10-K/A 1 h42306e10vkza.htm AMENDMENT TO FORM 10-K e10vkza
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K/A
þ Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.
o Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.
For the fiscal year ended December 31, 2005
Commission file number 001-13790
HCC Insurance Holdings, Inc.
 
(Exact name of registrant as specified in its charter)
     
Delaware   76-0336636
     
(State or other jurisdiction of
incorporation or organization)
  (IRS Employer
Identification No.)
     
13403 Northwest Freeway, Houston, Texas   77040-6094
     
(Address of principal executive offices)   (Zip Code)
(713) 690-7300
 
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12 (b) of the Act:
     
Title of each class:   Name of each exchange on 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 if the registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act.
Yes þ No o
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.
Yes o No þ
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 o No þ
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
         
Large accelerated filer þ   Accelerated filer o   Non-accelerated filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No þ
 
 

 


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The aggregate market value on June 30, 2005 (the last business day of the registrant’s most recently completed second fiscal quarter) of the voting stock held by non-affiliates of the registrant was approximately $2.6 billion. For purposes of the determination of the above-stated amount, only directors and executive officers are presumed to be affiliates, but neither the registrant nor any such person concede that they are affiliates of the registrant.
The number of shares outstanding of the registrant’s Common Stock, $1.00 par value, at February 28, 2006 was 111.1 million.
Documents incorporated by reference: Information called for in Part III of this Form 10-K is incorporated by reference to the registrant’s definitive Proxy Statement filed within 120 days of the close of the registrant’s fiscal year in connection with the registrant’s annual meeting of shareholders.

 


 

HCC INSURANCE HOLDINGS, INC.
TABLE OF CONTENTS
             
        Page  
           
  Business     10  
  Risk Factors     33  
  Unresolved Staff Comments     40  
  Properties     41  
  Legal Proceedings     41  
  Submission of Matters to a Vote of Security Holders     42  
 
           
           
  Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities     42  
  Selected Financial Data     43  
  Management's Discussion and Analysis of Financial Condition and Results of Operations     47  
  Quantitative and Qualitative Disclosures About Market Risk     80  
  Financial Statements and Supplementary Data     81  
  Changes in and Disagreements with Accountants on Accounting and Financial Disclosures     81  
  Controls and Procedures     81  
  Other Information     84  
 
           
           
  Directors and Executive Officers of the Registrant     85  
  Executive Compensation     85  
  Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters     85  
  Certain Relationships and Related Transactions     85  
  Principal Accountant Fees and Services     86  
 
           
           
  Exhibits and Financial Statement Schedules     86  
 
           
        87  
 Statement Regarding Computation of Ratios
 Powers of Attorney
 Certification by Chief Executive Officer
 Certification by Chief Financial Officer
 Certification with Respect to Annual Report
As used in this report, unless otherwise required by the context, the terms “we,” “us” and “our” refer to HCC Insurance Holdings, Inc. and its consolidated subsidiaries and the term “HCC” refers only to HCC Insurance Holdings, Inc.

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EXPLANATORY NOTE — RESTATEMENT OF CONSOLIDATED FINANCIAL STATEMENTS
In light of published reports concerning the pricing of stock options and the timing of stock option grants at numerous other companies, in the second quarter of 2006 we undertook a voluntary internal review of our past practices related to grants of stock options. The voluntary review by our management concluded that the actual accounting measurement dates for certain past stock option grants differed from the originally stated grant dates, which were also utilized as the measurement dates for such awards. In August 2006, our Board of Directors formed a Special Committee of independent directors to commence an investigation of our past stock option granting practices for the period 1995 through 2005. The Special Committee was composed of the members of the Audit Committee of the Board of Directors. The Special Committee retained the law firm of Skadden, Arps, Slate, Meagher & Flom, LLP as its independent legal counsel and LECG as forensic accountants to aid in the investigation.
On November 17, 2006, we announced that the Special Committee had made certain determinations as a result of its review of our past stock option granting practices. The Special Committee found that we had used incorrect accounting measurement dates for stock option grants covering a significant number of employees and members of our Board of Directors during the period 1997 through 2005 and that certain option grants were retroactively priced. Additionally, at the direction of the Special Committee, we reviewed our stock option granting practices from 1992, the year of our initial public stock offering, through 1994 and in 2006 and found incorrect measurement dates due to retroactive pricing were used in 2006. In substantially all of these instances, the price on the actual measurement date was higher than the price on the stated grant date; thus recipients of the options could exercise at a strike price lower than the actual measurement date price. To determine the actual measurement dates, the Special Committee utilized the following sources of information:
    The dates on documentation such as e-mails, regulatory form filings, acquisition agreements and other correspondence;
 
    The date that the relevant stock option grant was entered into Equity Edge, our stock option tracking and accounting system;
 
    Requirements of Accounting Principles Board (APB) No. 25, Accounting for Stock Issued to Employees, and related interpretations; and
 
    Guidance from the Office of Chief Accountant of the Securities and Exchange Commission (SEC) contained in a letter dated September 19, 2006.
The Special Committee concluded that mis-priced option grants, the effect of which, together with certain other adjustments, resulted in a cumulative net decrease in shareholders’ equity at December 31, 2005 of $3.3 million, affected all levels of employees. The Special Committee found that Stephen L. Way, Chief Executive Officer, retroactively priced options, that he should have known he was granting options in a manner that conflicted with our stock option plans and public statements, and that this constituted a failure to align the stock option granting process with our stock option plans and public statements. Although finding his actions were inconsistent with the duties and obligations of a chief executive officer of a publicly-traded company, the Special Committee also found that Mr. Way’s motivation appeared to be the attraction and retention of talent and to provide employees with the best option price. The Special Committee also concluded that Christopher L. Martin, Executive Vice President and General Counsel, was aware that options were being retroactively priced in a manner inconsistent with applicable plan terms and the procedures memoranda that he had prepared, that granting in-the-money options had accounting implications, and that he did not properly document our Compensation Committee’s informal delegation of authority to Mr. Way. The Special Committee also found that there was no evidence that Mr. Way or Mr. Martin intended to falsify the consolidated financial statements.
Before the Board of Directors reviewed the results of the investigation, the Chairman of our Compensation Committee tendered his resignation from the Board of Directors on November 8, 2006. After reviewing the results of the investigation, the Board of Directors determined that it would be appropriate to accept the resignations of Mr. Way and Mr. Martin, which both tendered on November 17, 2006. Mr. Way will remain a director of HCC and serve as the non-executive Chairman of the Board of Directors and has entered into a consulting agreement with us to assist in the transition of leadership and to provide strategic guidance. We have entered into agreements with Mr. Way and Mr. Martin which, among other things, require them to disgorge an amount equal to the difference between

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the actual measurement date prices determined by HCC and the prices at which these individuals exercised mis-priced options since 1997.
For more information on these matters, including a detailed discussion of the financial effects of these matters, refer to Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Restatement of Consolidated Financial Statements, Special Committee and Company Findings” and to Note 2, “Restatement of Consolidated Financial Statements, Special Committee and Company Findings,” of the Notes to Consolidated Financial Statements.
As a result of the determinations of the Special Committee and because the resulting cumulative charge would be material to the second quarter and full year 2006 consolidated net earnings, we concluded on December 19, 2006 that we needed to amend this Annual Report on Form 10-K for the year ended December 31, 2005 as filed on March 16, 2006 (the Original Filing), to restate our consolidated financial statements for the years ended December 31, 2005, 2004 and 2003 and the related disclosures. However, the impact of the restatement in any of the restated periods is not material. We are making the restatement in accordance with generally accepted accounting principles to record the following:
    Non-cash compensation expense for the difference between the stock price on the stated grant date and the actual measurement date and for the fluctuations in stock price in certain instances where variable accounting should have been applied;
 
    Other adjustments that were not recorded in the originally filed financial statements due to their immateriality; and
 
    Related tax effects for all items.
We also concluded we did not maintain an effective control environment as our controls were not adequate to prevent or detect management override by certain former members of senior management related to our stock option granting practices and procedures. Accordingly, we have restated our report on internal control over financial reporting to reflect this material weakness.
This Form 10-K/A also includes the restatement of selected financial data as of and for the years ended December 31, 2005, 2004, 2003, 2002 and 2001, and the unaudited quarterly financial data for each of the quarters in the years ended December 31, 2005 and 2004. We have not amended any of our other previously filed annual reports on Form 10-K or quarterly reports on Form 10-Q for the periods affected by the restatement other than our Quarterly Report on Form 10-Q for the quarter ended March 31, 2006, which we are filing concurrently with this Form 10-K/A. For this reason, the consolidated financial statements and related financial information contained in such previously filed reports should no longer be relied upon.
We were unable to timely file our quarterly reports on Form 10-Q for the quarters ended June 30, 2006 and September 30, 2006, primarily due to not knowing the financial impact of the Special Committee’s investigation. Our Form 10-Q’s for these quarters are being filed concurrently with this Form 10-K/A. We have also restated the June 30, 2005 and September 30, 2005 financial statements included in our quarterly reports on Form 10-Q for the respective 2006 quarters.

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The cumulative effect of the restatement for the period 1997 through 2005 was as follows (in thousands):
                 
Increase (decrease) in net earnings and retained earnings:
               
Non-cash compensation expense related to stock option grants (including $994 recorded as accrued expenses)
  $ (26,608 )        
Net adjustments for immaterial items previously unrecorded
    1,316          
 
             
Reduction in earnings from continuing operations before income tax expense
    (25,292 )        
Related income tax benefit
    6,667          
 
             
Reduction in net earnings from continuing operations and net earnings
          $ (18,625 )
Increase (decrease) to additional paid-in capital:
               
Increase related to non-cash compensation expense
  $ 25,614          
Reduction related to tax effects previously credited to additional paid-in capital
    (11,012 )        
 
             
Net increase in additional paid-in capital
            14,602  
Increase in other comprehensive income for immaterial items previously unrecorded
            762  
 
             
Net decrease in shareholders’ equity at December 31, 2005
          $ (3,261 )
 
             

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In order to further enhance investor understanding of the effects of the matters described above and to provide context for the composition of the cumulative adjustment to shareholders’ equity at December 31, 2002, we have provided the information below which shows the years to which the stock option compensation adjustments relate. Our consolidated financial statements and the related SEC reports for such periods have not been amended, except for the consolidated financial statements included in this Form 10-K/A. In addition to the stock option compensation adjustments, we also included the effect of other immaterial adjustments which were previously unrecorded and the related tax effects of all adjustments. The increase (decrease) in net earnings for each type of adjustment was as follows (in thousands):
                                                 
            Non-cash                                
            stock option                                
    Net earnings as     compensation                             Net earnings  
    previously reported     expense     Other     Tax effect     Total adjustments     as restated  
Years ended December 31, 1997
  $ 50,083     $ (3,789 )   $     $ 1,326     $ (2,463 )   $ 47,620  
1998
    73,110       (3,664 )           1,273       (2,391 )     70,719  
1999
    26,572       (1,474 )           (148 )     (1,622 )     24,950  
2000
    55,468       (4,586 )     (1,124 )     1,830       (3,880 )     51,588  
2001
    30,197       (2,201 )     1,881       88       (232 )     29,965  
2002
    105,828       (2,043 )     (27 )     561       (1,509 )     104,319  
 
                                   
Cumulative effect at December 31, 2002
    341,258       (17,757 )     730       4,930       (12,097 )     329,161  
2003
    143,561       (3,279 )     1,270       475       (1,534 )     142,027  
2004
    163,025       (2,571 )     2,453       (208 )     (326 )     162,699  
2005
    195,860       (3,001 )     (3,137 )     1,470       (4,668 )     191,192  
 
                                   
Cumulative effect at December 31, 2005
  $ 843,704     $ (26,608 )   $ 1,316     $ 6,667     $ (18,625 )   $ 825,079  
 
                                   
All information in this Form 10-K/A is as of December 31, 2005 and does not reflect events occurring after the date of the Original Filing, other than the restatement and updating of certain disclosures affected by events subsequent to the date of the Original Filing. For the convenience of the reader, this Form 10-K/A sets forth the Original Filing in its entirety, as amended and modified to reflect the restatement. The following sections of this Form 10-K/A were amended to reflect the determinations of the Special Committee and the restatement:
Part I — Item 1 — Business;
Part I — Item 1A — Risk Factors;
Part I — Item 3 — Legal Proceedings;
Part II — Item 6 — Selected Financial Data;
Part II — Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations;
Part II — Item 8 — Financial Statements and Supplementary Data;
Part II — Item 9A — Controls and Procedures;
Part III — Item 13 — Certain Relationships and Related Transactions; and
Part IV — Item 15 — Exhibits and Financial Statement Schedules.
This Form 10-K/A should be read in conjunction with our periodic filings made with the SEC, subsequent to the date of the Original Filing, including any amendments to those filings, as well as any Current Reports filed on Form 8-K subsequent to the date of the Original Filing. In addition, in accordance with applicable rules and regulations promulgated by the SEC, this Form 10-K/A includes updated certifications from our current Chief Executive Officer and Chief Financial Officer as Exhibits 31.1, 31.2, 32.1 and 32.2.

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FORWARD-LOOKING STATEMENTS
This report on Form 10-K/A contains certain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are intended to be covered by the safe harbors created by those laws. We have based these forward-looking statements on our current expectations and projections about future events. These forward-looking statements include information about possible or assumed future results of our operations. All statements, other than statements of historical facts, included or incorporated by reference in this report that address activities, events or developments that we expect or anticipate may occur in the future, including such things as future capital expenditures, business strategy, competitive strengths, goals, growth of our business and operations, plans and references to future successes may be considered forward-looking statements. Also, when we use words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “plan,” “probably” or similar expressions, we are making forward-looking statements.
Many risks and uncertainties may impact the matters addressed in these forward-looking statements, which could affect our future financial results and performance, including, among other things:
    the effects of catastrophic losses;
 
    the cyclical nature of the insurance business;
 
    inherent uncertainties in the loss estimation process, which can adversely impact the adequacy of loss reserves;
 
    the effects of emerging claim and coverage issues;
 
    the effects of extensive governmental regulation of the insurance industry;
 
    potential credit risk with brokers;
 
    our increased retention of risk, which could expose us to greater potential losses;
 
    the adequacy of reinsurance protection;
 
    the ability or willingness of reinsurers to pay balances due us;
 
    the occurrence of terrorist activities;
 
    our ability to maintain our competitive position;
 
    changes in our assigned financial strength ratings;
 
    our ability to raise capital in the future;
 
    attraction and retention of qualified employees;
 
    fluctuations in the fixed income securities market, which may reduce the value of our investment assets;
 
    our ability to successfully expand our business through the acquisition of insurance-related companies;
 
    our ability to receive dividends from our insurance company subsidiaries in needed amounts;
 
    fluctuations in foreign exchange rates;
 
    failures of our information technology systems, which could adversely affect our business;
 
    developments in the SEC’s informal inquiry related to our past practices in connection with grants of stock options;
 
    potential issues related to the effects of Sections 409A and 162(m) of the Internal Revenue Code and any expenses associated therewith;

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    changes to improve our internal controls related to the process of granting, documenting and accounting for stock option awards;
 
    additional expenses and taxes associated with our stock option investigation and related matters;
 
    potential litigation that could result from our stock option investigation;
 
    the ability of our Executive Officers to define and implement a strategic business plan; and
 
    our ability to cure all defaults or events of default under our outstanding loan agreements.
These events or factors could cause our results or performance to differ materially from those we express in our forward-looking statements. Although we believe that the assumptions underlying our forward-looking statements are reasonable, any of these assumptions, and, therefore, also the forward-looking statements based on these assumptions, could themselves prove to be inaccurate. In light of the significant uncertainties inherent in the forward-looking statements which are included in this report, our inclusion of this information is not a representation by us or any other person that our objectives and plans will be achieved.
Our forward-looking statements speak only at the date made and we will not update these forward-looking statements unless the securities laws require us to do so. In light of these risks, uncertainties and assumptions, any forward-looking events discussed in this report may not occur.

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PART I
ITEM 1. BUSINESS
Business Overview
HCC Insurance Holdings, Inc. is a Delaware corporation, which was formed in 1991. Its predecessor corporation was formed in 1974. Our principal executive offices are located at 13403 Northwest Freeway, Houston, Texas 77040, and our telephone number is (713) 690-7300. We maintain an Internet web-site at www.hcc.com. The reference to our Internet web-site address in this report does not constitute the incorporation by reference of the information contained at this site in this report. We will make available, free of charge through publication on our Internet web-site, a copy of our Annual Report on Form 10-K and quarterly reports on Form 10-Q and any current reports on Form 8-K or amendments to those reports, filed or furnished to the Securities and Exchange Commission as soon as reasonably practicable after we have filed or furnished such materials with the Securities and Exchange Commission.
As used in this report, unless otherwise required by the context, the terms “we,” “us” and “our” refer to HCC Insurance Holdings, Inc. and its consolidated subsidiaries and the term “HCC” refers only to HCC Insurance Holdings, Inc. All trade names or trademarks appearing in this report are the property of their respective holders.
We provide specialized property and casualty, surety, and group life, accident and health insurance coverages and related agency and reinsurance brokerage services to commercial customers and individuals. We concentrate our activities in selected, narrowly defined, specialty lines of business. We operate primarily in the United States, the United Kingdom, Spain, Bermuda and Ireland. Some of our operations have a broader international scope. We underwrite insurance both on a primary basis, where we insure a risk in exchange for a premium, and on a reinsurance basis, where we insure all or a portion of another insurance company’s risk in exchange for all or a portion of the premium. We market our products both directly to customers and through a network of independent and affiliated brokers, producers and agents.
Since our founding, we have been consistently profitable, generally reporting annual increases in total revenue and shareholders’ equity. During the period 2001 through 2004, which is the latest period for which industry information is available, we had an average statutory combined ratio of 92.1% versus the less favorable 105.5% (source: A.M. Best Company, Inc.) recorded by the U.S. property and casualty insurance industry overall. During the period 2001 through 2005, our gross written premium increased from $1.0 billion to $2.0 billion, an increase of 102%, while net written premium increased 303% from $373.0 million to $1.5 billion. During this period, our revenue increased from $512.5 million to $1.6 billion, an increase of 221%. During the period December 31, 2001 through December 31, 2005, our shareholders’ equity increased 121% from $765 million to $1.7 billion and our assets increased 115% from $3.3 billion to $7.0 billion.
Our insurance companies are risk-bearing and focus their underwriting activities on providing insurance and/or reinsurance in the following lines of business:
    Diversified financial products
 
    Group life, accident and health
 
    Aviation
 
    London market account
 
    Other specialty lines
Our operating insurance companies are rated “AA (Very Strong)” (3rd of 22 ratings) by Standard & Poor’s Corporation and AA- (Very Strong) by Fitch Ratings (4th of 24 ratings). Avemco Insurance Company, HCC Life Insurance Company, Houston Casualty Company and U.S. Specialty Insurance Company are rated “A+ (Superior)” (2nd of 16 ratings) by A.M. Best Company, Inc. American Contractors Indemnity Company, Perico Life Insurance Company and United States Surety Company are rated “A (Excellent)” (3rd of 16 ratings). A. M. Best placed our ratings under review with negative implications following our announcement on November 17, 2006 concerning the results of the independent investigation of our stock option granting practices and, at the same time, Standard & Poor’s and Fitch Ratings affirmed our ratings with a stable outlook. Standard & Poor’s, Fitch Ratings and A.M. Best are nationally recognized independent rating agencies. These ratings are intended to provide an independent opinion of an insurer’s ability to meet its obligations to policyholders and are not evaluations directed at investors.

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Our underwriting agencies underwrite on behalf of our insurance companies and in certain situations for other non-affiliated insurance companies. They receive fees for these services and do not bear any of the insurance risk of the companies for which they underwrite. Our underwriting agencies generate revenues based on fee income and profit commissions and specialize in contingency (including contest indemnification, event cancellation and weather coverages); directors’ and officers’ liability; individual disability (for athletes and other high profile individuals); kidnap and ransom; employment practices liability; marine; professional indemnity; mortgage and residual value insurance; and other specialty lines of business. Our principal underwriting agencies are Covenant Underwriters, HCC Global Financial Products, HCC Indemnity Guaranty Agency, HCC Specialty Underwriters and Professional Indemnity Agency.
Our brokers provide reinsurance and insurance brokerage services for our insurance companies and our clients and receive fees for their services. A reinsurance broker structures and arranges reinsurance between insurers seeking to cede insurance risks and reinsurers willing to assume such risks. Reinsurance brokers do not bear any of the insurance risks of their client companies. They earn commission income, and to a lesser extent, fees for certain services, generally paid by the insurance and reinsurance companies with whom the business is placed. Insurance broker operations consist of consulting with retail and wholesale clients by providing information about insurance coverage and marketing, placing and negotiating particular insurance risks. Our brokers specialize in placing insurance and reinsurance for group life, accident and health, surety and property and casualty lines of business. Our brokers are Rattner Mackenzie, HCC Risk Management and Continental Underwriters.
Our Strategy
Our business philosophy is to maximize underwriting profits and produce non-risk-bearing fee and commission income while limiting risk in order to preserve shareholders’ equity and maximize earnings. We concentrate our insurance writings in selected, narrowly defined, specialty lines of business where we believe we can achieve an underwriting profit. We also rely on our experienced underwriting personnel and our access to and expertise in the reinsurance marketplace to achieve our strategic objectives. We market our insurance products both directly to customers and through affiliated and independent brokers, agents and producers.
The property and casualty insurance industry and individual lines of business within the industry are cyclical. There are times when a large number of companies offer insurance on certain lines of business, causing premiums to trend downward. During other times, insurance companies limit their writings in certain lines of business due to lack of capital or following periods of excessive losses. This results in an increase in premiums for those companies that continue to write insurance in those lines of business.
In our insurance company operations, we believe our operational flexibility, which permits us to shift the focus of our insurance underwriting activity among our various lines of business and also to shift the emphasis from our insurance risk-bearing business to our non-insurance, fee-based business, allows us to implement a strategy of emphasizing more profitable lines of business during periods of increased premium rates and de-emphasizing less profitable lines of business during periods of increased competition. In addition, we believe that our underwriting agencies and brokers complement our insurance underwriting activities. Our ability to utilize affiliated insurers, underwriting agencies and reinsurance brokers permits us to retain a greater portion of the gross revenue derived from written premium.
After a three-year period in which premium rates rose substantially, premium rates in several of our lines of business became more competitive during the past two years. The rate decreases were more gradual than the prior rate increases; thus, our underwriting activities remain profitable. During the past several years, we expanded our underwriting activities and increased our retentions in response to these market conditions. During 2005, we again increased our retentions on certain of our lines of business that were not generally exposed to catastrophe risk and where profit margins were usually more predictable. These higher retention levels increased our net written and earned premium and have resulted in additional underwriting profits and net earnings.

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Through reinsurance, our insurance companies transfer or cede all or part of the risk we have underwritten to a reinsurance company in exchange for all or part of the premium we receive in connection with the risk. We purchase reinsurance to limit the net loss to our insurance companies from both individual and catastrophic risks. The amount of reinsurance we purchase varies by, among other things, the particular risks inherent in the policies underwritten, the pricing of reinsurance and the competitive conditions within the relevant line of business.
When we determine to retain more underwriting risk in a particular line of business, we do so with the intention of retaining a greater portion of any underwriting profits without increasing our exposure to severe or catastrophe losses. In this regard, we may purchase less proportional or quota share reinsurance applicable to that line, thus accepting more of the risk but possibly replacing it with specific excess of loss reinsurance, where we transfer to reinsurers both premium and losses on a non-proportional basis for individual and catastrophic risks above a retention point. Additionally, we may obtain facultative reinsurance protection on individual risks. In some cases, we may choose not to purchase reinsurance in a line of business where we believe there has been a favorable loss history, our policy limits are relatively low or we determine there is a low likelihood of catastrophe exposure.
We also acquire or make strategic investments in companies that present an opportunity for future profits or for the enhancement of our business. We expect to continue to acquire complementary businesses. We believe that we can enhance acquired businesses through the synergies created by our underwriting capabilities and our other operations.
Our business plan is shaped by our underlying business philosophy, which is to maximize underwriting profit and net earnings while preserving and achieving long-term growth of shareholders’ equity. As a result, our primary objective is to increase net earnings rather than market share or gross written premium.
In our ongoing operations, we will continue to:
    emphasize the underwriting of lines of business where there is an anticipation of underwriting profits based on various factors including premium rates, the availability and cost of reinsurance and market conditions;
 
    limit our insurance companies’ aggregate net loss exposure from a catastrophic loss through the use of reinsurance for those lines of business exposed to such losses and diversification into lines of business not exposed to such losses; and
 
    consider the potential acquisition of specialty insurance operations and other strategic investments.
Industry Segment and Geographic Information
Financial information concerning our operations by industry segment and geographic data is included in the Consolidated Financial Statements and Notes thereto.
Recent Acquisitions
We have made a series of acquisitions that have furthered our overall business strategy. Our recent major transactions are described below:
On July 1, 2003, we acquired all of the outstanding shares of Covenant Underwriters Ltd. and Continental Underwriters Ltd., an underwriting agency and an insurance broker, respectively, specializing in commercial marine insurance. We initially paid $11.6 million and issued 471,806 shares of our common stock in connection with the acquisition. We paid an additional $1.6 million in 2005 related to a contractual earnout and may pay additional amounts if certain earnings targets are reached through December 31, 2006. We expect to pay $4.7 million in 2006 based on 2005 earnings.

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On January 31, 2004, we acquired all of the shares of Surety Associates Holding Co., Inc., the parent company of American Contractors Indemnity Company, a California-domiciled surety company. We paid $46.8 million for the acquisition. American Contractors Indemnity Company now operates with our other surety operations as part of our HCC Surety Group.
On October 1, 2004, we acquired all of the shares of InsPro Corporation, a California underwriting agency specializing in professional indemnity insurance and which does business as RA&MCO Insurance Services. We paid $7.0 million and issued 74,750 shares of our common stock in connection with the acquisition. RA&MCO operates as a division of Professional Indemnity Agency.
On February 25, 2005, we acquired United States Surety Company through a merger effected with its parent company, USSC Holdings, Inc. We issued 1.2 million shares of our common stock in connection with the acquisition. United States Surety Company is a Maryland-domiciled surety company and now operates as a part of our HCC Surety Group.
On July 14, 2005, we acquired the remaining 66% of De Montfort Group Limited that we did not own for $10.5 million and 274,000 shares of our common stock. We acquired our initial 34% interest in January 2005. The key operating subsidiary, De Montfort Insurance Company, provides surety and credit insurance. It has been renamed HCC International Insurance Company and a significant amount of our other United Kingdom operations will be combined with this company in 2006.
On December 1, 2005, we acquired Perico Ltd., a medical stop-loss insurance underwriting agency headquartered in St. Louis, Missouri. We paid $30.0 million and issued 158,599 shares of our common stock in connection with the acquisition.
On December 13, 2005, we acquired MIC Life Insurance Corporation, a Delaware-domiciled insurance company, for $20.0 million. MIC has been renamed Perico Life Insurance Company and operations will be located in St. Louis, Missouri.
We continue to evaluate acquisition opportunities and we may complete additional acquisitions during 2006. Any future acquisitions will be designed to expand and strengthen our existing lines of business or to provide access to additional specialty sectors, which we expect to contribute to our overall growth.
Recent Disposition
On December 31, 2003, we sold the business of our retail brokerage subsidiary, HCC Employee Benefits, Inc. We received $73.2 million in total consideration related to the sale.
Insurance Company Operations
Lines of Business
This table shows our insurance companies’ total premium written, otherwise known as gross written premium, by line of business and the percentage of each line to total gross written premium (dollars in thousands):
                                                 
    2005     2004     2003  
Diversified financial products
  $ 908,526       45 %   $ 857,299       43 %   $ 553,501       32 %
Group life, accident and health
    593,382       29       584,747       30       565,494       33  
Aviation
    210,530       10       204,963       10       214,718       12  
London market account
    144,425       7       178,950       9       223,149       13  
Other specialty lines
    176,139       9       133,964       7       73,475       4  
Discontinued lines of business
    5,284             15,230       1       109,557       6  
 
                                   
Total gross written premium
  $ 2,038,286       100 %   $ 1,975,153       100 %   $ 1,739,894       100 %
 
                                   

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This table shows our insurance companies’ actual premium retained, otherwise known as net written premium, by line of business and the percentage of each line to total net written premium (dollars in thousands):
                                                 
    2005     2004     2003  
Diversified financial products
  $ 675,942       45 %   $ 404,870       37 %   $ 183,560       21 %
Group life, accident and health
    502,805       34       343,996       31       299,913       35  
Aviation
    130,743       9       144,687       13       99,447       12  
London market account
    78,809       5       107,509       10       155,987       18  
Other specialty lines
    109,106       7       83,980       7       36,837       4  
Discontinued lines of business
    3,819             20,477       2       89,758       10  
 
                                   
Total net written premium
  $ 1,501,224       100 %   $ 1,105,519       100 %   $ 865,502       100 %
 
                                   
This table shows our insurance companies’ net written premium as a percentage of gross written premium, otherwise referred to as percentage retained, for our continuing lines of business:
                         
    2005     2004     2003  
Diversified financial products
    74 %     47 %     33 %
Group life, accident and health
    85       59       53  
Aviation
    62       71       46  
London market account
    55       60       70  
Other specialty lines
    62       63       50  
 
                 
Continuing lines of business percentage retained
    74 %     55 %     48 %
 
                 
Underwriting
We underwrite primary business produced through affiliated underwriting agencies, independent and affiliated brokers and producers and by direct marketing efforts. We also write facultative or individual account reinsurance as well as some treaty reinsurance business.
Diversified Financial Products
We underwrite a variety of financial insurance risks in our diversified financial products line of business. These risks include:

  directors’ and officers’ liability
 
  employment practices liability
 
  mortgage guaranty
 
  professional indemnity
  residual value insurance
 
  surety and credit
 
  other financial products


We began to underwrite this line of business through a predecessor company in 1977. Our insurance companies started participating in this business in 2001. We have substantially increased our level of business in this area through the acquisition of a number of agencies and insurance companies that operate in this line, both domestically and internationally. Each of the acquired entities has significant experience in their respective specialties within this line of business. We have also formed entities which offer products in this line of business developed around teams of experienced underwriters.

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In 2002 and 2003, following several years of insurance industry losses, significant rate increases were experienced throughout our diversified financial products line of business, particularly directors’ and officers’ liability, which we began underwriting opportunistically in 2002. We benefited greatly from these improved conditions despite the fact that we had not been involved in the past losses. Gross written premium in the diversified financial products line rose to $908.5 million in 2005 compared to $857.3 million in 2004 due to acquisitions, premium rate increases and other organic growth in all products in this line. Rates have softened in 2004 and 2005 for some of the products in this line, but our underwriting margins are still very profitable. There is also considerable investment income derived from this line of business due to the extended periods involved in claims resolution.
We had previously maintained reinsurance on our diversified financial products line of business, primarily on a proportional basis, but over the past two years have substantially increased our retentions. Although individual losses primarily in the directors’ and officers’ public company liability business may have potential severity, there is a relatively low risk of catastrophe exposure in this line of business and a reasonable expectation of underwriting profitability. Net premium written for the public company directors’ and officers’ liability was approximately $196.8 million in 2005. The remainder of the diversified financial products business is less volatile with relatively low limits.
Group Life, Accident and Health
We write medical stop-loss business through HCC Life Insurance Company and since its December 2005 acquisition, Perico Life Insurance Company. Our medical stop-loss insurance provides coverages to companies, associations and public entities that elect to self-insure their employees’ medical coverage for losses within specified levels, allowing them to manage the risk of excessive health insurance exposure by limiting aggregate and specific losses to a predetermined amount. We first began writing this business through a predecessor company in 1980. Our insurance companies started participating in this business in 1997. This line of business has grown both organically and through acquisitions. We are considered a market leader in medical stop-loss insurance. We also underwrite a small program of group life insurance offered to our insureds as a complement to our medical stop-loss products.
Premium rates rose substantially beginning in 2000 and although competition has increased in recent years, underwriting results have remained profitable. Medical stop-loss business has relatively low limits, a low level of catastrophe exposure and a generally predictable result. Therefore, we have increased our retentions annually since 2001 and currently buy no reinsurance for this line of business.
We began writing alternative workers’ compensation and occupational accident insurance in 1996 and this business is currently written through U.S. Specialty Insurance Company. The business in this line has relatively low limits, a relatively low level of catastrophe exposure and a generally predictable result.
Aviation
We are a market leader in the general aviation insurance industry insuring aviation risks, both domestically and internationally. Types of aviation business include:

    antique and vintage military aircraft
 
    cargo operators
 
    commuter airlines
 
    corporate aircraft
    fixed base operations
 
    military and law enforcement aircraft
 
    private aircraft owners
 
    rotor wing aircraft


We offer coverages that include hulls, engines, avionics and other systems, liabilities, cargo and other ancillary coverages. We generally do not insure major airlines, major manufacturers or satellites. Insurance claims related to general aviation business tend to be seasonal, with the majority of the claims being incurred during the spring and summer months.
We have been underwriting aviation risks through Houston Casualty Company since 1981 and since 1959 in Avemco Insurance Company and U.S. Specialty Insurance Company, which were acquired in 1997. We are one of the largest writers of personal aircraft insurance in the United States. Our aviation gross premium has remained relatively stable since 1998, although we have increased our retentions as this business is predominantly written with small limits and has generally predictable results.

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London Market Account
Our London market account business consists of accident and health, marine, energy and property business, and has been primarily underwritten by Houston Casualty Company’s London branch office. In the future, we intend to utilize HCC International Insurance Company to underwrite the non-U.S. based risks which comprise this line of business. This line represents some of our accident and health business and most of our catastrophe exposure. We have underwritten these risks for more than 15 years, increasing or decreasing our premium volume depending on market conditions, which can be very volatile in this line. The following table presents the details of net premium written within the London market account line of business (in thousands):
                         
    2005     2004     2003  
Marine
  $ 23,799     $ 19,537     $ 14,552  
Energy
    15,621       26,258       40,065  
Property
    18,379       19,613       24,857  
Accident and health
    21,010       42,101       76,513  
 
                 
Total London market account net written premium
  $ 78,809     $ 107,509     $ 155,987  
 
                 
We underwrite marine risks for ocean-going vessels including hull, protection and indemnity, liabilities and cargo. We have underwritten marine risks since 1984 in varying amounts depending on market conditions.
In our energy business, we underwrite physical damage and business interruption. We have been underwriting both onshore and offshore energy risks since 1988. This business includes:

    drilling rigs
 
    gas production and gathering platforms
 
    natural gas facilities
    petrochemical plants
 
    pipelines
 
    refineries


Rates were relatively low for an extended period of time reaching levels where underwriting profitability was difficult to achieve. As a result, we have underwritten energy risks on a very selective basis, striving for quality rather than quantity. Underwriting profitability was adversely impacted by the 2004 and 2005 hurricane activity, but this has resulted in rates increasing substantially and policy conditions becoming more stringent. However, we continue to reinsure much of our catastrophe exposure, buying substantial amounts of reinsurance both on a proportional and excess basis.
We underwrite property business specializing in risks of large, often multinational, corporations, covering a variety of commercial properties including:

    factories
 
    hotels
 
    industrial plants
    office buildings
 
    retail locations
 
    utilities


We have written property business since 1986, including business interruption, physical damage and catastrophe risks, including flood and earthquake. Rates increased significantly following September 11, 2001, but had trended downward by 2005 despite the hurricane activity of 2004. The massive losses from hurricanes in 2005 have resulted in substantial rate increases, but due to over capacity, policy conditions have remained unchanged, unlike energy risks. Accordingly, we are substantially reducing our involvement in policies with exposures in the Florida and U.S. Gulf Coast regions. We continue to buy substantial catastrophe reinsurance which, unlike many industry participants, has shown to be adequate during 2004 and 2005 when large amounts of industry capital were lost. While seriously affecting our earnings in the third quarter of each year, we still were able to produce record annual earnings.

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We began writing London market accident and health risks in 1996, including trip accident, medical and disability. Due to past experience and other market factors, we significantly decreased premiums starting in 2004, although our business is now much more stable.
Our London market account is reinsured both proportionally and on an excess of loss basis. Catastrophe exposure is closely monitored and reinsurance is purchased accordingly to limit our net exposure to a level that any loss is not expected to impact our capital. Previous net catastrophe losses from Hurricane Andrew in 1992, the Northridge Earthquake in 1994, the terrorist attacks on September 11, 2001 and the hurricanes of 2004 and 2005 did not exceed net earnings in the affected quarter.
Other Specialty Lines
In addition to the above, we underwrite various other specialty lines of business for which individual premiums by line of business are not at this time significant to our overall results of operations.
Principal Insurance Companies
Houston Casualty Company
Houston Casualty Company is our largest insurance company subsidiary. It is domiciled in Texas and insures risks worldwide. Houston Casualty Company receives business through independent agents and brokers, our underwriting agencies and reinsurance brokers, and other insurance and reinsurance companies. Houston Casualty Company writes diversified financial products, aviation, London market account and other specialty lines of business. It is also an issuing carrier for our affiliated underwriting agencies. Houston Casualty Company’s 2005 gross written premium, including Houston Casualty Company-London, was $833.6 million.
Houston Casualty Company-London
Houston Casualty Company operates a branch office in London, England, in order to more closely align its underwriting operations with the London market, a historical focal point for some of the business that it underwrites. Houston Casualty Company-London underwrites diversified financial products and London market account business, some of which is produced by our affiliated underwriting agencies. Beginning in 2006, we intend to focus the underwriting activities of Houston Casualty Company-London’s office on risks based in the United States. We intend to use HCC International Insurance Company as a platform for much of the European and other international risks previously underwritten by Houston Casualty Company-London.
U.S. Specialty Insurance Company
U.S. Specialty Insurance Company is a Texas-domiciled property and casualty insurance company. It primarily writes diversified financial products, aviation, accident and health business. U.S. Specialty Insurance Company acts as an issuing carrier for certain business underwritten by our underwriting agencies. U.S. Specialty Insurance Company’s gross written premium in 2005 was $449.6 million.
HCC Life Insurance Company
HCC Life Insurance Company is an Indiana-domiciled life insurance company. It operates as a group life, accident and health insurer. In early 2005, we consolidated the operations of our underwriting agency, HCC Benefits Corporation, into HCC Life Insurance Company. HCC Life Insurance Company’s gross written premium in 2005 was $482.6 million.
Avemco Insurance Company
Avemco Insurance Company is a Maryland-domiciled property and casualty insurer and operates as a direct market underwriter of general aviation business. It has also been an issuing carrier for accident and health business and some other lines of business underwritten by our underwriting agencies and an unaffiliated underwriting agency. Avemco Insurance Company’s gross written premium in 2005 was $149.7 million.

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American Contractors Indemnity Company
American Contractors Indemnity Company is a California-domiciled surety company. It writes court, specialty contract, license and permit bonds. American Contractors Indemnity Company has been in operation since 1990 and operates as a part of our HCC Surety Group. American Contractors Indemnity Company’s 2005 gross written premium was $76.3 million.
HCC Europe
Houston Casualty Company Europe, Seguros y Reaseguros, S.A. is a Spanish insurer. It underwrites diversified financial products business. HCC Europe’s surety operations make up a part of our HCC Surety Group. HCC Europe is also an issuing carrier for business underwritten by our underwriting agencies and has been in operation since 1978. HCC Europe’s gross written premium in 2005 was $130.6 million.
HCC Reinsurance Company
HCC Reinsurance Company Limited is a Bermuda-domiciled reinsurance company which writes assumed reinsurance from our insurance companies and from unaffiliated insurance companies and a limited amount of primary insurance. HCC Reinsurance Company is an issuing carrier for diversified financial products business underwritten by our underwriting agency, HCC Indemnity Guaranty. HCC Reinsurance Company’s gross written premium in 2005 was $70.0 million.
HCC Specialty Insurance Company
HCC Specialty Insurance Company is an Oklahoma-domiciled property and casualty insurance company in operation since 2002. It writes diversified financial products and other specialty lines of business produced by our underwriting agencies. HCC Specialty Insurance Company’s gross written premium in 2005 was $17.6 million.
United States Surety Company
United States Surety Company was acquired in February 2005 and is a Maryland-domiciled surety company that has been in operation since 1996. The results of operations of United States Surety Company were included in our 2005 financial results as of March 1, 2005. It writes contract bonds and operates as a part of our HCC Surety Group. United States Surety Company’s 2005 gross written premium since its acquisition was $14.5 million.
Perico Life Insurance Company
Perico Life Insurance Company was a previously dormant company acquired in December 2005 and is a Delaware-domiciled life insurance company. Perico Life Insurance Company now operates as a group life, accident and health insurer. In 2006, we intend to consolidate the operations of our recently acquired underwriting agency, Perico Ltd., into Perico Life Insurance Company.
HCC International Insurance Company
HCC International Insurance Company PLC, formerly known as De Montfort Insurance Company, was acquired in 2005 and writes diversified financial products business, primarily in the surety and credit insurance areas. HCC International Insurance Company has been in operation since 1982 and is domiciled in the United Kingdom. The results of operations of HCC International Insurance Company were consolidated with our 2005 financial results as of July 1, 2005, and its 2005 gross written premium since its acquisition was $17.7 million. We intend to significantly expand the underwriting activities of HCC International Insurance Company beyond surety and credit insurance and to use it as an integral part of a European platform for our international insurance operations.

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Underwriting Agency Operations
Our underwriting agencies act on behalf of affiliated and non-affiliated insurance companies and provide insurance underwriting management and claims administration services. Our underwriting agencies do not assume any insurance
or reinsurance risk themselves and generate revenues based entirely on fee income and profit commissions. These subsidiaries are in a position to direct and control business they produce. Our insurance companies serve as policy issuing companies for the majority of the business written by our underwriting agencies. If an unaffiliated insurance company serves as the policy issuing company, our insurance companies may reinsure the business written by our underwriting agencies. Total revenue generated by our underwriting agencies in 2005 amounted to $157.0 million.
Professional Indemnity Agency
Professional Indemnity Agency, Inc., based in Mount Kisco, New York and with branch offices in San Francisco and Concord, California, acts as an underwriting manager for diversified financial products specializing in directors’ and officers’ liability and professional indemnity, kidnap and ransom, employment practice liability and other specialty lines of business on behalf of affiliated and unaffiliated insurance companies. It has been in operation since 1977.
HCC Specialty Underwriters
HCC Specialty Underwriters Inc., formerly known as ASU International, Inc., with its home office in Wakefield, Massachusetts and with branch offices in London, England, Los Angeles, California and New York, New York, acts as an underwriting manager for group life, accident and health and other specialty lines of business on behalf of affiliated and unaffiliated insurance companies. It has been in operation since 1982.
HCC Global Financial Products
HCC Global Financial Products, LLC acts as an underwriting manager for diversified financial products, specializing in directors’ and officers’ liability business on behalf of affiliated insurance companies. It has been in operation since 1999, underwriting domestic business from Farmington, Connecticut and international business from Barcelona, Spain and London, England.
HCC Diversified Financial Products
HCC Diversified Financial Products Limited is an underwriting agency based in London, England and underwrites diversified financial products, specializing in professional indemnity business principally in the United Kingdom on behalf of affiliated insurance companies. It has been in operation since 1997. In 2006, we intend to consolidate the operations of HCC Diversified Financial Products into HCC International Insurance Company.
Covenant Underwriters
Covenant Underwriters, Ltd. is an underwriting agency based in Covington, Louisiana with an office in New York, New York specializing in commercial marine insurance underwritten on behalf of affiliated and unaffiliated insurance companies. It has been in operation through predecessor entities since 1993.
HCC Indemnity Guaranty Agency
HCC Indemnity Guaranty Agency, Inc. underwrites mortgage guaranty, structured products and residual value insurance and reinsurance on behalf of affiliated insurance companies. It has been in operation since 2004.
Illium Insurance Group
In December 2005, we completed the acquisition of Illium Insurance Group, Ltd., the parent of a managing agent for a syndicate at Lloyd’s of London, which specializes in United Kingdom third party liability, employers’ liability and commercial motor risks. We previously had a minority ownership in Illium and provided underwriting capacity, along with other parties, to its Lloyd’s syndicate. We expect to use Illium and its managed syndicate as a platform for expanding our operations within the Lloyd’s market and to continue with the additional non-affiliated capacity for the syndicate.

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Reinsurance and Insurance Broker Operations
Our reinsurance and insurance brokers provide a variety of services, including marketing, placing, consulting on and servicing insurance risks for their clients, which include medium to large corporations, unaffiliated and affiliated insurance and reinsurance companies, and other risk taking entities. The brokers earn commission income and, to a lesser extent, fees for certain services, generally paid by the underwriters with whom the business is placed. Some of these risks may be initially underwritten by our insurance companies and they may retain a portion of the risk. Total revenue generated by our brokers in 2005 amounted to $31.9 million.
Rattner Mackenzie
Rattner Mackenzie Limited is a reinsurance broker based in London, England with additional operations in Hamilton, Bermuda and Mt. Kisco, New York. Rattner Mackenzie specializes in group life, accident and health reinsurance and some specialty property and casualty lines of business. It operates as a Lloyd’s broker for insurance and reinsurance business placed on behalf of unaffiliated and affiliated insurance companies, reinsurance companies and underwriting agencies and has been in operation since 1989.
Continental Underwriters
Continental Underwriters Ltd. is an insurance broker based in Covington, Louisiana specializing in commercial marine insurance and has been in operation since 1970.
HCC Risk Management
HCC Risk Management Corporation, based in Houston, Texas, is a reinsurance broker specializing in placing reinsurance on behalf of affiliated and unaffiliated insurance companies and has been in operation since 1991.
Other Operations
Other operating income consists of 1) equity in the earnings of mainly insurance-related companies in which we invest, 2) dividends and interest from certain other insurance-related strategic investments and gains or losses from the disposition of these investments, 3) income related to two mortgage impairment insurance contracts which, while written as insurance policies, receive accounting treatment as derivative financial instruments, 4) the profit or loss from an inventory of generally insurance-related trading securities and 5) other miscellaneous income. Other operating income was $39.8 million in 2005, but can vary considerably from period to period depending on the amount of investment or disposition activity.

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Operating Ratios
Premium to Surplus Ratio
This table shows the ratio of statutory gross written premium and net written premium to statutory policyholders’ surplus for our property and casualty insurance companies (dollars in thousands):
                                         
    2005     2004     2003     2002     2001  
Gross written premium
  $ 2,049,116     $ 1,992,361     $ 1,746,413     $ 1,163,397     $ 1,014,833  
Net written premium
    1,495,931       1,121,343       867,795       545,475       371,409  
Policyholders’ surplus
    1,110,268       844,851       591,889       523,807       401,393  
Gross written premium ratio
    184.6 %     235.8 %     295.1 %     222.1 %     252.8 %
Gross written premium industry average (1)
    *       201.6 %     219.3 %     244.4 %     210.8 %
Net written premium ratio
    134.7 %     132.7 %     146.6 %     104.1 %     92.5 %
Net written premium industry average (1)
    *       108.5 %     117.4 %     130.3 %     112.0 %
 
(1)   Source: A.M. Best Company, Inc.
 
*   Not available
While there is no statutory requirement regarding a permissible premium to policyholders’ surplus ratio, guidelines established by the National Association of Insurance Commissioners provide that a property and casualty insurer’s annual statutory gross written premium should not exceed 900% and net written premium should not exceed 300% of its policyholders’ surplus. However, industry standards and rating agency criteria place these ratios at 300% and 200%, respectively. Our property and casualty insurance companies have maintained ratios lower than such guidelines.
Combined Ratio — GAAP
The underwriting experience of a property and casualty insurance company is indicated by its combined ratio. The GAAP combined ratio is a combination of the loss ratio (the ratio of incurred losses and loss adjustment expenses to net earned premium) and the expense ratio (the ratio of policy acquisition costs and other underwriting expenses, net of ceding commissions, to net earned premium). We calculate the GAAP combined ratio using financial data derived from our consolidated financial statements reported under accounting principles generally accepted in the United States of America (generally accepted accounting principles). Our insurance companies’ GAAP loss ratios, expense ratios and combined ratios are shown in the following table:
                                         
    2005     2004     2003     2002     2001  
    (As restated)     (As restated)     (As restated)     (As restated)     (As restated)  
 
                                       
Loss ratio
    67.1 %     63.8 %     66.1 %     60.8 %     78.0 %
Expense ratio
    26.1       26.7       24.6       25.5       25.4  
 
                             
Combined ratio — GAAP
    93.2 %     90.5 %     90.7 %     86.3 %     103.4 %
 
                             

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Combined Ratio — Statutory
The statutory combined ratio is a combination of the loss ratio (the ratio of incurred losses and loss adjustment expenses to net earned premium) and the expense ratio (the ratio of policy acquisition costs and other underwriting expenses, net of ceding commissions, to net written premium). We calculate the statutory combined ratio using financial data derived from the combined financial statements of our insurance company subsidiaries reported in accordance with statutory accounting principles. Our insurance companies’ statutory loss ratios, expense ratios and combined ratios are shown in the following table:
                                         
    2005     2004     2003     2002     2001  
Loss ratio
    67.1 %     64.3 %     66.8 %     62.0 %     78.0 %
Expense ratio
    25.5       26.7       23.0       23.9       23.8  
 
                             
Combined ratio — Statutory
    92.6 %     91.0 %     89.8 %     85.9 %     101.8 %
 
                             
Industry average
    *       98.3 %     100.1 %     107.5 %     115.9 %
 
*   Not available
The statutory ratio data is not intended to be a substitute for results of operations in accordance with generally accepted accounting principles. We believe including this information is useful to allow a comparison of our operating results with those of other companies in the insurance industry. The source of the industry average is A.M. Best Company, Inc. A.M. Best Company, Inc. reports insurer performance based on statutory financial data to provide more standardized comparisons among individual companies and to provide overall industry performance; this data is not an evaluation directed at investors.
Reserves
Our net loss and loss adjustment expense reserves are composed of reserves for reported losses and reserves for incurred but not reported losses, less a reduction for reinsurance recoverables related to those reserves. Reserves are recorded by product line and are undiscounted, except for reserves related to acquisitions.
The process of estimating our loss and loss adjustment expense reserves involves a considerable degree of judgment by management and is inherently uncertain. The recorded reserves represent management’s best estimate of unpaid loss and loss adjustment expense by line of business. Because we provide insurance coverage in specialized lines of business that often lack statistical stability, management considers many factors and not just actuarial point estimates in determining ultimate expected losses and the level of net reserves required and recorded.
To record reserves on our lines of business, we utilize expected loss ratios, which management selects based on the following: 1) information used to price the applicable policies, 2) historical loss information where available, 3) any public industry data for that line or similar lines of business and 4) an assessment of current market conditions. Management also considers the point estimates and ranges calculated by our actuaries, together with input from our experienced underwriting and claims personnel. Because of the nature and complexities of the specialized types of business we insure, management may give greater weight to the expectations of our underwriting and claims personnel, who often perform a claim by claim review, rather than to the actuarial estimates. However, we utilize the actuarial point and range estimates to monitor the adequacy and reasonableness of our recorded reserves.
Each quarter-end, management compares recorded reserves to the most recent actuarial point estimate and range for each line of business. If the recorded reserves vary significantly from the actuarial point estimate, management determines the reasons for the variances and may adjust the reserves up or down to an amount that, in management’s judgment, is adequate based on all of the facts and circumstances considered, including the actuarial point estimates. Generally, we maintain total consolidated net reserves above the total actuarial point estimate but within the actuarial range.

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Our actuaries utilize standard actuarial techniques in making their actuarial point estimates. These techniques require a high degree of judgment and changing conditions can cause fluctuations in the reserve estimates. We believe that our review process is effective, such that any required changes are recognized in the period of change as soon as the need for the change is evident. Reinsurance recoverables offset our gross reserves based upon the contractual terms of our reinsurance agreements.
With the exception of 2004, our net reserves historically have shown positive development except for the effects of losses from commutations, which we have completed in the past and may negotiate in the future. Commutations can produce negative prior year development since, under generally accepted accounting principles, any excess of undiscounted reserves assumed over assets received must be recorded as a loss at the time the commutation is completed. Economically, the loss generally represents the discount for the time value of money that will be earned over the payout of the reserves; thus, the loss may be recouped as investment income is earned on the assets received. Based on our reserving techniques and our past results, we believe that our net reserves are adequate.
The reserving process is intended to reflect the impact of inflation and other factors affecting loss payments by taking into account changes in historical payment patterns and perceived trends. There is no precise method for the subsequent evaluation of the adequacy of the consideration given to inflation, or to any other specific factor, or to the way one factor may impact another.
We underwrite primary and reinsurance risks that are denominated in a number of foreign currencies and, therefore, maintain loss reserves with respect to these policies in the respective currencies. These reserves are subject to exchange rate fluctuations, which may have an effect on our net earnings.
The loss development triangles below show changes in our reserves in subsequent years from the prior loss estimates, based on experience at the end of each succeeding year, on the basis of generally accepted accounting principles. The estimate is increased or decreased as more information becomes known about the frequency and severity of losses for individual years. A redundancy means the original estimate was higher than the current estimate; a deficiency means that the current estimate is higher than the original estimate.
The first line of each loss development triangle presents, for the years indicated, our gross or net reserve liability including the reserve for incurred but not reported losses. The first section of each table shows, by year, the cumulative amounts of loss and loss adjustment expense paid at 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, at the date indicated, the difference between the latest re-estimated liability and the reserves as originally estimated.

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This loss development triangle shows development in loss reserves on a gross basis (in thousands):
                                                                                         
    2005     2004     2003     2002     2001     2000     1999     1998     1997     1996     1995  
 
                  (As restated)   (As restated)   (As restated)                                                
Balance sheet reserves
  $ 2,813,720     $ 2,089,199     $ 1,525,313     $ 1,158,915     $ 1,132,258     $ 944,117     $ 871,104     $ 460,511     $ 275,008     $ 229,049     $ 200,756  
Reserve adjustments from acquisition and disposition of subsidiaries
                      5,587             (66,571 )     (32,437 )     (136 )                  
Adjusted reserves
    2,813,720       2,089,199       1,525,313       1,164,502       1,132,258       877,546       838,667       460,375       275,008       229,049       200,756  
Cumulative paid at:
                                                                                       
One year later
            511,766       396,077       441,775       390,232       400,279       424,379       229,746       160,324       119,453       118,656  
Two years later
                    587,349       571,907       612,129       537,354       561,246       367,512       209,724       179,117       167,459  
Three years later
                            682,534       726,805       667,326       611,239       419,209       241,523       193,872       207,191  
Four years later
                                    803,152       720,656       686,730       435,625       259,067       212,097       214,046  
Five years later
                                            758,126       721,011       453,691       262,838       223,701       226,762  
Six years later
                                                    725,639       462,565       267,038       225,595       233,831  
Seven years later
                                                            462,126       270,362       227,177       235,236  
Eight years later
                                                                    268,939       228,621       235,950  
Nine years later
                                                                            230,745       236,726  
Ten years later
                                                                                    236,996  
Re-estimated liability at:
                                                                                       
End of year
    2,813,720       2,089,199       1,525,313       1,164,502       1,132,258       877,546       838,667       460,375       275,008       229,049       200,756  
One year later
            2,118,471       1,641,426       1,287,003       1,109,098       922,080       836,775       550,409       308,501       252,236       243,259  
Two years later
                    1,666,931       1,393,143       1,241,261       925,922       868,438       545,955       316,250       249,013       248,372  
Three years later
                            1,464,448       1,384,608       1,099,657       854,987       547,179       304,281       250,817       247,053  
Four years later
                                    1,455,046       1,102,636       900,604       537,968       305,022       247,245       248,687  
Five years later
                                            1,135,143       887,272       522,183       295,975       249,853       248,559  
Six years later
                                                    894,307       521,399       296,816       243,015       250,176  
Seven years later
                                                            513,918       292,544       242,655       246,661  
Eight years later
                                                                    291,164       241,904       246,159  
Nine years later
                                                                            244,687       245,408  
Ten years later
                                                                                    245,970  
Cumulative redundancy (deficiency)
          $ (29,272 )   $ (141,618 )   $ (299,946 )   $ (322,788 )   $ (257,597 )   $ (55,640 )   $ (53,543 )   $ (16,156 )   $ (15,638 )   $ (45,214 )

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The gross deficiencies reflected in the above table for years after 1998 resulted from the following:
    During 2005 and 2004, we recorded $49.8 million and $127.7 million, respectively, in gross losses related to the 2001 and 2000 accident years on certain assumed accident and health reinsurance contracts reported in discontinued lines of business, due to our processing of additional information received and our continuing evaluation of reserves on this business.
 
    During 2005, we reduced our gross reserves on the 2004 hurricanes by $13.4 million to reflect current estimates of our remaining liabilities, which partially offset the 2005 adverse development discussed above.
 
    During 2003, we recorded $132.9 million in gross losses related to 1999 and 2000 accident years on certain assumed accident and health reinsurance contracts reported in discontinued lines of business, due to our processing of additional information received and our continuing evaluation of reserves on this business.
 
    The 2000 and 1999 years in the table were also negatively affected by late reporting loss information received during 2001 for certain discontinued business.
The gross development in 2004 resulted in a $30.5 million negative effect on our net losses. The remainder of the gross development discussed above did not have a material effect on our net losses because the majority of the gross losses were reinsured.
The gross reserves in the discontinued line of business, particularly with respect to accident and health reinsurance, have shown substantial negative development in the last few years. This assumed accident and health reinsurance is primarily excess coverage for large losses related to workers’ compensation policies. Losses tend to develop and affect excess covers considerably after the original loss was incurred. Additionally, certain primary insurance companies that we reinsured have experienced financial difficulty and some of them are in liquidation, with guaranty funds now responsible for administering the business. Losses related to this business are historically late reporting. While we attempt to anticipate these conditions in setting our gross reserves, we have only been partially successful to date and there could be additional negative development in these reserves in the future. The gross losses that have developed negatively have been substantially reinsured and therefore have little effect on our net earnings.
The gross deficiencies reflected in the table for the years prior to 1999 resulted from two principal conditions:
    We had development of large claims on individual policies which were either reported late or for which reserves were increased as subsequent information became available. As these policies were substantially reinsured, there was no material effect on our net earnings.
 
    During 1999, in connection with the insolvency of one of the insurance companies that we reinsured and the commutation of all liabilities with another, we re-evaluated all loss reserves and incurred but not reported loss reserves related to business placed with these reinsurers to determine the ultimate losses we might conservatively expect. These reserves were then used as the basis for the determination of the provision for reinsurance recorded in 1999.

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The following table provides a reconciliation of the gross liability for loss and loss adjustment expense payable on the basis of generally accepted accounting principles (in thousands):
                         
    2005     2004     2003  
            (As restated)     (As restated)  
Reserves for loss and loss adjustment expense payable at beginning of year
  $ 2,089,199     $ 1,525,313     $ 1,158,915  
Reserve additions from acquisition of subsidiaries
    19,236       15,537       5,587  
Incurred loss and loss adjustment expense:
                       
Provision for loss and loss adjustment expense for claims occurring in current year
    1,567,501       1,173,042       922,838  
Increase in estimated loss and loss adjustment expense for claims occurring in prior years *
    29,272       116,113       122,501  
 
                 
Incurred loss and loss adjustment expense
    1,596,773       1,289,155       1,045,339  
 
                 
 
                       
Loss and loss adjustment expense payments for claims occurring during:
                       
Current year
    379,722       344,729       242,753  
Prior years
    511,766       396,077       441,775  
 
                 
Loss and loss adjustment expense payments
    891,488       740,806       684,528  
 
                 
Reserves for loss and loss adjustment expense payable at end of year
  $ 2,813,720     $ 2,089,199     $ 1,525,313  
 
                 
*   Changes in loss and loss adjustment expense reserves 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.

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This loss development triangle shows development in loss reserves on a net basis (in thousands):
                                                                                         
    2005     2004     2003     2002     2001     2000     1999     1998     1997     1996     1995  
    (As restated)                     (As restated)                                                          
Reserves, net of reinsurance
  $ 1,533,433     $ 1,059,283     $ 705,200     $ 458,702     $ 313,097     $ 249,872     $ 273,606     $ 118,912     $ 119,634     $ 117,283     $ 99,259  
Reserve adjustments from acquisition and disposition of subsidiaries
                      5,587             (6,048 )     (3,343 )     (410 )                  
Effect on loss reserves of 1999 write off of reinsurance recoverables
                                              63,851       15,008       2,636       1,442  
 
                                                                 
Adjusted reserves, net of reinsurance
    1,533,433       1,059,283       705,200       464,289       313,097       243,824       270,263       182,353       134,642       119,919       100,701  
Cumulative paid, net of reinsurance, at:
                                                                                       
One year later
            172,224       141,677       136,561       126,019       102,244       145,993       56,052       48,775       47,874       41,947  
Two years later
                    135,623       173,566       131,244       139,659       174,534       103,580       64,213       66,030       56,803  
Three years later
                            136,106       163,808       118,894       185,744       113,762       80,227       72,863       64,798  
Four years later
                                    93,405       138,773       180,714       121,293       81,845       81,620       67,355  
Five years later
                                            158,935       197,416       120,452       84,986       81,968       72,627  
Six years later
                                                    200,833       127,254       87,626       82,681       73,501  
Seven years later
                                                            131,631       89,194       84,108       73,792  
Eight years later
                                                                    88,061       84,847       74,836  
Nine years later
                                                                            84,770       75,216  
Ten years later
                                                                                    74,782  
Re-estimated liability, net of reinsurance, at:
                                                                                       
End of year
    1,533,433       1,059,283       705,200       464,289       313,097       243,824       270,263       182,353       134,642       119,919       100,701  
One year later
            1,084,677       735,678       487,403       306,318       233,111       260,678       186,967       120,049       116,145       95,764  
Two years later
                    770,497       500,897       338,194       222,330       254,373       175,339       116,745       101,595       94,992  
Three years later
                            571,403       366,819       259,160       244,650       171,165       110,673       97,353       85,484  
Four years later
                                    418,781       267,651       258,122       163,349       107,138       95,118       80,890  
Five years later
                                            296,396       254,579       155,931       103,243       93,528       79,626  
Six years later
                                                    271,563       157,316       101,538       91,413       79,968  
Seven years later
                                                            156,376       99,872       90,951       78,614  
Eight years later
                                                                    97,965       90,534       78,810  
Nine years later
                                                                            90,011       78,499  
Ten years later
                                                                                    77,732  
Cumulative redundancy (deficiency)
          $ (25,394 )   $ (65,297 )   $ (107,114 )   $ (105,684 )   $ (52,572 )   $ (1,300 )   $ 25,977     $ 36,677     $ 29,908     $ 22,969  

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The table below provides a reconciliation of the liability for loss and loss adjustment expense payable, net of reinsurance ceded, on the basis of generally accepted accounting principles (in thousands):
                         
    2005     2004     2003  
    (As restated)             (As restated)  
Net reserves for loss and loss adjustment expense payable at beginning of year
  $ 1,059,283     $ 705,200     $ 458,702  
Net reserve additions from acquisition of subsidiaries
    12,491       11,647       5,587  
Incurred loss and loss adjustment expense:
                       
Provision for loss and loss adjustment expense for claims occurring in current year
    894,303       614,752       464,886  
Increase in estimated loss and loss adjustment expense for claims occurring in prior years *
    25,394       30,478       23,114  
 
                 
Incurred loss and loss adjustment expense
    919,697       645,230       488,000  
 
                 
 
                       
Loss and loss adjustment expense payments for claims occurring during:
                       
Current year
    285,814       161,117       110,528  
Prior years
    172,224       141,677       136,561  
 
                 
Loss and loss adjustment expense payments
    458,038       302,794       247,089  
 
                 
Net reserves for loss and loss adjustment expense payable at end of year
  $ 1,533,433     $ 1,059,283     $ 705,200  
 
                 
 
*   Changes in loss and loss adjustment expense reserves 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.
We had net loss and loss adjustment expense adverse development relating to prior year losses of $25.4 million in 2005, $30.5 million in 2004 and $23.1 million in 2003. The 2005 development resulted from a commutation charge of $26.0 million, which primarily related to the 2001 and 2000 accident years, and a net redundancy of $0.6 million from all other sources. In 2004, as a result of adverse development in certain assumed accident and health business in our discontinued line of business, we strengthened our reserves on this line to bring them above our actuarial point estimate. Our 2004 deficiency included $27.3 million related to this charge, which primarily affected the 2001 and 2000 accident years, and we had a net deficiency of $3.2 million from all other sources. The 2003 development resulted from a commutation charge of $28.8 million, which primarily affected the 1999 and 2000 accident years, partially offset by a net redundancy of $5.7 million from all other sources. Deficiencies and redundancies in the reserves occur as we continually review our loss reserves with our actuaries, increasing or reducing loss reserves as a result of such reviews and as losses are finally settled and claims exposures are reduced. We believe we have provided for all material net incurred losses.
We have no material exposure to environmental pollution losses. Our largest insurance company subsidiary only began writing business in 1981 and its policies normally contain pollution exclusion clauses which limit pollution coverage to “sudden and accidental” losses only, thus excluding intentional dumping and seepage claims. Policies issued by our other insurance company subsidiaries do not have significant environmental exposures because of the types of risks covered. Therefore, we do not expect to experience any material loss development for environmental pollution claims. Likewise, we have no material exposure to asbestos claims.
Regulation
The business of insurance is extensively regulated by the government. At this time, the insurance business in the United States is regulated primarily by the individual states. Additional federal regulation of the insurance industry may occur in the future.

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Our business depends on our compliance with applicable laws and regulations and our ability to maintain valid licenses and approvals for our operations. We devote a significant effort toward obtaining and maintaining our licenses and compliance with a diverse and complex regulatory structure. In all jurisdictions, the applicable laws and regulations are subject to amendment or interpretation by regulatory authorities. Generally, regulatory authorities are vested with broad discretion to grant, renew and revoke licenses and approvals and to implement regulations governing the business and operations of insurers and insurance agents.
Insurance Companies
Our insurance companies are subject to regulation and supervision by the states and by other jurisdictions in which they do business. Regulation by the states varies, but generally involves regulatory and supervisory powers of a state insurance official. In the United States, the regulation and supervision of our insurance operations relates primarily to:
    approval of policy forms and premium rates;
 
    licensing of insurers and their agents;
 
    periodic examinations of our operations and finances;
 
    prescribing the form and content of records of financial condition required to be filed;
 
    requiring deposits for the benefit of policyholders;
 
    requiring certain methods of accounting;
 
    requiring reserves for unearned premium, losses and other purposes;
 
    restrictions on the ability of our insurance companies to pay dividends;
 
    restrictions on the nature, quality and concentration of investments;
 
    restrictions on transactions between insurance companies and their affiliates;
 
    restrictions on the size of risks insurable under a single policy; and
 
    standards of solvency, including risk-based capital measurement (which is a measure developed by the National Association of Insurance Commissioners and used by state insurance regulators to identify insurance companies that potentially are inadequately capitalized).
In the United States, state insurance regulations are intended primarily for the protection of policyholders rather than shareholders. The state insurance departments monitor compliance with regulations through periodic reporting procedures and examinations. The quarterly and annual financial reports to the state insurance regulators utilize accounting principles that are different from the generally accepted accounting principles we use in our reports to shareholders. Statutory accounting principles, in keeping with the intent to assure the protection of policyholders, are generally based on a liquidation concept, while generally accepted accounting principles are based on a going-concern concept.
In the United States, state insurance regulators classify primary insurance companies and some individual lines of business as “admitted,” also known as “licensed,” insurance, or “non-admitted,” also known as “surplus lines,” insurance. Surplus lines insurance is offered by non-admitted companies on risks that are not insured in the particular state by admitted companies. All surplus lines insurance is required to be written through licensed surplus lines insurance brokers, who are required to be knowledgeable of and follow specific state laws prior to placing a risk with a surplus lines insurer. Our insurance companies offer products on both an admitted and surplus lines basis.
In the United Kingdom, the Financial Services Authority supervises all securities, banking and insurance businesses,

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including Lloyd’s of London. The Financial Services Authority oversees compliance with established periodic auditing and reporting requirements, risk assessment reviews, minimum solvency margins, dividend restrictions, restrictions governing the appointment of key officers, restrictions governing controlling ownership interests and various other requirements. All of our United Kingdom operations, including Houston Casualty Company-London, are authorized and regulated by the Financial Services Authority.
HCC Europe is domiciled in Spain and operates on the equivalent of an “admitted” basis throughout the European Union. HCC Europe’s primary regulator is the General Directorate of Insurance and Pension Funds of the Ministry of the Economy and Treasury (Dirección General de Seguros y Fondos de Pensiones del Ministerio de Economía y Hacienda).
U.S. state insurance regulations also affect the payment of dividends and other distributions by insurance companies to their shareholders. Generally, insurance companies are limited by these regulations to the payment of dividends above a specified level. Dividends in excess of those thresholds are “extraordinary dividends” and are subject to prior regulatory approval.
Underwriting Agencies and Reinsurance and Insurance Brokers
In addition to the regulation of insurance companies, the states impose licensing and other requirements on the underwriting agency and service operations of our other subsidiaries. These regulations relate primarily to:
    advertising and business practice rules;
 
    contractual requirements;
 
    financial security;
 
    licensing as agents, brokers, reinsurance brokers, managing general agents or third party administrators;
 
    limitations on authority; and
 
    recordkeeping requirements.
Statutory Accounting Principles
The principal differences between statutory accounting principles for our domestic insurance company subsidiaries and generally accepted accounting principles, the method by which we report our financial results to our shareholders, are as follows:
    a liability is recorded for certain reinsurance recoverables under statutory accounting principles whereas, under generally accepted accounting principles, there is no such provision unless the recoverables are deemed to be doubtful of collection;
 
    certain assets which are considered “non-admitted assets” are eliminated from a balance sheet prepared in accordance with statutory accounting principles but are included in a balance sheet prepared in accordance with generally accepted accounting principles;
 
    only some of the deferred tax asset is recognized under statutory accounting principles;
 
    fixed-income investments classified as available for sale are recorded at market value for generally accepted accounting principles and at amortized cost under statutory accounting principles;

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  outstanding losses and unearned premium are reported on a gross basis under generally accepted accounting principles and on a net basis under statutory accounting principles; and
 
  under statutory accounting principles, policy acquisition costs are expensed as incurred and, under generally accepted accounting principles, such costs are deferred and amortized to expense as the related premium is earned.
Our international insurance company subsidiaries’ accounting principles are prescribed by regulatory authorities in each country. The prescribed principles do not vary significantly from generally accepted accounting principles.
Insurance Holding Company Acts
Because we are an insurance holding company, we are subject to the insurance holding company system regulatory requirements of a number of states. Under these regulations, we are required to report information regarding our capital structure, financial condition and management. We are also required to provide prior notice to, or seek the prior approval of, insurance regulatory authorities of certain agreements and transactions between our affiliated companies. These agreements and transactions must satisfy certain regulatory requirements.
Assessments
Many states require insurers licensed to do business in their state to bear a portion of the loss suffered by some insureds as a result of the insolvency of other insurers or to bear a portion of the cost of insurance for “high-risk” or otherwise uninsured individuals. Depending upon state law, insurers can be assessed an amount that is generally limited to between 1% and 2% of premiums written for the relevant lines of insurance in that state. Part of these payments may be recoverable through premium rates, premium tax credits or policy surcharges. Significant increases in assessments could limit the ability of our insurance subsidiaries to recover such assessments through tax credits or other means. In addition, there have been some legislative efforts to limit policy surcharges or repeal the tax offset provisions. We cannot predict the extent to which such assessments may increase or whether there may be limits imposed on our ability to recover or offset such assessments.
Insurance Regulations Concerning Change of Control
Many state insurance regulatory laws contain provisions that require advance approval by state agencies of any change of control of an insurance company that is domiciled or, in some cases, has substantial business in that state. “Control” is generally presumed to exist through the ownership of 10% or more of the voting securities of a domestic insurance company or of any company that controls a domestic insurance company. HCC owns, directly or indirectly, all of the shares of stock of insurance companies domiciled in a number of states. Any purchaser of shares of common stock representing 10% or more of the voting power of our common stock will be presumed to have acquired control of our domestic insurance subsidiaries unless, following application by that purchaser, the relevant state insurance regulators determine otherwise. Any transactions that would constitute a change in control of any of our individual insurance subsidiaries would generally require prior approval by the insurance departments of the states in which the insurance subsidiary is domiciled. Also, one of our insurance subsidiaries is domiciled in the United Kingdom and another in Spain. Insurers in those countries are also subject to change of control restrictions under their individual regulatory frameworks. These requirements may deter or delay possible significant transactions in our common stock or the disposition of our insurance companies to third parties, including transactions which could be beneficial to our shareholders.
Risk-Based Capital
The National Association of Insurance Commissioners has developed a formula for analyzing insurance companies called risk-based capital. The risk-based capital formula is intended to establish minimum capital thresholds that vary with the size and mix of a company’s business and assets. It is designed to identify companies with capital levels that may require regulatory attention. At December 31, 2005, each of our domestic insurance companies’ total adjusted capital was significantly in excess of the authorized control level risk-based capital.

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Insurance Regulatory Information System
The National Association of Insurance Commissioners has developed a rating system, the Insurance Regulatory Information System, primarily intended to assist state insurance departments in overseeing the financial condition of all insurance companies operating within their respective states. The Insurance Regulatory Information System consists of eleven key financial ratios that address various aspects of each insurer’s financial condition and stability. Our insurance companies’ Insurance Regulatory Information System ratios generally fall within the usual prescribed ranges.
Terrorism Risk Insurance Act
The Federal Terrorism Risk Insurance Act was initially enacted in 2002, and subsequently extended through the end of 2007, for the purpose of ensuring the availability of insurance coverage for terrorist acts in the United States. The law establishes a financial backstop program to assist the commercial property and casualty insurance industry in providing coverage related to future acts of terrorism within the United States. It is unknown at this time whether or not the law will be extended beyond December 31, 2007 or on what terms. If it is not renewed, our current policies allow us to cancel the terrorism coverage in force at that time and we will no longer be required to offer the coverage.
Under the Act, we are required to offer terrorism coverage to our commercial policyholders in certain lines of business written in the United States, for which we may, when warranted, charge an additional premium. The policyholders may or may not accept such coverage. This law also established a deductible that each insurer would have to meet before U.S. Federal reimbursement would occur. For 2006, our deductible is approximately $91.9 million. The Federal government would provide reimbursement for 90% of any additional covered losses in 2006 up to the maximum amount set out in the Act.
Legislative Initiatives
In recent years, state legislatures have considered or enacted laws that modify and, in many cases, increase state authority to regulate insurance companies and insurance holding company systems. State insurance regulators are members of the National Association of Insurance Commissioners, which seeks to promote uniformity of and to enhance the state regulation of insurance. In addition, the National Association of Insurance Commissioners and state insurance regulators, as part of the National Association of Insurance Commissioners’ state insurance department accreditation program and in response to new federal laws, have re-examined existing state laws and regulations, specifically focusing on insurance company investments, issues relating to the solvency of insurance companies, licensing and market conduct issues, streamlining agent licensing and policy form approvals, adoption of privacy rules for handling policyholder information, interpretations of existing laws, the development of new laws and the definition of extraordinary dividends.
In recent years, a variety of measures have been proposed at the federal level to reform the current process of federal and state regulation of the financial services industries in the United States, which include the banking, insurance and securities industries. These measures, which are often referred to as financial services modernization, have as a principal objective the elimination or modification of regulatory barriers to cross-industry combinations involving banks, securities firms and insurance companies. A form of financial services modernization legislation was enacted at the federal level in 1999 through the Gramm-Leach-Bliley Act. That federal legislation was expected to have significant implications on the banking, insurance and securities industries and to result in more cross-industry consolidations among banks, insurance companies and securities firms and increased competition in many of the areas of operations. Such wide-spread cross-industry consolidation has not occurred to date. It also mandated the adoption of laws allowing reciprocity among the states in the licensing of agents and, along with other federal laws, mandated the adoption of laws and regulations dealing with the protection of the privacy of policyholder information. Also, the federal government has from time to time considered whether to impose overall federal regulation of insurers. If so, we believe state regulation of the insurance business would likely continue. This could result in an additional layer of federal regulation. In addition, some insurance industry trade groups are actively lobbying for legislation that would allow an option for a separate federal charter for insurance companies. The full extent to which the federal government could decide to directly regulate the business of insurance has not been determined by lawmakers.

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Recently, state regulators in many states have initiated or are participating in industry-wide investigations of sales and marketing practices in the insurance industry. Such investigations have resulted in restitution and settlement payments by some companies and criminal charges against some individuals. The investigations are expected to lead to changes in the structure of compensation arrangements, the offering of certain products and increased transparency in the marketing of many insurance products, some of which changes may be legally required. We have cooperated fully with any such investigations and, based on presently available information, do not expect any adverse results from such investigations.
We do not know at this time the full extent to which these federal or state legislative or regulatory initiatives will or may affect our operations and no assurance can be given that they would not, if adopted, have a material adverse effect on our business or our results of operations.
Employees
At December 31, 2005, we had 1,448 employees. Of this number, 770 are employed by our insurance companies, 433 are employed by our underwriting agencies, 101 are employed by our reinsurance and insurance brokers and 144 are employed at the corporate headquarters and elsewhere. We are not a party to any collective bargaining agreement and have not experienced work stoppages or strikes as a result of labor disputes. We consider our employee relations to be good.
ITEM 1A. RISK FACTORS
RISKS RELATING TO OUR INDUSTRY
Because we are a property and casualty insurer, our business may suffer as a result of unforeseen catastrophic losses.
Property and casualty insurers are subject to claims arising from catastrophes. Catastrophic losses have had a significant impact on our historical results. Catastrophes can be caused by various events, including hurricanes, tsunamis, windstorms, earthquakes, hailstorms, explosions, severe winter weather and fires and may include man-made events, such as terrorist attacks. The incidence, frequency and severity of catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. Insurance companies are not permitted to reserve for a catastrophe until it has occurred. Catastrophes can cause losses in a variety of our property and casualty lines, and most of our past catastrophe-related claims have resulted from hurricanes and earthquakes; however, we experienced a significant loss as a result of the September 11, 2001 terrorist attack. Most of our exposure to catastrophes comes from our London market account. Although we typically purchase reinsurance protection for risks we believe bear a significant level of catastrophe exposure, the nature or magnitude of losses attributed to a catastrophic event or events may result in losses which exceed our reinsurance protection. It is therefore possible that a catastrophic event or multiple catastrophic events could have a material adverse effect on our financial position, results of operations and liquidity.
The insurance and reinsurance business is historically cyclical, and we expect to experience periods with excess underwriting capacity and unfavorable premium rates, which could cause our results to fluctuate.
The insurance and reinsurance business historically has been a cyclical industry characterized by periods of intense price competition due to excessive underwriting capacity, as well as periods when shortages of capacity permitted an increase in pricing and, thus, more favorable premium levels. An increase in premium levels is often over time offset by an increasing supply of insurance and reinsurance capacity, either by capital provided by new entrants or by the commitment of additional capital by existing insurers or reinsurers, which may cause prices to decrease. Any of these factors could lead to a significant reduction in premium rates, less favorable policy terms and fewer opportunities to underwrite insurance risks, which could have a material adverse effect on our results of operations and cash flows. In addition to these considerations, changes in the frequency and severity of losses suffered by insureds and insurers may affect the cycles of the insurance and reinsurance business significantly. These factors may also cause the price of our common stock to be volatile.

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Our loss reserves are based on an estimate of our future liability, which may prove to be inadequate.
We maintain loss reserves to cover our estimated liability for unpaid losses and loss adjustment expenses, including legal and other fees as well as a portion of our general expenses, for reported and unreported claims incurred at the end of each accounting period. Reserves do not represent an exact calculation of liability. Rather, reserves represent an estimate of what we expect the ultimate settlement and administration of claims will cost. These estimates, which generally involve actuarial projections, are based on our assessment of facts and circumstances then known, as well as estimates of future trends in claims severity, frequency, judicial theories of liability and other factors. These variables are affected by both internal and external events, such as changes in claims handling procedures, inflation, judicial trends and legislative changes. Many of these items are not directly quantifiable in advance. Additionally, there may be a significant reporting delay between the occurrence of the insured event and the time it is reported to us. The inherent uncertainties of estimating reserves are greater for certain types of liabilities, particularly those in which the various considerations affecting the type of claim are subject to change and in which long periods of time may elapse before a definitive determination of liability is made. Reserve estimates are continually refined in a regular and ongoing process as experience develops and further claims are reported and settled. Adjustments to reserves are reflected in our results of operations in the periods in which such estimates are changed. Because setting reserves is inherently uncertain, there can be no assurance that current reserves will prove adequate in light of subsequent events. If actual claims prove to be greater than our reserves, our financial position, results of operations and liquidity may be adversely affected.
The effects of emerging claim and coverage issues on our business are uncertain.
As industry practices and legal, judicial, social and other environmental conditions change, unexpected and unintended issues related to claims and coverage may emerge. These issues may adversely affect our business by either extending coverage beyond our underwriting intent or by increasing the number or size of claims. In some instances, these changes may not become apparent until some time after we have issued insurance or reinsurance contracts that are affected by the changes. As a result, the full extent of liability under our insurance or reinsurance contracts may not be known for many years after a contract is issued and our financial position and results of operations may be adversely affected.
We are subject to extensive governmental regulation, which could adversely affect our business.
We are subject to extensive governmental regulation and supervision. Our business depends on compliance with applicable laws and regulations and our ability to maintain valid licenses and approvals for our operations. Most insurance regulations are designed to protect the interests of policyholders rather than shareholders and other investors. In the United States, this regulation is generally administered by departments of insurance in each state in which we do business and includes a comprehensive framework of oversight of our operations and review of our financial position. U.S. Federal legislation may lead to additional federal regulation of the insurance industry in the coming years. Also, foreign governments regulate our international operations. Each foreign jurisdiction has its own unique regulatory framework which applies to our operations in that jurisdiction. Regulatory authorities have broad discretion to grant, renew or revoke licenses and approvals. Regulatory authorities may deny or revoke licenses for various reasons, including the violation of regulations. In some instances, we follow practices based on our interpretations of regulations, or those we believe to be generally followed by the industry, which may be different from the requirements or interpretations of regulatory authorities. If we do not have the requisite licenses and approvals and do not comply with applicable regulatory requirements, the insurance regulatory authorities could preclude or temporarily suspend us from carrying on some or all of our activities or otherwise penalize us. That type of action could have a material adverse effect on our results of operations. Also, changes in the level of regulation of the insurance industry (whether federal, state or foreign), or changes in laws or regulations themselves or interpretations by regulatory authorities, could have a material adverse effect on our business. Virtually all states require insurers licensed to do business in that state to bear a portion of the loss suffered by some insureds as the result of impaired or insolvent insurance companies. The effect of these arrangements could adversely affect our results of operations.

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Our reliance on brokers subjects us to their credit risk.
In accordance with industry practice, we generally pay amounts owed on claims under our insurance and reinsurance contracts to brokers, and these brokers, in turn, pay these amounts over to the clients that have purchased insurance or reinsurance from us. Although the law is unsettled and depends upon the facts and circumstances of the particular case, in some jurisdictions, if a broker fails to make such a payment, we might remain liable to the insured or ceding insurer for the deficiency. Conversely, in certain jurisdictions, when the insured or ceding insurer pays premiums for these policies to brokers for payment over to us, these premiums might be considered to have been paid and the insured or ceding insurer will no longer be liable to us for those amounts, whether or not we have actually received the premiums from the broker. Consequently, we assume a degree of credit risk associated with brokers with whom we transact business. However, due to the unsettled and fact-specific nature of the law, we are unable to quantify our exposure to this risk. To date, we have not experienced any material losses related to these credit risks.
RISKS RELATING TO OUR BUSINESS
Our increased retentions in various lines of business means that we are exposed to a greater portion of potential losses.
Over the past few years, we have significantly increased our retentions in a number of the lines of business underwritten by our insurance companies. The determination to reduce the amount of reinsurance we purchase or not to purchase reinsurance for a particular risk or line of business is based on a variety of factors including market conditions, pricing, availability of reinsurance, the level of our capital and loss history. Such determinations have the effect of increasing our financial exposure to losses associated with such risks or in the subject line of business and could have a material adverse effect on our financial position, results of operations and cash flows in the event of significant losses associated with such risks or lines of business.
If we are unable to purchase adequate reinsurance protection for some of the risks we have underwritten, we will be exposed to any resulting losses.
We purchase reinsurance for a portion of the risks underwritten by our insurance companies, especially volatile and catastrophe-exposed risks. Market conditions beyond our control determine the availability and cost of the reinsurance protection we purchase. In addition, the historical results of reinsurance programs and the availability of capital also affect the availability of reinsurance. Our reinsurance facilities are generally subject to annual renewal. We cannot assure that we can maintain our current reinsurance facilities or that we can obtain other reinsurance facilities in adequate amounts and at favorable rates. Further, we cannot determine what effect catastrophic losses will have on the reinsurance market in general and on our ability to obtain reinsurance in adequate amounts and at favorable rates in particular. If we are unable to renew or to obtain new reinsurance facilities, either our net exposures would increase or, if we are unwilling to bear such an increase, we would have to reduce the level of our underwriting commitments, especially in catastrophe-exposed risks. Either of these potential developments could have a material adverse effect on our financial position, results of operations and cash flows. The lack of available reinsurance may also adversely affect our ability to generate fee and commission income in our underwriting agency and reinsurance broker operations.
If the companies that provide our reinsurance do not pay all of our claims, we could incur severe losses.
We purchase reinsurance by transferring, or ceding, part of the risk we have assumed as a primary insurer to a reinsurance company in exchange for part of the premium we receive in connection with the risk. The part of the risk we retain for our own account is known as the retention. Through reinsurance, we have the contractual right to collect the amount above our retention from our reinsurers. Although reinsurance makes the reinsurer liable to us to the extent the risk is transferred or ceded to the reinsurer, it does not relieve us, the reinsured, of our full liability to our policyholders. Accordingly, we bear credit risk with respect to our reinsurers. We cannot assure you that our reinsurers will pay all of our reinsurance claims, or that they will pay our claims on a timely basis. Additionally, catastrophic losses from multiple primary insurers may accumulate within the more concentrated reinsurance market and result in claims which adversely impact the financial condition of such reinsurers and thus their ability to pay such claims. If we become liable for risks we have

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ceded to reinsurers or if our reinsurers cease to meet their obligations to us, whether because they are in a weakened financial position as a result of incurred losses or otherwise, our financial position, results of operations and cash flows could be materially adversely affected.
As a primary insurer, we may have significant exposure for terrorist acts.
To the extent that reinsurers have excluded coverage for terrorist acts or have priced such coverage at rates that we believe are not practical, we, in our capacity as a primary insurer, do not have reinsurance protection and are exposed for potential losses as a result of any terrorist acts. To the extent an act of terrorism is certified by the Secretary of Treasury, we may be covered under The Terrorism Risk Insurance Act, originally enacted in 2002 and subsequently extended, for up to 90% of our losses in 2006. However, any such coverage would be subject to a mandatory deductible. Our deductible under the Act during 2006 is $91.9 million. If the Act is not extended beyond its currently stated termination date of December 31, 2007 or replaced by a similar program, our liability for terrorist acts could be a material amount.
We may be unsuccessful in competing against larger or more well established business rivals.
In our specialty insurance operations, we compete in narrowly-defined niche classes of business such as the insurance of private aircraft (aviation), directors’ and officers’ liability (diversified financial products), employer sponsored, self-insured medical plans (medical stop-loss), professional indemnity (diversified financial products) and surety (diversified financial products), as distinguished from such general lines of business as automobile or homeowners insurance. We compete with a large number of other companies in our selected lines of business, including: Lloyd’s, ACE and XL in our London market business; American International Group and U.S. Aviation Insurance Group (a subsidiary of Berkshire Hathaway, Inc.) in our aviation line of business; United Health, Symetra Financial Corp. and Hartford Life in our group life, accident and health business; and American International Group, The Chubb Corporation, ACE, St. Paul Travelers and XL in our diversified financial products business. We face competition from specialty insurance companies, underwriting agencies and reinsurance brokers, as well as from diversified financial services companies that are larger than we are and that have greater financial, marketing and other resources than we do. Some of these competitors also have longer experience and more market recognition than we do in certain lines of business. In addition to competition in the operation of our business, we face competition from a variety of sources in attracting and retaining qualified employees. We cannot assure you that we will maintain our current competitive position in the markets in which we operate, or that we will be able to expand our operations into new markets. If we fail to do so, our results of operations and cash flows could be materially adversely affected.
If the rating agencies downgrade us, our business and competitive position in the industry may suffer.
Ratings have become an increasingly important factor in establishing the competitive position of insurance companies. Our insurance companies are rated by Standard & Poor’s Corporation, Fitch Ratings and A.M. Best Company, Inc. whose ratings reflect their opinions of an insurance company’s and insurance holding company’s financial strength, operating performance, strategic position and ability to meet its obligations to policyholders and are not evaluations directed to investors. Our ratings are subject to periodic review by those entities and the continuation of those ratings cannot be assured. A. M. Best placed our insurance company ratings under review with negative implications as a result of the Special Committee’s investigation of our stock option granting practices and subsequent non-compliance with financial reporting and other information delivery requirements under our debt instruments. Standard & Poor’s and Fitch Ratings affirmed their ratings of our insurance companies with a stable outlook, after considering our announcement of the substantial completion of the Special Committee’s investigation. If our ratings are reduced from their current levels, our financial position and results of operations could be adversely affected.
We may require additional capital in the future, which may not be available or may only be available on unfavorable terms.
Our future capital requirements depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover losses. We may need to raise additional funds through financings or curtail our growth and reduce our assets. Any equity or debt financing, if available at all, may be on terms that are not favorable to us. In the case of equity financings, dilution to our shareholders could result and, in any case,

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such securities may have rights, preferences and privileges that are senior to those of our common stock. If we cannot obtain adequate capital on favorable terms or at all, our business, results of operations and liquidity could be adversely affected.
As a result of our delayed filing of our Form 10-Q’s for the quarters ended June 30, 2006 and September 30, 2006, we are ineligible to register our securities on Form S-3 or use our previously filed shelf registration statement until we have timely filed all periodic reports under the Securities Exchange Act of 1934 for one year. We may use Form S-1 to raise capital and borrow money utilizing public debt or complete acquisitions of other companies, which could increase transaction costs and adversely impact our ability to raise capital and borrow money or complete acquisitions in a timely manner. In addition, the financial strength ratings of our insurance companies and our debt ratings, which A.M. Best placed under review with negative implications and Fitch Ratings and Standard & Poor’s affirmed with a stable outlook, if reduced, might significantly impede our ability to raise capital and borrow money.
We may be unable to attract and retain qualified employees.
We depend on our ability to attract and retain experienced underwriting talent and other skilled employees who are knowledgeable about our business. If the quality of our underwriting team and other personnel decreases, we may be unable to maintain our current competitive position in the specialized markets in which we operate and be unable to expand our operations into new markets, which could adversely affect our business.
We invest a significant amount of our assets in fixed income securities that have experienced market fluctuations, which may greatly reduce the value of our investment portfolio.
At December 31, 2005, $2.3 billion of our $3.3 billion investment portfolio was invested in fixed income securities. The fair value of these fixed income securities and the related investment income fluctuate depending on general economic and market conditions. With respect to our investments in fixed income securities, the fair value of these investments generally increases or decreases in an inverse relationship with fluctuations in interest rates, while net investment income realized by us from future investments in fixed income securities will generally increase or decrease with interest rates. In addition, actual net investment income and/or cash flows from investments that carry prepayment risk (such as mortgage-backed and other asset-backed securities) may differ from those anticipated at the time of investment as a result of interest rate fluctuations. An investment has prepayment risk when there is a risk that the timing of cash flows that result from the repayment of principal might occur earlier than anticipated because of declining interest rates or later than anticipated because of rising interest rates. Although we maintain an investment grade portfolio (99% are rated “A” or better), our fixed income securities are also subject to credit risk. If any of the issuers of our fixed income securities suffer financial setbacks, the ratings on the fixed income securities could fall (with a concurrent fall in fair value) and, in a worst case scenario, the issuer could default on its financial obligations. Historically, the impact of market fluctuations has affected our financial statements. Because all of our fixed income securities are classified as available for sale, changes in the fair value of our securities are reflected in our other comprehensive income. Similar treatment is not available for liabilities. Therefore, interest rate fluctuations could adversely affect our financial position. Unrealized pre-tax net investment losses on investments in fixed income securities were $29.3 million in 2005, $9.3 million in 2004 and $3.7 million in 2003.
Our strategy of acquiring other companies for growth may not succeed.
Our strategy for growth includes growing through acquisitions of insurance industry related companies. This strategy presents risks that could have a material adverse effect on our business and financial performance, including: 1) the diversion of our management’s attention, 2) our ability to assimilate the operations and personnel of the acquired companies, 3) the contingent and latent risks associated with the past operations of, and other unanticipated problems arising in, the acquired companies, 4) the need to expand management, administration and operational systems and 5) increased competition for suitable acquisition opportunities and qualified employees. We cannot predict whether we will be able to acquire additional companies on terms favorable to us or if we will be able to successfully integrate the acquired operations into our business. We do not know if we will realize any anticipated benefits of completed acquisitions or if there will be substantial unanticipated costs associated with new acquisitions. In addition, future acquisitions by us may result in potentially dilutive issuances of our equity securities, the incurrence of additional debt and the recognition of potential impairment of goodwill and other intangible assets. Each of these factors could adversely

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affect our financial position and results of operations. Moreover, our ability to use equity securities or to incur additional debt for acquisitions may be negatively affected by the effects of our options pricing investigation.
We are an insurance holding company and, therefore, may not be able to receive dividends in needed amounts from our subsidiaries.
Historically, we have had sufficient cash flow from our non-insurance company subsidiaries to meet our corporate cash flow requirements for paying principal and interest on outstanding debt obligations, dividends to shareholders and corporate expenses. However, in the future we may rely on dividends from our insurance companies to meet these requirements. The payment of dividends by our insurance companies is subject to regulatory restrictions and will depend on the surplus and future earnings of these subsidiaries, as well as the regulatory restrictions. As a result, should our other sources of funds prove to be inadequate, we may not be able to receive dividends from our insurance companies at times and in amounts necessary to meet our obligations, which could adversely affect our financial position and liquidity.
Because we operate internationally, fluctuations in currency exchange rates may affect our receivable and payable balances and our reserves.
We underwrite insurance coverages that are denominated in a number of foreign currencies and we establish and maintain our loss reserves with respect to these policies in their respective currencies. Our net earnings could be adversely affected by exchange rate fluctuations, which would adversely affect receivable and payable balances and reserves. Our principal area of exposure relates to fluctuations in exchange rates between the major European currencies (particularly the British pound sterling and the Euro) and the U.S. dollar. Consequently, a change in the exchange rate between the U.S. dollar and the British pound sterling or the Euro could have an adverse effect on our results of operations.
Our information technology systems may fail or suffer a loss of security, which could adversely affect our business.
Our business is highly dependent upon the successful and uninterrupted functioning of our computer and data processing systems. We rely on these systems to perform actuarial and other modeling functions necessary for writing business, as well as to process and make claims payments. We have a highly trained staff that is committed to the development and maintenance of these systems. However, the failure of these systems could interrupt our operations. This could result in a material adverse effect on our business results.
In addition, a security breach of our computer systems could damage our reputation or result in liability. We retain confidential information regarding our business dealings in our computer systems. We may be required to spend significant capital and other resources to protect against security breaches or to alleviate problems caused by such breaches. It is critical that these facilities and infrastructure remain secure. Despite the implementation of security measures, this infrastructure may be vulnerable to physical break-ins, computer viruses, programming errors, attacks by third parties or similar disruptive problems. In addition, we could be subject to liability if hackers were able to penetrate our network security or otherwise misappropriate confidential information.
The SEC’s informal inquiry related to our stock option granting procedures is on-going, and the scope and outcome could have a negative impact on the price of our securities and on our business.
As described in Note 2 to our Consolidated Financial Statements included in this Form 10-K/A, based on the Special Committee’s voluntary independent investigation of our past practices related to granting stock options, we determined that the price on the actual measurement date for a number of our stock option grants during the period 1997 through 2005 and into 2006 did not correspond to the price on the stated grant date and that certain option grants were retroactively priced. The investigation was conducted with the help of a law firm that was not previously involved with our stock option plans and procedures. The SEC has commenced an informal inquiry. In connection with its inquiry, we received a document request from the SEC. We intend to fully cooperate with the informal inquiry. We are unable to predict the outcome of the informal inquiry, but it may result in substantial legal, tax, accounting and other professional services costs, may continue to occupy the time and attention of our management team, could have a material adverse impact on our stock price, including increased stock price volatility, and could negatively impact our business and our ability to raise and borrow additional funds in the future.

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If we do not maintain compliance with the listing requirements of the New York Stock Exchange (NYSE), our common stock could be delisted, which would reduce the price of our common stock and the levels of liquidity available to our shareholders.
In connection with the Special Committee’s investigation of our option granting practices and the restatement of our consolidated financial statements, we were delinquent in filing certain of our periodic reports with the SEC. These circumstances could lead to a delisting of our common stock from the NYSE. If we are delisted from the NYSE, the price of our common stock and levels of liquidity available to our stockholders could be reduced. In addition, a delisting from the NYSE could result in other negative implications, including the potential loss of confidence by customers and employees and the loss of institutional investor interest in our company.
The matters relating to the Special Committee of the Board of Directors’ investigation of our historical stock option granting practices and the restatement of our consolidated financial statements may result in future litigation, which could harm our business and financial condition.
As a result of the Special Committee’s investigation of our historical stock option granting practices, we had to record non-cash compensation expense in each year for the period 1997 through 2005 and increase such expense in 2006. To correct these accounting errors, we are amending our Annual Report on Form 10-K for the year ended December 31, 2005 and our Quarterly Report on Form 10-Q for the three months ended March 31, 2006, to restate the consolidated financial statements and condensed consolidated financial statements, respectively, contained in those reports. Our historical stock option granting practices and the restatement of our prior consolidated financial statements have exposed us to greater risks associated with litigation. Publicity resulting from these actions may materially adversely affect us, regardless of the cause or effect of the actions. We cannot assure you that any future litigation will result in the same conclusions reached by the Special Committee. The conduct and resolution of litigation could be time consuming, expensive and may distract management from the conduct of our business. In addition, damages and other remedies awarded in any such litigation could harm our business and financial condition.
The loss of Stephen L. Way as our Chief Executive Officer could weaken our strategic leadership and have a material adverse effect on our business and development.
Since our founding, Stephen L. Way’s leadership and strategic direction have been critical elements to our success. On November 17, 2006, Mr. Way resigned as our Chief Executive Officer. However, Mr. Way will remain a director of HCC and serve as the non-executive Chairman of the Board of Directors and as a paid consultant. Although our executive officers have experience in the insurance industry, they do not have the same breadth of experience as Mr. Way in providing the strategic direction for our future growth and development. As a result, the loss of Mr. Way’s services as Chief Executive Officer could weaken our strategic leadership and have a material adverse effect upon our business and continuing development.
Our failure to comply with any of the covenants in the indentures for our convertible notes and in our revolving loan facility could have a material adverse impact on our business and our financial condition.
On October 30, 2006, we received a registered letter from U.S. Bank, as trustee for the holders of our 2.00% Convertible Notes due 2021, 1.30% Convertible Notes due 2023 and 2.00% Convertible Exchange Notes due 2021, stating that U.S. Bank, as trustee, had not received our consolidated financial statements for the quarter ended June 30, 2006. If we do not file our Quarterly Report on Form 10-Q for the quarter ended June 30, 2006 with the SEC and deliver the report to the trustee within sixty days from the date notice was received from the trustee, such failure to file and deliver will be considered an “Event of Default” under the indenture governing the notes. If an “Event of Default” were to occur under the indentures for any series of the notes, the trustee or holders of at least 25% of the aggregate principal of such series then outstanding could declare all the unpaid principal on such series of notes then outstanding to be immediately due and payable. Likewise, we have not timely delivered our Form 10-Q’s for the quarters ended June 30 and September 30, 2006 as required by the terms of our Revolving Loan Facility. The banks that are a party to the agreement waived certain “Defaults” or “Events of Default” until January 31, 2007. In addition, our restatement of our prior year financial statements might be considered an “Event of Default”, which has been waived until January 31, 2007 under our Revolving Loan Facility. Our failure to comply with the covenants in the indentures for our convertible notes and our Revolving Loan Facility in the future could have a material adverse effect on our stock price, business and financial condition if we would not have available funds at that time to repay any defaulted debt. A default and acceleration under

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the indentures for our convertible notes and loan agreement may also trigger cross-acceleration under our other debt instruments.
Our certificate of incorporation and our bylaws do not have provisions that could delay or prevent a change in control.
Our certificate of incorporation and bylaws do not have provisions that could make it more difficult for a third party to acquire a majority of our outstanding common stock. As a result, we may be more susceptible to an inadequate or coercive offer that could result in a change in control than a company whose charter documents have provisions that could delay or prevent a change in control.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.

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ITEM 2. PROPERTIES
Our principal and executive offices are located in Houston, Texas, in buildings owned by Houston Casualty Company. We also maintain offices in over 45 locations elsewhere in the United States, the United Kingdom, Spain, Bermuda and Ireland. The majority of these additional locations are in leased facilities. We are not dependent on our facilities to conduct business and such office space is suitable for the conduct of our business.
Our principal office facilities are as follows:
                 
Subsidiary   Location   Sq. Ft.   Termination Date of Lease
Houston Casualty Company
  Houston, Texas     77,000     Owned
 
               
HCC and Houston Casualty Company
  Houston, Texas     51,000     Owned
 
               
Professional Indemnity Agency
  Mount Kisco, New York     38,000     Owned
 
               
U.S. Specialty Insurance Company Aviation Division
  Dallas, Texas     28,000     August 31, 2013
 
               
HCC Specialty Underwriters
  Wakefield, Massachusetts     28,000     December 31, 2010
 
               
HCC Life Insurance Company
  Atlanta, Georgia     27,000     December 31, 2011
See also Note 13 to our Consolidated Financial Statements included in this Form 10-K/A.
ITEM 3. LEGAL PROCEEDINGS
As described in Note 2 to our Consolidated Financial Statements included in this Form 10-K/A, based on the Special Committee’s voluntary independent investigation of our past practices related to granting stock options, we determined that the price on the actual measurement date for a number of our stock option grants during the period 1997 through 2005 and into 2006 did not correspond to the price on the stated grant date and that certain option grants were retroactively priced. The investigation was conducted with the help of a law firm that was not previously involved with our stock option plans and procedures. The SEC has commenced an informal inquiry. In connection with its inquiry, we received a document request from the SEC. We intend to fully cooperate with the informal inquiry. We are unable to predict the outcome of or the future costs related to the informal inquiry.
We are party to lawsuits, arbitrations and other proceedings that arise in the normal course of our business. Many of such lawsuits, arbitrations and other proceedings involve claims under policies that we underwrite as an insurer or reinsurer, the liabilities for which, we believe, have been adequately included in our loss reserves. Also, from time to time, we are a party to lawsuits, arbitrations and other proceedings that relate to disputes over contractual relationships with third parties, or that involve alleged errors and omissions on the part of our subsidiaries. We have provided accruals for these items to the extent we deem the losses probable and reasonably estimable.
In April 2006, we were named as a defendant in a complaint related to insurance marketing and producer compensation practices. The lawsuit was filed in Federal District Court in Georgia by a number of corporate plaintiffs against approximately 100 insurance entity defendants. The suit has been transferred to the multi-district litigation proceeding pending in the United States District Court for the District of New Jersey for coordinated or consolidated pre-trial proceedings with suits previously transferred that appear to the court to involve common questions of fact. The complaint alleges violations of Federal antitrust law, the Racketeering Influence and Corrupt Organization Act and various state anti-fraud laws. The lawsuit seeks unspecified damages. We are vigorously contesting this action.
Although the ultimate outcome of these matters cannot be determined at this time, based on present information, the

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availability of insurance coverage and advice received from our outside legal counsel, we believe the resolution of these matters will not have a material adverse effect on our consolidated financial position, 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 2005.
PART II
ITEM 5.   MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Price Range of Common Stock
Our common stock trades on the New York Stock Exchange under the ticker symbol “HCC”.
The intra-day high and low sales prices for quarterly periods from January 1, 2003 through December 31, 2005, as reported by the New York Stock Exchange, were as follows:
                                                 
    2005     2004     2003  
    High     Low     High     Low     High     Low  
First quarter
  $ 26.17     $ 21.31     $ 23.17     $ 20.01     $ 17.64     $ 14.87  
Second quarter
    26.96       23.05       22.93       20.30       20.13       17.10  
Third quarter
    28.89       25.11       22.39       19.23       20.84       19.13  
Fourth quarter
    32.95       26.91       22.83       18.35       21.39       18.73  
On February 28, 2006, the last reported sales price of our common stock as reported by the New York Stock Exchange was $32.19 per share.
Shareholders
We have one class of authorized capital stock: 250.0 million shares of common stock, par value $1.00 per share. On February 28, 2006, there were 111.1 million shares of issued and outstanding common stock held by 853 shareholders of record; however, we estimate there are approximately 55,000 beneficial owners.
Dividend Policy
Cash dividends declared on a quarterly basis for the three years ended December 31, 2005 were as follows:
                         
    2005     2004     2003  
First quarter
  $ .057     $ .050     $ .043  
Second quarter
    .075       .050       .043  
Third quarter
    .075       .057       .050  
Fourth quarter
    .075       .057       .050  
Beginning in June 1996, we announced a planned quarterly program of paying cash dividends to shareholders. Our Board of Directors may review our dividend policy from time to time and any determination with respect to future dividends will be made in light of regulatory and other conditions at that time, including our earnings, financial condition, capital requirements, loan covenants and other related factors. Under the terms of our bank loan facility, we are prohibited from paying dividends in excess of an agreed upon maximum amount in any fiscal year. That limitation should not affect our ability to pay dividends in a manner consistent with our past practice and current expectations.

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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 Annual Report on Form 10-K/A.
As described in Note 2 to the audited Consolidated Financial Statements referred to above, our Consolidated Financial Statements have been restated to record adjustments for stock compensation expense and related taxes in connection with stock options that were granted during the period 1997 through 2005 and for other minor adjustments and related taxes that were not recorded in the originally filed financial statements due to their immateriality. These adjustments resulted in after-tax charges of $ 4.7 million, $ 0.3 million, $ 1.5 million, $ 1.5 million and $ 0.2 million for the years ended December 31, 2005, 2004, 2003, 2002 and 2001, respectively. Additionally, the cumulative effect of the related after-tax charges for periods prior to 2001 was $ 10.4 million.

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Years ended December 31,
(in thousands, except per share data) (1) (4) (5)
                                                                         
    2005     2004     2003     2002(2)     2001(2)(7)  
                            (As previously                     (As previously              
    (As restated)     (As restated)     (As restated)     reported)     (Adjustments)     (As restated)     reported)     (Adjustments)     (As restated)  
Statement of earnings data:
                                                                       
Revenue
                                                                       
Net earned premium
  $ 1,369,988     $ 1,010,692     $ 738,272     $ 505,521     $     $ 505,521     $ 342,787     $     $ 342,787  
Fee and commission income
    132,628       183,802       142,615       115,919       171       116,090       111,016       (171 )     110,845  
Net investment income
    98,851       64,885       47,335       37,755             37,755       39,562             39,562  
Net realized investment gain
    1,448       5,822       527       453             453       393       1,019       1,412  
Other operating income
    39,773       19,406       13,215       6,985             6,985       17,451       481       17,932  
 
                                                     
Total revenue
    1,642,688       1,284,607       941,964       666,633       171       666,804       511,209       1,329       512,538  
 
                                                     
Expense
                                                                       
Loss and loss adjustment expense, net
    919,697       645,230       488,000       306,491       652       307,143       267,390             267,390  
Policy acquisition costs, net
    261,708       222,323       137,212       99,521             99,521       66,313       (1,000 )     65,313  
Other operating expense
    180,990       168,045       144,574       99,924       1,589       101,513       113,806       2,273       116,079  
Interest expense
    7,684       8,374       7,453       8,301             8,301       8,875       376       9,251  
 
                                                     
Total expense
    1,370,079       1,043,972       777,239       514,237       2,241       516,478       456,384       1,649       458,033  
 
                                                     
Earnings from continuing operations before income tax expense
    272,609       240,635       164,725       152,396       (2,070 )     150,326       54,825       (320 )     54,505  
Income tax expense on continuing operations
    84,177       81,940       59,382       52,933       (561 )     52,372       27,764       (88 )     27,676  
 
                                                     
Earnings from continuing operations
    188,432       158,695       105,343       99,463       (1,509 )     97,954       27,061       (232 )     26,829  
Earnings from discontinued operations, net of income taxes (6)
    2,760       4,004       36,684       6,365             6,365       3,136             3,136  
 
                                                     
Net earnings
  $ 191,192     $ 162,699     $ 142,027     $ 105,828     $ (1,509 )   $ 104,319     $ 30,197     $ (232 )   $ 29,965  
 
                                                     
Basic earnings per share data:
                                                                       
Earnings from continuing operations
  $ 1.78     $ 1.63     $ 1.11     $ 1.06     $ (0.01 )   $ 1.05     $ 0.31     $ (0.01 )   $ 0.30  
Earnings from discontinued operations (6)
    0.03       0.04       0.39       0.07             0.07       0.04             0.04  
 
                                                     
Net earnings
  $ 1.81     $ 1.67     $ 1.50     $ 1.13     $ (0.01 )   $ 1.12     $ 0.35     $ (0.01 )   $ 0.34  
 
                                                     
Weighted average shares outstanding
    105,463       97,257       94,919       93,338             93,338       87,482             87,482          
 
                                                       
Diluted earnings per share data:
                                                                       
Earnings from continuing operations
  $ 1.72     $ 1.61     $ 1.09     $ 1.05     $ (0.01 )   $ 1.04     $ 0.30     $     $ .030  
Earnings from discontinued operations (6)
    0.03       0.04       0.38       0.07             0.07       0.04             0.04          
 
                                                     
Net earnings
  $ 1.75     $ 1.65     $ 1.47     $ 1.12     $ (0.01 )   $ 1.11     $ 0.34     $     $ 0.34  
 
                                                     
Weighted average shares outstanding
    109,437       98,826       96,576       94,406             94,406       89,429             89,429          
 
                                                       
Cash dividends declared, per share
  $ 0.282     $ 0.213     $ 0.187     $ 0.170     $     $ 0.170     $ 0.163     $     $ 0.163  
 
                                                     

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December 31,
(in thousands, except per share data) (1) (3) (4) (5)
                                                                                         
    2005     2004     2003(2)     2002(2)     2001(2)  
                    (As                     (As                     (As              
                    previously                     previously                     previously              
    (As restated)     (As restated)     reported)     (Adjustments)     (As restated)     reported)     (Adjustments)     (As restated)     reported)     (Adjustments)     (As restated)  
Balance sheet data:
                                                                                       
Total investments
  $ 3,257,428     $ 2,468,491     $ 1,707,300     $     $ 1,707,300     $ 1,777,775     $     $ 1,177,775     $ 885,659     $     $ 885,659  
Premium, claims and other receivables
    884,654       891,360       932,417       1,835       934,252       772,772       16,454       789,226       665,965       18,589       684,554  
Reinsurance recoverables
    1,361,983       1,104,026       916,190       (15,415 )     900,775       798,934       (1,739 )     797,195       899,128       19,068       918,196  
Ceded unearned premium
    239,416       311,973       291,591             291,591       164,224             164,224       71,140       813       71,953  
Goodwill
    532,947       444,031       386,507       1,516       388,023       335,288             335,288       315,318             315,318  
Total assets
    7,028,800       5,900,568       4,897,682       (14,337 )     4,883,345       3,723,396       15,567       3,738,963       3,219,120       46,390       3,265,510  
Loss and loss adjustment expense payable
    2,813,720       2,089,199       1,535,288       (9,975 )     1,525,313       1,155,290       3,625       1,158,915       1,130,748       1,510       1,132,258  
Unearned premium
    807,109       741,706       592,311             592,311       331,050             331,050       179,530             179,530  
Premium and claims payable
    753,859       766,765       778,945       5,093       784,038       750,046       9,864       759,910       717,159       15,500       732,659  
Notes payable
    309,543       311,277       310,404             310,404       230,027             230,027       181,928             181,928  
Shareholders’ equity
    1,690,435       1,325,498       1,046,920       (515 )     1,046,405       882,907       1,764       884,671       763,453       1,894       765,347  
Book value per share (8)
  $ 15.26     $ 12.99     $ 10.91     $     $ 10.91     $ 9.43     $ 0.02     $ 9.45     $ 8.27     $ 0.02     $ 8.29  

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  (1)   See Note 2 — “Restatement of Consolidated Financial Statements, Special Committee and Company Findings” to our Consolidated Financial Statements for a discussion of these adjustments.
 
  (2)   The consolidated statement of earnings data for 2002 and 2001, and the consolidated balance sheet data for 2003, 2002 and 2001, have been revised to reflect adjustments related to the restatement described under “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Restatement of Consolidated Financial Statements, Special Committee and Company Findings” and Note 2 of the Notes to Consolidated Financial Statements. Pre-tax adjustments recorded in 2002 and 2001 included non-cash stock-based compensation expense totaling $2.0 million and $2.2 million, respectively. The cumulative after-tax impact of all restatement adjustments related to years prior to 2001 totaled $10.4 million and has been reflected as an adjustment to shareholders’ equity at December 31, 2000.
 
      On a pre-tax basis, the cumulative net impact of all restatement adjustments related to years prior to 2001 totaled $14.6 million. These adjustments consisted primarily of the following:
    The pre-tax impact of charges related to stock option grant measurement date errors in the period 1997 through 2000 totaling $3.8 million, $3.7 million, $1.5 million, and $4.6 million, respectively;
 
    The pre-tax income decrease of other previously unrecorded adjustments in 2000 totaling $1.1 million; and
 
    Income tax expense (benefit) of $(1.3) million $(1.3) million, $0.1 million and $(1.8) million in the period 1997 through 2000.
      The impact on previously reported net income of these adjustments was a decrease of $3.9 million, $1.6 million, $2.4 million and $2.5 million, or 7%, 6%, 3% and 5%, for 2000, 1999, 1998 and 1997, respectively. The impact on previously reported diluted income per share of these adjustments was a decrease of $0.05, $0.02, $0.04 and $0.03 for 2000, 1999, 1998 and 1997, respectively.
 
  (3)   The consolidated balance sheet data has been adjusted to reflect the cumulative restatement adjustments. See Note 2 — “Restatement of Consolidated Financial Statements, Special Committee and Company Findings” to our Consolidated Financial Statements for a discussion of these statements.
 
  (4)   In 2005, the Board of Directors declared a three-for-two stock split in the form of a 50% stock dividend on our shares of $1.00 par value common stock. All shares outstanding and per share amounts have been adjusted to reflect the effect of the stock split for all periods presented.
 
  (5)   Certain amounts in the 2001-2004 selected consolidated financial data have been reclassified to conform to the 2005 presentation. The reclassifications included the elimination of certain intercompany premium receivable and premium payable balances. Such reclassifications had no effect on our consolidated net earnings, shareholders’ equity or cash flows.
 
  (6)   We sold our retail brokerage operation, HCC Employee Benefits, Inc., in 2003. The net earnings of HCC Employee Benefits, the 2003 gain on sale and the subsequent gains in 2004 and 2005 from a contractual earnout are classified as discontinued operations. Consistent with this presentation, all pre-sale revenue and expense of HCC Employee Benefits was reclassified to discontinued operations.
 
  (7)   During 2002, we adopted SFAS No. 142, Goodwill and Other Intangible Assets, which required that goodwill and indefinite-lived intangible assets no longer be amortized. The adjusted amounts that we would have reported in 2001 had we adopted SFAS 142 on January 1, 2001 are as follows:
         
Adjusted net earnings
  $ 41,352  
 
     
Adjusted basic earnings per share
  $ 0.47  
 
     
Adjusted diluted earnings per share
  $ 0.46  
 
     
  (8)   Book value per share is calculated by dividing the sum of outstanding shares plus contractually issuable shares into total shareholders’ equity.

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following Management’s Discussion and Analysis should be read in conjunction with the Selected Financial Data, the Consolidated Financial Statements, the related Notes thereto and the discussions under “Critical Accounting Estimates” and “Safe Harbor Disclosure.” As further described below, in Note 2 to our Consolidated Financial Statements and in our Selected Financial Data, we restated our Consolidated Financial Statements as of and for the years ended December 31, 1997 through 2005. The effects of these restatements are reflected in our Consolidated Financial Statements and the related Notes thereto. Management’s Discussion and Analysis has been updated to reflect the effects of the restatement.
Restatement of Consolidated Financial Statements, Special Committee and Company Findings
In light of published reports concerning the pricing of stock options and the timing of stock option grants at numerous other companies, in the second quarter of 2006 we undertook a voluntary internal review of our past practices related to grants of stock options. The voluntary review by our management concluded that the actual accounting measurement dates for certain past stock option grants differed from the originally stated grant dates, which were also utilized as the measurement dates for such awards. In August 2006, our Board of Directors formed a Special Committee of independent directors to commence an investigation of our past stock option granting practices for the period 1995 through 2005. The Special Committee was composed of the members of the Audit Committee of the Board of Directors. The Special Committee retained the law firm of Skadden, Arps, Slate, Meagher & Flom, LLP as its independent legal counsel and LECG as forensic accountants to aid in the investigation.
On November 17, 2006, we announced that the Special Committee had made certain determinations as a result of its review of our past stock option granting practices. The Special Committee found that we had used incorrect accounting measurement dates for stock option grants covering a significant number of employees and members of our Board of Directors during the period 1997 through 2005 and that certain option grants were retroactively priced. Additionally, at the direction of the Special Committee, we reviewed our stock option granting practices from 1992, the year of our initial public stock offering, through 1994 and in 2006 and found incorrect measurement dates due to retroactive pricing were used in 2006. In substantially all of these instances, the price on the actual measurement date was higher than the price on the stated grant date; thus recipients of the options could exercise at a strike price lower than the actual measurement date price. To determine the actual measurement dates, the Special Committee utilized the following sources of information:
    The dates on documentation such as e-mails, regulatory form filings, acquisition agreements and other correspondence;
 
    The date that the relevant stock option grant was entered into Equity Edge, our stock option tracking and accounting system;
 
    Requirements of Accounting Principles Board (APB) No. 25, Accounting for Stock Issued to Employees, and related interpretations; and
 
    Guidance from the Office of Chief Accountant of the Securities and Exchange Commission (SEC) contained in a letter dated September 19, 2006.
The Special Committee concluded that mis-priced option grants, the effect of which, together with certain other adjustments, resulted in a cumulative net decrease in shareholders’ equity at December 31, 2005 of $3.3 million, affected all levels of employees. The Special Committee found that Stephen L. Way, Chief Executive Officer, retroactively priced options, that he should have known he was granting options in a manner that conflicted with our stock option plans and public statements, and that this constituted a failure to align the stock option granting process with our stock option plans and public statements. Although finding his actions were inconsistent with the duties and obligations of a chief executive officer of a publicly-traded company, the Special Committee also found that Mr. Way’s motivation appeared to be the attraction and retention of talent and to provide employees with the best option price. The Special Committee also concluded that Christopher L. Martin, Executive Vice President and General Counsel, was aware that options were being retroactively priced in a manner inconsistent with applicable plan terms and the procedures memoranda that he had prepared, that granting in-the-money options had accounting implications, and that he did not properly document our Compensation Committee’s informal delegation of authority to Mr. Way. The Special Committee also found that there was no evidence that Mr. Way or Mr. Martin intended to falsify the consolidated financial statements.

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Before the Board of Directors reviewed the results of the investigation, the Chairman of our Compensation Committee tendered his resignation from the Board of Directors on November 8, 2006. After reviewing the results of the investigation, the Board of Directors determined that it would be appropriate to accept the resignations of Mr. Way and Mr. Martin, which both tendered on November 17, 2006. Mr. Way will remain a director of HCC and serve as the non-executive Chairman of the Board of Directors and has entered into a consulting agreement with us to assist in the transition of leadership and to provide strategic guidance. We have entered into agreements with Mr. Way and Mr. Martin which, among other things, require them to disgorge an amount equal to the difference between the actual measurement date prices determined by HCC and the prices at which these individuals exercised mis-priced options since 1997.
As a result of the determinations of the Special Committee and because the resulting cumulative charge would be material to the second quarter and full year 2006 consolidated net earnings, we concluded that we needed to amend this Annual Report on Form 10-K for the year ended December 31, 2005 as filed on March 16, 2006 (the Original Filing), to restate our consolidated financial statements for the years ended December 31, 2005, 2004 and 2003 and the related disclosures. However, the impact of the restatement in any of the restated periods is immaterial. We are making the restatement in accordance with generally accepted accounting principles to record the following:
    Non-cash compensation expense for the difference between the stock price on the stated grant date and the actual measurement date and for the fluctuations in stock price in certain instances where variable accounting should have been applied;
 
    Other adjustments that were not recorded in the originally filed financial statements due to their immateriality; and
 
    Related tax effects for all items.
This Form 10-K/A also includes the restatement of selected financial data as of and for the years ended December 31, 2005, 2004, 2003, 2002 and 2001, and the unaudited quarterly financial data for each of the quarters in the years ended December 31, 2005 and 2004. We have not amended any of our other previously filed annual reports on Form 10-K or quarterly reports on Form 10-Q for the periods affected by the restatement other than our Quarterly Report on Form 10-Q for the quarter ended March 31, 2006, which we are filing concurrently with this Form 10-K/A. For this reason, the consolidated financial statements and related financial information contained in such previously filed reports should no longer be relied upon.
We were unable to timely file our quarterly reports on Form 10-Q for the quarters ended June 30, 2006 and September 30, 2006, primarily due to not knowing the financial impact of the Special Committee’s investigation. Our Form 10-Q’s for these quarters are being filed concurrently with this Form 10-K/A. We have also restated the June 30, 2005 and September 30, 2005 financial statements included in our quarterly reports on Form 10-Q for the respective 2006 quarters.
Based on the determinations of the Special Committee and our voluntary internal review, we identified a number of occasions during the period 1997 through 2005 and into 2006 on which we used an incorrect measurement date for financial accounting and reporting purposes for options granted. In accordance with Accounting Principles Board (APB) No. 25, Accounting for Stock Issued to Employees, and its related interpretations, we should have recorded compensation expense related to these options for the excess of the market price of our stock on the actual measurement date over the exercise price of the option. For periods commencing January 1, 2006, compensation expense is being recognized in accordance with Statement of Financial Accounting Standards (SFAS) No. 123(R) (revised), Share-Based Payment. However, we determined an incremental amount related to the mis-priced options must be recorded.

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The types of errors identified were as follows:
    We determined that many block grants to employees during the period 1997 through 2005 were subject to a retroactive look-back period. In all such cases, the price of our stock at the end of the look-back period, which was generally 30 days or less, was higher than the price of our stock on the stated grant date.
 
    In addition to being subject to the retroactive pricing discussed above, we determined that the strike price of block grants in 1999, 2002 and 2005 was determined prior to the final determination of the identity of the employee and/or the number of options to be granted. Further, proper approval, in most cases, had not been given until after the grant date. In all such cases, the price of our stock at the time when all required determinations were final and proper approval had been obtained was higher than the price of our stock on the stated grant date. The time lag between the stated grant date and the finalization of the awards was typically 30-45 days, except in the case of the 2002 grant which was finalized several months subsequent to the stated grant date.
 
    For the period from 1997 to 2005 and into 2006, we determined that there was a regular practice of granting options to newly hired employees and existing employees being promoted after the end of a 30-45 day period following the hire or promotion date. This practice included the use of the 30-45 day period as a look-back period during which the date with the lowest price during that period was selected as the stated grant date.
 
    In several instances, grants to senior executives were determined at a date subsequent to the stated grant date. In most cases, this resulted from extended negotiations of employment agreements and, in some cases, administrative delays. In virtually all cases, the price of our stock at the time the grants were made and properly approved was higher than the price of our stock on the stated grant date.
 
    In a few cases, options were granted and then repriced downward. As a result, variable accounting should have been applied to these options.
 
    We lacked timely or adequate documentation to support the stated grant date in the case of certain of the above errors.
The gross compensation expense recorded to correct the above errors was a non-cash charge and had no impact on our reported net revenue, cash, cash flow or shareholders’ equity.
In connection with the investigation, we determined that a number of executive officers received in-the-money options. If such options are ultimately determined to be in-the-money grants for tax purposes, pursuant to Section 162(m) of the Internal Revenue Code and, if in the year of exercise the officers’ compensation, including proceeds from options exercised, exceeded $1.0 million, we would not be entitled to a tax deduction for any amount in excess of such $1.0 million for officers covered by Section 162(m). We estimate the effect of the tax deduction was $4.6 million, substantially all of which was recorded as a reduction to shareholders’ equity.
There were immaterial adjustments that were not made in the originally filed consolidated financial statements. We have taken the opportunity presented by this restatement to record these adjustments, which amounted to a net $2.4 million increase in earnings from continuing operations before income tax expense, for the years 2001 through 2005.

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The cumulative effect of the restatement for the period 1997 through 2005 was as follows (in thousands):
                 
Increase (decrease) in net earnings and retained earnings:
               
Non-cash compensation expense related to stock option grants (including $994 recorded as accrued expenses)
  $ (26,608 )        
Net adjustments for immaterial items previously unrecorded
    1,316          
 
             
Reduction in earnings from continuing operations before income tax expense
    (25,292 )        
Related income tax benefit
    6,667          
 
             
Reduction in net earnings from continuing operations and net earnings
          $ (18,625 )
Increase (decrease) to additional paid-in capital:
               
Increase related to non-cash compensation expense
  $ 25,614          
Reduction related to tax effects previously credited to additional paid-in capital
    (11,012 )        
 
             
Net increase in additional paid-in capital
            14,602  
Increase in other comprehensive income for immaterial items previously unrecorded
            762  
 
             
Net decrease in shareholders’ equity at December 31, 2005
          $ (3,261 )
 
             
In order to further enhance investor understanding of the effects of the matters described above and to provide context for the composition of the cumulative adjustment to shareholders’ equity at December 31, 2002, we have provided the information below which shows the years to which the stock option compensation adjustments relate. Our consolidated financial statements and the related SEC reports for such periods have not been amended, except for the consolidated financial statements included in this Form 10-K/A. In addition to the stock option compensation adjustments, we also included the effect of other immaterial adjustments which were previously unrecorded and the related tax effects of all adjustments. The increase (decrease) in net earnings for each type of adjustment was as follows (in thousands):
                                                 
            Non-cash                                
            stock option                                
    Net earnings as     compensation                             Net earnings  
    previously reported     expense     Other     Tax effect     Total adjustments     as restated  
Years ended December 31, 1997
  $ 50,083     $ (3,789 )   $     $ 1,326     $ (2,463 )   $ 47,620  
1998
    73,110       (3,664 )           1,273       (2,391 )     70,719  
1999
    26,572       (1,474 )           (148 )     (1,622 )     24,950  
2000
    55,468       (4,586 )     (1,124 )     1,830       (3,880 )     51,588  
2001
    30,197       (2,201 )     1,881       88       (232 )     29,965  
2002
    105,828       (2,043 )     (27 )     561       (1,509 )     104,319  
 
                                   
Cumulative effect at December 31, 2002
    341,258       (17,757 )     730       4,930       (12,097 )     329,161  
2003
    143,561       (3,279 )     1,270       475       (1,534 )     142,027  
2004
    163,025       (2,571 )     2,453       (208 )     (326 )     162,699  
2005
    195,860       (3,001 )     (3,137 )     1,470       (4,668 )     191,192  
 
                                   
Cumulative effect at December 31, 2005
  $ 843,704     $ (26,608 )   $ 1,316     $ 6,667     $ (18,625 )   $ 825,079  
 
                                   

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The restatement adjustments reduced previously reported diluted net earnings per share by $0.04, $0.00, $0.02, $0.01 and $0.00 for 2005, 2004, 2003, 2002 and 2001, respectively.
We are also amending certain other stock option disclosures in the accompanying notes to the consolidated financial statements.
Enacted October 22, 2004, Section 409A of the Internal Revenue Code significantly changed the rules for nonqualified deferred compensation plans. Section 409A imposes certain restrictions and taxes on stock awards that constitute deferred compensation. Section 409A relates specifically to the personal tax liabilities of our employees that have received discounted options. We are currently reviewing the implications of Section 409A on grants awarded with intrinsic value that vested after December 31, 2004 and modifications made to existing grants after October 3, 2004 along with potential remedial actions.
As of December 15, 2006, we have paid direct costs of approximately $6.0 million for costs associated with the Special Committee’s investigation and additional related professional services and consulting fees associated with the restatement effort. We expect to pay up to several million dollars of additional expense in the next few months associated with the conclusion of the investigation and restatement of our consolidated financial statements.

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Overview
We are a specialty insurance group with offices in the United States, the United Kingdom, Spain, Bermuda and Ireland transacting business in more than 50 countries. Our group consists of insurance companies, underwriting agencies and intermediaries. Our shares are traded on the New York Stock Exchange and had a market capitalization of $3.6 billion at February 28, 2006. We earned $191.2 million or $1.75 per diluted share in 2005 compared to $162.7 million or $1.65 earned in 2004, despite higher losses from hurricanes, a loss from a commutation in 2005 and the dilution from a $96.7 million common stock offering in December 2004. We grew shareholders’ equity by 28% in 2005 to $1.7 billion at December 31, 2005, principally from a combination of net earnings and a $150.0 million equity offering in November 2005.
In 2005 and 2004, the property and casualty insurance industry suffered record losses from nine major hurricanes that affected the Atlantic and Gulf Coasts of the United States. We estimate our gross losses were $394.6 million from the 2005 hurricanes and $89.8 million from the 2004 hurricanes which, after recoveries expected from our reinsurance programs, reduces our net losses to $89.7 million in 2005 and $33.1 million in 2004. In 2005, we also opportunistically commuted a large block of reinsurance recoverables. As a result of this transaction, we recognized a loss of $26.0 million which is principally the discount for the time value of money on the recoverable amount. We expect to recoup this loss over future years as we earn interest on the cash proceeds from the commutation prior to the related claims being paid. Despite the large losses from the hurricanes and the commutation, we generated a 18% increase to a record level of net earnings in 2005.
We underwrite a variety of specialty lines of business identified as diversified financial products; group life, accident and health; aviation; London market account; and other specialty lines of business. Products in each line are marketed by our insurance companies and agencies, either through a network of independent agents and brokers, or directly to customers. With the exception of our public company directors’ and officers’ liability business, certain international aviation risks and our London market business, the majority of our business is generally lower limit, smaller premium business that is less susceptible to price competition, severity of loss or catastrophe risk.
Our major insurance companies are rated “AA (Very strong)” by Standard & Poor’s Corporation, “AA- (Very Strong)” by Fitch Ratings and “A+ (Superior)” by A.M. Best Company, Inc. A.M. Best placed our ratings under review with negative implications following our announcement on November 17, 2006 concerning the results of the independent investigation of our stock option granting practices and, at the same time, Standard & Poor’s and Fitch Ratings affirmed our ratings with a stable outlook.
We generate our revenue from four primary sources: 1) risk-bearing earned premium produced by our insurance company operations, 2) non-risk-bearing fee and commission income received by our underwriting agency and intermediary operations, 3) ceding commissions in excess of policy acquisition costs earned by our insurance company operations and 4) investment income earned by all of our operations. We produced $1.6 billion of revenue in 2005, an increase of 28% over 2004, primarily from higher net earned premium as a result of increased retentions, recent acquisitions, organic growth, increased investment income and increases in other operating income.
During the past several years, we substantially increased our shareholders’ equity by retaining most of our earnings and issuing additional shares of common stock. With this additional equity, we increased the underwriting capacity of our insurance companies and made strategic acquisitions, adding new lines of business or expanding those with favorable underwriting characteristics.

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Our acquisitions during the past three years are listed below. Net earnings and cash flows from each acquired entity are included in our operations beginning on the effective date of each transaction.
         
Company   Segment   Effective date acquired
Covenant Underwriters and Continental Underwriters
  Agency   July 1, 2003
American Contractors Indemnity Company
  Insurance company   January 31, 2004
RA&MCO Insurance Services
  Agency   October 1, 2004
United States Surety Company
  Insurance company   March 1, 2005
HCC International Insurance Company
(formerly De Montfort Insurance Company)
  Insurance company   July 1, 2005
Perico Life Insurance Company
(formerly MIC Life Insurance Corporation)
  Insurance company   November 30, 2005
Perico Ltd.
  Agency   December 1, 2005
Illium Insurance Group
  Agency   December 31, 2005
The following section discusses our key operating results. The reasons for any significant variations between 2004 and 2003 are the same as those discussed for variations between 2005 and 2004, unless otherwise noted. Amounts in the following tables are in thousands, except for earnings per share, percentages, ratios and number of employees.
Results of Operations
Net earnings increased 18% to $191.2 million ($1.75 per diluted share) in 2005 from $162.7 million ($1.65 per diluted share) in 2004. Net earnings in 2005 included after-tax losses of $58.2 million ($0.53 per diluted share) due to the combined effects of five hurricanes and $16.9 million ($0.15 per diluted share) due to a reinsurance commutation. Earnings from continuing operations grew 19% to $188.4 million ($1.72 per diluted share) in 2005 from $158.7 million ($1.61 per diluted share) in 2004. Growth in underwriting profits, net investment income and other operating income contributed to the increase in 2005 earnings. Net earnings increased 15% to $162.7 million ($1.65 per diluted share) in 2004 from $142.0 million ($1.47 per diluted share) in 2003. Net earnings in 2004 included an after-tax loss of $21.5 million ($0.22 per diluted share) due to the combined effects of four hurricanes. Earnings from continuing operations grew 51% to $158.7 million ($1.61 per diluted share) in 2004 from $105.3 million ($1.09 per diluted share) in 2003. Growth in all segments contributed to the increase in 2004 net earnings. Net earnings in 2003 included an after-tax loss of $18.7 million ($0.19 per diluted share) due to a commutation and after-tax earnings from discontinued operations of $36.7 million ($0.38 per diluted share), which included an after-tax gain of $30.1 million from the sale of a subsidiary.
During 2005 and 2004, catastrophic events occurred related to three major hurricanes, Katrina, Rita and Wilma, and two others (collectively, the 2005 hurricanes) and four major hurricanes, Charley, Frances, Ivan and Jeanne (collectively, the 2004 hurricanes). We recognized pre-tax losses after reinsurance recoveries and including the cost of premiums to reinstate our reinsurance protection of $89.7 million in 2005 and $33.1 million in 2004 in our insurance company segment.
During the past three years, we reached agreements with various reinsurers to commute certain reinsurance recoverables, some of which related to our discontinued accident and health line of business. In 2005 and 2003, we received cash payments that were less than the related recoverables, from certain reinsurers, in consideration for discounting the recoverables and reassuming the associated loss reserves. We recorded pre-tax losses of $26.0 million in 2005 and $28.8 million in 2003 related to these commutations, which were included in loss and loss adjustment expense in our insurance company segment.

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The following table shows the reported amounts, as well as the effect of the hurricanes and commutations on those amounts. The impact on ceded earned premium relates to the effect of premiums to reinstate our excess of loss reinsurance, which reduced net earned premium.
                                                 
                            Effect of hurricanes and commutations  
    2005     2004     2003     2005     2004     2003  
    (As restated)     (As restated)     (As restated)                          
Gross incurred loss and loss adjustment expense
  $ 1,596,773     $ 1,289,155     $ 1,045,339     $ 394,625     $ 89,795     $  
Net incurred loss and loss adjustment expense
    919,697       645,230       488,000       99,226       23,335       28,751  
Ceded earned premium
    617,402       849,610       748,799       16,533       9,806        
Net earnings (loss)
    191,192       162,699       142,027       (75,171 )     (21,464 )     (18,688 )
Diluted earnings (loss) per share
    1.75       1.65       1.47       (0.69 )     (0.22 )     (0.19 )
The following table shows our net loss, expense and combined ratios and the effect that the losses related to the hurricanes and commutations had on these ratios. To determine the effect of the hurricanes and commutations, we calculated the 2005, 2004 and 2003 net loss ratios by excluding $99.2 million, $23.3 million and $28.8 million, respectively, of losses from the numerator of the net loss ratio and $16.5 million and $9.8 million of reinstatement premium from the denominator of both the net loss ratio and the expense ratio in 2005 and 2004, respectively.
                         
    2005     2004     2003  
    (As restated)     (As restated)     (As restated)  
Ratios:
                       
Net loss ratio
    67.1 %     63.8 %     66.1 %
Expense ratio
    26.1       26.7       24.6  
 
                 
Combined ratio
    93.2 %     90.5 %     90.7 %
 
                 
Effect of hurricanes and commutations:
                       
Net loss ratio
    7.9 %     2.9 %     3.9 %
Expense ratio
    0.3       0.3        
 
                 
Combined ratio
    8.2 %     3.2 %     3.9 %
 
                 

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The following table sets forth the relationships of certain income statement items as a percent of total revenue.
                         
    2005     2004     2003  
    (As restated)     (As restated)     (As restated)  
Net earned premium
    83.4 %     78.7 %     78.4 %
Fee and commission income
    8.1       14.3       15.1  
Net investment income
    6.0       5.1       5.0  
Net realized investment gain
    0.1       0.4       0.1  
Other operating income
    2.4       1.5       1.4  
 
                 
Total revenue
    100.0       100.0       100.0  
Loss and loss adjustment expense, net
    56.0       50.2       51.8  
Policy acquisition costs, net
    15.9       17.3       14.6  
Other operating expense
    11.0       13.1       15.3  
Interest expense
    0.5       0.7       0.8  
 
                 
Earnings from continuing operations before income tax expense
    16.6       18.7       17.5  
Income tax expense
    5.1       6.3       6.3  
 
                 
Earnings from continuing operations
    11.5 %     12.4 %     11.2 %
 
                 
Total revenue increased 28% to $1.6 billion in 2005 and 36% to $1.3 billion in 2004, driven by significant growth in net earned premium and investment income, which more than offset the expected decrease in fee and commission income in 2005. Approximately 6% of the increase in 2005 revenue and 16% of the increase in 2004 revenue was due to the acquisition of subsidiaries. We expect total revenue to continue to grow in 2006.
Gross written premium, net written premium and net earned premium are detailed below. Premium increased from organic growth, particularly in our diversified financial products line of business, acquisitions and, with respect to net premiums, from increased retentions. See the Insurance Company Segment section below for further discussion of the relationship and changes in premium revenue.
                         
    2005     2004     2003  
Gross written premium
  $ 2,038,286     $ 1,975,153     $ 1,739,894  
Net written premium
    1,501,224       1,105,519       865,502  
Net earned premium
    1,369,988       1,010,692       738,272  
The table below shows the source of our fee and commission income.
                         
    2005     2004     2003  
    (As restated)     (As restated)          
Agencies
  $ 94,972     $ 127,453     $ 105,899  
Insurance companies
    37,656       56,349       43,244  
Other
                (6,528 )
 
                 
Fee and commission income
  $ 132,628     $ 183,802     $ 142,615  
 
                 

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Fee and commission income decreased to $132.6 million in 2005, as expected, resulting from a decrease in the level of ceded reinsurance by our insurance company subsidiaries, which resulted in reduced revenue from our reinsurance brokers and reduced ceding commissions earned by our insurance companies and underwriting agencies. Also, effective January 1, 2005, we consolidated the operations of our largest underwriting agency into one of our life insurance company subsidiaries. This higher retention of our premium and the consolidation of operations resulted in increased underwriting revenue and profitability in our insurance company subsidiaries. Fee and commission income increased 29% in 2004, primarily due to new business from subsidiaries acquired in 2003.
The sources of net investment income are detailed below.
                         
    2005     2004     2003  
Fixed income securities
  $ 77,842     $ 55,929     $ 40,927  
Short-term investments
    21,208       9,735       7,422  
Other investments
    3,615       1,366       488  
 
                 
Total investment income
    102,665       67,030       48,837  
Investment expense
    (3,814 )     (2,145 )     (1,502 )
 
                 
Net investment income
  $ 98,851     $ 64,885     $ 47,335  
 
                 
Net investment income increased 52% in 2005 and 37% in 2004. These increases were primarily due to higher investment assets, which increased to $3.3 billion at December 31, 2005 compared to $2.5 billion at December 31, 2004 and $1.7 billion at December 31, 2003. The growth in investment assets resulted from: 1) cash flow from operations, 2) higher retentions, 3) commutations of reinsurance recoverables, 4) our public offerings of common stock in 2005 and 2004 and 5) the increase in net loss reserves particularly from our diversified financial products line of business, which generally has a longer time period between reporting and payment of claims. Additionally, average yields on our short-term investments increased from 1.7% in 2004 to 2.7% in 2005. We continue to invest our funds primarily in fixed income securities, extending their duration to 4.9 years at the end of 2005 from 4.6 years and 3.7 years at the end of 2004 and 2003, respectively, and have increased the percentage of tax-exempt municipal bonds in our investment portfolio. We expect investment assets to continue to increase in 2006, consistent with our anticipated growth in revenue and earnings. If market interest rates rise, investment income will accelerate, since new funds and current maturities could be invested at higher rates.
At December 31, 2005, our unrealized loss on fixed income securities was $8.5 million, down from an unrealized gain of $20.7 million at December 31, 2004, due to increases in market interest rates. The change in the unrealized gain or loss, net of the related income tax effect, is recorded in other comprehensive income. This loss is unlikely to affect net earnings as we typically hold our fixed income securities to maturity when we receive the full principal amount.
Other operating income increased $20.4 million in 2005 and $6.2 million in 2004. The 2005 increase related primarily to gains from strategic investments, higher gains on sales of trading securities and a $4.3 million gain on the sale of a dormant subsidiary. The 2004 increase included $4.3 million income from two mortgage impairment insurance policies treated as derivatives and a $1.5 million gain from the sale of a building. Period to period comparisons in this category may vary substantially depending on market values of trading securities and other financial instruments and on income from strategic investments or dispositions of such investments. The following table details the components of other operating income.

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    2005     2004     2003  
Trading securities
  $ 16,619     $ 2,604     $ 5,583  
Strategic investments
    10,241       5,103       3,212  
Sale of non-operating assets
    4,271       1,531        
Financial instruments
    3,898       4,297        
Other
    4,744       5,871       4,420  
 
                 
Other operating income
  $ 39,773     $ 19,406     $ 13,215  
 
                 
Loss and loss adjustment expense increased 43% in 2005 and 32% in 2004 due to the 2005 and 2004 hurricane losses and the 2005 commutation, as well as growth in net retained premium in both years. Policy acquisition costs increased 18% in 2005 and 62% in 2004, primarily due to the growth in net earned premium. See the Insurance Company Segment section below for further discussion of the changes in loss and loss adjustment expense and policy acquisition costs.
Other operating expense, which includes compensation expense, increased 8% in 2005 and 16% in 2004. The increases primarily related to higher incentive compensation based on increased profitability, operating expenses of subsidiaries acquired or formed, and the expensing of $8.9 million for an indemnification claim in 2005 and $10.1 million to cover estimated settlement costs related to pending litigation in 2004. We had 1,448 employees at December 31, 2005, compared to 1,268 a year earlier. The increase in employees was primarily due to acquisitions.
Our effective income tax rate on earnings from continuing operations was 30.9% for 2005, compared to 34.1% for 2004 and 36.0% for 2003. The effective tax rate decreased because our tax exempt interest income increased as a percentage of our pre-tax income in both 2004 and 2005, and we recorded a special $2.8 million repatriation tax benefit in 2005.
In December 2003, we sold the business of our retail brokerage subsidiary, HCC Employee Benefits, Inc., for $62.5 million in cash. We recognized a gain of $52.7 million ($30.1 million after-tax) in 2003 and additional gains of $6.3 million ($4.0 million after-tax) in 2004 and $4.4 million ($2.8 million after-tax) in 2005 from a contractual earnout, which is now completed. The after-tax earnings from discontinued operations and the after-tax gain on sale are reported as earnings from discontinued operations in the consolidated statements of earnings. Cash flows from the subsidiary’s 2003 operations are included with cash flows from continuing operations within each major category of the consolidated statements of cash flows. Cash flows from the sale and earnout are included in investing activities.
At December 31, 2005, book value per share was $15.26, up from $12.99 at December 31, 2004 and $10.91 at December 31, 2003. Total assets were $7.0 billion and shareholders’ equity was $1.7 billion, up from $5.9 billion and $1.3 billion, respectively, at December 31, 2004.
Segments
We operate our businesses in three segments: 1) insurance company, 2) agency and 3) other operations. Our Chairman and Chief Executive Officer, as chief decision maker, monitors and evaluates the individual financial results of each subsidiary in the insurance company and agency segments. Each subsidiary provides monthly reports of its actual and budgeted results, which are aggregated on a segment basis for management review and monitoring. The operating results of our insurance company and agency segments are discussed below.
Insurance Company Segment
Net earnings of our insurance company segment increased 15% to $126.1 million in 2005 compared to $109.3 million in 2004, which in turn increased 45% from $75.3 million in 2003. The 2005 net earnings included $75.2 million of after-tax losses related to hurricanes and a commutation, while 2004 net earnings included $21.5 million of after-tax hurricane losses and 2003 net earnings included an $18.7 million after-tax commutation loss. The growth in segment net earnings was driven by: 1) improved underwriting results, 2) increased retentions, which resulted in higher earned premium, 3)

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increased investment income and 4) the operations of acquired subsidiaries. Effective January 1, 2005, we consolidated the operations of our largest underwriting agency into one of our life insurance companies, which reduced fee and commission income of our agency segment but increased the underwriting profitability of our insurance company segment. Even though there is some pricing competition in certain of our markets, our margins remain at an acceptable level of profitability due to our underwriting expertise and discipline. We expect net earnings from our insurance companies to continue to grow in 2006.
Premium
Gross written premium increased 3% to $2.0 billion in 2005 and 14% in 2004. We expect gross written premium to be relatively flat in 2006. Net written premium increased 36% to $1.5 billion and net earned premium increased 36% to $1.4 billion in 2005 compared to increases of 28% and 37%, respectively, in 2004. These increases were primarily due to higher retention levels on most non-catastrophe business, acquisitions and the mix of business due to increased premium in lines where we had greater retentions. The overall percentage of retained premium increased to 74% in 2005 from 56% in 2004 and 50% in 2003. Net written and net earned premium are expected to continue to grow in 2006.
The following table details premium amounts and their percentages of gross written premium.
                                                 
    2005     2004     2003  
    Amount     %     Amount     %     Amount     %  
Primary
  $ 1,768,284       87 %   $ 1,674,075       85 %     1,377,999     $ 79 %
Reinsurance assumed
    270,002       13       301,078       15       361,895       21  
 
                                   
Gross written premium
    2,038,286       100       1,975,153       100       1,739,894       100  
Reinsurance ceded
    (537,062 )     (26 )     (869,634 )     (44 )     (874,392 )     (50 )
 
                                   
Net written premium
    1,501,224       74       1,105,519       56       865,502       50  
Change in unearned premium
    (131,236 )     (7 )     (94,827 )     (5 )     (127,230 )     (8 )
 
                                   
Net earned premium
  $ 1,369,988       67 %   $ 1,010,692       51 %   $ 738,272       42 %
 
                                   
The following tables provide premium information by line of business.
                                 
    Gross     Net     NWP     Net  
    written     written     as % of     earned  
    premium     premium     GWP     premium  
Year ended December 31, 2005
                               
Diversified financial products
  $ 908,526     $ 675,942       74 %   $ 531,136  
Group life, accident and health
    593,382       502,805       85       504,382  
Aviation
    210,530       130,743       62       136,197  
London market account
    144,425       78,809       55       93,017  
Other specialty lines
    176,139       109,106       62       97,721  
Discontinued lines
    5,284       3,819     nm       7,535  
 
                       
Totals
  $ 2,038,286     $ 1,501,224       74 %   $ 1,369,988  
 
                       

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    Gross     Net     NWP     Net  
    written     written     as % of     earned  
    premium     premium     GWP     premium  
Year ended December 31, 2004
                               
Diversified financial products
  $ 857,299     $ 404,870       47 %   $ 310,809  
Group life, accident and health
    584,747       343,996       59       343,913  
Aviation
    204,963       144,687       71       127,248  
London market account
    178,950       107,509       60       111,341  
Other specialty lines
    133,964       83,980       63       69,089  
Discontinued lines
    15,230       20,477       nm       48,292  
 
                       
Totals
  $ 1,975,153     $ 1,105,519       56 %   $ 1,010,692  
 
                       
 
                               
Year ended December 31, 2003
                               
Diversified financial products
  $ 553,501     $ 183,560       33 %   $ 123,562  
Group life, accident and health
    565,494       299,913       53       290,009  
Aviation
    214,718       99,447       46       97,536  
London market account
    223,149       155,987       70       137,572  
Other specialty lines
    73,475       36,837       50       12,443  
Discontinued lines
    109,557       89,758       nm       77,150  
 
                       
Totals
  $ 1,739,894     $ 865,502       50 %   $ 738,272  
 
                       
nm — Not meaningful comparison
The changes in premium volume and retention levels between years resulted principally from the following factors:
    Diversified financial products — The largest gross and net premium growth in 2005 and 2004 was in our diversified financial products line of business. We experienced significant growth in our directors’ and officers’ liability gross written premium in 2004. In response to some increased competition and a reduction in available reinsurance at an acceptable cost, we scaled back our writing of this business in 2005. Rates for the other products in this line have been relatively stable with the exception of surety for which rates have been increasing. Our professional indemnity and surety business increased in 2005 due to organic growth and acquisitions. The growth in net written and net earned premium in both years was due to increased retentions resulting from a reduction in proportional reinsurance, some of which has been replaced by excess of loss reinsurance.
 
    Group life, accident and health — Profit margins remain at acceptable levels despite increased competition from the fully insured market. We increased our retentions in 2005 and 2004 as this line of business generally is not volatile and has very little catastrophe exposure.
 
    Aviation — Our aviation premium retention levels were mostly unchanged in 2005 after excluding the effects of a portfolio transfer that occurred in 2004. This 2004 portfolio transfer recaptured ceded unearned premium and increased net written premium, but not gross written premium, as a result of a reduction in ceded reinsurance. There has been increasing competition in the international aviation component of this line, but margins are still acceptable. Our domestic business is very stable.

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    London market account — We reduced our London market account premium writings in 2004 and again in 2005, due to more selective underwriting in response to reduced premium rates from increased competition. Premium rates have generally increased in 2006 as a result of the hurricane losses. Net written premium was reduced by $18.7 million in 2005 and $15.3 million in 2004 for additional excess of loss premium to reinstate catastrophe reinsurance coverage, which distorts the retention percentages. Because of the catastrophe exposure, we purchase excess of loss reinsurance at a significant cost. Since there generally is a fixed minimum cost, the retention percentage decreases as our written premium decreases.
 
    Other specialty lines — We experienced organic growth in our other specialty lines of business from increased writings in several products. The mix of products will affect the retention percentages. Rates in this line have been relatively stable.
Reinsurance
Annually, we analyze our overall threshold for risk in each line of business based upon a number of factors including market conditions, pricing, competition and the inherent risks associated with the business type, then structure a specific reinsurance program for each of our lines of business. Based on our analysis of these factors, we may determine not to purchase reinsurance for some lines of business. We generally purchase reinsurance to reduce our net liability on individual risks, to protect against catastrophe losses and volatility and to achieve a desired ratio of net written premium to policyholders’ surplus. We purchase reinsurance on a proportional basis to cover loss frequency, individual risk severity and catastrophe exposure. Some of the proportional insurance agreements may have maximum loss limits, which are currently well above a 100% combined ratio. We also purchase reinsurance on an excess of loss basis to cover individual risk severity and catastrophe exposure. Additionally, we may obtain facultative reinsurance protection on a single risk. The type and amount of reinsurance we purchase varies year to year based on our risk assessment, our desired retention levels based on profitability and other considerations, and the market availability of quality reinsurance at prices we consider acceptable. Our reinsurance programs renew throughout the year and, during 2005, some of those renewals contained price increases, which were not material to our net underwriting results. Our reinsurance generally does not cover war or terrorism risks, which are excluded from most of our policies.
We decided for the 2005 underwriting year to retain more underwriting risk in certain lines of business with the intention of retaining a greater proportion of any underwriting profits. In doing so, we will necessarily purchase less reinsurance applicable to that line or choose to restructure the applicable reinsurance programs, obtaining more excess of loss reinsurance and less proportional reinsurance, which significantly reduces the amount of ceded premium. Also, we have chosen not to purchase any reinsurance on other business where volatility or catastrophe risks are considered remote.
In our proportional reinsurance programs, we generally receive an overriding (ceding) commission on the premium ceded to reinsurers. This compensates our insurance companies for the direct costs associated with the production of the business, the servicing of the business during the term of the policies ceded and the costs associated with the placement of the related reinsurance. In addition, certain of our reinsurance treaties allow us to share in any net profits generated under such treaties with the reinsurers. Various reinsurance brokers, including subsidiaries, arrange for the placement of this proportional and other reinsurance coverage on our behalf and are compensated, directly or indirectly, by the reinsurers.
We have a reserve of $12.1 million at December 31, 2005 for potential collectibility issues related to reinsurance recoverables, including disputed amounts and associated expenses. While we believe the reserve is adequate based on information currently available, conditions may change or additional information might be obtained which may require us to change the reserve in the future. We periodically review our financial exposure to the reinsurance market and the level of our reserve and continue to take actions in an attempt to mitigate our exposure to possible loss.

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Losses and Loss Adjustment Expenses
The table below shows the composition of gross incurred loss and loss adjustment expense.
                                                 
    2005     2004     2003  
                                    (As restated)  
            Loss             Loss             Loss  
    Amount     ratio     Amount     ratio     Amount     ratio  
2005 hurricanes
  $ 394,625       19.9 %   $       %   $       %
2004 hurricanes
    (13,423 )     (0.7 )     89,795       4.8              
Other reserve redundancies
    (7,080 )     (0.4 )     (11,594 )     (0.6 )     (10,423 )     (0.7 )
Discontinued line of business adjustments
    49,775       2.5       127,707       6.9       132,924       8.9  
All other gross incurred loss and loss adjustment expense
    1,172,876       59.0       1,083,247       58.2       922,838       62.1  
 
                                   
Gross incurred loss and loss expense adjustment
  $ 1,596,773       80.3 %   $ 1,289,155       69.3 %   $ 1,045,339       70.3 %
 
                                   
Our gross reserve development relating to prior year losses was $29.3 million in 2005, $116.1 million in 2004 and $122.5 million in 2003.
We increased our gross losses related to prior accident years on certain assumed accident and health reinsurance contracts reported in our discontinued line of business by $49.8 million in 2005, $127.7 million in 2004 and $132.9 million in 2003 due to our processing of additional information received and our continuing evaluation of gross and net reserves related to this business. We considered a combination of factors including: 1) the nature of the business, which is primarily excess of loss reinsurance, 2) late reported losses by insureds, reinsureds and state guaranty associations and 3) changes in our actuarial assumptions to reflect additional information received during the year. The assumed accident and health business is primarily reinsurance that provides excess coverage for large losses related to workers’ compensation policies. This business is slow to develop and may take as many as twenty years to pay out. Primary losses must develop first before the excess coverage attaches. Thus, the losses are reported to excess of loss reinsurers later in the life cycle of the claim. Compounding this late reporting is the fact that a number of large insurance companies that were cedants of this business failed and were taken over by state regulatory authorities in 2002 and 2003. The state guaranty associations covering these failed companies have been slow to report losses to us. Based on the higher amount of actual losses reported, we revised the expected loss ratios used in our actuarial calculations. After consideration of all available information, we increased our gross and net reserves to amounts that management determined were appropriate to cover losses projected, given the risk inherent in this type of business. Reserves at December 31, 2005, although in excess of the actuarial point estimate, are within the actuarial range for this business.

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The table below shows the composition of net incurred loss and loss adjustment expense.
                                                 
    2005     2004     2003  
    (As restated)                     (As restated)  
            Loss                             Loss  
    Amount     ratio     Amount     Loss ratio     Amount     ratio  
2005 hurricanes
  $ 73,185       5.3 %   $       %   $       %
2004 hurricanes
    (7,167 )     (0.5 )     23,335       2.3              
Commutations
    26,041       1.9                   28,751       3.9  
Discontinued line of business adjustments
    8,929       0.7       27,326       2.7              
Other reserve deficiencies (redundancies)
    (2,409 )     (0.2 )     3,152       0.3       (5,637 )     (0.8 )
All other net incurred loss and loss adjustment expense
    821,118       59.9       591,417       58.5       464,886       63.0  
 
                                   
Net incurred loss and loss adjustment expense
  $ 919,697       67.1 %   $ 645,230       63.8 %   $ 488,000       66.1 %
 
                                   
The discontinued line of business and hurricane losses were substantially reinsured; therefore, the net losses are substantially less than the gross losses in each year. Our net adverse development relating to prior year losses was $25.4 million in 2005, $30.5 million in 2004 and $23.1 million in 2003, including $26.0 million in 2005 and $28.8 million in 2003 due to commutations, which primarily affected our discontinued line of business. The commutation losses primarily represent the discount for the time value of money on the reinsurance recoverables commuted. We reduced our net loss reserves on the 2004 hurricanes by $7.2 million in 2005 to reflect current estimates of our remaining liabilities. In 2004 and 2005, as a result of adverse development of certain assumed accident and health business in our discontinued line of business, we strengthened our reserves for this line to bring them above our actuarial point estimate. See our discussion of factors that caused the deficiencies in the section covering gross losses above. Deficiencies and redundancies in reserves occur as a result of our continuing review and as losses are finally settled or claims exposures change. We have no material exposure to environmental or asbestos losses and believe we have provided for all material net incurred losses.
The following table provides comparative net loss ratios by line of business.
                                                 
    2005     2004     2003  
    Net     Net     Net     Net     Net     Net  
    earned     loss     earned     loss     earned     loss  
    premium     ratio     premium     ratio     premium     ratio  
            (As             (As             (As  
            restated)             restated)             restated)  
Diversified financial products
  $ 531,136       48.1 %   $ 310,809       47.6 %   $ 123,562       47.8 %
Group life, accident and health
    504,382       71.6       343,913       66.7       290,009       61.6  
Aviation
    136,197       67.3       127,248       63.2       97,536       61.5  
London market account
    93,017       106.0       111,341       65.9       137,572       52.8  
Other specialty lines
    97,721       72.6       69,089       63.5       12,443       62.1  
Discontinued lines
    7,535       551.3       48,292       145.2       77,150       142.6  
 
                                   
Totals
  $ 1,369,988       67.1 %   $ 1,010,692       63.8 %   $ 738,272       66.1 %
 
                                         
Expense ratio
            26.1               26.7               24.6  
 
                                         
Combined ratio
            93.2 %             90.5 %             90.7 %
 
                                         

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Comments on significant changes in net loss ratios by line of business follow:
    Group life, accident and health — Rate pressure from competition as well as medical cost inflation have resulted in increasing loss ratios in this line of business, however our underwriting margins remain satisfactory.
 
    Aviation — The 2005 hurricanes increased the net loss ratio 5.0% and the 2004 hurricanes increased the net loss ratio 6.5%. The 2005 net loss ratio also includes the positive impact from the release of redundant reserves related to the 2004 hurricanes. Excluding the impact of the hurricanes, 2005 had worse than expected underwriting experience due to some unusually large international losses.
 
    London market account — The 2005 hurricanes increased the net loss ratio 63.2% and the 2004 hurricanes increased the net loss ratio 14.1%. The London market account line of business can have relatively high year-to-year volatility due to catastrophe exposure.
 
    Other specialty lines —The 2005 hurricanes increased the net loss ratio 14.0% and the 2004 hurricanes increased the net loss ratio 6.5%.
 
    Discontinued lines — The commutation losses in 2005 and 2003 affected the net loss ratios for those years. In addition, the 2005 and 2004 net loss ratios were impacted by loss reserve strengthening of $8.9 million and $27.3 million, respectively, on certain assumed accident and health reinsurance contracts.
Policy Acquisition Costs
Policy acquisition costs, which are net of the related portion of commissions on reinsurance ceded, increased to $261.7 million in 2005 from $222.3 million in 2004 and $137.2 million in 2003. Policy acquisition costs as a percentage of net earned premium declined to 19.1% in 2005 from 22.0% in 2004 due to a change in the mix of business, reductions in commission rates on certain lines of business and our increased retentions, which increased our net earned premium at a higher rate than our non-commission acquisition costs. The expense ratio decreased in 2005 compared to 2004 for the same reasons. Policy acquisition costs as a percentage of net earned premium were 18.6% in 2003 and lower than 2004 due to changes in the mix of business.
Statutory
Regulatory guidelines suggest that a property and casualty insurer’s annual statutory gross written premium should not exceed 900% of its statutory policyholders’ surplus and net written premium should not exceed 300% of its statutory policyholders’ surplus. However, industry standards and rating agency criteria place these ratios at 300% and 200%, respectively. Our property and casualty insurance companies have maintained premium to surplus ratios lower than such guidelines. For 2005, our statutory gross written premium to policyholders’ surplus was 184.6% and our statutory net written premium to policyholders’ surplus was 134.7%. At December 31, 2005, each of our domestic insurance companies’ total adjusted capital was significantly in excess of the authorized control level risk-based capital level prescribed by the National Association of Insurance Commissioners.
Agency Segment
Revenue from our agency segment decreased to $188.9 million in 2005 from $226.8 million in 2004, primarily due to the consolidation of our largest underwriting agency into one of our life insurance companies effective January 1, 2005, less business produced in certain lines and the overall effect of ceding less reinsurance. As a result, segment net earnings also decreased in 2005 to $38.5 million from $53.6 million in 2004. While these actions resulted in less fee and commission income to our agency segment, they resulted in increased insurance company revenue and net earnings. Segment revenue increased 13% and net earnings increased 8% in 2004, primarily from increased new business and acquisitions. We expect the revenue and net earnings of this segment will decline slightly in 2006 due to continuing changes in the mix of business.

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Liquidity and Capital Resources
Cash Flow
The restatement of previously issued financial statements discussed in Note 2 to our Consolidated Financial Statements had no impact on our reported net cash flows.
We receive substantial cash from premiums, reinsurance recoverables, commutations, fee and commission income, proceeds from sales and redemptions of investments and investment income. Our principal cash outflows are for the payment of claims and loss adjustment expenses, premium payments to reinsurers, purchases of investments, debt service, policy acquisition costs, operating expenses, taxes and dividends.
Cash provided by operating activities can fluctuate due to timing differences in the collection of premiums and reinsurance recoverables and the payment of losses and premium and reinsurance balances payable, the completion of commutations and activity in our trading portfolio. Our cash provided by operating activities has been strong in recent years due to: 1) our increasing net earnings, 2) growth in net written premium and net loss reserves due to organic growth and increased retentions, 3) commutations of selected reinsurance agreements and 4) expansion of our diversified financial products line of business as a result of which we retain premium longer due to the longer duration of claims liabilities.
The components of our net operating cash flows are detailed in the following table.
                         
    2005     2004     2003  
    (As restated)     (As restated)     (As restated)  
 
                       
Net earnings
  $ 191,192     $ 162,699     $ 142,027  
Change in premium, claims and other receivables, net of reinsurance, other payables and restricted cash
    (59,717 )     237       (26,513 )
Change in unearned premium, net
    121,242       104,895       133,894  
Change in loss and loss adjustment expense payable, net of reinsurance recoverables
    454,859       349,813       262,818  
Gain on sale of subsidiaries
    (8,717 )     (6,317 )     (52,681 )
Change in trading portfolio
    (66,809 )     25,673       12,741  
Other, net
    (8,060 )     31,703       55,812  
 
                 
Cash provided by operating activities
  $ 623,990     $ 668,703     $ 528,098  
 
                 
Cash provided by operating activities decreased $44.7 million in 2005 and increased $140.6 million in 2004. Cash received from commutations, included in cash provided by operating activities, totaled $180.8 million, $79.5 million and $49.0 million in 2005, 2004 and 2003, respectively. Excluding the commutations, cash provided by operating activities decreased $146.0 million in 2005 compared to an increase of $110.1 million in 2004. The decrease in 2005 was principally due to an increase in paid claims in 2005 as a result of payments of 2004 hurricane losses and claims related to business commuted in 2004, the timing of receipt of premiums and payment of payables, and the effect of our trading portfolio activity. Cash flows increased in 2004 principally due to increasing retentions, the growth of our diversified financial products line of business and an increase in earnings from continuing operations, net of a $21.0 million tax payment in 2004 on the 2003 gain on the sale of a subsidiary. Cash flows are expected to be strong again in 2006.

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Investments
At December 31, 2005, we had $3.3 billion of investment assets, an increase of $788.9 million from the end of 2004. The increase resulted from strong operating cash flows and our $150.0 million common stock offering. The majority of our investment assets are held by our insurance companies. All of our fixed income securities are classified as available for sale and are recorded at market value.
Our investment policy is determined by our Board of Directors and our Investment and Finance Committee and is reviewed on a regular basis. Our policy for each of our insurance company subsidiaries must comply with applicable State and Federal regulations which prescribe the type, quality and concentration of investments. These regulations permit investments, within specified limits and subject to certain qualifications, in federal, state and municipal obligations, obligations of foreign countries, corporate bonds and preferred and common equity securities. The regulations generally allow certain other types of investments subject to maximum limitations.
We engage independent investment advisors to oversee our fixed income investments and to make investment recommendations. We invest our funds principally in highly rated fixed income securities. Our historical investment strategy is to maximize interest income and yield, rather than to maximize total return. In accordance with our strategy, realized gains and losses from sales of investment securities are usually minimal, unless we decide to capture gains to enhance statutory capital and surplus of our insurance company subsidiaries. Although we generally intend to hold fixed income securities to maturity, we regularly re-evaluate our position based on market conditions. Our portfolio turnover will fluctuate, depending upon opportunities to increase yields by replacing one security with another higher yielding security.
At December 31, 2005, we had cash and short-term investments of $913.5 million, of which $589.2 million is held by our insurance companies. We maintain cash and liquid short-term instruments in our insurance companies in order to be able to fund losses of our insureds. Cash and short-term investments were higher than normal at December 31, 2005 and 2004 due to proceeds from common stock offerings and commutations that were consummated close to each year end. Those proceeds had not yet been invested on a longer term basis.
This table shows a profile of our fixed income and short-term investments. The table shows the average amount of investments, income earned and the yield thereon.
                         
    2005     2004     2003  
Average investments, at cost
  $ 2,822,686     $ 2,054,620     $ 1,403,690  
Net investment income *
    98,851       64,885       47,335  
Average short-term yield *
    2.7 %     1.7 %     1.8 %
Average long-term yield *
    4.0 %     3.9 %     4.2 %
Average long-term tax equivalent yield *
    4.9 %     4.8 %     5.0 %
Weighted average combined tax equivalent yield *
    4.1 %     3.8 %     3.8 %
Weighted average maturity
    7.6 years     6.6 years     4.5 years
Weighted average duration
    4.9 years     4.6 years     3.7 years
Average S&P rating
  AAA   AAA   AA+
 
*   Excluding realized and unrealized investment gains and losses.

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This table summarizes the estimated market value of our investments by type at December 31, 2005.
                 
    Amount     %  
Short-term investments
  $ 839,581       26 %
U.S. government
    89,724       3  
States, municipalities and political subdivisions
    418,873       13  
Special revenue fixed income securities
    723,101       22  
Corporate fixed income securities
    375,582       11  
Asset-backed and mortgage-backed securities
    355,372       11  
Foreign securities
    305,972       9  
Other investments
    149,223       5  
 
           
Total investments
  $ 3,257,428       100 %
 
           
This table summarizes, by rating, the market value of our investments in fixed income securities at December 31, 2005.
                 
    Amount     %  
AAA
  $ 1,593,663       70 %
AA
    273,714       12  
A
    390,074       17  
BBB
    10,526       1  
BB and below
    647        
 
           
Total fixed income securities
  $ 2,268,624       100 %
 
           
This table indicates the expected maturity distribution of the estimated market value of our fixed income securities at December 31, 2005.
                 
    Amount     %  
One year or less
  $ 146,924       6 %
One year to five years
    561,240       25  
Five years to ten years
    467,542       21  
Ten years to fifteen years
    301,264       13  
More than fifteen years
    436,282       19  
 
           
Securities with fixed maturities
    1,913,252       84  
Asset-backed and mortgage-backed securities
    355,372       16  
 
           
Total fixed income securities
  $ 2,268,624       100 %
 
           
The weighted average life of our asset-backed and mortgage-backed securities is 2.6 years.
The market value of our fixed income securities is sensitive to changing interest rates. As interest rates increase, the market value will generally decrease and as rates decrease, the market value will generally increase. The fluctuations in market value are somewhat muted by the relatively short duration of our portfolio and our relatively high level of investments in state and municipal obligations. During 2005, the net pre-tax unrealized gain on our fixed income securities decreased $29.3 million due to market value changes. We estimate that a 1% increase in interest rates would decrease the market value of our fixed income securities by approximately $111.2 million and a 1% decrease would increase the market value by a like amount. Fluctuations in interest rates have a minimal effect on the value of our short-term investments due to their very short maturities. In our current position, higher interest rates would have a positive effect on net earnings.

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Some of our fixed income securities have call or prepayment options. This could subject us to reinvestment risk should interest rates fall or issuers call their securities and we reinvest the proceeds at lower interest rates. We mitigate this risk by investing in securities with varied maturity dates, so that only a portion of our portfolio will mature at any point in time.
The average duration of claims in many of our lines of business is relatively short and, accordingly, our investment portfolio had a relatively short duration. In recent years we have expanded the directors’ and officers’ liability and professional indemnity components of our diversified financial products line of business, which have a longer claims duration than our other lines of business. We are taking these changes into consideration in determining the duration of our investment portfolio. We have also kept the duration of our portfolio relatively short in recent years when rates were very low, in expectation of higher interest rates. We have recently extended the duration and maturities of our investments to take advantage of higher long-term market interest rates.
The following table compares our insurance company subsidiaries’ cash and investment maturities with their estimated future claims payments at December 31, 2005.
                                         
            Maturities / Estimated payment dates  
    Total     2006     2007-2008     2009-2010     Thereafter  
Cash and investment maturities of insurance companies
  $ 2,969,277     $ 897,421     $ 469,980     $ 380,460     $ 1,221,416  
Estimated loss and loss adjustment expense payments, net of reinsurance
    1,533,433       537,968       552,721       259,741       183,003  
 
                             
Estimated available cash flow
  $ 1,435,844     $ 359,453     $ (82,741 )   $ 120,719     $ 1,038,413  
 
                             
As demonstrated in the above table, we maintain sufficient liquidity to pay anticipated policyholder claims on their expected payment dates. In addition, we can use current operating cash flow to pay claims as they become due. We manage the liquidity of our insurance company subsidiaries such that each subsidiary’s anticipated claims payments will be met by its own current operating cash flows, cash, short-term investments or investment maturities. We do not foresee the need to sell securities prior to their maturity to fund claims payments, nor do we anticipate needing to use our $200.0 million Revolving Loan Facility to pay claims. However, this credit facility can provide additional short-term liquidity if an unexpected event was to occur.

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Contractual Obligations
The following table presents a summary of our total contractual cash payment obligations by estimated payment date at December 31, 2005.
                                         
            Estimated Payment Dates  
    Total     2006     2007-2008     2009-2010     Thereafter  
Gross loss and loss adjustment expense payable (1)
                                       
Diversified financial products
  $ 953,131     $ 199,984     $ 388,204     $ 238,847     $ 126,096  
Group life, accident and health
    204,100       169,698       26,734       6,077       1,591  
Aviation
    193,242       95,036       65,946       21,309       10,951  
London market account
    578,253       239,558       284,154       48,084       6,457  
Other specialty lines
    195,918       93,245       75,064       22,276       5,333  
Discontinued lines
    689,076       146,469       222,988       122,863       196,756  
 
                             
Total loss and loss adjustment expense payable
    2,813,720       943,990       1,063,090       459,456       347,184  
Life and annuity policy benefits
    73,415       1,859       3,577       3,397       64,582  
1.30% Convertible Notes (2) (3)
    125,812       125,812                    
2.00% Convertible Exchange Notes (2) (3)
    174,120       174,120                    
Other notes payable (3)
    13,899       1,003       11,753       508       635  
$200.0 million Revolving Loan Facility
                             
Operating leases
    59,123       10,582       18,936       12,150       17,455  
Earnout liabilities
    32,318       32,318                    
Indemnifications
    20,748       13,294       1,968       2,172       3,314  
 
                             
Total obligations
  $ 3,313,155     $ 1,302,978     $ 1,099,324     $ 477,683     $ 433,170  
 
                             
In preparing the previous table, we made the following estimates and assumptions.
(1)   The estimated loss and loss adjustment expense payments for future periods assume that the percentage of ultimate losses paid from one period to the next will be relatively consistent over time. Actual payments will be influenced by many factors and could vary from the estimated amounts above.
 
(2)   The 1.30% Convertible Notes mature in 2023 and the 2.00% Convertible Exchange Notes mature in 2021, but are shown in the 2006 column since they may be surrendered for cash at the option of the holders in the first quarter of 2006 because our stock traded at specified price levels in 2005. Both convertible notes have various put and redemption dates as disclosed in Note 6 to the Consolidated Financial Statements.
 
(3)   Amounts include interest payable in respective periods.
The purchase agreements for two of our acquisitions provide for earnout payments. The above table includes the amounts earned in 2005, which are payable in 2006.
In conjunction with the sales of business assets and subsidiaries, we have provided indemnifications to the buyers. Certain indemnifications cover typical representations and warranties related to our responsibilities to perform under the sales contracts. Other indemnifications agree to reimburse the purchasers for taxes or ERISA-related amounts, if any, assessed after the sale date but related to pre-sale activities. We cannot quantify the maximum potential exposure covered by all of our indemnifications because the indemnifications cover a variety of matters, operations and scenarios. Certain of these indemnifications have no time limit. For those with a time limit, the longest such indemnification expires on December 31, 2009.

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We accrue a loss related to our indemnifications when a valid claim is made by a buyer and we believe we have potential exposure. We currently have several claims under indemnifications that cover certain net losses alleged to have been incurred in periods prior to our sale of certain subsidiaries or otherwise alleged to be covered under indemnification agreements related to such sales. As of December 31, 2005, we have recorded a liability of $20.7 million and have provided $8.1 million of letters of credit to cover our obligations or anticipated payments under these indemnifications.
Subsidiary Dividends
The principal assets of HCC are the shares of capital stock of its insurance company subsidiaries. Historically, we have not relied on dividends from our insurance companies to meet the parent holding company’s obligations, which are primarily outstanding debt and debt service obligations, dividends to shareholders and corporate expenses, since we have had sufficient cash flow from our agencies and intermediaries to meet our corporate cash flow requirements. However, as more profit is now expected to be earned in our insurance companies, we may have to partially depend on cash flow from our insurance companies in the future.
The payment of dividends by our insurance companies is subject to regulatory restrictions and will depend on the surplus and future earnings of these subsidiaries. HCC’s direct domestic insurance company subsidiaries can pay an aggregate of $90.3 million in dividends in 2006 without obtaining special permission from state regulatory authorities. In 2005 and 2004, one insurance company subsidiary paid HCC a dividend of $50.0 million and $20.0 million, respectively. The funds were then contributed to another insurance company subsidiary.
Lines of Credit
Our $200.0 million Revolving Loan Facility allows us to borrow up to the maximum allowed by the facility on a revolving basis until the facility expires on November 30, 2009. The facility is collateralized in part by the pledge of our insurance companies’ stock and guarantees entered into by our underwriting agencies and reinsurance brokers. The facility agreement contains certain restrictive covenants, which we believe are typical for similar financing arrangements. We had no borrowings under this facility at December 31, 2005.
In 2006, we entered into a $34.0 million Standby Letter of Credit Facility, which allows us to replace a portion of our funds at Lloyd’s of London with standby letters of credit. Any letters of credit issued under the Standby Letter of Credit Facility will be unsecured commitments of HCC. The Standby Letter of Credit Facility contains standard restrictive covenants, which in many cases are identical to or incorporate by reference the restrictive covenants from our Revolving Loan Facility.
At December 31, 2005, certain of our subsidiaries maintained revolving lines of credit with a bank in the combined maximum amount of $45.2 million available through November 30, 2009. Advances under the lines of credit are limited to amounts required to fund draws, if any, on letters of credit issued by the bank on behalf of the subsidiaries and short-term direct cash advances. The lines of credit are collateralized by securities having an aggregate market value of up to $56.5 million, the actual amount of collateral at any one time being 125% of the aggregate amount outstanding. Interest on the lines is payable at the bank’s prime rate of interest (7.25% at December 31, 2005) for draws on the letters of credit and either prime or prime less 1% on short-term cash advances. At December 31, 2005, letters of credit totaling $16.7 million had been issued to insurance companies by the bank on behalf of our subsidiaries, with total securities of $20.9 million collateralizing the lines.

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Other
In May 2005, the Board of Directors declared a three-for-two stock split in the form of a 50% stock dividend on our shares of common stock, payable to shareholders of record on July 1, 2005. The distribution of the 35.1 million shares had no impact on our consolidated shareholders’ equity, results of operations or cash flows.
In the second quarter of 2006, we filed a “Universal Shelf” registration statement with the Securities and Exchange Commission, which replaced our previously filed registration statements and provides for the issuance of an aggregate of $1.0 billion of our securities. These securities may be debt securities, equity securities, trust preferred securities, or a combination thereof. We sold 4.7 million and 4.5 million shares of our common stock at prices of $32.05 and $22.17 per share in 2005 and 2004, respectively, under this shelf registration. Net proceeds of $150.0 million in 2005 were used to make $108.0 million of capital contributions to our insurance company subsidiaries and to fund acquisitions. We used the net proceeds of $96.7 million in 2004 to make a $75.0 million capital contribution to an insurance company subsidiary and $17.0 million to pay down bank debt.
As a result of our delayed filing of our Form 10-Q’s for the quarters ended June 30, 2006 and September 30, 2006, we are ineligible to register our securities on Form S-3 or use our previously filed shelf registration statement until we have timely filed all periodic reports under the Securities Exchange Act of 1934 for one year. We may use Form S-1 to raise capital and borrow money utilizing public debt or complete acquisitions of other companies, which could increase transaction costs and adversely impact our ability to raise capital and borrow money or complete acquisitions in a timely manner. In addition, the financial strength ratings of our insurance companies and our debt ratings, which A.M. Best placed under review with negative implications and Fitch Ratings and Standard & Poor’s affirmed with a stable outlook, if reduced, might significantly impede our ability to raise capital and borrow money.
On October 30, 2006, we received a registered letter from U.S. Bank, as trustee for the holders of our 2.00% Convertible Notes due 2021, 1.30% Convertible Notes due 2023 and 2.00% Convertible Exchange Notes due 2021, stating that U.S. Bank, as trustee, had not received our consolidated financial statements for the quarter ended June 30, 2006. If we do not file our Quarterly Report on Form 10-Q for the quarter ended June 30, 2006 with the SEC and deliver the report to the trustee within sixty days from the date notice was received from the trustee, such failure to file and deliver will be considered an “Event of Default” under the indenture governing the notes. If an “Event of Default” were to occur under the indentures for any series of the notes, the trustee or holders of at least 25% of the aggregate principal of such series then outstanding could declare all the unpaid principal on such series of notes then outstanding to be immediately due and payable. Likewise, we have not timely delivered our Form 10-Q’s for the quarters ended June 30 and September 30, 2006 as required by the terms of our Revolving Loan Facility. The banks that are a party to the agreement waived certain “Defaults” or “Events of Default” until January 31, 2007. In addition, our restatement of our prior year financial statements might be considered an “Event of Default”, which has been waived until January 31, 2007 under our Revolving Loan Facility. Our failure to comply with the covenants in the indentures for our convertible notes and our Revolving Loan Facility in the future could have a material adverse effect on our stock price, business and financial condition if we would not have available funds at that time to repay any defaulted debt. A default and acceleration under the indentures for our convertible notes and loan agreement may also trigger cross-acceleration under our other debt instruments.
In December 2006, our existing Revolving Loan Facility was increased by $100.0 million to $300.0 million. Pursuant to the terms of the agreement, the Company can borrow up to $25 million in addition to what is currently borrowed for working capital purposes. However, the full unfunded amount of the facility would be available to pay any potential convertible note conversion or put.
As described in Note 2 to our Consolidated Financial Statements included in this Form 10-K/A, based on the Special Committee’s voluntary independent investigation of our past practices related to granting stock options, we determined that the price on the actual measurement date for a number of our stock option grants during the period 1997 through 2005 and into 2006 did not correspond to the price on the stated grant date and that certain option grants were retroactively priced. The investigation was conducted with the help of a law firm that was not previously involved with our stock option plans and procedures. The SEC has commenced an informal inquiry. In connection with its inquiry, we received a document request from the SEC. We intend to fully cooperate with the informal inquiry. We are unable to predict the outcome of or the future costs related to the informal inquiry.

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Our debt to total capital ratio was 15.5% at December 31, 2005 and 19.0% at December 31, 2004.
We believe that our operating cash flows, investments, Revolving Loan Facility and other sources of liquidity are sufficient to meet our operating needs for the foreseeable future.
Impact of Inflation
Our 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 loss adjustment expense are known. Although we consider the potential effects of inflation when setting premium rates, for competitive reasons, such premiums may not fully offset the effects of inflation. However, because the majority of our business is comprised of lines which have relatively short lead times between the occurrence of an insured event, reporting of the claims to us and the final settlement of the claims or have claims that are not significantly impacted by inflation, the effects of inflation are minimized.
A portion of our revenue is related to healthcare insurance and reinsurance products that are subject to the effects of the underlying inflation of healthcare 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 also 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. We do not specifically provide for inflation when setting underwriting terms and claim reserves, although we do consider trends. We continually review claim reserves to assess their adequacy and make necessary adjustments.
Inflation can also affect interest rates. Any significant increase in interest rates could have a material adverse effect on the market value of our investments. In addition, the interest rate payable under our Revolving Loan Facility fluctuates with market interest rates. Any significant increase in interest rates could have a material adverse effect on our net earnings, depending on the amount borrowed on that facility.
Foreign Exchange Rate Fluctuations
We underwrite risks which are denominated in a number of foreign currencies. As a result, we have receivables and payables in foreign currencies and we establish and maintain loss reserves with respect to our insurance policies in their respective currencies. Our net earnings could be impacted by exchange rate fluctuations affecting these balances. Our principal area of exposure is related to fluctuations in the exchange rates between the British pound sterling, the Euro and the U.S. dollar. We constantly monitor the balance between our receivables and payables and loss reserves to mitigate the potential exposure should an imbalance be expected to exist for other than a short period of time. Our gain (loss) from currency conversion was $(1.0) million in 2005 compared to $1.2 million in 2004 and $3.7 million in 2003. Included in the 2003 amount was a one-time gain of $1.3 million from the settlement of an advance of funds to an unaffiliated entity.
Critical Accounting Policies
The preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (generally accepted accounting principles) requires us to make estimates and assumptions when applying our accounting policies. The following sections provide information about our estimation processes related to certain of our critical accounting policies.
Loss and Loss Adjustment Expense
Our net loss and loss adjustment expense reserves are composed of reserves for reported losses and reserves for incurred but not reported losses, less a reduction for reinsurance recoverables related to those reserves. Reserves are recorded by product line and are undiscounted, except for reserves related to acquisitions.

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The process of estimating our loss and loss adjustment expense reserves involves a considerable degree of judgment by management and is inherently uncertain. The recorded reserves represent management’s best estimate of unpaid loss and loss adjustment expense by line of business. Because we provide insurance coverage in specialized lines of business that often lack statistical stability, management considers many factors, and not just the actuarial point estimates discussed below, in determining ultimate expected losses and the level of net reserves required and recorded.
To record reserves on our lines of business, we utilize expected loss ratios, which management selects based on the following: 1) information used to price the applicable policies, 2) historical loss information where available, 3) any public industry data for that line or similar lines of business and 4) an assessment of current market conditions. Management also considers the point estimates and ranges calculated by our actuaries, together with input from our experienced underwriting and claims personnel. Because of the nature and complexities of the specialized types of business we insure, management may give greater weight to the expectations of our underwriting and claims personnel, who often perform a claim by claim review, rather than to the actuarial estimates. However, we utilize the actuarial point and range estimates to monitor the adequacy and reasonableness of our recorded reserves.
Each quarter-end, management compares recorded reserves to the most recent actuarial point estimate and range for each line of business. If the recorded reserves vary significantly from the actuarial point estimate, management determines the reasons for the variances and may adjust the reserves up or down to an amount that, in management’s judgment, is adequate based on all of the facts and circumstances considered, including the actuarial point estimates. Generally, we maintain total consolidated net reserves above the total actuarial point estimate but within the actuarial range.
The table below shows our recorded net reserves at December 31, 2005 by line of business, the actuarial reserve point estimates, and the high and low ends of the actuarial reserve range as determined by our reserving actuaries.
                                 
    Recorded     Actuarial     Low end of     High end of  
    net reserves     point estimate     actuarial range     actuarial range  
Total net reserves
  $ 1,533,433     $ 1,509,149     $ 1,418,139     $ 1,647,937  
 
                       
 
                               
Individual lines of business:
                               
Diversified financial products
  $ 551,350     $ 548,060     $ 477,296     $ 644,673  
Group life, accident and health
    162,076       165,545       151,301       181,882  
Aviation
    104,727       97,998       91,060       106,615  
London market account
    197,142       192,228       182,571       217,638  
Other specialty lines
    105,020       98,112       92,944       108,997  
Discontinued lines
    413,118       407,206       358,389       490,719  
 
                             
Total net reserves
  $ 1,533,433                          
 
                             
The actuarial point estimates represent our actuaries’ estimate of the most likely amount that will ultimately be paid to settle the net reserves we have recorded at a particular point in time. While, from an actuarial standpoint, a point estimate is considered the most likely amount to be paid, there is inherent uncertainty in the point estimate, and it can be thought of as the expected value in a distribution of possible reserve estimates. The actuarial ranges represent our actuaries’ estimate of a likely lowest amount and highest amount that will ultimately be paid to settle the net reserves we have recorded at a particular point in time. While there is still a possibility of ultimately paying an amount below the range or above the range, the actuarial probability is very small. The range determinations are based on estimates and actuarial judgments and are intended to encompass reasonably likely changes in one or more of the variables that were used to determine the point estimates.
The low end of the actuarial range and the high end of the actuarial range for the total net reserves will not equal the sum of the low and high ends for the individual lines of business. Moreover, in actuarial terms, it would not be appropriate to add the ranges for each line of business to obtain a range around the total net reserves because this would not reflect the diversification effects across our various lines of business. The diversification effects result from the fact that losses across the different lines of business are not completely correlated.

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In actuarial practice, some of our lines of business are more effectively modeled by a statistical distribution that is skewed or non-symmetric. These distributions are usually skewed towards large losses, which causes the midpoint of the range to be above the actuarial point estimate or mean value of the range. This should be kept in mind when using the midpoint as a proxy for the mean. Our assumptions, estimates and judgments can change based on new information and changes in conditions and, if they change, it will affect the determination of the range amounts.
The following table details the characteristics and major actuarial assumptions by major products within our lines of business utilized by our actuaries in the determination of actuarial point estimates and ranges. We considered all major lines of business written by the insurance industry when determining the relative characteristics of claims duration, speed of loss reporting and reserve volatility. Other companies may classify their own insurance products in different lines of business or utilize different actuarial assumptions.
                         
            Claims        
            Characteristics        
                Speed of        
                loss   Reserve   Major actuarial
Line of Business   Products   Underwriting   Duration   reporting   volatility   assumptions
Diversified
financial products
  Directors’ and officers’ liability   Primary   Medium   Moderate   Medium   Historical and industry loss reporting patterns
 
                       
 
  Professional
indemnity
  Primary   Medium   Moderate   Low   Historical loss reporting patterns
 
                       
 
  Surety   Primary   Medium   Fast   Low   Historical loss payment and reporting patterns
 
Group life, accident and health
  Medical stop-loss   Primary   Short   Fast   Low   Medical cost and utilization trends
Historical loss payment and reporting
      patterns
Rate changes
 
Aviation
  Aviation   Primary and subscription   Medium   Fast   Medium   Historical loss payment and reporting patterns Rate changes
 
London
market
account
  Accident and health   Primary and assumed   Medium to Long   Slow   High   Historical loss payment and reporting patterns
 
                       
 
  Energy *   Subscription   Medium   Moderate   Medium   Historical loss payment and reporting patterns Historical severity and frequency
Historical large loss experience
 
                       
 
  Property *   Subscription   Medium   Moderate   Medium   Historical loss payment and reporting patterns Historical severity and frequency
Historical large loss experience
 
                       
 
Other specialty
  Surplus lines
business
  Assumed   Medium   Moderate   Medium   Historical loss payment and reporting patterns
 
Discontinued
  Accident and health reinsurance   Assumed   Long   Slow   High   Historical and industry loss payment and
     reporting patterns
 
 
*   Includes catastrophe losses

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Assumed reinsurance represented 13% of our gross written premium in 2005 and 35% of our gross reserves at December 31, 2005. Approximately 55% of the assumed reinsurance reserves related to assumed accident and health business in our discontinued line, 20% related to assumed reinsurance in our London market account and 13% related to assumed reinsurance in our aviation and diversified financial products lines of business. The remaining assumed reinsurance reserves covered various minor reinsurance programs. The table above recaps the underwriting, claims characteristics and major actuarial assumptions for our assumed reinsurance business.
The assumed accident and health business is primarily reinsurance that provides excess coverage for large losses related to workers’ compensation policies. As discussed previously, we recorded $8.9 million of adverse development, net of reinsurance, in 2005 and $27.3 million in 2004. These losses resulted from late reporting of claims by cedants and state guaranty associations and changes in our actuarial assumptions related to this business. To mitigate our exposure to unexpected losses reported by cedants, our claims personnel review reported losses to ensure they are reasonable and consistent with our expectations. In addition, our claims personnel periodically audit the cedants’ claims processing functions to assess whether cedants are submitting timely and accurate claims reports to us. Disputes with insureds related to claims or coverage issues are administered in the normal course of business or settled through arbitration. Based on the negative factors we experienced in the past two years and the higher risk of this discontinued line of business relative to our continuing lines of business, management believes there may be a greater likelihood of future adverse development in this assumed accident and health business than in our other lines of business. We periodically reassess loss reserves for this assumed business and adjust them, if needed. We are pursuing commutations with certain cedants to limit our future exposure to unanticipated losses from this business.
The majority of the assumed reinsurance in our London market account, aviation and diversified financial products lines of business is facultative reinsurance. This business involves reinsurance of a company’s entire captive insurance program or business that must be written through another insurance company licensed to write insurance in a particular country or locality. In all cases, we underwrite the business and administer the claims, which are reported without a lag by the brokers. Disputes, if any, generally relate to claims or coverage issues with insureds and are administered in the normal course of business. We establish loss reserves for this assumed reinsurance using the same methods and assumptions we use to set reserves for comparable primary business.

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The following tables show the composition of our gross, ceded and net reserves at the respective balance sheet dates.
                                 
                            % Net IBNR  
                            to net total  
    Gross     Ceded     Net     reserves  
            (As restated)     (As restated)          
At December 31, 2005
                               
 
                               
Reported loss reserves:
                               
Diversified financial products
  $ 319,000     $ 126,665     $ 192,335          
Group life, accident and health
    129,601       6,366       123,235          
Aviation
    118,122       55,602       62,520          
London market account
    345,605       260,473       85,132          
Other specialty lines
    51,634       27,590       24,044          
 
                         
Subtotal reported reserves
    963,962       476,696       487,266          
 
                         
 
                               
Incurred but not reported reserves:
                               
Diversified financial products
    634,131       275,116       359,015       65 %
Group life, accident and health
    74,499       35,658       38,841       24  
Aviation
    75,120       32,913       42,207       40  
London market account
    232,648       120,638       112,010       57  
Other specialty lines
    144,284       63,308       80,976       77  
 
                         
Subtotal incurred but not reported reserves
    1,160,682       527,633       633,049       57  
 
                         
 
                               
Discontinued lines reported reserves
    437,681       159,529       278,152          
Discontinued lines incurred but not reported reserves
    251,395       116,429       134,966       33  
 
                         
Total loss and loss adjustment expense payable
  $ 2,813,720     $ 1,280,287     $ 1,533,433       50 %
 
                         

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                            % Net IBNR  
                            to net total  
    Gross     Ceded     Net     reserves  
At December 31, 2004
                               
 
                               
Reported loss reserves:
                               
Diversified financial products
  $ 149,448     $ 64,852     $ 84,596          
Group life, accident and health
    128,973       31,235       97,738          
Aviation
    108,277       48,301       59,976          
London market account
    182,585       106,249       76,336          
Other specialty lines
    26,717       14,349       12,368          
 
                         
Subtotal reported reserves
    596,000       264,986       331,014          
 
                         
 
                               
Incurred but not reported reserves:
                               
Diversified financial products
    462,795       257,853       204,942       71 %
Group life, accident and health
    90,396       30,131       60,265       38  
Aviation
    55,169       24,117       31,052       34  
London market account
    98,530       31,090       67,440       47  
Other specialty lines
    62,206       28,930       33,276       73  
 
                         
Subtotal incurred but not reported reserves
    769,096       372,121       396,975       55  
 
                         
 
                               
Discontinued lines reported reserves
    453,394       241,481       211,913          
Discontinued lines incurred but not reported reserves
    270,709       151,328       119,381       36  
 
                         
Total loss and loss adjustment expense payable
  $ 2,089,199     $ 1,029,916     $ 1,059,283       49 %
 
                         
We determine our incurred but not reported reserves by first projecting the ultimate expected losses by product within each line of business. We then subtract paid losses and reported loss reserves from the ultimate loss reserves. The remainder is our incurred but not reported reserves. The level of incurred but not reported reserves in relation to total reserves depends upon the characteristics of the particular line of business, particularly with respect to the speed by which losses are reported and outstanding claims reserves are adjusted. Lines for which losses are reported fast will have a lower percentage incurred but not reported reserve than slower reporting lines, and lines for which reserve volatility is low will have a lower percentage incurred but not reported loss reserve than high volatility lines.
The reserves for reported losses related to our primary business and certain reinsurance assumed are initially set by our claims personnel or independent claims adjusters we retain. The reserves are subject to our review, with a goal of setting them at the ultimate expected loss amount as soon as possible when the information becomes available. Reserves for reported losses related to other reinsurance assumed are recorded based on information supplied to us by the ceding company. Our claims personnel monitor these reinsurance assumed reserves on a current basis and audit ceding companies’ claims to ascertain that claims are being recorded currently and that net reserves are being set at levels that properly reflect the liability related to the claims.
The percentage of net incurred but not reported reserves to net total reserves increased slightly from 49% at December 31, 2004 to 50% at December 31, 2005. The reasons for the significant changes in net reserves by line of business follow:
    Diversified financial products — Total net reserves in our diversified financial products line of business increased $261.8 million from 2004 to 2005 as this relatively new line of business continues to grow. The incurred but not reported portion of the total reserves for this line of business is higher than in most of our other lines, since these losses report slower and have a longer duration.

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    Group life, accident and health — Incurred but not reported reserves have decreased and reported reserves have increased due to a speed up in the reporting of medical stop-loss claims.
 
    London market account — Total net reserves in our London market account increased $53.4 million and the percentage of incurred but not reported reserves increased in 2005, due to estimated unreported claims for the 2005 hurricanes.
 
    Discontinued lines — Total net reserves for our discontinued lines increased $81.8 million in 2005 primarily as a result of a commutation. The percentage of net incurred but not reported reserves to total reserves for discontinued lines decreased to 33% as claims continued to be reported and reported reserves were reassessed.
With the exception of 2004 when we had negative development principally in the reserves related to our discontinued line of business, our net reserves historically have shown positive development except for the effects of losses on commutations, which we have completed in the past and may negotiate in the future. Commutations can produce negative prior year development since, under generally accepted accounting principles, any excess of undiscounted reserves assumed over assets received must be recorded as a loss at the time the commutation is completed. Economically, the loss generally represents the discount for the time value of money that will be earned over the payout of the reserves; thus, the loss may be recouped as investment income is earned on the assets received. Based on our reserving techniques and our past results, we believe that our net reserves are adequate.
We have no material exposure to environmental pollution losses. Our largest insurance company subsidiary only began writing business in 1981 and its policies normally contain pollution exclusion clauses which limit pollution coverage to “sudden and accidental” losses only, thus excluding intentional dumping and seepage claims. Policies issued by our other insurance company subsidiaries do not have significant environmental exposures because of the types of risks covered. Therefore, we do not expect to experience any material loss development for environmental pollution claims. Likewise, we have no material exposure to asbestos claims.
Reinsurance Recoverables
Certain reinsurers have delayed or suspended payment of amounts recoverable under reinsurance contracts to which we are a party. We limit our liquidity exposure for uncollected recoverables by holding funds, letters of credit or other security, such that net balances due are significantly less than the gross balances shown in our consolidated balance sheets. We constantly monitor the collectibility of the reinsurance recoverables of our insurance companies and record a reserve for uncollectible reinsurance when we determine an amount is potentially uncollectible. Our evaluation is based on our periodic reviews of our disputed and aged recoverables, as well as our assessment of recoverables due from reinsurers known to be in financial difficulty. In some cases, we make estimates as to what portion of a recoverable may be uncollectible. Our estimates and judgment about the collectibility of the recoverables and the financial condition of reinsurers can change, and these changes can affect the level of reserve required.
The reserve was $12.1 million at December 31, 2005, compared to $20.4 million at December 31, 2004. We increased the reserve in 2005 by $5.8 million to cover additional recoverables for which changed conditions caused us to believe that part or all of the outstanding balances may not be collectible. Amounts charged against the reserve in 2005 were $5.0 million and in 2004 were immaterial. We also reclassified $9.0 million to our liability for indemnifications during the year. We recently assessed the collectibility of our year-end recoverables related to our hurricane losses and believe amounts are collectible or adequately reserved based on currently available information.
We are currently in negotiations with most reinsurers who have delayed or suspended payments, but if such negotiations do not result in a satisfactory resolution, we may seek or be involved in litigation or arbitration. We resolved certain arbitrations in 2005; amounts with respect to the remaining arbitration and litigation proceedings that we initiated are not material.

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Deferred Taxes
We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. We regularly review our deferred tax assets for recoverability and establish a valuation allowance based on our history of earnings, expectations for future earnings, taxable income in carry back years and the expected timing of the reversals of existing temporary differences. Although realization is not assured, we believe it is more likely than not that we will be able to realize the benefit of our deferred tax assets, with the exception of the benefit of certain pre-acquisition tax loss carryforwards for which valuation allowances have been provided. If there is a material change in the tax laws such that the actual effective tax rate changes or the time periods within which the underlying temporary differences become taxable or deductible change, we will need to reevaluate our assumptions, which could result in a change in the valuation allowance required.
Valuation of Goodwill
We assess the impairment of goodwill annually, or sooner if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. In determining the fair value of a reporting unit, we utilize the expected cash flow approach in Statement of Financial Accounting Concepts CON 7, Using Cash Flow Information and Present Values in Accounting Measurements. This approach utilizes a risk-free rate of interest, estimates of future cash flows and probabilities as to the occurrence of the future cash flows. We utilize our budgets and projection of future operations based on historical and expected industry trends to estimate our future cash flows and the probability of their occurring as projected. Based on our latest impairment test, the fair value of each of our reporting units exceeded its carrying amount by a satisfactory margin.
Other-Than-Temporary Impairments on Investments
Declines in the market value of invested assets below cost are evaluated for other-than-temporary impairment losses on a quarterly basis. Impairment losses for declines in value of fixed income securities below cost attributable to issuer-specific events are based on all relevant facts and circumstances for each investment and are recognized when appropriate. For fixed income securities with unrealized losses due to market conditions or industry-related events where we have the positive intent and ability to hold the investment for a period of time sufficient to allow a market recovery or to maturity, declines in value below cost are not assumed to be other-than-temporary. At December 31, 2005, we had gross unrealized losses on fixed income securities of $22.1 million (1.0% of aggregate market value) compared to $5.1 million (0.3% of aggregate market value) at December 31, 2004.
Recent Accounting Pronouncements
Share-Based Payment
The Financial Accounting Standards Board (FASB) has issued Statement of Financial Accounting Standards (SFAS) No. 123(R), Share-Based Payment, which requires companies to recognize the fair value of stock-based compensation with adoption required as of January 1, 2006. SFAS 123(R) allows either a prospective or retrospective adoption method. We will adopt SFAS 123(R) in 2006 using the modified prospective method, whereby results for prior periods will not be restated for the adoption of SFAS 123(R). Compensation expense recognized going forward will be based on our unvested stock options granted before January 1, 2006 and all options granted after that date. We will use the Black-Scholes option pricing model to determine the fair value of an option on its grant date and will expense that value over the option’s vesting period. At December 31, 2005, there was approximately $43.7 million of total unrecognized compensation expense related to unvested options that is expected to be recognized through 2010, of which we expect to recognize approximately $13.6 million in 2006.
Had we adopted SFAS 123(R) in prior periods, the impact would have approximated the pro forma net income and earnings per share amounts calculated under SFAS 123, as disclosed in Note 1 to the Consolidated Financial Statements. The ultimate impact of adoption of SFAS 123(R) in future periods will depend on the following: 1) the amount and timing of options granted, exercised and forfeited, 2) the assumptions used to model fair value and 3) certain tax reporting requirements. We generally recognize a tax benefit when our employees exercise options. SFAS 123(R)

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requires that, in future periods, we report the benefit of tax deductions in excess of recognized compensation expense as a financing cash flow, rather than as an operating cash flow. We cannot estimate what the tax benefits or cash flow amounts will be in the future because they depend on a variety of factors, including when employees exercise stock options. However, we recognized operating cash flows of $6.2 million, $3.0 million and $1.8 million in 2005, 2004 and 2003, respectively, for tax deductions associated with options exercised.
Other-Than-Temporary Impairments
The FASB has issued FASB Staff Position (FSP) No. 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. The FSP requires recognition of an impairment loss on a debt security no later than when the investor deems the impairment is other-than-temporary, even if the investor has not decided to sell the security. This standard replaces current guidance in Emerging Issues Task Force Issue 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. The new standard is effective January 1, 2006. We expect that adoption of this FSP will have an immaterial impact on our consolidated financial position and results of operations.

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Accounting Changes and Corrections
The FASB has issued SFAS No. 154, Accounting Changes and Error Corrections, as a replacement of APB No. 20, Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. SFAS 154 requires restatement of all prior period financial statements if a company makes an accounting change or corrects an error. The standard is effective January 1, 2006. We will apply the standard, if applicable, in the future.
Uncertainty in Income Taxes
The FASB has issued FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes. Effective January 1, 2007, FIN 48 clarifies the accounting for uncertain income tax positions. We are currently reviewing the requirements of FIN 48 to determine the effect it will have on our consolidated financial statements.
Fair Value Measurements
The FASB has issued SFAS No. 157, Fair Value Measurements, which clarifies the definition of fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurement. SFAS 157 does not require any new fair value measurements and eliminates inconsistencies in guidance found in various prior accounting pronouncements. SFAS 157 is effective January 1, 2008. We are currently assessing whether the adoption of SFAS 157 will have an impact on our consolidated financial statements.
Prior Year Misstatements
The Securities and Exchange Commission has issued Staff Accounting Bulletin (SAB) No.108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. SAB 108 establishes a standard approach for quantifying the materiality of errors to current and prior period financial statements. SAB 108’s guidelines must be applied in the fourth quarter of 2006, and adjustments, if any, will be recorded either by restating prior year financial statements or recording a cumulative effect adjustment as of January 1, 2006. We believe the requirements of SAB 108 will have no effect on our consolidated financial statements.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our principal assets and liabilities are financial instruments which are subject to the market risk of potential losses from adverse changes in market rates and prices. Our primary market risk exposures are interest rate risk on fixed income securities and variable rate debt, and foreign currency exchange rate risk.
Caution should be used in evaluating overall market risk utilizing the information below. Actual results could differ materially from estimates below for a variety of reasons, including: 1) amounts and balances on which the estimates are based are likely to change over time, 2) assumptions used in the models may prove to be inaccurate, 3) market changes could be different from market changes assumed below and 4) not all factors and balances are taken into account.
Interest Rate Risk
To manage the exposures of our investment risks, we generally invest in investment grade securities with characteristics of duration and liquidity to reflect the underlying characteristics of the insurance liabilities of our insurance companies. We have not used derivatives to manage any of our investment related market risks. The value of our portfolio of fixed income securities is inversely correlated to changes in the market interest rates. In addition, some of our fixed income securities have call or prepayment options. This could subject us to reinvestment risk should interest rates fall or issuers call their securities and we reinvest the proceeds at lower interest rates. We attempt to mitigate this risk by investing in securities with varied maturity dates, so that only a portion of the portfolio will mature at any point in time.

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The fair value of our fixed income securities was $2.3 billion at December 31, 2005 and $1.7 billion at December 31, 2004. If market interest rates were to change 1% (e.g. from 5% to 6%), the fair value of our fixed income securities would have changed approximately $111.2 million at December 31, 2005. This compares to a change in value of $78.9 million at December 31, 2004 for the same 1% change in market interest rates. The change in fair value was determined using duration modeling assuming no prepayments.
Our $200.0 million Revolving Loan Facility is subject to variable interest rates. Thus, our interest expense on this loan is directly correlated to market interest rates. At December 31, 2005 and 2004, there was no balance outstanding under this line of credit. Our 1.30% and 2.00% convertible notes are not subject to interest rate changes.
Foreign Exchange Risk
The table below shows the net amounts of significant foreign currency balances for subsidiaries with a U.S. dollar functional currency at December 31, 2005 and 2004 converted to U.S. dollars. It also shows the expected dollar change in fair value (in thousands) that would occur if exchange rates changed 10% from exchange rates in effect at those times.
                                 
            December 31,          
    2005     2004  
            Hypothetical             Hypothetical  
    U.S. dollar     10% change     U.S. dollar     10% change  
    equivalent     in fair value     equivalent     in fair value  
British pound sterling
  $ 11,590     $ 1,159     $ 6,163     $ 616  
Euro
    2,291       229       2,117       212  
Canadian dollar
    522       52       2,537       254  
See Foreign Exchange Rate Fluctuations section contained in Item 7, Management’s Discussion and Analysis, and Note 1 in the Notes to Consolidated Financial Statements for additional information.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and financial statement schedules listed in the accompanying Index to Consolidated Financial Statements and Schedules are filed as part of this Report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
None.
ITEM 9A. CONTROLS AND PROCEDURES
a. Disclosure Controls and Procedures
Background of Restatement
As disclosed in Explanatory Note — Restatement of Consolidated Financial Statements on page 4 of this Form 10-K/A and in Note 2 to the Consolidated Financial Statements, in August 2006, our Board of Directors formed a Special Committee of independent directors to commence an investigation of our past stock option granting practices for the period 1995 through 2005. On November 17, 2006, we announced that the Special Committee found that we had used incorrect accounting measurement dates for stock option grants covering a significant number of employees and members of our Board of Directors during the period 1997 through 2005 and that certain option grants were retroactively priced. Additionally, at the direction of the Special Committee, we reviewed our stock option granting practices from 1992, the year of our initial public stock offering, through 1994 and in 2006 and found incorrect measurement dates due to retroactive pricing were used in 2006. In substantially all of these instances, the price on the actual measurement date was higher than the price on the stated grant date.

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The Special Committee concluded that mis-priced option grants, the effect of which, together with certain other adjustments, resulted in a cumulative net decrease in shareholders’ equity at December 31, 2005 of $3.3 million, affected all levels of employees. The Special Committee found that Stephen L. Way, Chief Executive Officer, retroactively priced options, that he should have known he was granting options in a manner that conflicted with our stock option plans and public statements, and that this constituted a failure to align the stock option granting process with our stock option plans and public statements. Although finding his actions were inconsistent with the duties and obligations of a chief executive officer of a publicly-traded company, the Special Committee also found that Mr. Way’s motivation appeared to be the attraction and retention of talent and to provide employees with the best option price. The Special Committee also concluded that Christopher L. Martin, Executive Vice President and General Counsel, was aware that options were being retroactively priced in a manner inconsistent with applicable plan terms and the procedures memoranda that he had prepared, that granting in-the-money options had accounting implications, and that he did not properly document our Compensation Committee’s informal delegation of authority to Mr. Way. The Special Committee also found that there was no evidence that Mr. Way or Mr. Martin intended to falsify the consolidated financial statements.
Before the Board of Directors reviewed the results of the investigation, the Chairman of our Compensation Committee tendered his resignation from the Board of Directors on November 8, 2006. After reviewing the results of the investigation, the Board of Directors determined that it would be appropriate to accept the resignations of Mr. Way and Mr. Martin, which both tendered on November 17, 2006.
We determined that, in accordance with Accounting Principles Board (APB) No. 25, Accounting for Stock Issued to Employees, and its related interpretations, we should have recorded compensation expense related to these mis-priced options for the excess of the market price of our stock on the actual accounting measurement date over the exercise price of the option. As a result, we concluded that we needed to amend this Annual Report on Form 10-K for the year ended December 31, 2005 to restate our consolidated financial statements and the related disclosures for the years ended December 31, 2005, 2004 and 2003 and the condensed consolidated financial statements for the quarter ended March 31, 2006 and all quarters for the years ended December 31, 2005 and 2004, and to record an adjustment to the condensed consolidated financial statements for the quarters ended June 30, 2006 and September 30, 2006. In addition, as discussed below, we concluded that we had a material weakness in our internal control over financial reporting as of December 31, 2005 and through the third quarter of 2006.
As part of the restatement process, we recorded other adjustments in the period 2000 through 2005 that were not recorded in the originally filed financial statements due to their immateriality. We evaluated the control deficiencies that resulted in these adjustments and concluded that these immaterial errors were the result of control deficiencies that did not constitute a material weakness, individually or in the aggregate, in our internal control over financial reporting.
Evaluation of Disclosure Controls and Procedures
We maintain disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Act)) that are designed to ensure that required information is recorded, processed, summarized and reported within the required timeframe, as specified in rules set forth by the Securities and Exchange Commission. Our disclosure controls and procedures are also designed to ensure that information required to be disclosed is accumulated and communicated to management, including the Chief Executive Officer (CEO) and Chief Financial Officer (CFO), to allow timely decisions regarding required disclosures.
At the time that our Annual Report on Form 10-K for the year ended December 31, 2005 was filed on March 16, 2006, our former CEO and our CFO concluded that our disclosure controls and procedures were effective as of December 31, 2005. Subsequent to that evaluation, our management, including our current CEO and our CFO, concluded that our disclosure controls and procedures were not effective as of December 31, 2005 because of the material weakness described below in Management’s Report on Internal Control Over Financial Reporting (Restated). Notwithstanding this material weakness, our current management has concluded that our consolidated financial statements for the periods covered by and included in this Annual Report on Form 10-K/A are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) and fairly present, in all material respects, our financial position, results of operations and cash flows for each of the periods presented herein.

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Management’s Report on Internal Control Over Financial Reporting (Restated)
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Act. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP.
Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk.
Management, including our current CEO and our CFO, conducted an assessment of the effectiveness of our internal control over financial reporting as of December 31, 2005 based on the framework established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. Our current management identified the following material weakness in our internal control over financial reporting as of December 31, 2005 and through the third quarter of 2006:
We did not maintain an effective control environment based on the criteria established in the COSO framework. We did not maintain adequate controls to prevent or detect management override by certain former members of senior management related to our stock option granting practices and procedures. This lack of an effective control environment permitted certain former members of senior management to override controls and retroactively price stock option grants, resulting in ineffective controls over our stock option granting practices and procedures. Effective controls, including monitoring and adequate communication, were not maintained to ensure the accuracy, valuation and presentation of activity related to our stock option granting practices and procedures. This control deficiency resulted in misstatement of our stock-based compensation expense, additional paid-in capital and related income tax accounts and related disclosures, and in the restatement of our consolidated financial statements for the years ended December 31, 2005, 2004 and 2003 and the condensed consolidated financial statements for the quarter ended March 31, 2006 and all quarters for the years ended December 31, 2005 and 2004, and the adjustment of the condensed consolidated financial statements for the quarters ended June 30, 2006 and September 30, 2006. This control deficiency could result in misstatement of the aforementioned accounts and disclosures that would result in a material misstatement of our annual or interim consolidated financial statements that would not be prevented or detected. Accordingly, management has determined this control deficiency constitutes a material weakness.
In conducting our assessment, we excluded from our assessment the five companies that we acquired in purchase business combinations in 2005. These companies are wholly owned subsidiaries whose combined total assets and total revenue represented 3% and 1%, respectively, of the related consolidated financial statements as of and for the year ended December 31, 2005.
In Management’s Report on Internal Control Over Financial Reporting included in our original Annual Report on Form 10-K for the year ended December 31, 2005, our former CEO and our CFO concluded that we maintained effective internal control over financial reporting as of December 31, 2005. Our current CEO and our CFO have subsequently concluded that the material weakness described above existed as of December 31, 2005 and through the third quarter of 2006. As a result, we have concluded that we did not maintain effective internal control over financial reporting as of December 31, 2005, based on the criteria in Internal Control-Integrated Framework. Accordingly, management has restated our report on internal control over financial reporting as of December 31, 2005 and our present opinion on internal control over financial reporting, as presented herein, is different from that expressed in our previous report.

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Our assessment of the effectiveness of our internal control over financial reporting as of December 31, 2005 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which is included herein.
Changes in Internal Control Over Financial Reporting
There have been no changes in our internal control over financial reporting during the last quarter of the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Remediation Plans
We are committed to remediating the material weakness identified above by implementing changes to our internal control over financial reporting to enhance our control environment. During 2006, we implemented or are in the process of implementing new policies and controls related to our stock option granting practices and procedures, as follows:
    Before the Board of Directors reviewed the results of the investigation, the Chairman of our Compensation Committee tendered his resignation from the Board of Directors on November 8, 2006. After reviewing the results of the investigation, our Board of Directors determined that it would be appropriate to accept the resignations of our former CEO and General Counsel, which both tendered on November 17, 2006. Our Board of Directors has appointed a new Chairman of our Compensation Committee and a new CEO who, together with other members of our senior management, are committed to achieving transparency through effective corporate governance, a strong control environment, application of business standards reflected in our Code of Business Conduct and Ethics, and completeness and integrity of our financial reporting and disclosure.
 
    We have changed our option granting approval policies and procedures to require Compensation Committee approval of all new option grants on the day of each Compensation Committee meeting preceding the regularly scheduled quarterly Board of Directors meeting. All grants will be appropriately approved and documented in minutes of the meeting, taken contemporaneously with the meeting. All grants will be priced at the market closing price on the day of each such Compensation Committee meeting. We have established processes and procedures to increase the level of communication between the Compensation Committee, senior management and our financial reporting and accounting personnel regarding stock option grants.
We are actively engaged in the implementation of other remediation efforts to address the material weakness identified in our internal control over financial reporting. Although we have not fully remediated the material weakness as of the date of this Form 10-K/A filing, we believe we have made substantial progress.
ITEM 9B. OTHER INFORMATION
We have disclosed all information required to be disclosed in a current report on Form 8-K during the fourth quarter of 2005 in previously filed reports on Form 8-K.

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PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Code of Business Conduct and Ethics
We have adopted a Code of Business Conduct and Ethics which applies to all employees, officers and directors of our company. The complete text of our Code of Business Conduct and Code of Ethics is available on our website at www.hcc.com and will be provided to any person free of charge upon request made to: HCC Insurance Holdings, Inc., Investor Relations Department, 13403 Northwest Freeway, Houston, Texas 77040. Any amendments to, or waivers of, the Code of Business Conduct and Ethics which apply to the Chief Executive Officer and the Senior Financial Officers will be disclosed on our website.
For information regarding our Directors and Executive Officers, reference is made to our definitive proxy statement for our Annual Meeting of Shareholders, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 2005 and which is incorporated herein by reference.
On June 10, 2005, we filed with the New York Stock Exchange the Annual CEO Certification regarding our compliance with the New York Stock Exchange’s Corporate Governance listing standards as required by Section 303A-12(a) of the New York Stock Exchange Listed Company Manual. The Annual CEO Certification was issued without qualification. In addition, we have filed as exhibits to this report on Form 10-K and to the report on Form 10-K for the year ended December 31, 2004, the applicable certifications of our Chief Executive Officer and our Chief Financial Officer required under Section 302 of the Sarbanes-Oxley Act of 2002.
ITEM 11. EXECUTIVE COMPENSATION
For information regarding Executive Compensation, reference is made to our definitive proxy statement for our Annual Meeting of Shareholders, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 2005 and which is incorporated herein by reference.
ITEM 12.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER MATTERS
For information regarding Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters, reference is made to our definitive proxy statement for our Annual Meeting of Shareholders, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 2005 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 our definitive proxy statement for our Annual Meeting of Shareholders, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 2005 and which is incorporated herein by reference.
Stephen L. Way has resigned as Chief Executive Officer effective November 17, 2006. Mr. Way will remain a director of HCC and serve as the non-executive Chairman of the Board of Directors. On November 17, 2006, HCC entered into a consulting agreement with Mr. Way to provide assistance to the Company’s new CEO Frank J. Bramanti and guidance to HCC with respect to strategic planning (the Consulting Agreement). Under the terms of the Consulting Agreement, Mr. Way agreed to terminate his employment agreement with the loss of any further compensation including any 2006 bonus and, regarding options that Mr. Way had already exercised at any time, Mr. Way agreed to reimburse HCC for all gains or profit he received or obtained resulting from any difference between the exercise price at which Mr. Way exercised any option and the exercise price on the accurate grant date as determined by HCC with the concurrence of its independent auditors. In addition, with respect to unexercised vested options, Mr. Way also agreed that each new strike price would be based on the new measurement date as determined by HCC. Unvested options have been terminated.

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Christopher L. Martin has resigned as Executive Vice President and General Counsel effective November 17, 2006. On November 28, 2006, HCC entered into a Separation Agreement and Release with Mr. Martin effective as of November 17, 2006, pursuant to which Mr. Martin’s employment agreement with HCC dated April 1, 2006, was terminated and, regarding options that Mr. Martin had already exercised at any time, Mr. Martin agreed to reimburse HCC for all gains or profit he received or obtained resulting from any difference between the exercise price at which Mr. Martin exercised any option and the exercise price on the accurate grant date as determined by HCC with the concurrence of its independent auditors. In addition, with respect to unexercised vested options, Mr. Martin also agreed that each new strike price will be based on the new measurement date as determined by HCC. Unvested options have been terminated.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
For information regarding Principal Accountant Fees and Services, reference is made to our definitive proxy statement for our Annual Meeting of Shareholders, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 2005 and which is incorporated herein by reference.
PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) Financial Statement Schedules
The restated financial statements and financial statement schedules listed in the accompanying Index to Consolidated Financial Statements and Schedules are filed as part of this Report.
(b) Exhibits
The exhibits listed on the accompanying Index to Exhibits are filed as part of this Report.

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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)
 
 
Dated: December 26, 2006  By:   /s/ FRANK J. BRAMANTI    
    (Frank J. Bramanti)   
    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
/s/ FRANK J. BRAMANTI
 
(Frank J. Bramanti)
  Director, Chief Executive Officer and Principal Executive Officer   December 26, 2006
/s/ PATRICK B. COLLINS*
 
(Patrick B. Collins)
  Director   December 26, 2006
/s/ JAMES R. CRANE*
 
(James R. Crane)
  Director   December 26, 2006
/s/ J. ROBERT DICKERSON*
 
(J. Robert Dickerson)
  Director   December 26, 2006
/s/ WALTER M. DUER*
 
(Walter M. Duer)
  Director   December 26, 2006
/s/ EDWARD H. ELLIS, JR.
 
(Edward H. Ellis, Jr.)
  Director, Executive Vice President and Chief Financial Officer (Chief Accounting Officer)   December 26, 2006
/s/ JAMES C. FLAGG, PH.D.*
 
(James C. Flagg, Ph.D.)
  Director   December 26, 2006
/s/ ALLAN W. FULKERSON*
 
(Allan W. Fulkerson)
  Director   December 26, 2006
/s/ JOHN N. MOLBECK, JR.*
 
(John N. Molbeck, Jr.)
  Director, President and Chief Operating Officer   December 26, 2006
/s/ MICHAEL A. F. ROBERTS*
 
(Michael A. F. Roberts)
  Director   December 26, 2006
 
 
(Stephen L. Way)
  Chairman of the Board, Director    
         
     
  By:   */s/ EDWARD H. ELLIS, JR.    
    Edward H. Ellis, Jr., Attorney-in-fact   
       
 

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INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES
         
Report of Independent Registered Public Accounting Firm
    F-1  
Consolidated Balance Sheets at December 31, 2005 and 2004, As restated
    F-3  
Consolidated Statements of Earnings for the three years ended December 31, 2005, As restated
    F-4  
Consolidated Statements of Comprehensive Income for the three years ended December 31, 2005, As restated
    F-5  
Consolidated Statements of Changes in Shareholders’ Equity for the three years ended December 31, 2005, As restated
    F-6  
Consolidated Statements of Cash Flows for the three years ended December 31, 2005, As restated
    F-7  
Notes to Consolidated Financial Statements
    F-8  
SCHEDULES:
       
Schedule 1 Summary of Investments other than Investments in Related Parties
    S-1  
Schedule 2 Condensed Financial Information of Registrant, As restated
    S-2  
Schedule 3 Supplementary Insurance Information, As restated
    S-7  
Schedule 4 Reinsurance
    S-8  
Schedule 5 Valuation and Qualifying Accounts
    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 Notes thereto or other Schedules.

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Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders
HCC Insurance Holdings, Inc.:
We have completed integrated audits of HCC Insurance Holdings, Inc.’s 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005, and an audit of its 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions on HCC Insurance Holdings Inc.’s 2005, 2004, and 2003 consolidated financial statements and on its internal control over financial reporting as of December 31, 2005, based on our audits, are presented below.
Consolidated financial statements and financial statement schedules
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of HCC Insurance Holdings, Inc. and its subsidiaries at December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the accompanying index present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). 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 of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 2 to the consolidated financial statements, the Company has restated its 2005, 2004, and 2003 consolidated financial statements.
Internal control over financial reporting
Also, we have audited management’s assessment, included in Management’s Report on Internal Control over Financial Reporting (restated) appearing under Item 9A, that HCC Insurance Holdings, Inc. did not maintain effective internal control over financial reporting as of December 31, 2005, because of the effect of not maintaining an effective control environment, resulting in ineffective controls over stock option granting practices and procedures, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
As described in Management’s Report on Internal Control Over Financial Reporting, management has excluded from its assessment of internal control over financial reporting as of December 31, 2005 the five companies that it acquired in purchase business combinations in 2005. We have also excluded these five companies from our audit of internal control over financial reporting. These companies are wholly-owned subsidiaries whose combined total assets and total revenues represent 3% and 1%, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2005.
A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weakness has been identified and included in management’s assessment. As of December 31, 2005, management has concluded the Company did not maintain an effective control environment based on the

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criteria established in the COSO framework. The Company did not maintain adequate controls to prevent or detect management override by certain former members of senior management related to the Company’s stock option granting practices and procedures. This lack of an effective control environment permitted certain former members of senior management to override controls and retroactively price stock option grants, resulting in ineffective controls over the Company’s stock option granting practices and procedures. Effective controls, including monitoring and adequate communication, were not maintained to ensure the accuracy, valuation and presentation of activity related to the Company’s stock option granting practices and procedures. This control deficiency resulted in misstatement of the Company’s stock-based compensation expense, additional paid-in capital and related income tax accounts and related disclosures, and in the restatement of the Company’s consolidated financial statements for the years ended December 31, 2005, 2004 and 2003 and the condensed consolidated financial statements for the quarter ended March 31, 2006 and all quarters for the years ended December 31, 2005 and 2004, and the adjustment of the condensed consolidated financial statements for the quarters ended June 30, 2006 and September 30, 2006. This control deficiency could result in misstatement of the aforementioned accounts and disclosures that would result in a material misstatement of the Company’s annual or interim consolidated financial statements that would not be prevented or detected. Accordingly, management has determined this control deficiency constitutes a material weakness. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2005 consolidated financial statements, and our opinion regarding the effectiveness of the Company’s internal control over financial reporting does not affect our opinion on those consolidated financial statements.
Management and we previously concluded that the Company maintained effective internal control over financial reporting as of December 31, 2005. However, management has subsequently determined that the material weakness described above existed as of December 31, 2005. Accordingly, Management’s Report on Internal Control Over Financial Reporting has been restated and our present opinion on internal control over financial reporting, as presented herein, is different from that expressed in our previous report.
In our opinion, management’s assessment that HCC Insurance Holdings, Inc. did not maintain effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control — Integrated Framework issued by the COSO. Also, in our opinion, because of the effects of the material weakness described above on the achievement of the objectives of the control criteria, HCC Insurance Holdings, Inc. has not maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control — Integrated Framework issued by the COSO.
PricewaterhouseCoopers LLP
Houston, Texas
March 15, 2006, except for the restatement discussed in Note 2 to the consolidated financial statements and the matter discussed in the penultimate paragraph of Management’s Report on Internal Control over Financial Reporting, as to which the date is December 22, 2006.

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HCC Insurance Holdings, Inc. and Subsidiaries
Consolidated Balance Sheets
(in thousands, except per share data)
                 
    December 31,  
    2005     2004  
    (As restated)     (As restated)  
ASSETS
               
Investments:
               
Fixed income securities, at fair value (amortized cost: 2005 - $2,277,139; 2004 - $1,682,421)
  $ 2,268,624     $ 1,703,171  
Short-term investments, at cost, which approximates fair value
    839,581       729,985  
Other investments, at fair value (cost: 2005 - $144,897; 2004 - $34,137)
    149,223       35,335  
 
           
Total investments
    3,257,428       2,468,491  
Cash
    73,935       69,933  
Restricted cash and cash investments
    170,978       188,510  
Premium, claims and other receivables
    884,654       891,360  
Reinsurance recoverables
    1,361,983       1,104,026  
Ceded unearned premium
    239,416       311,973  
Ceded life and annuity benefits
    73,415       74,627  
Deferred policy acquisition costs
    156,253       139,199  
Goodwill
    532,947       444,031  
Other assets
    277,791       208,418  
 
           
Total assets
  $ 7,028,800     $ 5,900,568  
 
           
LIABILITIES
               
 
               
Loss and loss adjustment expense payable
  $ 2,813,720     $ 2,089,199  
Life and annuity policy benefits
    73,415       74,627  
Reinsurance balances payable
    176,954       217,938  
Unearned premium
    807,109       741,706  
Deferred ceding commissions
    67,886       93,480  
Premium and claims payable
    753,859       766,765  
Notes payable
    309,543       311,277  
Accounts payable and accrued liabilities
    335,879       280,078  
 
           
 
               
Total liabilities
    5,338,365       4,575,070  
 
               
SHAREHOLDERS’ EQUITY
               
 
               
Common stock, $1.00 par value; 250.0 million shares authorized (shares issued and outstanding: 2005 - 110,803; 2004 - 102,057)
    110,803       68,038  
Additional paid-in capital
    762,170       582,566  
Retained earnings
    798,388       637,259  
Accumulated other comprehensive income
    19,074       37,635  
 
           
 
               
Total shareholders’ equity
    1,690,435       1,325,498  
 
           
 
               
Total liabilities and shareholders’ equity
  $ 7,028,800     $ 5,900,568  
 
           
See Notes to Consolidated Financial Statements.

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HCC Insurance Holdings, Inc. and Subsidiaries
Consolidated Statements of Earnings
(in thousands, except per share data)
                         
    Years ended December 31,  
    2005     2004     2003  
    (As restated)     (As restated)     (As restated)  
REVENUE
                       
Net earned premium
  $ 1,369,988     $ 1,010,692     $ 738,272  
Fee and commission income
    132,628       183,802       142,615  
Net investment income
    98,851       64,885       47,335  
Net realized investment gain
    1,448       5,822       527  
Other operating income
    39,773       19,406       13,215  
 
                 
Total revenue
    1,642,688       1,284,607       941,964  
 
                 
EXPENSE
                       
Loss and loss adjustment expense, net
    919,697       645,230       488,000  
Policy acquisition costs, net
    261,708       222,323       137,212  
Other operating expense
    180,990       168,045       144,574  
Interest expense
    7,684       8,374       7,453  
 
                 
Total expense
    1,370,079       1,043,972       777,239  
 
                 
Earnings from continuing operations before income tax expense
    272,609       240,635       164,725  
Income tax expense on continuing operations
    84,177       81,940       59,382  
 
                 
Earnings from continuing operations
    188,432       158,695       105,343  
Earnings from discontinued operations, net of income taxes of $1,686 in 2005, $2,313 in 2004 and $26,289 in 2003
    2,760       4,004       36,684  
 
                 
Net earnings
  $ 191,192     $ 162,699     $ 142,027  
 
                 
Basic earnings per share data:
                       
Earnings from continuing operations
  $ 1.78     $ 1.63     $ 1.11  
Earnings from discontinued operations
    0.03       0.04       0.39  
 
                 
Net earnings
  $ 1.81     $ 1.67     $ 1.50  
 
                 
Weighted average shares outstanding
    105,463       97,257       94,919  
 
                 
Diluted earnings per share data:
                       
Earnings from continuing operations
  $ 1.72     $ 1.61     $ 1.09  
Earnings from discontinued operations
    0.03       0.04       0.38  
 
                 
Net earnings
  $ 1.75     $ 1.65     $ 1.47  
 
                 
Weighted average shares outstanding
    109,437       98,826       96,576  
 
                 
See Notes to Consolidated Financial Statements.

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HCC Insurance Holdings, Inc. and Subsidiaries
Consolidated Statements of Comprehensive Income
(in thousands)
                         
    Years ended December 31,  
    2005     2004     2003  
    (As restated)     (As restated)     (As restated)  
Net earnings
  $ 191,192     $ 162,699     $ 142,027  
 
                       
Other comprehensive income (loss):
                       
 
                       
Investment gains (losses):
                       
Investment gains (losses) during the year, net of income tax charge (benefit) of $(2,946) in 2005, $6,091 in 2004 and $(1,048) in 2003
    (4,257 )     10,955       (1,962 )
 
                       
Less reclassification adjustment for gains included in net earnings, net of income tax charge of $2,479 in 2005, $2,433 in 2004 and $184 in 2003
    (4,605 )     (4,518 )     (343 )
 
                       
Foreign currency translation adjustment
    (9,699 )     6,287       6,451  
 
                 
 
                       
Other comprehensive income (loss)
    (18,561 )     12,724       4,146  
 
                 
Comprehensive income
  $ 172,631     $ 175,423     $ 146,173  
 
                 
See Notes to Consolidated Financial Statements.

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HCC Insurance Holdings, Inc. and Subsidiaries
Consolidated Statements of Changes in Shareholders’ Equity
Years ended December 31, 2005, 2004 and 2003
(As restated)
(in thousands, except per share data)
                                         
                            Accumulated        
            Additional             other     Total  
    Common     paid-in     Retained     comprehensive     shareholders’  
    stock     capital     earnings     income     equity  
Balance at December 31, 2002 — As previously reported
  $ 62,358     $ 416,406     $ 383,378     $ 20,765     $ 882,907  
Cumulative effect of restatement (Note 2)
          13,861       (12,097 )           1,764  
 
                             
Balance at December 31, 2002, as restated
  62,358     430,267     371,281     20,765     884,671  
Net earnings
                142,027             142,027  
Other comprehensive income
                      4,146       4,146  
Issuance of 1,860 shares for exercise of options, including tax benefit of $1,811
    1,240       20,850                   22,090  
Issuance of 78 shares of contractually issuable stock
    52       (52 )                  
Issuance of 472 shares for purchased company
    314       7,958                   8,272  
Stock-based compensation
          2,979                   2,979  
Cash dividends declared, $0.187 per share
                (17,780 )           (17,780 )
 
                             
Balance at December 31, 2003
    63,964       462,002       495,528       24,911       1,046,405  
Net earnings
                162,699             162,699  
Other comprehensive income
                      12,724       12,724  
Issuance of 4,500 shares in public offering, net of costs
    3,000       93,668                   96,668  
Issuance of 1,485 shares for exercise of options, including tax benefit of $2,969
    990       22,087                   23,077  
Issuance of 126 shares for purchased company and strategic investment
    84       2,576                   2,660  
Stock-based compensation
          2,233                   2,233  
Cash dividends declared, $0.213 per share
                (20,968 )           (20,968 )
 
                             
Balance at December 31, 2004
    68,038       582,566       637,259       37,635       1,325,498  
Net earnings
                191,192             191,192  
Other comprehensive loss
                      (18,561 )     (18,561 )
Issuance of 4,688 shares in public offering, net of costs
    4,688       145,276                   149,964  
Issuance of 2,439 shares for exercise of options, including tax benefit of $6,168
    1,785       40,522                   42,307  
Issuance of 1,624 shares for purchased companies and convertible debt
    1,227       26,226                   27,453  
Stock-based compensation
          2,645                   2,645  
Three-for-two stock split
    35,065       (35,065 )                  
Cash dividends declared, $0.282 per share
                (30,063 )           (30,063 )
 
                             
Balance at December 31, 2005
  $ 110,803     $ 762,170     $ 798,388     $ 19,074     $ 1,690,435  
 
                             
See Notes to Consolidated Financial Statements.

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HCC Insurance Holdings, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(in thousands)
                         
    Years ended December 31,  
    2005     2004     2003  
    (As restated)     (As restated)     (As restated)  
Cash flows from operating activities:
                       
Net earnings
  $ 191,192     $ 162,699     $ 142,027  
Adjustments to reconcile net earnings to net cash provided by operating activities:
                       
Change in premium, claims and other receivables
    (6,094 )     70,411       (121,834 )
Change in reinsurance recoverables
    (250,829 )     (198,536 )     (103,580 )
Change in ceded unearned premium
    82,433       (17,422 )     (127,367 )
Change in loss and loss adjustment expense payable
    705,688       548,349       366,398  
Change in reinsurance balances payable
    (49,772 )     (72,009 )     120,064  
Change in unearned premium
    38,809       122,317       261,261  
Change in premium and claims payable, net of restricted cash
    (3,851 )     1,835       (24,743 )
Gain on sale of subsidiaries
    (8,717 )     (6,317 )     (52,681 )
Change in trading portfolio
    (66,809 )     25,673       12,741  
Depreciation and amortization expense
    14,647       16,139       12,828  
Stock-based compensation expense
    2,645       2,233       2,979  
Other, net
    (25,352 )     13,331       40,005  
 
                 
 
                       
Cash provided by operating activities
    623,990       668,703       528,098  
 
                 
 
                       
Cash flows from investing activities:
                       
Sales of fixed income securities
    237,480       253,398       167,357  
Maturity or call of fixed income securities
    186,075       154,357       142,652  
Cost of securities acquired
    (1,054,529 )     (935,053 )     (694,211 )
Change in short-term investments
    (72,703 )     (160,229 )     (202,904 )
Payments for purchase of subsidiaries, net of cash received
    (94,056 )     (93,543 )     (16,680 )
Sale of subsidiaries and other operating investments
    21,116             82,618  
Other, net
    3,637       268       (17,655 )
 
                 
 
                       
Cash used by investing activities
    (772,980 )     (780,802 )     (538,823 )
 
                 
 
                       
Cash flows from financing activities:
                       
Issuance of notes payable, net of costs
    46,528       29,000       174,845  
Payments on notes payable
    (48,181 )     (40,176 )     (108,813 )
Sale of common stock, net of costs
    186,103       116,776       20,279  
Dividends paid and other, net
    (31,458 )     (19,984 )     (19,476 )
 
                 
 
                       
Cash provided by financing activities
    152,992       85,616       66,835  
 
                 
 
                       
Net increase (decrease) in cash
    4,002       (26,483 )     56,110  
 
                       
Cash at beginning of year
    69,933       96,416       40,306  
 
                 
Cash at end of year
  $ 73,935     $ 69,933     $ 96,416  
 
                 
See Notes to Consolidated Financial Statements.

F-7


Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(tables in thousands, except per share data)
(1)   GENERAL INFORMATION AND SIGNIFICANT ACCOUNTING AND REPORTING POLICIES
 
    HCC Insurance Holdings, Inc. and its subsidiaries (collectively, we, us or our) include domestic and foreign property and casualty and life insurance companies, underwriting agencies and reinsurance brokers. We provide specialized property and casualty, surety, and group life, accident and health insurance coverages and related agency and reinsurance brokerage services to commercial customers and individuals. We market our products both directly to customers and through a network of independent and affiliated brokers, producers and agents. Our lines of business include diversified financial products (which includes directors’ and officers’ liability, professional indemnity, employment practices liability and surety); group life, accident and health; aviation; our London market account (which includes energy, marine, property, and accident and health); and other specialty lines of insurance. We operate primarily in the United States, the United Kingdom, Spain, Bermuda and Ireland, although some of our operations have a broader international scope.
 
    Our principal domestic insurance companies are Houston Casualty Company, U.S. Specialty Insurance Company, HCC Life Insurance Company, Avemco Insurance Company and American Contractors Indemnity Company. These companies operate throughout the United States with headquarters in Houston, Texas, Atlanta, Georgia and Los Angeles, California. All of our principal domestic insurance companies operate on an admitted basis, except Houston Casualty Company, which also insures international risks. Our foreign insurance companies are HCC International Insurance Company, HCC Europe, HCC Reinsurance Company and the London branch of Houston Casualty Company. These companies operate from the United Kingdom, Spain, Bermuda and Ireland.
 
    Our underwriting agencies provide underwriting management and claims servicing for insurance and reinsurance companies, in specialized lines of business within the property and casualty and group life, accident and health insurance sectors. Our principal domestic agencies are Professional Indemnity Agency, Inc., HCC Specialty Underwriters, HCC Global Financial Products, Covenant Underwriters and HCC Indemnity Guaranty Agency. Our agencies operate throughout the United States. Our principal foreign agency is HCC Global Financial Products, with headquarters in Barcelona, Spain. In 2006, we intend to consolidate the operations of one of our foreign agencies, HCC Diversified Financial Products, into HCC International Insurance Company.
 
    Our reinsurance and insurance brokers provide brokerage, consulting and other broker services to insurance and reinsurance companies, commercial customers and individuals in the same lines of business as the insurance companies and underwriting agencies operate. Our principal reinsurance brokers are Rattner Mackenzie and HCC Risk Management, operating principally in London, England, Hamilton, Bermuda and Houston, Texas. Our insurance broker is Continental Underwriters.

F-8


Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(continued, tables in thousands, except per share data)
Basis of Presentation
Our consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (generally accepted accounting principles) and include the accounts of HCC Insurance Holdings, Inc. and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. Management must make estimates and assumptions that affect amounts reported in our financial statements and in disclosures of contingent assets and liabilities. Ultimate results could differ from those estimates.
We have reclassified certain amounts in our 2004 and 2003 consolidated financial statements to conform to the 2005 presentation. The reclassifications included the elimination of certain intercompany premium receivable and premium payable balances in the consolidated balance sheet and reclassification of the corresponding lines in the consolidated statements of cash flows. None of our reclassifications had an effect on our consolidated net earnings, shareholders’ equity or cash flows.
Investments
All fixed income securities are classified as available for sale and reported 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 on these securities is recorded as a component of other comprehensive income, net of the related deferred income tax effect. We purchase fixed income securities with the intent to hold to maturity, but they may be available for sale if market conditions warrant or if our investment policies dictate in order to maximize our investment yield.
For asset-backed and mortgage-backed securities in our fixed income portfolio, we recognize income using a constant effective yield based on anticipated prepayments and the estimated economic life of the securities. When actual prepayments differ significantly from anticipated prepayments, the estimated economic life is recalculated and the remaining unamortized premium or discount is amortized prospectively over the remaining economic life.
Short-term investments and restricted cash investments are carried at cost, which approximates fair value. Other investments includes trading securities, which are carried at quoted market value. The change in unrealized gain or loss on trading securities, as well as realized gains or losses and dividend income thereon, are included in other operating income in the consolidated statements of earnings.

F-9


Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(continued, tables in thousands, except per share data)
Realized gains or losses are 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-than-temporary, the decrease in value is reported in earnings as a realized investment loss and a new cost basis is established. Declines in the market value of invested assets below cost are evaluated for other-than-temporary impairment losses on a quarterly basis. Impairment losses for declines in value of fixed income securities below cost attributable to issuer-specific events are based on all relevant facts and circumstances for each investment and are recognized when appropriate. For fixed income securities with unrealized losses due to market conditions or industry-related events where we have the positive intent and ability to hold the investment for a period of time sufficient to allow a market recovery or to maturity, declines in value below cost are not assumed to be other-than-temporary.
Derivative Financial Instruments
We have reinsured interests in two long-term mortgage impairment insurance contracts. The exposure with respect to these two contracts is measured based on movement in a specified index. These insurance contracts qualify as derivative financial instruments, are unhedged and are reported in other assets at fair value, which was $6.4 million and $3.0 million at December 31, 2005 and 2004, respectively. We determine fair value based on our estimate of the present value of expected future cash flows, modified to reflect specific contract terms and validated based on current market quotes. Changes in fair value are recorded each period as a component of other operating income in the consolidated statements of earnings.
Net Earned Premium, Policy Acquisition Costs and Ceding Commissions
Substantially all of the property and casualty and accident and health policies written by our insurance companies qualify as short-duration contracts. We recognize in current earned income the portion of the premium that provides insurance coverage in the period. Written premium, net of reinsurance, is primarily recognized in earnings on a pro rata basis over the term of the related policies. However, for certain policies, written premium is recognized in earnings over the period of risk in proportion to the amount of insurance risk provided. Unearned premium represents the portion of premium written in relation to the unexpired term of coverage. Premium related to our group life policies is recognized when due. When coverage under a specific excess of loss reinsurance layer has been utilized, we effectively expense the remaining initial premium and defer and amortize the reinstatement premium over the period of risk.
We defer our direct costs to underwrite insurance policies, less amounts reimbursed by reinsurers, and charge or credit the costs to earnings proportionate with the premium earned. These policy acquisition costs include commissions, taxes, fees, and other direct underwriting costs. Historical and current loss adjustment expense experience and anticipated investment income are considered in determining premium deficiencies and the recoverability of deferred policy acquisition costs.

F-10


Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(continued, tables in thousands, except per share data)
Fee and Commission Income
Fee and commission income in our consolidated statements of earnings includes fee income from our underwriting agencies, commission income from our reinsurance brokers and proceeds from ceded reinsurance (ceding commissions in excess of acquisition costs). When there is no significant future servicing obligation, we recognize fee and commission income from third parties on the later of the effective date of the policy, the date when the premium can be reasonably established, or the date when substantially all services related to the insurance placement have been rendered to the client. We record revenue from profit commissions, which are based on the profitability of business written, at the end of each accounting period, calculated using the respective commission formula. Such amounts are adjusted should experience change. When additional services are required, the service revenue is deferred and recognized over the service period. We record an allowance for estimated return commissions that we may be required to pay on the early termination of policies. Proceeds from ceded reinsurance are earned pro rata over the term of the underlying policy.
When our underwriting agencies utilize one of our insurance company subsidiaries as the policy issuing company and the business is reinsured with a third-party reinsurer, we eliminate in consolidation the fee and commission income against the related insurance company’s policy acquisition costs and defer the policy acquisition costs of the underwriting agencies.
Strategic Investments and Other Operating Income
Included in other assets are certain strategic investments in insurance-related companies. When we own a 20% to 50% equity interest in a strategic investment, the investment and income are recorded using the equity method of accounting. We carry the remaining investments that are marketable at fair value and the remaining investments that are not readily marketable at management’s estimate of fair value. We record any interest, dividends and realized gains or losses in other operating income and unrealized gains or losses in other comprehensive income.
Premium, Claims and Other Receivables
We use the gross method for reporting receivables and payables on brokered transactions. We review the collectibility of our receivables on a current basis and provide an allowance for doubtful accounts if we deem that there are accounts that are doubtful of collection. The allowance was $7.4 million and $4.9 million at December 31, 2005 and 2004, respectively. Our estimate of the level of the allowance could change as conditions change in the future.
Loss and Loss Adjustment Expense Payable
Loss and loss adjustment expense payable by our insurance companies is based on estimates of payments to be made for reported losses, incurred but not reported losses, and anticipated receipts from salvage and subrogation. Reserves are recorded on an undiscounted basis, except for reserves of acquired companies. The discount on those reserves is not material. Estimates for reported losses are based on all available information, including reports received from ceding companies on assumed business. Estimates for incurred but not reported losses are based both on our experience and the industry’s experience. While we believe that amounts included in our consolidated financial statements are adequate, such estimates may be more or less than the amounts ultimately paid when the claims are settled. We continually review the estimates with our actuaries and any changes are reflected in the period of the change.

F-11


Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(continued, tables in thousands, except per share data)
Reinsurance
We record all reinsurance recoverables and ceded unearned premium as assets, and deferred ceding commissions as liabilities. All such amounts are recorded in a manner consistent with the underlying reinsured contracts. We also record a reserve for uncollectible reinsurance. Our estimates utilized to calculate the reserve are subject to change, which could affect the level of the reserve required.
Goodwill and Intangible Assets
When we acquire a new subsidiary, goodwill is either allocated to that particular subsidiary or, if there are synergies with other subsidiaries, allocated to the different reporting units based on their respective share of the estimated future cash flows. In our agency segment, the reporting units are the individual subsidiaries. In our insurance company segment, the reporting units are either individual subsidiaries or groups of subsidiaries that share common licensing and other characteristics.
To determine the fair value of a reporting unit, we utilize the expected cash flow approach in Statement of Financial Accounting Concepts CON 7, Using Cash Flow Information and Present Value in Accounting Measurements. This approach utilizes a risk-free rate of interest, estimates of future cash flows, and probabilities as to the occurrence of the future cash flows. We utilize our budgets and projection of future operations based on historical and expected industry trends to estimate our future cash flows and their probability of occurring as projected.
We assess the impairment of goodwill annually, or sooner if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Based on our latest impairment test, the fair value of each of our reporting units exceeded its carrying amount. Intangible assets not subject to amortization are tested for impairment annually, or sooner if an event occurs or circumstances change that indicate that an intangible asset might be impaired. Other intangible assets are amortized over their respective useful lives.
Cash and Short-term Investments
Cash consists of cash in banks, generally in operating accounts. We classify certificates of deposit and money market funds as short-term investments. Short-term investments are classified as investments in our consolidated balance sheets as they relate principally to our investment activities.
We generally maintain our cash deposits in major banks and invest our short-term investments in institutional money-market funds and in investment grade commercial paper and repurchase agreements. These securities typically mature within ninety days and, therefore, bear minimal risk. We have not experienced any losses on our cash deposits or our short-term investments.
Certain fiduciary funds totaling $286.1 million and $295.2 million were included in cash, short-term investments and fixed income securities at December 31, 2005 and 2004, respectively. These funds are held by underwriting agencies, reinsurance brokers, or surety companies for the benefit of insurance or reinsurance clients. We earn the interest on these funds net of expenses.

F-12


Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(continued, tables in thousands, except per share data)
Restricted Cash and Cash Investments
Our agencies withhold premium funds for the payment of claims. These funds are shown as restricted cash and cash investments in our consolidated balance sheets. The corresponding liability is included within premium and claims payable in our consolidated balance sheets. These amounts are considered fiduciary funds, and interest earned on these funds accrues to the benefit of the insurance companies for whom the agencies write business. Therefore, we do not include these amounts as cash in our consolidated statements of cash flows.
Foreign Currency
The functional currency of some of our foreign subsidiaries and branches is the U.S. dollar. Assets and liabilities recorded in foreign currencies are translated into U.S. 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. Transaction gains and losses are recorded in earnings and included in other operating expenses. Our foreign currency transactions are principally denominated in British pound sterling and the Euro. The gain (loss) from currency conversion was $(1.0) million, $1.2 million and $3.7 million in 2005, 2004 and 2003, respectively. The 2003 amount included a one-time gain of $1.3 million from settlement of an advance of funds to an unaffiliated entity.
We utilize the Euro, the British pound sterling and the Canadian dollar as the functional currency in our other foreign operations. The cumulative translation adjustment, representing the effect of translating these subsidiaries’ assets and liabilities into U.S. dollars, is included in the foreign currency translation adjustment within accumulated other comprehensive income. The effect of exchange rate changes on cash balances held in foreign currencies was immaterial for all periods presented and is not shown separately in the consolidated statements of cash flows.
Income Taxes
We file a 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 for financial reporting purposes and such bases as measured by tax laws and regulations. We provide a deferred tax liability for un-repatriated earnings of our foreign subsidiaries at prevailing statutory rates when required. Due to our history of earnings, expectations for future earnings, and taxable income in carryback years, we expect to be able to fully realize the benefit of any net deferred tax asset.
Earnings Per Share
Basic earnings per share is computed by dividing net earnings by the weighted average number of common shares outstanding during the year. Diluted earnings per share is computed by dividing net earnings by the weighted average number of common shares outstanding plus potential common shares outstanding during the year. Outstanding common stock options, when dilutive, are considered to be potential common shares in the diluted calculation. Also included are common shares that would be issued for any premium in excess of the principal amount of our convertible debt. We use the treasury stock method to calculate potential common shares outstanding due to options and our convertible debt.

F-13


Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(continued, tables in thousands, except per share data)
Stock-Based Compensation
As allowed under SFAS No. 123, Accounting for Stock-Based Compensation, we account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees and its related interpretations. Under APB No. 25, compensation cost is measured as of the date the number of shares and exercise price become fixed. The terms of an award are generally fixed on the date of grant, requiring the stock option to be accounted for as a fixed award. For fixed awards, compensation expense is measured as the excess, if any, of the quoted market price of our stock at the date of grant over the exercise price of the option granted. Compensation expense for fixed awards is recognized ratably over the vesting period using the straight-line single option method.
If the number of shares or exercise price is not fixed upon the date of grant, the award is accounted for as a variable award until the number of shares or the exercise price become fixed, or until the award is exercised, canceled, or expires unexercised. For variable awards, intrinsic value is remeasured each period and is equal to the fair market value of our stock as of the end of the reporting period less the grant exercise price. As a result, the amount of compensation expense or benefit to be recognized each period fluctuates based on change in our closing price from the end of the previous reporting period to the end of the current reporting period. In cases when our closing stock price does not exceed the recipient’s exercise price, no compensation expense results. Compensation expense for variable awards, if any, is recognized in accordance with FIN No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plan, An Interpretation of APB Opinions No. 15 and 25.
We account for modifications to stock options under APB No. 25, as subsequently interpreted by FIN No. 44 Accounting for Certain Transactions Involving Stock Compensation — an interpretation of APB Opinion No. 25. Modifications include, but are not limited to, acceleration of vesting, extension of the exercise period following termination of employment and/or continued vesting while not providing substantive services. Compensation expense for modified awards is recorded in the period of modification for the intrinsic value of the vested portion of the award, including vesting that occurs while not providing substantive services, after the date of modification. The intrinsic value of the award is the difference between the fair market value of our common stock on the date of modification and the recipient’s exercise price.
Stock options issued to non-employees are accounted for in accordance with the provisions of SFAS No. 123 and EITF No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. Compensation expense for stock options issued to non-employees is valued using the Black-Scholes model and is amortized over the vesting period in accordance with FIN No. 28.

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Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(continued, tables in thousands, except per share data)
The following table illustrates what the effect on net earnings and earnings per share would be if we had used the fair value method of Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, to value stock options.
                         
    2005     2004     2003  
    (As restated)     (As restated)     (As restated)  
Reported net earnings
  $ 191,192     $ 162,699     $ 142,027  
Stock-based compensation included in reported net earnings, net of income taxes
    2,114       1,920       2,359  
Stock-based compensation using fair value method, net of income taxes
    (8,258 )     (6,140 )     (9,031 )
 
                 
Pro forma net earnings
  $ 185,048     $ 158,479     $ 135,355  
 
                 
Reported basic earnings per share
  $ 1.81     $ 1.67     $ 1.50  
Fair value stock-based compensation
    (0.06 )     (0.04 )     (0.07 )
 
                 
Pro forma basic earnings per share
  $ 1.75     $ 1.63     $ 1.43  
 
                 
Reported diluted earnings per share
  $ 1.75     $ 1.65     $ 1.47  
Fair value stock-based compensation
    (0.06 )     (0.05 )     (0.07 )
 
                 
Pro forma diluted earnings per share
  $ 1.69     $ 1.60     $ 1.40  
 
                 
For purposes of the above presentation, we estimate the fair value of each option grant on the grant date using the Black-Scholes single option pricing model. The table below shows the average fair value of options granted and the related assumptions used in the model.
                         
    2005     2004     2003  
Average fair value of options (As restated):
                       
Granted at market value
  $ 7.17     $ 6.34     $ 4.38  
Granted below market value
    8.96       6.11       4.90  
Risk free interest rate
    4.0 %     3.4 %     2.8 %
Expected volatility factor
    32 %     32 %     32 %
Dividend yield
    1.11 %     1.02 %     1.07 %
Expected option life
  4.8 years   4.5 years   4.4 years
The Financial Accounting Standards Board (FASB) has issued SFAS No. 123(R), Share-Based Payment, which requires companies to recognize the fair value of stock-based compensation cost, with adoption required as of January 1, 2006. SFAS 123(R) allows either a prospective or retrospective adoption method. We will adopt SFAS 123(R) in 2006 using the modified prospective method, whereby results for prior periods will not be restated. Compensation expense recognized going forward will be based on our unvested stock options granted before January 1, 2006 and all options granted after that date. We will use the Black-Scholes option pricing model to determine the fair value of an option on its grant date and will expense that value over the option’s vesting period. At December 31, 2005, there was approximately $43.7 million of total unrecognized compensation expense related to unvested options that is expected to be recognized through 2010, of which we expect to recognize approximately $13.6 million in 2006.

F-15


Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(continued, tables in thousands, except per share data)
Had we adopted SFAS 123(R) in prior periods, the impact would have approximated the pro forma net income and earnings per share amounts calculated under SFAS 123, as disclosed above. The ultimate impact of adoption of SFAS 123(R) in future periods will depend on the following: 1) the amount and timing of options granted, exercised and forfeited, 2) the assumptions used to model fair value and 3) certain tax reporting requirements. We generally recognize a tax benefit when our employees exercise options. SFAS 123(R) requires that, in future periods, we report the benefit of tax deductions in excess of recognized compensation expense as a financing cash flow, rather than as an operating cash flow. We cannot estimate what the tax benefits or cash flow amounts will be in the future because they depend on a variety of factors, including when employees exercise stock options. However, we recognized operating cash flows of $6.2 million, $3.0 million and $1.8 million in 2005, 2004 and 2003, respectively, for tax deductions associated with options exercised.
Stock Split
In May 2005, the Board of Directors declared a three-for-two stock split in the form of a 50% stock dividend on our shares of $1.00 par value common stock, payable to shareholders of record on July 1, 2005. The distribution, consisting of 35.1 million newly issued shares, was reflected as of June 30, 2005 in our consolidated financial statements. The distribution had no impact on consolidated shareholders’ equity, results of operations or cash flows. All references in the Consolidated Financial Statements and Notes to the number of shares outstanding, per share amounts, and stock option and convertible debt data have been restated to reflect the effect of the stock split for all periods presented.
Large Loss Events
During 2005 and 2004, catastrophic events occurred related to three major hurricanes, Katrina, Rita and Wilma, and two minor ones (collectively, the 2005 hurricanes) and four major hurricanes, Charley, Frances, Ivan and Jeanne (collectively, the 2004 hurricanes). As a result of these events, we recognized a pre-tax loss, after reinsurance, of $89.7 million in 2005 and $33.1 million in 2004 in our insurance company segment. The 2005 loss included $73.2 million recorded in loss and loss adjustment expense and $16.5 million for premiums to reinstate our excess of loss reinsurance protection, which reduced net earned premium. The 2004 loss included $23.3 million of loss and loss adjustment expense and $9.8 million of reinstatement premium. Net earnings were reduced $58.2 million in 2005 and $21.5 million in 2004.
During the past three years, we reached agreements with various reinsurers to commute certain reinsurance recoverables, some of which related to our discontinued accident and health line of business. In 2005 and 2003, we received cash payments that were less than the related recoverables, from certain reinsurers, in consideration for discounting the recoverables and reassuming the associated loss reserves. We recorded a pre-tax loss of $26.0 million in 2005 and $28.8 million in 2003 related to these commutations, which were included in loss and loss adjustment expense in our insurance company segment. Net earnings were reduced $16.9 million in 2005 and $18.7 million in 2003.

F-16


Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(continued, tables in thousands, except per share data)
The following table shows the reported amounts, as well as the effect of the hurricanes and commutations on those amounts.
                                                 
                            Effect of hurricanes and commutations  
    2005     2004     2003     2005     2004     2003  
    (As restated)     (As restated)     (As restated)                          
Gross incurred loss and loss adjustment expense
  $ 1,596,773     $ 1,289,155     $ 1,045,339     $ 394,625     $ 89,795     $  
Net incurred loss and loss adjustment expense
    919,697       645,230       488,000       99,226       23,335       28,751  
Ceded earned premium
    617,402       849,610       748,799       16,533       9,806        
Net earnings (loss)
    191,192       162,699       142,027       (75,171 )     (21,464 )     (18,688 )
Recent Accounting Pronouncements
The FASB has issued FASB Staff Position (FSP) No. 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. The FSP requires recognition of an impairment loss on a debt security no later than when the investor deems the impairment is other-than-temporary, even if the investor has not decided to sell the security. This standard replaces current guidance in Emerging Issues Task Force Issue 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. The new standard is effective January 1, 2006. We expect that adoption of this FSP will have an immaterial impact on our consolidated financial position and results of operations.
The FASB has issued SFAS No. 154, Accounting Changes and Error Corrections, as a replacement of APB No. 20, Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. SFAS 154 requires restatement of all prior period financial statements if a company makes an accounting change or corrects an error. The standard is effective January 1, 2006. We will apply the standard, if applicable, in the future.

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Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(continued, tables in thousands, except per share data)
(2)   RESTATEMENT OF CONSOLIDATED FINANCIAL STATEMENTS, SPECIAL COMMITTEE AND COMPANY FINDINGS
 
    In light of published reports concerning the pricing of stock options and the timing of stock option grants at numerous other companies, in the second quarter of 2006 we undertook a voluntary internal review of our past practices related to grants of stock options. The voluntary review by our management concluded that the actual accounting measurement dates for certain past stock option grants differed from the originally stated grant dates, which were also utilized as the measurement dates for such awards. In August 2006, our Board of Directors formed a Special Committee of independent directors to commence an investigation of our past stock option granting practices for the period 1995 through 2005. The Special Committee was composed of the members of the Audit Committee of the Board of Directors. The Special Committee retained the law firm of Skadden, Arps, Slate, Meagher & Flom, LLP as its independent legal counsel and LECG as forensic accountants to aid in the investigation.
 
    On November 17, 2006, we announced that the Special Committee had made certain determinations as a result of its review of our past stock option granting practices. The Special Committee found that we had used incorrect accounting measurement dates for stock option grants covering a significant number of employees and members of our Board of Directors during the period 1997 through 2005 and that certain option grants were retroactively priced. Additionally, at the direction of the Special Committee, we reviewed our stock option granting practices from 1992, the year of our initial public stock offering, through 1994 and in 2006 and found incorrect measurement dates due to retroactive pricing were used in 2006. In substantially all of these instances, the price on the actual measurement date was higher than the price on the stated grant date; thus recipients of the options could exercise at a strike price lower than the actual measurement date price. To determine the actual measurement dates, the Special Committee utilized the following sources of information:
 
    The dates on documentation such as e-mails, regulatory form filings, acquisition agreements and other correspondence;
 
    The date that the relevant stock option grant was entered into Equity Edge, our stock option tracking and accounting system;
 
    Requirements of Accounting Principles Board (APB) No. 25, Accounting for Stock Issued to Employees, and related interpretations; and
 
    Guidance