
- ---------------------------------------------------------- ---------- --------------- ----------- ---------- -----------
Under $10.00.............................................. 743,829 4.63 years $ 6.26 459,615 $ 5.52
$10.01--$15.00............................................ 1,006,747 7.89 12.39 511,130 12.36
$15.01--$21.00............................................ 160,300 4.95 17.11 120,300 16.50
Over $21.00............................................... 1,597,350 8.75 23.18 139,100 24.70
---------- --------------- ----------- ---------- -----------
Total options............................................. 3,508,226 7.46 years $ 16.22 1,230,145 $ 11.60
---------- --------------- ----------- ---------- -----------
---------- --------------- ----------- ---------- -----------
F-30
HCC INSURANCE HOLDINGS,INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(14) EARNINGS PER SHARE
The following table provides reconciliation of the denominators used in the
earnings per share calculations for the three years ended December 31, 1997:
1997 1996 1995
------------- ------------- -------------
Net earnings........................................................ $ 49,751,000 $ 38,530,000 $ 31,688,000
------------- ------------- -------------
------------- ------------- -------------
Reconciliation of number of shares outstanding:
Shares of Common Stock outstanding at year end...................... 46,159,000 44,115,000 17,299,000
Changes in Common Stock due to issuance............................. (764,000) (920,000) (908,000)
Effect of five-for-two stock split.................................. -- -- 24,586,000
------------- ------------- -------------
Weighted average Common Stock outstanding......................... 45,395,000 43,195,000 40,977,000
Additional dilutive effect of outstanding options (as determined by
the application of the treasury stock method)..................... 1,214,000 1,248,000 215,000
Effect of five-for-two stock split.................................. -- -- 321,000
------------- ------------- -------------
Weighted average Common Stock and potential common stock
outstanding....................................................... 46,609,000 44,443,000 41,513,000
------------- ------------- -------------
------------- ------------- -------------
As of December 31, 1997, there were 142,183 options that were not included
in the computation of diluted earnings per share because to do so would have
been antidilutive.
(15) STATUTORY TO GAAP RECONCILIATIONS
Reconciliations of statutory policyholders' surplus as of December 31, 1997
and 1996, and net income for the three years ended December 31, 1997, of the
Company's insurance company subsidiaries included
F-31
HCC INSURANCE HOLDINGS,INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(15) STATUTORY TO GAAP RECONCILIATIONS (CONTINUED)
in those companies' respective filings with regulatory authorities to the
amounts shown in the accompanying consolidated financial statements on the basis
of GAAP are as follows:
1997 1996
-------------- --------------
Statutory policyholders' surplus................................................. $ 331,922,000 $ 288,863,000
Difference in carrying value of fixed income securities.......................... 11,970,000 4,519,000
Difference in unearned premium................................................... 1,653,000 (4,309,000)
Assets non-admitted for statutory reporting...................................... 4,390,000 3,770,000
Deferred policy acquisition costs net of deferred ceding commissions capitalized
for GAAP....................................................................... 2,713,000 7,303,000
Deferred income taxes recorded for GAAP.......................................... 3,899,000 5,175,000
Statutory provisions for reinsurance, net of GAAP reserve for uncollectible
reinsurance.................................................................... 5,838,000 2,904,000
Excess of statutory reserves over statement reserves............................. -- 2,511,000
Other............................................................................ -- (2,662,000)
-------------- --------------
Shareholder's equity of insurance company subsidiaries on basis of GAAP........ 362,385,000 308,074,000
Equity attributable to non-insurance company parent and subsidiaries, net of
elimination entries in consolidation......................................... 3,095,000 (11,661,000)
-------------- --------------
Total shareholders' equity per accompanying consolidated financial
statements................................................................... $ 365,480,000 $ 296,413,000
-------------- --------------
-------------- --------------
1997 1996 1995
------------- ------------- -------------
Statutory net income................................................ $ 56,626,000 $ 45,079,000 $ 31,102,000
Difference in unearned premium...................................... 285,000 (4,175,000) (881,000)
Deferred income tax benefit not recorded for statutory purposes..... 380,000 552,000 1,886,000
Change in deferred policy acquisition costs and deferred ceding
commissions capitalized for GAAP.................................. (5,647,000) 3,279,000 503,000
Gain on transfer of subsidiary, eliminated for GAAP................. (4,663,000) -- --
Provision for reinsurance not expensed for statutory purposes....... -- 100,000 (900,000)
Other, net.......................................................... (30,000) 195,000 517,000
------------- ------------- -------------
Net income of insurance company subsidiaries on basis of GAAP..... 46,951,000 45,030,000 32,227,000
Net income (loss) attributable to non-insurance parent and
subsidiaries...................................................... 2,800,000 (6,500,000) (539,000)
------------- ------------- -------------
Net earnings per accompanying consolidated financial statements... $ 49,751,000 $ 38,530,000 $ 31,688,000
------------- ------------- -------------
------------- ------------- -------------
F-32
HCC INSURANCE HOLDINGS,INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(16) SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental cash flow information for the three years ended December 31,
1997, is summarized below:
1997 1996 1995
------------- ------------- -------------
Interest paid....................................................... $ 6,712,000 $ 5,027,000 $ 6,344,000
Income tax paid..................................................... 24,132,000 16,426,000 10,747,000
Dividends declared but not paid at year end......................... 1,386,000 717,000 --
The unrealized gain or loss on securities available for sale, deferred taxes
related thereto, and the issuance of the Company's Common Stock for the purchase
of subsidiaries are non-cash transactions which have been included as direct
increases or decreases in shareholders' equity. During the year ended December
31, 1995, non-cash contributions to LDG's additional paid-in capital of $50,000
were recorded by a reduction in certain payable balances.
(17) LIABILITY FOR UNPAID LOSS AND LOSS ADJUSTMENT EXPENSE
The following table provides a reconciliation of the liability of loss and
loss adjustment expense ("LAE"), for the three years ended December 31, 1997:
1997 1996 1995
-------------- -------------- --------------
Reserves for loss and LAE at beginning of the year.............. $ 229,049,000 $ 200,756,000 $ 170,957,000
Less reinsurance recoverables................................... 111,766,000 101,497,000 95,279,000
-------------- -------------- --------------
Net reserves at beginning of the year....................... 117,283,000 99,259,000 75,678,000
Net reserves acquired with purchase of subsidiary............... 1,919,000 -- --
Provision for loss and LAE for claims occurring in the current
year.......................................................... 100,288,000 119,401,000 108,140,000
Increase (decrease) in estimated loss and LAE for claims
occurring in prior years...................................... (3,774,000) (4,937,000) (2,766,000)
-------------- -------------- --------------
Incurred loss and LAE, net of reinsurance..................... 96,514,000 114,464,000 105,374,000
-------------- -------------- --------------
Loss and LAE payments for claims occurring during:
Current year.................................................... 48,208,000 54,493,000 45,291,000
Prior years..................................................... 47,874,000 41,947,000 36,502,000
-------------- -------------- --------------
Loss and LAE payments, net of reinsurance..................... 96,082,000 96,440,000 81,793,000
-------------- -------------- --------------
Net reserves at end of the year................................. 119,634,000 117,283,000 99,259,000
Plus reinsurance recoverables................................... 155,374,000 111,766,000 101,497,000
-------------- -------------- --------------
Reserves for loss and LAE at end of the year................ $ 275,008,000 $ 229,049,000 $ 200,756,000
-------------- -------------- --------------
-------------- -------------- --------------
F-33
HCC INSURANCE HOLDINGS,INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(18) QUARTERLY FINANCIAL DATA (UNAUDITED)
FOURTH QUARTER THIRD QUARTER SECOND QUARTER FIRST QUARTER
1997 1997 1997 1997
-------------- ------------- -------------- -------------
Net earned premium................................ $ 38,659,000 $31,622,000 $ 48,134,000 $ 44,675,000
Management fee and commission income.............. 25,722,000 17,946,000 16,142,000 16,057,000
Net investment income............................. 7,294,000 7,695,000 6,526,000 6,203,000
Total revenue..................................... 73,294,000 59,072,000 72,519,000 68,525,000
Loss and loss adjustment expense.................. 25,977,000 14,467,000 29,452,000 26,618,000
Merger expense.................................... 487,000 305,000 5,404,000 1,873,000
Total expense..................................... 59,202,000 33,548,000 57,779,000 49,833,000
Earnings before income tax provision.............. 14,092,000 25,524,000 14,740,000 18,692,000
Income tax provision.............................. 3,472,000 8,406,000 5,758,000 5,661,000
-------------- ------------- -------------- -------------
Net earnings...................................... $ 10,620,000 $17,118,000 $ 8,982,000 $ 13,031,000
-------------- ------------- -------------- -------------
-------------- ------------- -------------- -------------
Basic earnings per share data:
Earnings per share................................ $ 0.23 $ 0.37 $ 0.20 $ 0.29
-------------- ------------- -------------- -------------
-------------- ------------- -------------- -------------
Weighted average shares outstanding............... 46,096,000 45,831,000 45,120,000 44,515,000
-------------- ------------- -------------- -------------
-------------- ------------- -------------- -------------
Diluted earnings per share data:
Earnings per share................................ $ 0.23 $ 0.36 $ 0.19 $ 0.28
-------------- ------------- -------------- -------------
-------------- ------------- -------------- -------------
Weighted average shares outstanding............... 47,036,000 47,122,000 46,383,000 45,848,000
-------------- ------------- -------------- -------------
-------------- ------------- -------------- -------------
A charge of $10.0 million (pre tax) for reserve strengthening was recorded
during the fourth quarter of 1997.
F-34
HCC INSURANCE HOLDINGS,INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(18) QUARTERLY FINANCIAL DATA (UNAUDITED) (CONTINUED)
FOURTH QUARTER THIRD QUARTER SECOND QUARTER FIRST QUARTER
1996 1996 1996 1996
-------------- ------------- -------------- -------------
Net earned premium................................ $ 49,673,000 $41,394,000 $ 41,953,000 $ 42,289,000
Management fee and commission income.............. 12,082,000 13,143,000 13,750,000 12,381,000
Net investment income............................. 6,269,000 5,892,000 5,742,000 5,692,000
Total revenue..................................... 71,426,000 67,841,000 67,506,000 63,606,000
Loss and loss adjustment expense.................. 30,652,000 30,155,000 26,421,000 27,236,000
Merger expense.................................... -- -- 24,984,000 1,176,000
Total expense..................................... 51,637,000 49,268,000 72,333,000 48,737,000
Earnings (loss) before income tax provision....... 19,789,000 18,573,000 (4,827,000) 14,869,000
Income tax provision (benefit).................... 5,495,000 5,394,000 (4,354,000) 3,339,000
-------------- ------------- -------------- -------------
Net earnings (loss)............................... $ 14,294,000 $13,179,000 $ (473,000) $ 11,530,000
-------------- ------------- -------------- -------------
-------------- ------------- -------------- -------------
Basic earnings (loss) per share data:
Earnings (loss) per share......................... $ 0.33 $ 0.31 $ (0.01) $ 0.27
-------------- ------------- -------------- -------------
-------------- ------------- -------------- -------------
Weighted average shares outstanding............... 43,365,000 42,986,000 43,097,000 43,333,000
-------------- ------------- -------------- -------------
-------------- ------------- -------------- -------------
Diluted earnings (loss) per share data:
Earnings (loss) per share......................... $ 0.32 $ 0.30 $ (0.01) $ 0.26
-------------- ------------- -------------- -------------
-------------- ------------- -------------- -------------
Weighted average shares outstanding............... 44,718,000 44,356,000 44,263,000 44,384,000
-------------- ------------- -------------- -------------
-------------- ------------- -------------- -------------
All amounts have been restated to include the accounts and operations of LDG
and AVEMCO (See Note 2). All share and per share data have been retroactively
adjusted to reflect the effects of the shares issued in connection with the
combination with LDG and AVEMCO (See Note 1).
F-35
REPORT OF INDEPENDENT ACCOUNTANTS
Our report on the consolidated financial statements of HCC Insurance
Holdings, Inc. and Subsidiaries is included on page F-1 of this Form 10-K. Such
report states that for the years ended December 31, 1996 and 1995, our opinion,
insofar as it relates to data included for AVEMCO Corporation for 1996 and 1995,
is based solely on the report of the other auditors. In connection with our
audits and the report of other auditors, we have also audited the related
financial statement schedules listed in the index of this Form 10-K. Our opinion
on the financial statement schedules, insofar as it relates to data included for
AVEMCO Corporation for 1996 and 1995, is based solely on the report of the other
auditors.
In our opinion, based on our audits and the report of other auditors, the
financial statement schedules referred to above, when considered in relation to
the basic financial statements taken as a whole, present fairly, in all material
respects, the information required to be included therein.
COOPERS & LYBRAND L.L.P.
Houston, Texas
March 26, 1998
S-1
INDEPENDENT AUDITORS' CONSENT AND REPORT ON SCHEDULES
The Board of Directors and Shareholder,
AVEMCO Corporation:
The audits referred to in our report dated January 31, 1997 (February 28,
1997, as to note 12 and February 18, 1998, as to note 14) include the related
financial statement schedules as of December 31, 1996 and for each of the years
in the two-year period ended December 31, 1996, not included separately herein.
These financial statement schedules are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statement schedules based on our audits. In our opinion, such financial
statement schedules, when considered in relation to the basic consolidated
financial statements taken as a whole, present fairly in all material respects
the information set forth therein.
We consent to incorporation by reference in the registration statements
(Nos. 33-94472, 33-94468, 333-14479, 333-14471, and 333-88664) on Form S-8 of
HCC Insurance Holdings, Inc. of our report dated January 31, 1997 (February 28,
1997, as to note 12 and February 18, 1998, as to note 14), relating to the
consolidated balance sheet of AVEMCO Corporation and subsidiaries as of December
31, 1996, and the related consolidated statements of income, stockholders'
equity, and cash flows for each of the years in the two-year period ended
December 31, 1996, and all related schedules, which reports appear in the
December 31, 1997 annual report on Form 10-K of HCC Insurance Holdings, Inc.
KPMG PEAT MARWICK LLP
Washington, D.C.
March 26, 1998
S-2
SCHEDULE 1
HCC INSURANCE HOLDINGS, INC.
SUMMARY OF INVESTMENTS
OTHER THAN INVESTMENTS IN RELATED PARTIES
DECEMBER 31, 1997
COLUMN A COLUMN B COLUMN C COLUMN D
- ---------------------------------------------------------------- -------------- -------------- --------------
AMOUNT AT
WHICH
SHOWN IN THE
BALANCE
TYPE OF INVESTMENT COST VALUE SHEET
- ---------------------------------------------------------------- -------------- -------------- --------------
Fixed maturities:
Bonds--United States government and government agencies and
authorities................................................. $ 11,807,000 $ 12,214,000 $ 12,214,000
Bonds--states, municipalities and political subdivisions...... 173,620,000 180,028,000 180,028,000
Bonds--special revenue........................................ 208,488,000 216,259,000 216,259,000
Bonds--Canadian government.................................... 343,000 329,000 329,000
Bonds--corporate.............................................. 75,000 76,000 76,000
Redeemable preferred stocks................................... 788,000 795,000 795,000
-------------- -------------- --------------
Total fixed maturities.................................... 395,121,000 $ 409,701,000 409,701,000
-------------- -------------- --------------
--------------
Equity securities:
Common stocks--banks, trusts & insurance companies............ 8,228,000 $ 6,582,000 6,582,000
Common stocks--industrial..................................... 986,000 723,000 723,000
Non-redeemable preferred stocks............................... 1,007,000 1,034,000 1,034,000
-------------- -------------- --------------
Total equity securities................................... 10,221,000 $ 8,339,000 8,339,000
-------------- -------------- --------------
--------------
Short-term investments.......................................... 105,255,000 105,255,000
-------------- --------------
Total investments......................................... $ 510,597,000 $ 523,295,000
-------------- --------------
-------------- --------------
S-3
SCHEDULE 2
HCC INSURANCE HOLDINGS, INC.
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
BALANCE SHEETS
DECEMBER 31,
------------------------------
1997 1996
-------------- --------------
ASSETS
Cash............................................................................. $ 192,000 $ 202,000
Short-term investments........................................................... 1,200,000 3,990,000
Investment in subsidiaries....................................................... 404,013,000 309,403,000
Intercompany loan to subsidiary.................................................. 41,250,000 --
Deferred Federal income tax...................................................... 5,174,000 9,999,000
Other assets..................................................................... 696,000 205,000
-------------- --------------
Total assets................................................................. $ 452,525,000 $ 323,799,000
-------------- --------------
-------------- --------------
LIABILITIES AND SHAREHOLDERS' EQUITY
Notes payable.................................................................... $ 80,750,000 $ 16,250,000
Payable to subsidiaries.......................................................... 4,755,000 8,636,000
Accounts payable and accrued liabilities......................................... 1,540,000 2,500,000
-------------- --------------
Total liabilities............................................................ 87,045,000 27,386,000
Total shareholders' equity................................................... 365,480,000 296,413,000
-------------- --------------
Total liabilities and shareholders' equity................................... $ 452,525,000 $ 323,799,000
-------------- --------------
-------------- --------------
See Note to Condensed Financial Information.
S-4
SCHEDULE 2
HCC INSURANCE HOLDINGS, INC.
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF EARNINGS
FOR THE YEARS ENDED DECEMBER 31,
-------------------------------------------
1997 1996 1995
------------- ------------- -------------
Equity in earnings of subsidiaries.................................. $ 56,016,000 $ 41,853,000 $ 33,909,000
Interest income..................................................... 24,000 41,000 36,000
Interest expense.................................................... 1,904,000 1,110,000 2,196,000
Merger related expenses............................................. 3,326,000 907,000 --
Other operating expense............................................. 2,032,000 1,832,000 784,000
------------- ------------- -------------
Earnings before income tax benefit.............................. 48,778,000 38,045,000 30,965,000
Income tax benefit.................................................. 973,000 485,000 723,000
------------- ------------- -------------
Net earnings.................................................... $ 49,751,000 $ 38,530,000 $ 31,688,000
------------- ------------- -------------
------------- ------------- -------------
See Note to Condensed Financial Information.
S-5
SCHEDULE 2
HCC INSURANCE HOLDINGS, INC.
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31,
----------------------------------------------
1997 1996 1995
-------------- -------------- --------------
Cash flows from operating activities:
Net earnings................................................... $ 49,751,000 $ 38,530,000 $ 31,688,000
Adjustment to reconcile net earnings to net cash provided
(used) by operating activities:
Undistributed net income of subsidiaries....................... (56,016,000) (41,853,000) (33,909,000)
Change in deferred Federal income tax, net of tax effect of
unrealized gain or loss...................................... 197,000 (5,423,000) (1,546,000)
Amortization and other non-cash expenses....................... 30,000 29,000 10,000
Change in payable to subsidiary and other...................... (533,000) 8,971,000 230,000
-------------- -------------- --------------
Cash provided (used) by operating activities................. (6,571,000) 254,000 (3,527,000)
Cash flows from investing activities:
Cash contributions to subsidiaries............................. (62,442,000) -- (24,072,000)
Purchase of subsidiaries....................................... (6,483,000) (1,753,000) --
Change in short-term investments............................... 2,790,000 (3,206,000) (784,000)
Intercompany loan to subsidiary................................ (41,250,000) -- --
Cash dividends from subsidiaries............................... 43,526,000 5,180,000 7,102,000
-------------- -------------- --------------
Cash provided (used) by investing activities................. (63,859,000) 221,000 (17,754,000)
Cash flows from financing activities:
Proceeds from note payable..................................... 97,500,000 -- --
Payments on notes payable...................................... (33,000,000) -- (28,000,000)
Sale of Common Stock, net of costs............................. 10,470,000 843,000 48,799,000
Dividends paid................................................. (4,550,000) (1,387,000) --
-------------- -------------- --------------
Cash provided (used) by financing activities................. 70,420,000 (544,000) 20,799,000
-------------- -------------- --------------
Net decrease in cash......................................... (10,000) (69,000) (482,000)
Cash at beginning of year.................................... 202,000 271,000 753,000
-------------- -------------- --------------
Cash at end of year.......................................... $ 192,000 $ 202,000 $ 271,000
-------------- -------------- --------------
-------------- -------------- --------------
See Note to Condensed Financial Information.
S-6
HCC INSURANCE HOLDINGS, INC.
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
NOTE TO CONDENSED FINANCIAL INFORMATION
The accompanying condensed financial information should be read in
conjunction with the consolidated financial statements and the related notes
thereto of HCC Insurance Holdings, Inc. and Subsidiaries. Investments in
subsidiaries are accounted for using the equity method.
S-7
SCHEDULE 3
HCC INSURANCE HOLDINGS, INC.
SUPPLEMENTARY INSURANCE INFORMATION
(DOLLARS IN THOUSANDS)
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN F COLUMN G COLUMN H
------------ --------------- ------------- ----------- ----------- --------------- -----------
(1) (1) (2)
DECEMBER 31,
------------------------------------------- FOR THE YEARS ENDED DECEMBER 31,
FUTURE POLICY -----------------------------------------
BENEFITS, BENEFITS,
LOSSES, CLAIMS,
DEFERRED POLICY CLAIMS LOSSES AND
ACQUISITION AND LOSS UNEARNED PREMIUM NET INVESTMENT SETTLEMENT
SEGMENTS COSTS EXPENSES PREMIUMS REVENUE INCOME EXPENSES
------------ --------------- ------------- ----------- ----------- --------------- -----------
1997 Company...................... $ 2,051 $ 275,008 $ 152,094 $ 163,090 $ 23,516 $ 96,514
Agency....................... 2,976
Corporate.................... 1,226
------- ------------- ----------- ----------- ------- -----------
Total........................ $ 2,051 $ 275,008 $ 152,094 $ 163,090 $ 27,718 $ 96,514
------- ------------- ----------- ----------- ------- -----------
------- ------------- ----------- ----------- ------- -----------
1996 Company...................... $ 7,908 $ 229,049 $ 156,268 $ 175,309 $ 20,154 $ 114,464
Agency....................... 1,971
Corporate.................... 1,470
------- ------------- ----------- ----------- ------- -----------
Total........................ $ 7,908 $ 229,049 $ 156,268 $ 175,309 $ 23,595 $ 114,464
------- ------------- ----------- ----------- ------- -----------
------- ------------- ----------- ----------- ------- -----------
1995 Company...................... $ 4,529 $ 200,756 $ 151,976 $ 159,588 $ 19,097 $ 105,374
Agency....................... 1,292
Corporate.................... 1,359
------- ------------- ----------- ----------- ------- -----------
Total........................ $ 4,529 $ 200,756 $ 151,976 $ 159,588 $ 21,748 $ 105,374
------- ------------- ----------- ----------- ------- -----------
------- ------------- ----------- ----------- ------- -----------
COLUMN I COLUMN J COLUMN K
------------- --------------- -----------
(2)
AMORTIZATION
OF DEFERRED
POLICY
ACQUISITION OTHER OPERATING PREMIUMS
COSTS EXPENSES WRITTEN
------------- --------------- -----------
1997 $ 14,099 $ 17,700 $ 143,372
47,047
18,998
------------- ------- -----------
$ 14,099 $ 83,745 $ 143,372
------------- ------- -----------
------------- ------- -----------
1996 $ 13,459 $ 17,171 $ 188,275
55,728
16,160
------------- ------- -----------
$ 13,459 $ 89,059 $ 188,275
------------- ------- -----------
------------- ------- -----------
1995 $ 11,590 $ 19,613 $ 184,325
34,630
14,735
------------- ------- -----------
$ 11,590 $ 68,978 $ 184,325
------------- ------- -----------
------------- ------- -----------
- ------------------------
(1) Columns C and D are shown ignoring the effects of reinsurance.
(2) Net investment income was allocated to the company, and therefore the
segment, on which the related investment asset was recorded. Other operating
expenses were allocated to the company, and therefore the corresponding
segment, which actually incurred those expenses.
Note: Column E is omitted because the Company has no other policy claims and
benefits payable
S-8
SCHEDULE 4
HCC INSURANCE HOLDINGS, INC.
REINSURANCE
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F
- --------------------------------------------- -------------- -------------- -------------- -------------- --------------
(1)
ASSUMED FROM PERCENT OF
CEDED TO OTHER OTHER AMOUNT
EARNED PREMIUM GROSS AMOUNT COMPANIES COMPANIES NET AMOUNT ASSUMED TO NET
- --------------------------------------------- -------------- -------------- -------------- -------------- --------------
For the year ended December 31, 1997:
Property and liability insurance............. $ 173,032,000 $ 176,852,000 $ 140,423,000 $ 136,603,000 103%
Accident and health insurance................ 1,501,000 14,930,000 39,916,000 26,487,000 151%
-------------- -------------- -------------- --------------
Total.................................... $ 174,533,000 $ 191,782,000 $ 180,339,000 $ 163,090,000 111%
-------------- -------------- -------------- -------------- -------
-------------- -------------- -------------- -------------- -------
For the year ended December 31, 1996:
Property and liability insurance............. $ 185,477,000 $ 157,588,000 $ 135,552,000 $ 163,441,000 83%
Accident and health insurance................ 940,000 126,000 11,054,000 11,868,000 93%
-------------- -------------- -------------- --------------
Total.................................... $ 186,417,000 $ 157,714,000 $ 146,606,000 $ 175,309,000 84%
-------------- -------------- -------------- -------------- -------
-------------- -------------- -------------- -------------- -------
For the year ended December 31, 1995:
Property and liability insurance............. $ 172,541,000 $ 142,245,000 $ 120,240,000 $ 150,536,000 80%
Accident and health insurance................ 471,000 103,000 8,684,000 9,052,000 96%
-------------- -------------- -------------- --------------
Total.................................... $ 173,012,000 $ 142,348,000 $ 128,924,000 $ 159,588,000 81%
-------------- -------------- -------------- -------------- -------
-------------- -------------- -------------- -------------- -------
- ------------------------
(1) Substantially all of the reinsurance assumed by the Company's insurance
company subsidiaries was underwritten directly by the Company but issued by
other non-affiliated companies in order to satisfy local licensing or other
requirements.
S-9