10-Q 1 d431046d10q.htm FORM 10-Q Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

 

þ Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

for the Quarterly Period Ended September 30, 2012.

¨ Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

from                              to                             

Commission file number 001-13790

HCC Insurance Holdings, Inc.

 

(Exact name of registrant as specified in its charter)

 

Delaware   76-0336636

(State or other jurisdiction of

incorporation or organization)

 

(IRS Employer

Identification No.)

13403 Northwest Freeway, Houston, Texas   77040-6094
(Address of principal executive offices)   (Zip Code)

(713) 690-7300

 

(Registrant’s telephone number, including area code)

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

Yes þ    No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes þ    No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer þ   Accelerated filer ¨    Non-accelerated filer ¨   Smaller reporting company ¨
     (Do not check if a smaller reporting company)  

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ¨    No þ

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

On October 26, 2012, there were approximately 101.3 million shares of common stock outstanding.

 

 

 


Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries

Table of Contents

 

         Page    

Part I. FINANCIAL INFORMATION

    

Item 1. Financial Statements

    

Consolidated Balance Sheets — September 30, 2012 and December 31, 2011

       5  

Consolidated Statements of Earnings — Nine and three months ended September 30, 2012 and 2011

       6  

Consolidated Statements of Comprehensive Income — Nine and three months ended September  30, 2012 and 2011

       7  

Consolidated Statement of Changes in Shareholders’ Equity — Nine months ended September  30, 2012

       8  

Consolidated Statements of Cash Flows — Nine months ended September 30, 2012 and 2011

       9  

Notes to Consolidated Financial Statements

       10  

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

       24  

Item 3. Quantitative and Qualitative Disclosures About Market Risk

       43  

Item 4. Controls and Procedures

       43  

Part II. OTHER INFORMATION

    

Item 1. Legal Proceedings

       44  

Item 1A. Risk Factors

       44  

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

       44  

Item 3. Defaults Upon Senior Securities

       44  

Item 4. Mine Safety Disclosures

       44  

Item 5. Other Information

       44  

Item 6. Exhibits

       45  

Signatures

       46  

 

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FORWARD-LOOKING STATEMENTS

This Report on Form 10-Q contains certain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are intended to be covered by the safe harbors created by those laws. These forward-looking statements reflect our current expectations and projections about future events and 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 growth of our business and operations, business strategy, competitive strengths, goals, plans, future capital expenditures and references to future successes may be considered forward-looking statements. Generally, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “plan,” “probably” or similar expressions indicate forward-looking statements.

Many risks and uncertainties may have an impact on the matters addressed in these forward-looking statements, which could affect our future financial results and performance, including, among other things:

 

   

the effects of catastrophe 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 impact of past and future potential credit market downturns, including any potential additional ratings downgrade and/or impairment or perceived impairment of the debt securities of sovereign issuers, including the United States of America,

 

   

the effects of emerging claim and coverage issues,

 

   

the effects of extensive governmental regulation of the insurance industry,

 

   

changes to the country’s health care delivery system,

 

   

the effects, if any, of climate change, on the risks we insure,

 

   

potential credit risk with brokers,

 

   

the effects of industry consolidations,

 

   

our assessment of underwriting risk,

 

   

our retention of risk, which could expose us to potential losses,

 

   

the adequacy of reinsurance protection,

 

   

the ability and willingness of reinsurers to pay balances due us,

 

   

the occurrence of terrorist activities,

 

   

our ability to maintain our competitive position,

 

   

fluctuations in securities markets, including defaults, which may reduce the value of our investment assets, reduce investment income or generate realized investment losses,

 

   

changes in our assigned financial strength ratings,

 

   

our ability to raise capital and funds for liquidity in the future,

 

   

attraction and retention of qualified employees,

 

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our ability to successfully expand our business through the acquisition of insurance-related companies,

 

   

impairment of goodwill,

 

   

the ability of our insurance company subsidiaries to pay dividends in needed amounts,

 

   

fluctuations in foreign exchange rates,

 

   

failure of, or loss of security related to, our information technology systems,

 

   

difficulties with outsourcing relationships, and

 

   

change of control.

We describe these risks and uncertainties in greater detail in Item 1A, Risk Factors of our Annual Report on Form 10-K for the year ended December 31, 2011.

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, 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 that are included in this Report, our inclusion of this information is not a representation by us or any other person that our objectives or 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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HCC Insurance Holdings, Inc. and Subsidiaries

Consolidated Balance Sheets

(unaudited, in thousands except per share data)

 

     September 30,
2012
    December 31,
2011
 
           (as adjusted)  
ASSETS     

Investments

    

Fixed maturity securities – available for sale, at fair value (amortized cost: 2012 – $5,847,178 and 2011 – $5,385,432)

   $ 6,315,365     $ 5,718,834  

Fixed maturity securities – held to maturity, at amortized cost (fair value: $163,136)

     -        161,102  

Equity securities – available for sale, at fair value (cost: $197,469)

     202,864       -   

Short-term investments, at cost (approximates fair value)

     160,138       133,917  

Other investments, at fair value (amortized cost: 2012 – $31,550 and 2011 – $38,230)

     34,044       35,897  
  

 

 

   

 

 

 

Total investments

     6,712,411         6,049,750  
  

 

 

   

 

 

 

Cash

     64,293       104,550  

Restricted cash

     125,974       229,821  

Premium, claims and other receivables

     604,881       688,732  

Reinsurance recoverables

         1,013,957       1,056,068  

Ceded unearned premium

     262,168       222,300  

Ceded life and annuity benefits

     58,771       61,061  

Deferred policy acquisition costs

     199,401       189,633  

Goodwill

     885,860       872,814  

Other assets

     152,668       122,549  
  

 

 

   

 

 

 

Total assets

   $ 10,080,384     $ 9,597,278  
  

 

 

   

 

 

 
LIABILITIES     

Loss and loss adjustment expense payable

   $ 3,692,250     $ 3,658,317  

Life and annuity policy benefits

     58,771       61,061  

Reinsurance, premium and claims payable

     321,064       366,499  

Unearned premium

     1,118,094       1,031,034  

Deferred ceding commissions

     74,441       62,364  

Notes payable

     548,906       478,790  

Accounts payable and accrued liabilities

     762,038       665,231  
  

 

 

   

 

 

 

Total liabilities

     6,575,564       6,323,296  
  

 

 

   

 

 

 
SHAREHOLDERS’ EQUITY     

Common stock, $1.00 par value; 250,000 shares authorized (shares issued: 2012 – 124,459 and 2011 – 122,720; outstanding: 2012 – 101,297 and 2011 – 104,101)

     124,459       122,720  

Additional paid-in capital

     1,046,435       1,001,308  

Retained earnings

     2,664,745       2,429,818  

Accumulated other comprehensive income

     318,239       227,659  

Treasury stock, at cost (shares: 2012 – 23,162 and 2011 – 18,619)

     (649,058     (507,523
  

 

 

   

 

 

 

Total shareholders’ equity

     3,504,820       3,273,982  
  

 

 

   

 

 

 

Total liabilities and shareholders’ equity

   $ 10,080,384     $ 9,597,278  
  

 

 

   

 

 

 

See Notes to Consolidated Financial Statements.

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Consolidated Statements of Earnings

(unaudited, in thousands except per share data)

 

     Nine months ended September 30,     Three months ended September 30,  
      2012     2011     2012     2011  

REVENUE

        

Net earned premium

   $ 1,676,122     $ 1,576,987     $ 563,650     $ 544,256  

Net investment income

     166,642       158,782       56,342       54,765  

Other operating income

     23,229       23,625       10,840       8,829  

Net realized investment gain

     8,519       3,169       1,472       2,674  

Other-than-temporary impairment credit losses

     (1,028     (3,479     (631     -   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total revenue

     1,873,484       1,759,084       631,673       610,524  
  

 

 

   

 

 

   

 

 

   

 

 

 

EXPENSE

        

Loss and loss adjustment expense, net

     969,767       1,062,240       304,014       380,372  

Policy acquisition costs, net

     211,554       193,180       67,620       57,496  

Other operating expense

     268,164       244,491       100,458       84,254  

Interest expense

     19,101       16,597       5,962       5,610  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total expense

     1,468,586       1,516,508       478,054       527,732  
  

 

 

   

 

 

   

 

 

   

 

 

 

Earnings before income tax expense

     404,898       242,576       153,619       82,792  

Income tax expense

     121,759       65,671       46,557       22,355  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net earnings

   $ 283,139     $ 176,905     $ 107,062     $ 60,437  
  

 

 

   

 

 

   

 

 

   

 

 

 

Earnings per common share

        

Basic

   $ 2.77     $ 1.58     $ 1.06     $ 0.56  
  

 

 

   

 

 

   

 

 

   

 

 

 

Diluted

   $ 2.76     $ 1.57     $ 1.05     $ 0.56  
  

 

 

   

 

 

   

 

 

   

 

 

 

See Notes to Consolidated Financial Statements.

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Consolidated Statements of Comprehensive Income

(unaudited, in thousands)

 

     Nine months ended September 30,     Three months ended September 30,  
     2012     2011     2012     2011  

Net earnings

   $ 283,139     $ 176,905     $ 107,062     $ 60,437  

Other comprehensive income:

        

Investment gains:

        

Investment gains during the period

     152,498       155,933       91,185       100,555  

Income tax charge

     54,078       51,356       32,274       36,059  
  

 

 

   

 

 

   

 

 

   

 

 

 

Investment gains, net of tax

     98,420       104,577       58,911       64,496  
  

 

 

   

 

 

   

 

 

   

 

 

 

Less reclassification adjustments for:

        

Gains (losses) included in net earnings

     7,491       (306     832       2,672  

Income tax charge (benefit)

     2,622       (107     291       935  
  

 

 

   

 

 

   

 

 

   

 

 

 

Gains (losses) included in net earnings, net of tax

     4,869       (199     541       1,737  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net unrealized investment gains

     93,551       104,776       58,370       62,759  
  

 

 

   

 

 

   

 

 

   

 

 

 

Foreign currency translation adjustment

     (3,454     1,865       (141     (6,297

Income tax charge (benefit)

     (483     1,809       (234     331  
  

 

 

   

 

 

   

 

 

   

 

 

 

Foreign currency translation adjustment, net of tax

     (2,971     56       93       (6,628
  

 

 

   

 

 

   

 

 

   

 

 

 

Other comprehensive income

     90,580       104,832       58,463       56,131  
  

 

 

   

 

 

   

 

 

   

 

 

 

Comprehensive income

   $ 373,719     $ 281,737     $ 165,525     $ 116,568  
  

 

 

   

 

 

   

 

 

   

 

 

 

See Notes to Consolidated Financial Statements.

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Consolidated Statement of Changes in Shareholders’ Equity

Nine months ended September 30, 2012

(unaudited, in thousands except per share data)

 

     Common
stock
     Additional
paid-in
capital
     Retained
earnings
    Accumulated
other
comprehensive
income
     Treasury
stock
    Total
shareholders’
equity
 

Balance at December 31, 2011

(as previously reported)

   $ 122,720      $ 1,001,308      $ 2,447,850     $ 227,659      $ (507,523   $ 3,292,014  

Cumulative effect of accounting change (deferred policy acquisition costs)

     -         -         (18,032     -         -        (18,032
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Balance at December 31, 2011

(as adjusted)

     122,720        1,001,308        2,429,818       227,659        (507,523       3,273,982  

Net earnings

     -         -         283,139       -         -        283,139  

Other comprehensive income

     -         -         -        90,580        -        90,580  

Issuance of 1,437 shares for exercise of

options, including tax effect

     1,437        38,668        -        -         -        40,105  

Purchase of 4,543 common shares

     -         -         -        -         (141,535     (141,535

Stock-based compensation

     302        6,459        -        -         -        6,761  

Cash dividends declared, $0.475 per share

     -         -         (48,212     -         -        (48,212
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Balance at September 30, 2012

   $   124,459      $   1,046,435      $   2,664,745     $   318,239      $   (649,058   $ 3,504,820  
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

See Notes to Consolidated Financial Statements.

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(unaudited, in thousands)

 

     Nine months ended September 30,  
     2012      2011  

Operating activities

     

Net earnings

   $ 283,139       $ 176,905   

Adjustments to reconcile net earnings to net cash provided by operating activities:

     

Change in premium, claims and other receivables

     6,623         (76,927)   

Change in reinsurance recoverables

     47,149         (56,510)   

Change in ceded unearned premium

     (39,918)         47,477   

Change in loss and loss adjustment expense payable

     16,052         196,046   

Change in unearned premium

     87,177         24,655   

Change in reinsurance, premium and claims payable, excluding restricted cash

     (32,743)         (34,052)   

Change in accounts payable and accrued liabilities

     79,500         5,082   

Stock-based compensation expense

     10,361         10,017   

Depreciation and amortization expense

     13,919         13,214   

Other, net

     24,776         (17,948)   
  

 

 

    

 

 

 

Cash provided by operating activities

     496,035         287,959   
  

 

 

    

 

 

 

Investing activities

     

Sales of available for sale fixed maturity securities

     293,969         494,532   

Sales of equity securities

     7,145           

Maturity or call of available for sale fixed maturity securities

     504,583         318,558   

Maturity or call of held to maturity fixed maturity securities

     28,511         24,950   

Cost of available for sale fixed maturity securities acquired

     (1,056,909)         (1,243,124)   

Cost of equity securities acquired

     (205,092)           

Change in short-term investments

     (5,401)         288,909   

Cost of other investments acquired

             (33,060)   

Payments for purchase of businesses, net of cash received

     (32,590)         (1,892)   

Other, net

     (2,911)         (14,184)   
  

 

 

    

 

 

 

Cash used by investing activities

     (468,695)         (165,311)   
  

 

 

    

 

 

 

Financing activities

     

Advances on line of credit

     140,000         210,000   

Payments on line of credit

     (70,000)         (15,000)   

Sale of common stock

     40,105         36,245   

Purchase of common stock

     (135,151)         (303,311)   

Dividends paid

     (47,617)         (49,301)   

Other, net

     5,066         (6,001)   
  

 

 

    

 

 

 

Cash used by financing activities

     (67,597)         (127,368)   
  

 

 

    

 

 

 

Net decrease in cash

     (40,257)         (4,720)   

Cash at beginning of year

     104,550         97,857   
  

 

 

    

 

 

 

Cash at end of period

   $ 64,293       $ 93,137   
  

 

 

    

 

 

 

See Notes to Consolidated Financial Statements.

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

(1) General Information

HCC Insurance Holdings, Inc. (HCC) and its subsidiaries (collectively we, us or our) include domestic and foreign property and casualty and life insurance companies and underwriting agencies with offices in the United States, the United Kingdom, Spain and Ireland. We underwrite a variety of relatively non-correlated specialty insurance products, including property and casualty, accident and health, surety, credit and aviation product lines, in approximately 180 countries. We market our products through a network of independent agents and brokers, producers, managing general agents and directly to customers.

Basis of Presentation

Our unaudited consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (GAAP) and include the accounts of HCC and its subsidiaries. We have made all adjustments that, in our opinion, are necessary for a fair statement of results of the interim periods, and all such adjustments are of a normal recurring nature. All significant intercompany balances and transactions have been eliminated in consolidation. The consolidated financial statements should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2011. The consolidated balance sheet at December 31, 2011 was derived from the audited financial statements but does not include all disclosures required by GAAP.

Management must make estimates and assumptions that affect amounts reported in our consolidated financial statements and in disclosures of contingent assets and liabilities. Ultimate results could differ from those estimates. We have reclassified certain amounts in our 2011 consolidated financial statements to conform to the 2012 presentation. None of our reclassifications had an effect on our consolidated net earnings, shareholders’ equity or cash flows.

Accounting Guidance Adopted in 2012

Deferred Policy Acquisition Costs

A new accounting standard clarifies the definition of acquisition costs incurred by an insurance company and limits capitalization to such costs directly related to renewing or acquiring new insurance contracts. Under the new standard, we expense all costs incurred for unsuccessful marketing or underwriting efforts, along with indirect costs, as incurred. We adopted this guidance on January 1, 2012 through retrospective adjustment of the capitalized deferred policy acquisition costs, deferred income taxes and consolidated shareholders’ equity in our prior years’ consolidated financial statements. We also reclassified expenses in our prior years’ consolidated income statements to reflect the new definition of policy acquisition costs. Application of the new guidance did not impact our reported consolidated net earnings or cash flows in prior years. The following line items in our consolidated financial statements were affected by this change in accounting guidance:

 

     December 31, 2011  
      As originally
reported
     Change       As adjusted   

Deferred policy acquisition costs

   $ 217,608      $ (27,975)       $ 189,633  

Accounts payable and accrued liabilities (deferred income taxes)

     675,174        (9,943)         665,231  

Retained earnings

       2,447,850          (18,032)           2,429,818  

 

     Nine months ended September 30, 2011      Three months ended September 30, 2011  
     As originally                   As originally               
     reported      Change     As adjusted      reported      Change     As adjusted  

Policy acquisition costs, net

   $   239,160      $   (45,980 )   $   193,180      $   71,299      $   (13,803 )   $   57,496  

Other operating expense

     198,511        45,980       244,491        70,451        13,803       84,254  

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

(2) Investments

On March 31, 2012, we reclassified our entire portfolio of fixed maturity securities classified as held to maturity, which consisted of corporate, U.S. government and foreign government securities, to fixed maturity securities classified as available for sale. The European debt crisis and the August 2011 downgrade of U.S. government debt by Standard & Poor’s Corporation had recently disrupted the financial markets. Due to these market disruptions and our desire to maintain greater flexibility in managing our entire investment portfolio in an uncertain economy, we changed our prior intent to hold these securities to maturity. On the date of transfer, these securities had a fair value of $139.1 million and an amortized cost of $136.0 million. The securities’ net unrealized appreciation, net of tax, increased our accumulated other comprehensive income and shareholders’ equity by $2.0 million as of March 31, 2012.

The cost or amortized cost, gross unrealized gain or loss, and fair value of our fixed maturity and equity securities were as follows:

 

     Cost or      Gross      Gross         
     amortized      unrealized      unrealized         
     cost      gain      loss      Fair value  

September 30, 2012

           

U.S. government and government agency securities

   $ 224,267       $ 7,769       $       $ 232,036   

Fixed maturity securities of states, municipalities and political subdivisions

     977,682         101,493                 1,079,175   

Special purpose revenue bonds of states, municipalities and political subdivisions

     1,895,991         180,049         (23)         2,076,017   

Corporate securities

     1,152,593         66,475         (1,761)         1,217,307   

Residential mortgage-backed securities

     789,172         52,999         (629)         841,542   

Commercial mortgage-backed securities

     479,517         44,635         (52)         524,100   

Asset-backed securities

     47,354         370         -         47,724   

Foreign government securities

     280,602         16,866         (4)         297,464   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total fixed maturity securities – available for sale

   $ 5,847,178       $ 470,656       $ (2,469)       $ 6,315,365   
  

 

 

    

 

 

    

 

 

    

 

 

 

Equity securities – available for sale

   $ 197,469       $ 8,741       $ (3,346)       $ 202,864   
  

 

 

    

 

 

    

 

 

    

 

 

 

December 31, 2011

           

U.S. government and government agency securities

   $ 285,166       $ 10,523       $ (10)       $ 295,679   

Fixed maturity securities of states, municipalities and political subdivisions

     999,940         85,528         (127)         1,085,341   

Special purpose revenue bonds of states, municipalities and political subdivisions

     1,741,297         122,746         (155)         1,863,888   

Corporate securities

     817,886         35,221         (6,774)         846,333   

Residential mortgage-backed securities

     1,036,436         65,771         (2,121)         1,100,086   

Commercial mortgage-backed securities

     244,535         15,162         (3,573)         256,124   

Asset-backed securities

     34,655         147         (56)         34,746   

Foreign government securities

     225,517         11,203         (83)         236,637   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total fixed maturity securities – available for sale

   $   5,385,432       $   346,301       $   (12,899)       $   5,718,834   
  

 

 

    

 

 

    

 

 

    

 

 

 

U.S. government securities

   $ 6,998       $ 69       $      $ 7,067   

Corporate securities

     110,284         1,814         (455)         111,643   

Foreign government securities

     43,820         746         (140)         44,426   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total fixed maturity securities – held to maturity

   $ 161,102       $ 2,629       $ (595)       $ 163,136   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

11


Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

Substantially all of our fixed maturity securities are investment grade and only one security was non-income producing in 2012. The following table displays the gross unrealized losses and fair value of all available for sale securities that were in a continuous unrealized loss position for the periods indicated.

 

     Less than 12 months      12 months or more      Total  
      Fair value      Unrealized
losses
     Fair value      Unrealized
losses
     Fair value      Unrealized
losses
 

September 30, 2012

                 

Fixed maturity securities

                 

Special purpose revenue bonds of states, municipalities and political subdivisions

   $ 2,813       $ (23)       $       $       $ 2,813       $ (23)   

Corporate securities

     89,993         (1,727)         2,441         (34)         92,434         (1,761)   

Residential mortgage-backed securities

     11,540         (97)         6,633         (532)         18,173         (629)   

Commercial mortgage-backed securities

     7,906         (52)                         7,906         (52)   

Foreign government securities

     9,259         (4)                         9,259         (4)   

Equity securities

     74,051         (3,346)                         74,051         (3,346)   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $   195,562       $   (5,249)       $   9,074       $   (566)       $   204,636       $   (5,815)   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

December 31, 2011

                 

Fixed maturity securities

                 

U.S. government and government agency securities

   $ 13,984       $ (10)       $       $       $ 13,984       $ (10)   

Fixed maturity securities of states,
municipalities and political subdivisions

     10,256         (107)         899         (20)         11,155         (127)   

Special purpose revenue bonds of states, municipalities and political subdivisions

     21,856         (67)         6,796         (88)         28,652         (155)   

Corporate securities

     154,856         (6,391)         18,005         (383)         172,861         (6,774)   

Residential mortgage-backed securities

     32,430         (1,364)         7,582         (757)         40,012         (2,121)   

Commercial mortgage-backed securities

     39,075         (3,573)                         39,075         (3,573)   

Asset-backed securities

     19,648         (56)                         19,648         (56)   

Foreign government securities

     4,198         (83)                         4,198         (83)   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 296,303       $  (11,651)       $  33,282       $  (1,248)       $ 329,585       $  (12,899)   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Our other-than-temporary impairment losses were as follows:

 

                                                               
     Nine months ended September 30,      Three months ended September 30,  
     2012      2011      2012      2011  

Total other-than-temporary impairment loss

   $ (2,069)       $ (4,677)       $ (686)       $   

Portion recognized in other comprehensive income

     1,041         1,198         55           
  

 

 

    

 

 

    

 

 

    

 

 

 

Net other-than-temporary impairment loss recognized in earnings (credit loss)

   $   (1,028)       $   (3,479)       $   (631)       $       -    
  

 

 

    

 

 

    

 

 

    

 

 

 

 

12


Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

Certain of our securities with an other-than-temporary impairment loss have had both a credit loss and an impairment loss recorded in other comprehensive income. The rollforward of credit losses on these securities was as follows:

 

     Nine months ended September 30,      Three months ended September 30,  
     2012      2011      2012      2011  

Balance at beginning of period

   $ 5,047       $ 4,273       $ 5,444       $ 3,847   

Credit losses recognized in earnings

           

Securities previously impaired

     899         1,597         631           

Securities not previously impaired

     129         1,882                   

Securities sold

             (3,905)                   
  

 

 

    

 

 

    

 

 

    

 

 

 

Balance at September 30

   $   6,075       $   3,847       $   6,075       $   3,847   
  

 

 

    

 

 

    

 

 

    

 

 

 

We do not consider the $5.8 million of gross unrealized losses on fixed maturity and equity securities in our portfolio at September 30, 2012 to be other-than-temporary impairments because: 1) as of September 30, 2012, we have received substantially all contractual interest and principal payments on the fixed maturity securities, 2) we do not intend to sell these securities, 3) it is more likely than not that we will not be required to sell the securities before recovery of their amortized cost or cost bases and 4) the unrealized loss relates to non-credit factors, such as interest rate changes and market conditions.

The amortized cost and fair value of our fixed maturity securities at September 30, 2012, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. The weighted-average life of our mortgage-backed and asset-backed securities was 5.2 years at September 30, 2012.

 

     Cost or
amortized cost
     Fair value  

Due in 1 year or less

   $ 335,455       $ 340,330   

Due after 1 year through 5 years

     1,063,361         1,121,440   

Due after 5 years through 10 years

     1,331,492         1,462,880   

Due after 10 years through 15 years

     869,485         961,876   

Due after 15 years

     931,342         1,015,473   
  

 

 

    

 

 

 

Securities with contractual maturities

     4,531,135         4,901,999   

Mortgage-backed and asset-backed securities

     1,316,043         1,413,366   
  

 

 

    

 

 

 

Total fixed maturity securities

   $   5,847,178       $   6,315,365   
  

 

 

    

 

 

 

The sources of net investment income were as follows:

 

     Nine months ended September 30,      Three months ended September 30,  
     2012      2011      2012      2011  

Fixed maturity securities

           

Taxable

   $ 86,548       $ 84,228       $ 28,330       $ 30,009   

Exempt from U.S. income taxes

     80,163         74,713         27,291         24,887   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total fixed maturity securities

     166,711         158,941         55,621         54,896   

Equity securities

     2,339                 1,346           

Short-term investments

     397         420         295         99   

Other investment income

     1,699         2,992         831         962   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total investment income

     171,146         162,353         58,093         55,957   

Investment expense

     (4,504)         (3,571)         (1,751)         (1,192)   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net investment income

   $   166,642       $   158,782       $   56,342       $   54,765   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

13


Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

Realized pretax gains (losses) on the sale of investments, which exclude other-than-temporary impairment credit losses, included the following:

 

     Nine months ended September 30,      Three months ended September 30,  
     2012      2011      2012      2011  

Gains

   $   11,596       $ 8,538       $ 3,469       $ 4,219   

Losses

     (3,077)           (5,369)           (1,997)           (1,545)   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net realized investment gain (loss)

   $ 8,519       $ 3,169       $ 1,472       $ 2,674   
  

 

 

    

 

 

    

 

 

    

 

 

 

(3) Derivative Financial Instrument

We utilize the British pound sterling and the Euro as the functional currency in certain of our foreign operations. As a result, we have exposure to fluctuations in exchange rates between these currencies and the U.S. dollar. From time to time, we may use derivative instruments to protect our investment in these foreign operations by limiting our exposure to fluctuations in exchange rates.

During the second quarter of 2012, we entered into a forward contract to sell 45.0 million Euros for U.S. dollars in the third quarter of 2013. This transaction has been designated and qualifies as a hedge of a portion of our net investment in a Euro-functional currency subsidiary. Changes in the fair value of the forward contract, net of the related deferred tax effect, are recognized in our foreign currency translation adjustment, which is a component of accumulated other comprehensive income. This amount will offset changes in the value of the net investment being hedged as the cumulative translation adjustment related to the foreign subsidiary, representing the effect of translating the subsidiary’s assets and liabilities from Euros to U.S. dollars, is also reported in our foreign currency translation adjustment.

The fair value of the forward contract was a $1.7 million liability at September 30, 2012. This amount is reported in accounts payable and accrued liabilities on our consolidated balance sheet. At inception of the hedge and quarterly thereafter, we assess whether the hedge transaction is effective. Any ineffectiveness would be recognized in earnings immediately as other operating expense. There was no ineffectiveness on the forward contract during 2012.

(4) Fair Value Measurements

Our financial instruments include assets and liabilities carried at fair value, as well as assets and liabilities carried at cost or amortized cost but disclosed at fair value in our financial statements. In determining fair value, we generally apply the market approach, which uses prices and other relevant data based on market transactions involving identical or comparable assets and liabilities. We classify our financial instruments into the following three-level hierarchy:

 

   

Level 1 – Inputs are based on quoted prices in active markets for identical instruments.

 

   

Level 2 – Inputs are based on observable market data (other than quoted prices), or are derived from or corroborated by observable market data.

 

   

Level 3 – Inputs are unobservable and not corroborated by market data.

Our Level 1 investments consist of U.S. Treasuries, money market funds, and equity securities traded in an active exchange market. We use unadjusted quoted prices for identical instruments to measure fair value.

Our Level 2 investments include most of our fixed maturity securities, which consist of U.S. government agency securities, municipal bonds, corporate debt securities, bank loans, and mortgage-backed and asset-backed securities. Level 2 also includes certificates of deposit and other interest-bearing deposits at banks, which we report as short-term investments, and a forward contract, which hedges our net investment in a Euro-functional currency foreign subsidiary. We measure fair value for the majority of our Level 2 investments using quoted prices of securities with similar characteristics. The remaining investments are valued using pricing models or matrix pricing. The fair value measurements consider observable assumptions, including benchmark yields, reported trades,

 

14


Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, default rates, loss severity and other economic measures.

We use independent pricing services to assist us in determining fair value for approximately 99% of our Level 2 investments. The pricing services provide a single price or quote per security. We use data provided by our third party investment managers to value the remaining Level 2 investments. To validate that these quoted and modeled prices are reasonable estimates of fair value, we perform various quantitative and qualitative procedures, including: 1) evaluation of the underlying methodologies, 2) analysis of recent sales activity, 3) analytical review of our fair values against current market prices and 4) comparison of the pricing services’ fair value to other pricing services’ fair value for the same investment. No markets for our investments were judged to be inactive at period end. Based on these procedures, we did not adjust the prices or quotes provided by our independent pricing services or third party investment managers as of September 30, 2012 or December 31, 2011.

Our Level 2 financial instruments also include our notes payable. We determine the fair value of our 6.30% Senior Notes based on quoted prices, but the market is inactive. The fair value of borrowings under our Revolving Loan Facility approximates the carrying amount because interest is based on 30-day LIBOR plus a margin.

Our Level 3 securities include certain fixed maturity securities and an insurance contract that we account for as a derivative and classify in other assets. We determine fair value of our Level 3 securities based on internally developed models that use assumptions or other data that are not readily observable from objective sources.

The following tables present the fair value of our financial instruments that were carried or disclosed at fair value. Unless indicated, these items were carried at fair value on our consolidated balance sheet.

 

                                                                   
     Level 1      Level 2      Level 3      Total  

September 30, 2012

           

Fixed maturity securities – available for sale

           

U.S. government and government agency securities

   $ 193,051      $ 38,985      $ -       $ 232,036  

Fixed maturity securities of states, municipalities and
political subdivisions

     -         1,079,175        -         1,079,175  

Special purpose revenue bonds of states, municipalities and political subdivisions

     -         2,076,017        -         2,076,017  

Corporate securities

     -         1,217,145        162        1,217,307  

Residential mortgage-backed securities

     -         841,542        -         841,542  

Commercial mortgage-backed securities

     -         524,100        -         524,100  

Asset-backed securities

     -         47,724        -         47,724  

Foreign government securities

     -         297,464        -         297,464  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total fixed maturity securities – available for sale

     193,051        6,122,152        162        6,315,365  

Equity securities – available for sale

     202,864        -         -         202,864  

Short-term investments*

     81,947        78,191        -         160,138  

Other investments

     34,044        -         -         34,044  

Other assets

     -         -         206        206  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total assets measured at fair value

   $ 511,906      $ 6,200,343      $ 368      $ 6,712,617  
  

 

 

    

 

 

    

 

 

    

 

 

 

Notes payable*

   $ -       $ 595,804      $ -       $ 595,804  

Accounts payable and accrued liabilities – forward contract

     -         1,705        -         1,705  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total liabilities measured at fair value

   $ -       $ 597,509      $ -       $ 597,509  
  

 

 

    

 

 

    

 

 

    

 

 

 

 

*Carried at cost or amortized cost on our consolidated balance sheet.

 

15


Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

     Level 1      Level 2      Level 3      Total  

December 31, 2011

           

Fixed maturity securities – available for sale

           

U.S. government and government agency securities

   $     201,582      $ 94,097      $ -       $ 295,679  

Fixed maturity securities of states, municipalities and political subdivisions

     -         1,085,341        -         1,085,341  

Special purpose revenue bonds of states, municipalities and political subdivisions

     -         1,863,888        -         1,863,888  

Corporate securities

     -         846,178        155        846,333  

Residential mortgage-backed securities

     -         1,100,086        -         1,100,086  

Commercial mortgage-backed securities

     -         256,124        -         256,124  

Asset-backed securities

     -         33,731        1,015        34,746  

Foreign government securities

     -         236,637        -         236,637  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total fixed maturity securities – available for sale

     201,582        5,516,082        1,170        5,718,834  

Fixed maturity securities – held to maturity*

     -         163,136        -         163,136  

Short-term investments*

     67,288        66,629        -         133,917  

Other investments

     35,720        -         -         35,720  

Other assets

     -         -         1,516        1,516  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total assets measured at fair value

   $     304,590      $     5,745,847      $     2,686      $     6,053,123  
  

 

 

    

 

 

    

 

 

    

 

 

 

Notes payable*

   $ -       $ 505,671      $ -       $ 505,671  
  

 

 

    

 

 

    

 

 

    

 

 

 

 

*Carried at cost or amortized cost on our consolidated balance sheet.

The following tables present the changes in fair value of our Level 3 financial instruments.

 

     2012     2011  
     Fixed                 Fixed               
     income     Other           income     Other         
     securities     assets     Total     securities     assets      Total  

Balance at beginning of year

   $     1,170     $     1,516     $     2,686     $     1,438     $     857      $     2,295  

Net gains (losses)

     2       215       217       (13     263        250  

Sales

     -        -        -        (144     -         (144

Transfers out of Level 3

     (1,015     -        (1,015     -        -         -   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Balance at March 31

     157       1,731       1,888       1,281       1,120        2,401  

Net gains (losses)

     2        116       118       18       122        140  

Sales

     -        -        -        (55     -         (55
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Balance at June 30

     159       1,847       2,006       1,244       1,242        2,486  

Settlements

     -        (1,863     (1,863     -        -         -   

Net gains (losses)

     3        222        225        17       131        148  

Sales

     -        -        -        (43     -         (43
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Balance at September 30

   $ 162     $ 206     $ 368     $     1,218     $     1,373      $     2,591  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

 

16


Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

We transferred an investment from Level 3 to Level 2 in the first quarter of 2012 because we were able to determine its fair value using inputs based on observable market data in the period transferred. There were no transfers between Level 1, Level 2 or Level 3 in the second and third quarters of 2012 or the first nine months of 2011.

(5) Goodwill

The goodwill balances by reportable segment and the changes in goodwill are shown in the table below.

 

     U.S. Property      Professional      Accident &     U.S. Surety                
     & Casualty      Liability      Health     & Credit      International      Total  

Balance at beginning of year

   $     223,000      $     301,547      $     144,132     $     79,700      $     124,435         $     872,814  

Earnout and other

     -         12,542        (19     -         523           13,046  
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

  

 

 

 

Balance at September 30, 2012

   $     223,000      $     314,089      $     144,113     $     79,700      $     124,958         $     885,860  
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

  

 

 

 

We acquired HCC Global Financial Products (HCC Global), which underwrites our U.S. and International directors’ and officers’ liability business, in 2002. The purchase agreement, as amended, includes a contingency for future earnout payments. The earnout is based on HCC Global’s pretax earnings on business written from the acquisition date through September 30, 2007, with no maximum amount due to the former owners. When conditions specified under the purchase agreement are met, we record a net amount owed to or due from the former owners based on our estimate, at that point in time, of how claims will ultimately be settled. This net amount will fluctuate in the future, and the ultimate total net earnout payments cannot be finally determined until all claims are settled or paid. In the third quarter of 2012, we increased goodwill by $11.8 million for additional earnout earned and accrued under the purchase agreement.

We conducted our 2012 goodwill impairment test as of June 30, 2012, which is consistent with the timeframe for our annual assessment in prior years. Based on our latest assessment, the fair value of each of our five reporting units exceeded its carrying amount.

 

17


Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

(6) Reinsurance

In the normal course of business, our insurance companies cede a portion of their premium to domestic and foreign reinsurers through treaty and facultative reinsurance agreements. Although reinsurance does not discharge the direct insurer from liability to its policyholder, our insurance companies participate in such agreements in order to limit their loss exposure, protect them against catastrophic losses and diversify their business. The following tables present the effect of such reinsurance transactions on our premium, loss and loss adjustment expense and policy acquisition costs.

 

     Nine months ended September 30,      Three months ended September 30,  
     2012      2011      2012      2011  

Direct written premium

   $ 1,826,610       $ 1,724,869       $ 603,844       $ 555,427   

Reinsurance assumed

     313,395         295,268         61,919         73,420   

Reinsurance ceded

     (409,206)         (359,046)         (135,456)         (116,513)   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net written premium

   $ 1,730,799       $ 1,661,091       $ 530,307       $ 512,334   
  

 

 

    

 

 

    

 

 

    

 

 

 

Direct earned premium

   $ 1,795,109       $ 1,728,082       $ 601,572       $ 574,571   

Reinsurance assumed

     259,870         255,293         90,988         96,799   

Reinsurance ceded

     (378,857)         (406,388)         (128,910)         (127,114)   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net earned premium

   $ 1,676,122       $ 1,576,987       $ 563,650       $ 544,256   
  

 

 

    

 

 

    

 

 

    

 

 

 

Direct loss and loss adjustment expense

   $ 1,029,227       $ 1,197,225       $ 301,306       $ 410,573   

Reinsurance assumed

     96,143         186,805         35,108         44,600   

Reinsurance ceded

     (155,603)         (321,790)         (32,400)         (74,801)   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net loss and loss adjustment expense

   $ 969,767       $ 1,062,240       $ 304,014       $ 380,372   
  

 

 

    

 

 

    

 

 

    

 

 

 

Policy acquisition costs

   $ 299,854       $ 292,645       $ 101,698       $ 100,975   

Ceding commissions

     (88,300)         (99,465)         (34,078)         (43,479)   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net policy acquisition costs

   $ 211,554       $ 193,180       $ 67,620       $ 57,496   
  

 

 

    

 

 

    

 

 

    

 

 

 

The table below shows the components of our reinsurance recoverables in our consolidated balance sheets.

 

     September 30,     December 31,  
     2012     2011  

Reinsurance recoverable on paid losses

   $ 58,220     $ 83,109  

Reinsurance recoverable on outstanding losses

     479,378       477,760  

Reinsurance recoverable on incurred but not reported losses

     477,859       497,074  

Reserve for uncollectible reinsurance

     (1,500     (1,875
  

 

 

   

 

 

 

Total reinsurance recoverables

   $ 1,013,957     $ 1,056,068  
  

 

 

   

 

 

 

 

18


Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

Reinsurers not authorized by the respective states of domicile of our U.S. domiciled insurance companies are required to collateralize reinsurance obligations due to us. The table below shows the amounts of letters of credit and cash available to us as collateral, plus other potential offsets at September 30, 2012 and December 31, 2011.

 

     September 30,      December 31,  
     2012      2011  

Payables to reinsurers

   $ 201,598      $ 195,806  

Letters of credit

     97,357        120,589  

Cash

     112,105        83,731  
  

 

 

    

 

 

 

Total credits

   $  411,060      $  400,126  
  

 

 

    

 

 

 

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

 

     September 30,     December 31,  
     2012     2011  

Loss and loss adjustment expense payable

   $ 3,692,250     $ 3,658,317  

Reinsurance recoverable on outstanding losses

     (479,378     (477,760

Reinsurance recoverable on incurred but not reported losses

     (477,859     (497,074
  

 

 

   

 

 

 

Net reserves

   $  2,735,013     $  2,683,483  
  

 

 

   

 

 

 

Unearned premium

   $ 1,118,094     $ 1,031,034  

Ceded unearned premium

     (262,168     (222,300
  

 

 

   

 

 

 

Net unearned premium

   $ 855,926     $ 808,734  
  

 

 

   

 

 

 

Deferred policy acquisition costs

   $ 199,401     $ 189,633  

Deferred ceding commissions

     (74,441     (62,364
  

 

 

   

 

 

 

Net deferred policy acquisition costs

   $ 124,960     $ 127,269  
  

 

 

   

 

 

 

(7) Notes Payable

Notes payable were as follows:

 

     September 30,      December 31,  
     2012      2011  

6.30% Senior Notes

   $  298,906      $  298,790  

$600.0 million Revolving Loan Facility

     250,000        180,000  
  

 

 

    

 

 

 

Total notes payable

   $ 548,906      $ 478,790  
  

 

 

    

 

 

 

We have a $90.0 million Standby Letter of Credit Facility that is used to guarantee our performance in our Lloyd’s of London Syndicate 4141. There have been no changes to the terms and conditions related to our 6.30% Senior Notes, the $600.0 million Revolving Loan Facility (the Facility) or the Standby Letter of Credit Facility from those described in Note 7, “Notes Payable” to the Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2011.

The weighted-average interest rate on borrowings under the Facility at September 30, 2012 was 1.60%. The borrowings and letters of credit issued under the Facility reduced our available borrowing capacity on the Facility to $340.1 million at September 30, 2012.

We were in compliance with debt covenants related to our 6.30% Senior Notes, the Facility and the Standby Letter of Credit Facility at September 30, 2012.

 

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Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

(8) Earnings Per Share

The following table details the numerator and denominator used in our earnings per share calculations.

 

     Nine months ended September 30,     Three months ended September 30,  
     2012     2011      2012      2011  

Net earnings

   $ 283,139      $ 176,905      $ 107,062      $ 60,437  

Less: net earnings attributable to unvested restricted stock

     (5,150     (2,551     (1,912     (950
  

 

 

   

 

 

   

 

 

   

 

 

 

Net earnings available to common stock

   $ 277,989      $ 174,354      $ 105,150      $ 59,487  
  

 

 

   

 

 

   

 

 

   

 

 

 

Weighted-average common shares outstanding

     100,340        110,665        99,424        106,919  

Dilutive effect of outstanding options (determined using treasury stock method)

     261        245        276        129  
  

 

 

   

 

 

   

 

 

   

 

 

 

Weighted-average common shares and potential common shares outstanding

     100,601         110,910        99,700        107,048  
  

 

 

   

 

 

   

 

 

   

 

 

 

Anti-dilutive stock options not included in treasury stock method computation

     717        2,279        461        2,744  
  

 

 

   

 

 

   

 

 

   

 

 

 

(9) Stock-Based Compensation

In 2012, we granted the following shares of common stock, restricted stock awards, restricted stock units and stock options for the purchase of shares of our common stock. For all grants except stock options, we measure fair value based on the closing stock price of our common stock on the grant date. For stock options, we use the Black-Scholes single option pricing model to determine the fair value of an option on its grant date. The fair value of the common stock was expensed on the grant date. The fair value of the restricted stock awards, restricted stock units and stock options is being expensed over the vesting period.

 

     Number
of shares
     Weighted-average
grant date fair
value
     Aggregate
fair value
     Vesting
period
 

Common stock

     29       $ 31.49           $ 920         None   

Restricted stock awards

     313         31.20             9,758         2-4 years   

Restricted stock units

     13         30.60             403         4 years   

Stock options

     218         8.00             1,741         1-5 years   

 

20


Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

(10) Segments

We report HCC’s results in six operating segments, including the following five insurance segments:

 

•    U.S. Property & Casualty

  

•    U.S. Surety & Credit

 

•    Professional Liability

  

•    International

 

•    Accident & Health

  

The Investing segment includes our consolidated investment portfolio, as well as all investment income, investment related expenses, realized investment gains and losses, and other-than-temporary impairment credit losses on investments. All investment activity is reported as revenue, consistent with our consolidated presentation.

In addition to our segments, we include a Corporate & Other category to reconcile segment results to consolidated totals. The Corporate & Other category includes corporate operating expenses not allocable to the segments, interest expense on long-term debt, foreign currency expense (benefit), and underwriting results of our Exited Lines.

Our Exited Lines include product lines that we no longer write and do not expect to write in the future. In the third quarter of 2012, we exited the HMO and medical excess reinsurance businesses that had previously been included in our Accident & Health segment. We have recast all prior financial data to report these two lines of business in Exited Lines for all periods presented.

The following tables present information by business segment.

 

                                                                                                                                                               
     U.S. Property
& Casualty
     Professional
Liability
     Accident
&  Health
     U.S. Surety
& Credit
     International      Investing      Corporate
& Other
     Consolidated  

Nine months ended September 30, 2012

                       

Net earned premium

   $ 265,593       $ 298,454       $ 624,077       $ 154,232       $ 302,303       $       $ 31,463       $ 1,676,122   

Other revenue

     15,300         799         3,589         659         2,766         174,133         116         197,362   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Segment revenue

     280,893         299,253         627,666         154,891         305,069         174,133         31,579         1,873,484   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Loss and LAE

     154,156         170,506         447,262         42,444         126,547                 28,852         969,767   

Other expense

     89,348         49,621         93,127         83,402         108,018                 75,303         498,819   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Segment expense

     243,504         220,127         540,389         125,846         234,565                 104,155         1,468,586   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Segment pretax earnings (loss)

   $ 37,389       $ 79,126       $ 87,277       $ 29,045       $ 70,504       $ 174,133       $ (72,576)       $ 404,898   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

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Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

                                                                                                                                                               
     U.S. Property
& Casualty
     Professional
Liability
    Accident
&  Health
     U.S. Surety
& Credit
     International     Investing      Corporate
& Other
    Consolidated  

Nine months ended September 30, 2011

  

                 

Net earned premium

   $ 245,121      $ 307,240     $ 568,318      $ 153,309      $ 267,458     $ -       $ 35,541     $ 1,576,987  

Other revenue

     16,556        358       3,468        955        2,791       158,472        (503     182,097  
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Segment revenue

     261,677        307,598       571,786        154,264        270,249       158,472        35,038       1,759,084  
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Loss and LAE

     148,783        257,632       411,851        42,351        175,635       -         25,988       1,062,240  

Other expense

     82,202        40,055       89,228        82,909        99,754       -         60,120       454,268  
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Segment expense

     230,985        297,687       501,079        125,260        275,389       -         86,108       1,516,508  
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Segment pretax earnings (loss)

   $ 30,692      $ 9,911     $ 70,707      $ 29,004      $ (5,140   $ 158,472      $ (51,070   $ 242,576  
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Three months ended September 30, 2012

  

                 

Net earned premium

   $ 87,741      $ 97,549     $ 209,049      $ 53,388      $ 105,831     $ -       $ 10,092     $ 563,650  

Other revenue

     8,415        532       1,095        244        631       57,183        (77     68,023  
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Segment revenue

     96,156        98,081       210,144        53,632        106,462       57,183        10,015       631,673  
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Loss and LAE

     53,229        36,183       140,344        15,721        46,924       -         11,613       304,014  

Other expense

     29,581        13,414       32,025        27,879        39,253       -         31,888       174,040  
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Segment expense

     82,810        49,597       172,369        43,600        86,177       -         43,501       478,054  
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Segment pretax earnings (loss)

   $ 13,346      $ 48,484     $ 37,775      $ 10,032      $ 20,285     $ 57,183      $ (33,486   $ 153,619  
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Three months ended September 30, 2011

                    

Net earned premium

   $ 85,946      $ 104,066     $ 191,715      $ 51,906      $ 99,294     $ -       $ 11,329     $ 544,256  

Other revenue

     6,890        109       1,275        254        889       57,439        (588     66,268  
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Segment revenue

     92,836        104,175       192,990        52,160        100,183       57,439        10,741       610,524  
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Loss and LAE

     56,355        119,617       138,566        12,664        45,242       -         7,928       380,372  

Other expense

     26,627        6,023       29,897        27,657        35,734       -         21,422       147,360  
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Segment expense

     82,982        125,640       168,463        40,321        80,976       -         29,350       527,732  
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Segment pretax earnings (loss)

   $ 9,854      $ (21,465   $ 24,527      $ 11,839      $ 19,207     $ 57,439      $ (18,609   $ 82,792  
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Catastrophe losses reduced the International segment’s pretax earnings by $15.9 million and $101.7 million in the first nine months of 2012 and 2011, respectively, and $7.6 million and $29.4 million in the third quarter of 2012 and 2011, respectively. The Professional Liability segment’s pretax earnings were reduced by $75.4 million in the first nine months and $58.5 million in the third quarter of 2011 due to net adverse loss development and an increase in the 2011 accident year loss ratio for the diversified financial products line of business.

 

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Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

(11) Commitments and Contingencies

Catastrophe and Large Loss Exposure

We have exposure to catastrophic losses caused by natural perils (such as hurricanes, earthquakes, floods, tsunamis and tornados), as well as from man-made events (such as terrorist attacks). The incidence, timing and severity of catastrophe losses are unpredictable. We assess our exposures in areas most vulnerable to natural catastrophes and apply procedures to ascertain our probable maximum loss from a single event. We maintain reinsurance protection that we believe is sufficient to limit our exposure to a foreseeable event. Following a catastrophic loss, we often incur additional costs for reinstatement premium to continue our reinsurance coverage for future loss events. Our pretax catastrophe losses were $22.7 million gross and $20.3 million net (after reinsurance and reinstatement premium) in the first nine months of 2012 and $168.0 million gross and $107.9 million net in the same period of 2011.

Litigation

We are a 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 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. Although the ultimate outcome of these matters cannot be determined at this time, based on present information, the availability of insurance coverage and advice received from our outside legal counsel, we believe the resolution of any such matters will not, individually or in the aggregate, have a material adverse effect on our consolidated financial position, results of operations or cash flows.

Indemnifications

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. Under other indemnifications, we 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 in 2025. We accrue a loss when a valid claim is made by a purchaser and we believe we have potential exposure. At September 30, 2012, we have an accrued liability of $11.2 million, as well as $6.1 million in escrow and $3.2 million of letters of credit, to cover our obligations or anticipated payments under these indemnifications.

(12) Supplemental Information

Supplemental cash flow information was as follows:

 

                                                                               
     Nine months ended September 30,      Three months ended September 30,  
     2012      2011      2012      2011  

Income taxes paid

   $ 83,979        $ 88,973        $ 44,531        $ 31,366    

Interest paid

     13,321          12,937          1,321          785    

Proceeds from sales of available for sale fixed maturity securities

     293,969          494,532          75,397          248,201    

Proceeds from sales of equity securities

     7,145          -           5,406          -     

Dividends declared but not paid at end of period

     16,728          16,535          

(13) Subsequent Event

On October 29, 2012, Hurricane Sandy made landfall in the United States. We have begun assessing our exposures but are unable to reasonably quantify the extent of our losses with respect to this event at this time.

 

23


Table of Contents

Item 2. 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 Consolidated Financial Statements and the related Notes as of September 30, 2012 and December 31, 2011.

Overview

We are a specialty insurance group with offices in the United States, the United Kingdom, Spain and Ireland, transacting business in approximately 180 countries. Our shares trade on the New York Stock Exchange and closed at $35.08 on October 26, 2012, resulting in market capitalization of $3.6 billion.

We underwrite a variety of relatively non–correlated specialty insurance products, including property and casualty, accident and health, surety and credit product lines. We market our insurance products through a network of independent agents and brokers, managing general agents and directly to consumers. In addition, we assume insurance written by other insurance companies. We manage our businesses through five insurance underwriting segments and our Investing segment. Our insurance underwriting segments are U.S. Property & Casualty, Professional Liability, Accident & Health, U.S. Surety & Credit and International.

Our business philosophy is to maximize underwriting profit while managing risk. We concentrate our insurance writings in selected specialty lines of business in which we believe we can achieve meaningful underwriting profit. We also rely on our experienced underwriting personnel and our access to and expertise in the reinsurance marketplace to limit or reduce our risk. Our business plan is shaped by our underlying business philosophy. As a result, our primary objective is to maximize net earnings and grow book value per share, rather than to grow gross written premium or market share.

Our major domestic and international insurance companies have financial strength ratings of AA (Very Strong) from Standard & Poor’s Corporation, A+ (Superior) from A.M. Best Company, Inc., AA (Very Strong) from Fitch Ratings and A1 (Good Security) from Moody’s Investors Service, Inc.

Key facts about our consolidated group as of and for the nine months and quarter ended September 30, 2012 were as follows:

 

   

We had consolidated shareholders’ equity of $3.5 billion, with a book value per share of $34.60.

 

   

We generated year-to-date net earnings of $283.1 million, or $2.76 per diluted share. Our third quarter earnings were $107.1 million, or $1.05 per diluted share.

 

   

We produced total revenue of $1.9 billion and $631.7 million in the first nine months and third quarter, respectively. In the first nine months, 89% related to net earned premium and 9% related to net investment income.

 

   

In the first nine months, we recognized $20.3 million of pretax net catastrophe losses — $4.4 million in our U.S. Property & Casualty segment from storms in the United States and $15.9 million in our International segment from other small catastrophes. The third quarter included pretax net catastrophe losses of $8.0 million.

 

   

We recorded net favorable loss development of $34.6 million in the first nine months and third quarter of 2012.

 

   

Our year-to-date net loss ratio was 57.9% and our combined ratio was 83.3%.

 

   

Our debt to capital ratio was 13.5%.

 

   

We purchased $141.5 million, or 4.5 million shares, of our common stock at an average cost of $31.15 per share in the first nine months of 2012.

 

   

We increased our regular cash dividend to $0.165 per share, marking the 16th consecutive year of increases in our dividend. In the first nine months of 2012, we declared dividends of $0.475 per share and paid $47.6 million of dividends.

 

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Comparisons in the following sections refer to the first nine months of 2012 compared to the same period of 2011, unless otherwise noted. Amounts in tables are in thousands, except for earnings per share, percentages, ratios and number of employees. We adjusted certain 2011 amounts to reflect our adoption of a new accounting standard in 2012 (see Note 1, “General Information” to the Consolidated Financial Statements). We also recast all prior segment data to reflect our exit from two lines of business previously included in our Accident & Health segment (see Note 10, “Segments”).

Results of Operations

Our results and key metrics for the first nine months and third quarter of 2012 and 2011 were as follows:

 

     Nine months ended September 30,     Three months ended September 30,  
     2012      2011      2012      2011   

Net earnings

   $ 283,139      $ 176,905      $ 107,062      $ 60,437   
  

 

 

   

 

 

   

 

 

   

 

 

 

Earnings per diluted share

   $ 2.76      $ 1.57      $ 1.05      $ 0.56   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss ratio

     57.9     67.4     53.9     69.9

Expense ratio *

     25.4        25.2        25.2        23.2   
  

 

 

   

 

 

   

 

 

   

 

 

 

Combined ratio *

     83.3     92.6     79.1     93.1
  

 

 

   

 

 

   

 

 

   

 

 

 

 

* 2011 adjusted to reflect 2012 change in Exited Lines.

 

In 2012, we recognized catastrophe losses from United States storms, primarily in our aviation and public risk lines of business within our U.S. Property and Casualty segment, and from other small catastrophes in our property treaty line of business within our International segment. In 2011, we recognized losses from catastrophic events in Japan, New Zealand, Australia, the United States and Denmark. Our third quarter 2011 catastrophe losses, which primarily related to Hurricane Irene in the United States, impacted our U.S. Property and Casualty and International segments. We reinsure a portion of our exposure to catastrophic events, although we incur some additional cost for reinstatement premium to continue our reinsurance coverage for future loss events. The following table summarizes our catastrophe losses, as well as the impact on our net earnings and key metrics in 2012 and 2011:

 

  

        

     Nine months ended September 30,     Three months ended September 30,  
     2012     2011     2012     2011  

Net losses, after reinsurance and reinstatement premium

   $ 20,283     $ 107,915     $ 8,026     $ 34,587  

Impact of net catastrophe losses on:

        

Net earnings per diluted share

   $ (0.13   $ (0.63   $ (0.05   $ (0.21

Net loss ratio (percentage points)

     1.3      6.5      1.4      6.2 

Combined ratio (percentage points)

     1.3      6.7      1.4      6.3 

We recognized net favorable loss development of $34.6 million in the first nine months of 2012, compared to net adverse loss development of $21.6 million in the same period of 2011. See the “Loss and Loss Adjustment Expense” and “Segment Operations” sections below for discussion of our 2012 and 2011 loss activity.

 

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Revenue

Total revenue increased $114.4 million in the first nine months of 2012, primarily due to higher net earned premium.

Gross written premium, net written premium and net earned premium are detailed below by segment.

 

                                                                               
     Nine months ended September 30,      Three months ended September 30,  
     2012      2011      2012      2011  

U.S. Property & Casualty

   $ 481,024       $ 409,733       $ 162,411       $ 144,222   

Professional Liability

     377,876         392,903         132,126         130,631   

Accident & Health

     622,613         565,235         209,738         191,472   

U.S. Surety & Credit

     166,678         169,368         55,976         55,415   

International

     460,111         447,355         95,200         95,774   

Exited Lines

     31,703         35,543         10,312         11,333   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total gross written premium

   $ 2,140,005       $ 2,020,137       $ 665,763       $ 628,847   
  

 

 

    

 

 

    

 

 

    

 

 

 

U.S. Property & Casualty

   $ 297,866       $ 273,212       $ 99,972       $ 92,776   

Professional Liability

     264,398         287,494         93,261         96,846   

Accident & Health

     622,018         564,805         209,647         191,359   

U.S. Surety & Credit

     146,865         155,761         50,769         50,660   

International

     368,189         344,286         66,566         69,364   

Exited Lines

     31,463         35,533         10,092         11,329   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total net written premium

   $ 1,730,799       $ 1,661,091       $ 530,307       $ 512,334   
  

 

 

    

 

 

    

 

 

    

 

 

 

U.S. Property & Casualty

   $ 265,593       $ 245,121       $ 87,741       $ 85,946   

Professional Liability

     298,454         307,240         97,549         104,066   

Accident & Health

     624,077         568,318         209,049         191,715   

U.S. Surety & Credit

     154,232         153,309         53,388         51,906   

International

     302,303         267,458         105,831         99,294   

Exited Lines

     31,463         35,541         10,092         11,329   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total net earned premium

   $ 1,676,122       $ 1,576,987       $ 563,650       $ 544,256   
  

 

 

    

 

 

    

 

 

    

 

 

 

Growth in premium occurred in the U.S. Property & Casualty segment from our new business lines started in 2011 and increased public risk and residual value premium; in the Accident & Health segment from higher writings of our medical stop-loss product; and in the International segment from new business and pricing increases in our energy and property treaty lines of business. In 2011, we recorded $14.0 million ($15.9 million ceded, net of $1.9 million assumed) of catastrophe-related reinstatement premium, which reduced the International segment’s 2011 net written and net earned premium. See the “Segment Operations” section below for further discussion of the relationship and changes in premium revenue within each segment.

Net investment income, which is included in our Investing segment, increased 5% year-over-year and 3% quarter-over-quarter primarily due to higher income from fixed maturity securities, generated from an increased amount of investments. Our fixed maturity portfolio increased 9% from $5.8 billion at September 30, 2011 to $6.3 billion at September 30, 2012. In addition, at September 30, 2012, we had $202.9 million of publicly traded equity securities, which is an asset class we added to our portfolio during 2012. The growth in investments resulted primarily from cash flow from operations and an increase of $185.2 million in the net unrealized gain on available for sale securities since September 30, 2011.

 

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The following table details the components of our other operating income. The fee and commission income relates to third party agency and broker commissions.

 

                                                                               
     Nine months ended September 30,     Three months ended September 30,  
     2012     2011     2012     2011  

Fee and commission income

   $ 20,682     $ 21,708     $ 10,140     $ 8,487  

Financial instruments

     552       516       222       131  

Other

     1,995       1,401       478       211  
  

 

 

   

 

 

   

 

 

   

 

 

 

Other operating income

   $ 23,229     $ 23,625     $ 10,840     $ 8,829  
  

 

 

   

 

 

   

 

 

   

 

 

 

 

Loss and Loss Adjustment Expense

 

The tables below detail, by segment, our net loss and loss adjustment expense and our net loss ratios.

 

  

  

     Nine months ended September 30,     Three months ended September 30,  
     2012     2011     2012     2011  

U.S. Property & Casualty

   $ 154,156      $ 148,783      $ 53,229      $ 56,355   

Professional Liability

     170,506        257,632        36,183        119,617   

Accident & Health

     447,262        411,851        140,344        138,566   

U.S. Surety & Credit

     42,444        42,351        15,721        12,664   

International

     126,547        175,635        46,924        45,242   

Exited Lines

     28,852        25,988        11,613        7,928   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss and loss adjustment expense

   $ 969,767      $ 1,062,240      $ 304,014      $ 380,372   
  

 

 

   

 

 

   

 

 

   

 

 

 

(Favorable) adverse loss development:

        

U.S. Property & Casualty

   $ 2,138      $ (4,613)      $ 2,138      $ (7,163)   

Professional Liability

     (26,186)        48,137        (26,186)        31,153   

Accident & Health

     (10,695)        1,956        (10,695)        60   

U.S. Surety & Credit

            (2,767)               (2,786)   

International

            (20,623)               (21,287)   

Exited Lines

     111        (467)        111        (620)   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total (favorable) adverse loss development

     (34,632)        21,623        (34,632)        (643)   

Catastrophe losses

     21,406        93,907        8,738        32,187   

All other net loss and loss adjustment expense

     982,993        946,710        329,908        348,828   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss and loss adjustment expense

   $ 969,767      $ 1,062,240      $ 304,014      $ 380,372   
  

 

 

   

 

 

   

 

 

   

 

 

 

U.S. Property & Casualty

     58.0      60.7      60.7      65.6 

Professional Liability

     57.1         83.9         37.1         114.9    

Accident & Health

     71.7         72.5         67.1         72.3    

U.S. Surety & Credit

     27.5         27.6         29.4         24.4    

International

     41.9         65.7         44.3         45.6    

Exited Lines

     91.7         73.1         115.1         70.0    
  

 

 

   

 

 

   

 

 

   

 

 

 

Consolidated net loss ratio

     57.9      67.4      53.9      69.9 
  

 

 

   

 

 

   

 

 

   

 

 

 

Consolidated accident year net loss ratio

     59.9      66.0      60.1      70.0 
  

 

 

   

 

 

   

 

 

   

 

 

 

 

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Loss development represents an increase or decrease in estimates of ultimate losses related to prior accident years. Deficiencies and redundancies in ultimate loss estimates occur as we review our loss exposure with our actuaries, increasing or reducing estimates of our ultimate losses as a result of such reviews and as losses are finally settled or claims exposures change. The excess of total recorded net reserves over the actuarial point estimate approximated 6.1% of our recorded net reserves at September 30, 2012, compared to 4.2% at December 31, 2011. We recognized (favorable) adverse loss development of $(34.6) million and $21.6 million in the first nine months of 2012 and 2011, respectively, and $(34.6) million and $(0.6) million in the third quarter of 2012 and 2011, respectively. Our consolidated accident year net loss ratio was lower in 2012 due to higher catastrophe losses and higher losses on our diversified financial products line of business in 2011. See the “Segment Operations” section below for additional discussion of the changes in our net loss and loss adjustment expense and net loss ratios for each segment.

The table below provides a reconciliation of our consolidated reserves for loss and loss adjustment expense payable, net of reinsurance ceded, the amount of our paid claims, and our net paid loss ratio.

 

     Nine months ended September 30,     Three months ended September 30,  
     2012     2011      2012      2011  

Net reserves for loss and loss adjustment expense payable at beginning of period

   $     2,683,483       $     2,537,772       $     2,748,995       $     2,612,945    

Net reserve additions from acquired businesses

     14,705         645                  

Foreign currency adjustment

     11,261         5,364         15,717         (22,622)   

Net loss and loss adjustment expense

     969,767         1,062,240         304,014         380,372    

Net loss and loss adjustment expense payments

     (944,203)        (937,171)        (333,713)        (301,845)   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net reserves for loss and loss adjustment expense payable at end of period

   $ 2,735,013       $ 2,668,850       $ 2,735,013       $ 2,668,850    
  

 

 

   

 

 

   

 

 

   

 

 

 

Net paid loss ratio

     56.3      59.4      59.2      55.5
  

 

 

   

 

 

   

 

 

   

 

 

 

The amount of claims paid fluctuates period to period due to our mix of business and the timing of claims settlement and catastrophic events. Our year-to-date net loss and loss adjustment expense payments include $27.5 million and $26.7 million that we paid in 2012 and 2011, respectively, to commute large contracts included in our Exited Lines. These commutations had no material effect on net earnings but increased our year-to-date net paid loss ratios by 1.6 percentage points in 2012 and 1.7 percentage points in 2011.

Policy Acquisition Costs

Our policy acquisition cost percentage was 12.6% and 12.2% for the first nine months of 2012 and 2011, respectively, and 12.0% and 10.6% for the third quarter of 2012 and 2011, respectively. We record profit commissions due from reinsurers as an offset to policy acquisition costs, which impacted our policy acquisition cost percentages as follows:

 

     Nine months ended September 30,     Three months ended September 30,  
     2012      2011      2012      2011  

Profit commissions

   $     10,013       $     16,494       $     7,403       $     15,684    

Impact of profit commissions (percentage points)

     0.6      1.1      1.3      2.8 

 

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Other Operating Expense

For the first nine months of 2012, 61% of our other operating expense related to compensation and benefits for our 1,875 employees. Other operating expense increased 10% year-over-year and 19% quarter-over-quarter, primarily due to increased compensation expense, including higher bonus expense directly related to higher pretax earnings in 2012, and the fluctuation in foreign currency gain and loss. We recognized foreign currency loss of $5.3 million and $6.8 million in the first nine months and third quarter of 2012, respectively, primarily related to the fluctuations in the British pound sterling. Conversely, we recognized foreign currency benefit of $2.5 million and $0.5 million in the first nine months and third quarter of 2011, respectively. Other operating expense included stock-based compensation expense of $10.6 million in 2012 and $10.4 million in 2011. At September 30, 2012, there was approximately $27.2 million of total unrecognized compensation expense related to unvested options and restricted stock awards and units that is expected to be recognized over a weighted-average period of 3.0 years.

Interest Expense

Interest expense on debt and short-term borrowings was $19.1 million and $16.6 million in the first nine months of 2012 and 2011, respectively, and $6.0 million and $5.6 million in the third quarter of 2012 and 2011, respectively. Our interest expense increased in 2012 due to a higher amount of outstanding borrowings on our $600.0 million Revolving Loan Facility, primarily to fund purchases of our common stock. Our year-to-date interest expense for 2012 and 2011 included $14.5 million for our Senior Notes.

Income Tax Expense

Our effective income tax rate was 30.1% for the first nine months of 2012, compared to 27.1% for the same period of 2011. The higher effective rate in 2012 is due to the relationship of pretax income and tax-exempt investment income in the two periods. Our pretax income was substantially higher in 2012 from larger underwriting profit than in 2011, whereas our tax-exempt investment income was essentially flat in 2012 and 2011.

 

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Segment Operations

Each of our insurance segments bears risk for insurance coverage written within its portfolio of insurance products. Each segment generates income from premium written by our underwriting agencies, through third party agents and brokers, or on a direct basis. The insurance segments also write facultative or individual account reinsurance, as well as treaty reinsurance business. In some cases, we purchase reinsurance to limit the segments’ net losses from both individual policy losses and multiple policy losses from catastrophe occurrences. Our segments maintain disciplined expense management and a streamlined management structure, which results in favorable expense ratios. The following provides operational information about our five insurance segments and our Investing segment.

U.S. Property & Casualty Segment

The following tables summarize the operations of the U.S. Property & Casualty segment.

 

                                                                                       
     Nine months ended September 30,     Three months ended September 30,  
     2012     2011     2012     2011  

Net earned premium

   $ 265,593      $ 245,121      $ 87,741      $ 85,946   

Other revenue

     15,300        16,556        8,415        6,890   
  

 

 

   

 

 

   

 

 

   

 

 

 

Segment revenue

     280,893        261,677        96,156        92,836   
  

 

 

   

 

 

   

 

 

   

 

 

 

Loss and loss adjustment expense, net

     154,156        148,783        53,229        56,355   

Other expense

     89,348        82,202        29,581        26,627   
  

 

 

   

 

 

   

 

 

   

 

 

 

Segment expense

     243,504        230,985        82,810        82,982   
  

 

 

   

 

 

   

 

 

   

 

 

 

Segment pretax earnings

   $ 37,389      $ 30,692      $ 13,346      $ 9,854   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss ratio

     58.0      60.7      60.7      65.6 

Expense ratio

     31.8        31.4        30.8        28.7   
  

 

 

   

 

 

   

 

 

   

 

 

 

Combined ratio

     89.8      92.1      91.5      94.3 
  

 

 

   

 

 

   

 

 

   

 

 

 

Aviation

   $ 87,890      $ 83,879      $  29,670      $  29,279   

E&O

     47,177        56,354        15,198        17,997   

Public Risk

     48,363        36,523        16,571        13,344   

Other

     82,163        68,365        26,302        25,326   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total net earned premium

   $ 265,593      $ 245,121      $ 87,741      $ 85,946   
  

 

 

   

 

 

   

 

 

   

 

 

 

Aviation

     56.9      64.9      58.9      67.1 

E&O

     74.1         73.7         102.1         108.6    

Public Risk

     95.9         84.5         130.8         115.1    

Other

     27.8         32.1         (5.5)        7.1    
  

 

 

   

 

 

   

 

 

   

 

 

 

Total net loss ratio

     58.0      60.7      60.7      65.6 
  

 

 

   

 

 

   

 

 

   

 

 

 

 

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     Nine months ended September 30,      Three months ended September 30,  
     2012      2011      2012      2011  

Aviation

   $ 117,300       $ 116,933       $ 34,430       $ 37,877   

E&O

     46,483         52,961         14,990         15,963   

Public Risk

     67,066         55,724         23,821