10-Q 1 h01192e10vq.txt HCC INSURANCE HOLDINGS, INC.- SEPTEMBER 30, 2002 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, for the Quarter Ended September 30, 2002. [ ] Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 from _______ to __________ Commission file number 0-20766 ---------------------------------------------------- HCC Insurance Holdings, Inc. -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) Delaware 76-0336636 -------------------------------------------------------------------------------- (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) 13403 Northwest Freeway, 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 X No ----- ----- Indicate the number of shares outstanding of each of the issuer's classes of common stock as of the latest practicable date. On October 31, 2002, there were 62.3 million shares of common stock, $1.00 par value issued and outstanding. HCC INSURANCE HOLDINGS, INC. INDEX
PAGE NO. -------- Part I. FINANCIAL INFORMATION Item 1. Condensed Consolidated Balance Sheets September 30, 2002 and December 31, 2001 ..................................................3 Condensed Consolidated Statements of Earnings For the nine months and the three months ended September 30, 2002 and 2001 ................4 Condensed Consolidated Statements of Changes in Shareholders' Equity For the nine months ended September 30, 2002 and for the year ended December 31, 2001 ......................................................5 Condensed Consolidated Statements of Cash Flows For the nine months and the three months ended September 30, 2002 and 2001 ................7 Notes to Condensed Consolidated Financial Statements............................................8 Item 2. Management's Discussion and Analysis...........................................................25 Item 3. Quantitative and Qualitative Disclosures About Market Risk.....................................35 Item 4. Controls and Procedures........................................................................35 Part II. OTHER INFORMATION.......................................................................................36
This report on Form 10-Q contains certain "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934, which are intended to be covered by the safe harbors created by those laws. We have based these forward-looking statements on our current expectations and projections about future events. These forward-looking statements include information about possible or assumed future results of our operations. All statements, other than statements of historical facts, included or incorporated by reference in this report that address activities, events or developments that we expect or anticipate may occur in the future, including such things as future capital expenditures, business strategy, competitive strengths, goals, growth of our business and operations, plans and references to future successes may be considered forward-looking statements. Also, when we use words such as "anticipate," "believe," "estimate," "expect," "intend," "plan," "probably" or similar expressions, we are making forward-looking statements. Many risks and uncertainties may impact the matters addressed in these forward-looking statements. Many possible events or factors could affect our future financial results and performance. These could cause our results or performance to differ materially from those we express in our forward-looking statements. Although we believe that the assumptions underlying our forward-looking statements are reasonable, any of these assumptions, and therefore also the forward-looking statements based on these assumptions, could themselves prove to be inaccurate. In light of the significant uncertainties inherent in the forward-looking statements which are included in this report, our inclusion of this information is not a representation by us or any other person that our objectives and plans will be achieved. Our forward-looking statements speak only as of the date made and we will not update these forward-looking statements unless the securities laws require us to do so. In light of these risks, uncertainties and assumptions, any forward-looking events discussed in this report may not occur. 2 HCC Insurance Holdings, Inc. and Subsidiaries --------- Condensed Consolidated Balance Sheets (unaudited, in thousands) --------
September 30, 2002 December 31, 2001 ------------------ ------------------ ASSETS Investments: Fixed income securities, at market (cost: 2002 - $682,732; 2001 - $513,674) $ 720,410 $ 525,428 Marketable equity securities, at market (cost: 2002 - $16,971; 2001 - $16,431) 16,851 16,569 Short-term investments, at cost, which approximates market 283,037 338,904 Other investments, at estimated fair value (cost: 2002 - $17,401; 2001 - $8,007) 16,751 7,565 ------------------ ------------------ Total investments 1,037,049 888,466 Cash 34,749 16,891 Restricted cash 159,365 138,545 Premium, claims and other receivables 718,405 665,965 Reinsurance recoverables 846,159 899,128 Ceded unearned premium 135,033 71,140 Ceded life and annuity benefits 80,022 83,013 Deferred policy acquisition costs 61,916 32,071 Property and equipment, net 51,023 52,486 Goodwill 315,610 315,318 Other assets 32,566 56,097 ------------------ ------------------ TOTAL ASSETS $ 3,471,897 $ 3,219,120 ================== ================== LIABILITIES Loss and loss adjustment expense payable $ 1,084,443 $ 1,130,748 Life and annuity policy benefits 80,022 83,013 Reinsurance balances payable 147,049 88,637 Unearned premium 280,330 179,530 Deferred ceding commissions 41,762 16,681 Premium and claims payable 721,114 717,159 Notes payable 207,029 181,928 Accounts payable and accrued liabilities 54,567 57,971 ------------------ ------------------ Total liabilities 2,616,316 2,455,667 SHAREHOLDERS' EQUITY Common stock, $1.00 par value; 250.0 million shares authorized; (shares issued and outstanding: 2002 - 62,294; 2001 - 61,438) 62,294 61,438 Additional paid-in capital 414,253 402,089 Retained earnings 355,946 293,426 Accumulated other comprehensive income 23,088 6,500 ------------------ ------------------ Total shareholders' equity 855,581 763,453 ------------------ ------------------ TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 3,471,897 $ 3,219,120 ================== ==================
See Notes to Condensed Consolidated Financial Statements. 3 HCC Insurance Holdings, Inc. and Subsidiaries -------- Condensed Consolidated Statements of Earnings (unaudited, in thousands, except per share data) --------
For the nine months ended For the three months ended September 30, September 30, 2002 2001 2002 2001 -------------- -------------- -------------- -------------- REVENUE Net earned premium $ 362,399 $ 249,080 $ 136,294 $ 93,471 Management fees 57,052 43,668 18,057 14,033 Commission income 31,631 34,299 10,403 9,507 Net investment income 28,123 30,613 9,945 10,105 Net realized investment gain (loss) 1,159 (237) (10) 123 Other operating income 2,929 15,846 983 10,382 -------------- -------------- -------------- -------------- Total revenue 483,293 373,269 175,672 137,621 EXPENSE Loss and loss adjustment expense 221,246 216,143 85,163 119,174 Operating expense: Policy acquisition costs, net 44,467 21,515 18,933 9,262 Compensation expense 58,744 51,135 19,203 15,669 Other operating expense 36,583 55,340 12,591 27,800 -------------- -------------- -------------- -------------- Net operating expense 139,794 127,990 50,727 52,731 Interest expense 6,892 6,631 2,051 1,470 -------------- -------------- -------------- -------------- Total expense 367,932 350,764 137,941 173,375 -------------- -------------- -------------- -------------- Earnings (loss) before income tax provision 115,361 22,505 37,731 (35,754) Income tax provision (benefit) 41,028 16,145 13,462 (6,678) -------------- -------------- -------------- -------------- NET EARNINGS (LOSS) $ 74,333 $ 6,360 $ 24,269 $ (29,076) ============== ============== ============== ============== BASIC EARNINGS (LOSS) PER SHARE DATA: Earnings (loss) per share $ 1.20 $ 0.11 $ 0.39 $ (0.49) ============== ============== ============== ============== Weighted average shares outstanding 62,170 57,411 62,335 59,399 ============== ============== ============== ============== DILUTED EARNINGS (LOSS) PER SHARE DATA: Earnings (loss) per share $ 1.18 $ 0.11 $ 0.39 $ (0.49) ============== ============== ============== ============== Weighted average shares outstanding 62,841 58,755 62,871 59,399 ============== ============== ============== ============== Cash dividends declared, per share $ 0.19 $ 0.1825 $ 0.065 $ 0.0625 ============== ============== ============== ==============
See Notes to Condensed Consolidated Financial Statements. 4 HCC Insurance Holdings, Inc. and Subsidiaries Condensed Consolidated Statements of Changes in Shareholders' Equity For the nine months ended September 30, 2002 and for the year ended December 31, 2001 (unaudited, in thousands, except per share data) --------
Accumulated Additional other Total Common paid-in Retained comprehensive shareholders' stock capital earnings income equity --------- ---------- --------- ------------- ------------- BALANCE AS OF DECEMBER 31, 2000 $ 51,342 $ 196,999 $ 277,876 $ 4,713 $ 530,930 Net earnings -- -- 30,197 -- 30,197 Other comprehensive income -- -- -- 1,787 1,787 ------------- Comprehensive income 31,984 6,900 shares of common stock issued in public offering, net of costs 6,900 145,505 -- -- 152,405 2,715 shares of common stock issued for exercise of options, including tax benefit of $12,312 2,715 50,023 -- -- 52,738 300 shares of common stock issued for purchased companies 300 8,031 -- -- 8,331 Issuance of 114 shares of contractually issuable common stock 114 (114) -- -- -- Issuance of 67 shares of contingently issuable common stock 67 1,645 -- -- 1,712 Cash dividends declared, $0.245 per share -- -- (14,647) -- (14,647) --------- ---------- --------- ------------- ------------- BALANCE AS OF DECEMBER 31, 2001 $ 61,438 $ 402,089 $ 293,426 $ 6,500 $ 763,453 ========= ========== ========= ============= =============
See Notes to Condensed Consolidated Financial Statements. 5 HCC Insurance Holdings, Inc. and Subsidiaries Condensed Consolidated Statements of Changes in Shareholders' Equity For the nine months ended September 30, 2002 and for the year ended December 31, 2001 (unaudited, in thousands, except per share data) (continued) ------
Accumulated Additional other Total Common paid-in Retained comprehensive shareholders' stock capital earnings income equity --------- ---------- --------- ------------- ------------- BALANCE AS OF DECEMBER 31, 2001 $ 61,438 $ 402,089 $ 293,426 $ 6,500 $ 763,453 Net earnings -- -- 74,333 -- 74,333 Other comprehensive income -- -- -- 16,588 16,588 ------------- Comprehensive income 90,921 753 shares of common stock issued for exercise of options, including tax benefit of $2,982 753 12,267 -- -- 13,020 Issuance of 103 shares of contractually issuable common stock 103 (103) -- -- -- Cash dividends declared, $0.19 per share -- -- (11,813) -- (11,813) --------- ---------- --------- ------------- ------------- BALANCE AS OF SEPTEMBER 30, 2002 $ 62,294 $ 414,253 $ 355,946 $ 23,088 $ 855,581 ========= ========== ========= ============= =============
See Notes to Condensed Consolidated Financial Statements. 6 HCC Insurance Holdings, Inc. and Subsidiaries --------- Condensed Consolidated Statements of Cash Flows (unaudited, in thousands)
For the nine months ended For the three months ended September 30, September 30, 2002 2001 2002 2001 ----------- ----------- ----------- ----------- Cash flows from operating activities: Net earnings (loss) $ 74,333 $ 6,360 $ 24,269 $ (29,076) Adjustments to reconcile net earnings (loss) to net cash provided by operating activities: Change in premium, claims and other receivables (52,440) (100,469) (14,989) (48,720) Change in reinsurance recoverables 52,969 (190,056) 22,933 (136,645) Change in ceded unearned premium (63,893) 16,284 (24,583) 11,659 Change in other assets 13,445 (16,375) 4,380 (21,825) Change in loss and loss adjustment expense payable (46,305) 266,322 (11,141) 209,055 Change in reinsurance balances payable 58,412 (18,258) 19,953 4,763 Change in unearned premium 100,800 2,626 32,421 (12,653) Change in premium and claims payable, net of restricted cash (16,865) 82,763 24,513 60,607 Gains on dispositions -- (8,171) -- (8,171) Depreciation, amortization and impairments 7,933 29,782 2,555 20,483 Other, net (5,561) 11,168 (4,165) 15,963 ----------- ----------- ----------- ----------- Cash provided by operating activities 122,828 81,976 76,146 65,440 Cash flows from investing activities: Sales of fixed income securities 197,466 88,621 43,302 17,493 Maturity or call of fixed income securities 32,951 25,843 13,260 5,189 Sales of equity securities 3,417 11,960 -- 9,489 Other proceeds -- 1,042 -- 1,042 Change in short-term investments 55,867 (148,364) 14,365 (170,125) Cost of securities acquired (412,521) (187,383) (125,421) (51,871) Purchases of property and equipment (3,948) (4,637) (1,110) (1,646) ----------- ----------- ----------- ----------- Cash used by investing activities (126,768) (212,918) (55,604) (190,429) Cash flows from financing activities: Issuance of notes payable 40,000 168,058 -- 168,058 Sale of common stock, net of costs 10,038 172,538 777 10,701 Payments on notes payable (15,409) (209,523) (2,140) (51,023) Dividends paid and other, net (12,831) (10,619) (3,887) (3,542) ----------- ----------- ----------- ----------- Cash provided (used) by financing activities 21,798 120,454 (5,250) 124,194 ----------- ----------- ----------- ----------- Net change in cash 17,858 (10,488) 15,292 (795) Cash at beginning of period 16,891 13,991 19,457 4,298 ----------- ----------- ----------- ----------- CASH AT END OF PERIOD $ 34,749 $ 3,503 $ 34,749 $ 3,503 =========== =========== =========== ===========
See Notes to Condensed Consolidated Financial Statements 7 HCC Insurance Holdings, Inc. and Subsidiaries --------- Notes to Condensed Consolidated Financial Statements (unaudited, in thousands) --------- (1) GENERAL INFORMATION HCC Insurance Holdings, Inc. and its subsidiaries ("we," "us" and "our") provide specialized property and casualty and accident and health insurance coverages, underwriting agency and intermediary services to commercial customers and individuals. Our lines of business include group life, accident and health; aviation; property, marine and energy; and other specialty insurance and reinsurance. We operate primarily in the United States and in the United Kingdom, although some of our operations have a broader international scope. We underwrite insurance on both a direct basis, where we insure a risk in exchange for a premium, and a reinsurance basis, where we insure all or a portion of another insurance company's risk in exchange for all or portion of the premium. We market our products both directly to customers and through a network of independent and affiliated agents and brokers. Basis of Presentation The unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and include all adjustments which are, in our opinion, necessary for a fair presentation of the results of the interim periods. All adjustments made to the interim periods are of a normal recurring nature. The condensed consolidated financial statements include the accounts of HCC Insurance Holdings, Inc. and those of its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated. The condensed consolidated financial statements for periods reported should be read in conjunction with the annual audited consolidated financial statements and related notes. The condensed consolidated balance sheet as of December 31, 2001, and the condensed consolidated statement of changes in shareholders' equity for the year then ended were derived from audited financial statements, but do not include all disclosures required by accounting principles generally accepted in the United States of America. Income Tax For the nine months ended September 30, 2002 and 2001, the income tax provision has been calculated based on an estimated effective tax rate for each of the fiscal years. The difference between our effective tax rate and the Federal statutory rate is primarily the result of state income taxes, tax exempt municipal bond interest and, in 2001, goodwill amortization. Effects of Recent Accounting Pronouncements Statement of Financial Accounting Standards ("SFAS") No. 142 entitled "Goodwill and Other Intangible Assets" was issued in June, 2001, and became effective for us on January 1, 2002. SFAS No. 142 requires goodwill to be tested for impairment at a level referred to as a reporting unit. After the initial adoption, goodwill of a reporting unit will be tested for impairment on an annual basis and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. SFAS No. 142 also requires the discontinuance of the amortization of 8 HCC Insurance Holdings, Inc. and Subsidiaries --------- Notes to Condensed Consolidated Financial Statements (unaudited, in thousands) (continued) (1) GENERAL INFORMATION, CONTINUED goodwill effective January 1, 2002 and that goodwill recognized for acquisitions which were consummated after July 1, 2001 not be amortized. During the first six months of 2002, we determined our reporting units, completed our initial goodwill impairment testing, completed our first annual impairment testing as of June 30, 2002 and determined we did not have to record an impairment charge. SFAS No. 142 is not expected to have a material effect on our financial position or cash flows. The tables below reconcile net earnings and earnings per share we reported to adjusted amounts that we would have reported had we adopted SFAS No. 142 on January 1, 2001 instead of January 1, 2002:
For the nine months ended For the three months ended September 30, September 30, 2002 2001 2002 2001 ------------- ------------- ------------- ------------- Net earnings (loss): Reported net earnings (loss) $ 74,333 $ 6,360 $ 24,269 $ (29,076) Add back goodwill amortization -- 9,162 -- 3,241 Add back license amortization -- 409 -- 96 Less tax benefit from goodwill amortization -- (819) -- (286) ------------- ------------- ------------- ------------- ADJUSTED NET EARNINGS (LOSS) $ 74,333 $ 15,112 $ 24,269 $ (26,025) ============= ============= ============= ============= Basic earnings (loss) per share: Reported basic earnings (loss) per share $ 1.20 $ 0.11 $ 0.39 $ (0.49) Add back amortization, net of tax effect -- 0.15 -- 0.05 ------------- ------------- ------------- ------------- ADJUSTED BASIC EARNINGS (LOSS) PER SHARE $ 1.20 $ 0.26 $ 0.39 $ (0.44) ============= ============= ============= ============= Diluted earnings (loss) per share: Reported diluted earnings (loss) per share $ 1.18 $ 0.11 $ 0.39 $ (0.49) Add back amortization, net of tax effect -- 0.15 -- 0.05 ------------- ------------- ------------- ------------- ADJUSTED DILUTED EARNINGS (LOSS) PER SHARE $ 1.18 $ 0.26 $ 0.39 $ (0.44) ============= ============= ============= =============
9 HCC Insurance Holdings, Inc. and Subsidiaries --------- Notes to Condensed Consolidated Financial Statements (unaudited, in thousands) (continued) (1) GENERAL INFORMATION, CONTINUED The following tables show the balances of our intangible assets, which are included in other assets on our condensed consolidated balance sheets, after our adoption of SFAS No. 142 effective January 1, 2002: Intangible assets not subject to amortization -- insurance company and other licenses $ 6,792 ============ Intangible assets subject to amortization: Gross amounts recorded $ 10,231 Less accumulated amortization (722) ------------ NET INTANGIBLE ASSETS SUBJECT TO AMORTIZATION $ 9,509 ============
Amortization of intangible assets which are subject to amortization under SFAS No. 142 amounted to $2.5 million during the first nine months of 2002. There was an insignificant amount of amortization for the same period of 2001, as substantially all of our intangible assets subject to amortization were acquired in our October 2001 acquisitions. Estimated amortization expense for 2002 and future years as of January 1, 2002 are as follows: 2002 $ 3,267 2003 2,294 2004 1,477 2005 972 2006 367 Thereafter 1,132 --------------- TOTAL $ 9,509 ===============
SFAS No. 146 entitled " Accounting for Costs Associated with Exit or Disposal Activities" was issued in July, 2002 and will become effective for us on January 1, 2003. SFAS No. 146 will spread out the reporting of expenses related to restructurings and is a change to existing guidance. The commitment to a plan to exit an activity or dispose of long-lived assets will no longer be enough to record a one-time charge for most anticipated coats. Instead, companies will record exit or disposal costs when they are incurred and can be measured at fair value and the liability will be subsequently adjusted for changes in estimated cash flow. We do not expect the adoption of SFAS No. 146 to have a material effect on our financial position, results of operations or cash flows. 10 HCC Insurance Holdings, Inc. and Subsidiaries --------- Notes to Condensed Consolidated Financial Statements (unaudited, in thousands) (continued) (1) GENERAL INFORMATION, CONTINUED Unusual Loss Events During 2001, we experienced three significant gross losses. The first loss was the September 11 terrorist attacks, which produced the largest loss to our insurance company operations in our history. At that time we recorded our initial estimates of gross and net incurred losses of $141.0 million and $35.0 million, respectively. The other two losses were the Petrobras and Total Oil Company incidents, which produced gross losses of $55.0 million and $49.0 million, respectively. Because these policies were substantially reinsured, the net losses were not material to our results of operations. Additionally, during 2002, as a result of further evaluation, we reduced our gross losses from the September 11, terrorist attacks by $21.5 million and reduced our gross losses from the Total loss by $14.0 million. The Petrobras loss was paid during 2001 and all reinsurance recoverables were collected at that time. A substantial portion of the Total Oil Company loss has been paid during 2002 and the related reinsurance recoverables have been collected. We expect the remainder to be settled during the fourth quarter of 2002. During the first nine months of 2002 we recorded incurred losses in the amount of $7.7 million related to certain business included in discontinued lines. This business was acquired as part of our purchase of Centris in 1999 and was subsequently sold. The business was of the type that we have not historically written. Other Information During September, 2001 we recorded several charges totaling $37.3 million related to our primary workers' compensation line of business. Included in this charge was $15.0 million related to the impairment of goodwill associated with the primary workers' compensation line of business. Reclassifications Certain amounts in our 2001 condensed consolidated financial statements have been reclassified to conform to the 2002 presentation. Such reclassifications had no effect on our net earnings, shareholders' equity or cash flows. (2) STRATEGIC INVESTMENTS AND ACQUISITIONS SureTec Financial Corp. During September, 2002, we invested a total of $5.0 million in SureTec Financial Corp. The investment consisted of a combination of a 23% equity interest and a $2.5 million note receivable and will provide SureTec with additional capital for its insurance company subsidiary, SureTec Insurance Company. We will use the equity method of accounting for our equity investment in SureTec. SureTec is a Houston based property and casualty insurance holding company whose subsidiaries specialize in underwriting contract surety and providing other related services to the construction industry, primarily in Texas. Recently, A.M. Best Company assigned an initial rating of A- (Excellent) to SureTec Insurance Company based upon the expertise of SureTec's management and in anticipation of this additional capital contribution. 11 HCC Insurance Holdings, Inc. and Subsidiaries -------- Notes to Condensed Consolidated Financial Statements (unaudited, in thousands) (continued) (2) STRATEGIC INVESTMENTS AND ACQUISITIONS, CONTINUED MAG Global Financial Products, LLC During October 2002, we completed the acquisition of all of the outstanding shares of a specialty underwriting agency, MAG Global Financial Products, LLC ("MAG"). This business combination will be recorded using the purchase method of accounting. The agency is a leader in the directors and officers liability line of business and was acquired to expand our agency operations and provide us an entry into underwriting that line of business. It has a profitable history, a market leadership position and a workforce with significant expertise and reputation to justify any goodwill to be recorded. The results of operations will be included in our consolidated financial statements beginning on the effective date of the acquisition. Total consideration paid in October was $6.2 million which approximates the stockholders' equity of MAG based on generally accepted accounting principles in the United States of America. Initial consideration will be adjusted to actual stockholders' equity during the fourth quarter of 2002 after MAG's financial statements as of the acquisition date are finalized. Additional payments to the sellers are due based on MAG's pre-tax earnings from the acquisition date through September 30, 2007. Although the purchase accounting for the acquisition has not been finalized, we do not expect significant intangible assets to result from the acquisition. Any goodwill ultimately recorded will be deductible for U.S. Federal income tax purposes. (3) REINSURANCE In the normal course of business our insurance companies cede a portion of their premium to non-affiliated domestic and foreign reinsurers through treaty and facultative reinsurance agreements. Although the ceding of reinsurance does not discharge the primary insurer from liability to its policyholders, our insurance companies participate in such agreements for the purpose of limiting their loss exposure, protecting them against catastrophic loss and diversifying their business. The following table represents the effect of such reinsurance transactions on premium and loss and loss adjustment expense:
Loss and Loss Written Earned Adjustment Premium Premium Expense --------------- --------------- --------------- For the nine months ended September 30, 2002: Direct business $ 674,258 $ 586,386 $ 389,359 Reinsurance assumed 177,826 162,304 71,321 Reinsurance ceded (449,856) (386,291) (239,434) --------------- --------------- --------------- NET AMOUNTS $ 402,228 $ 362,399 $ 221,246 =============== =============== ===============
12 HCC Insurance Holdings, Inc. and Subsidiaries -------- Notes to Condensed Consolidated Financial Statements (unaudited, in thousands) (continued) (3) REINSURANCE, CONTINUED
Loss and Loss Written Earned Adjustment Premium Premium Expense --------------- --------------- --------------- For the nine months ended September 30, 2001: Direct business $ 604,433 $ 600,363 $ 498,344 Reinsurance assumed 162,174 160,316 359,085 Reinsurance ceded (495,343) (511,599) (641,286) --------------- --------------- --------------- NET AMOUNTS $ 271,264 $ 249,080 $ 216,143 =============== =============== =============== For the three months ended September 30, 2002: Direct business $ 237,478 $ 208,300 $ 128,201 Reinsurance assumed 60,986 57,308 42,055 Reinsurance ceded (153,898) (129,314) (85,093) --------------- --------------- --------------- NET AMOUNTS $ 144,566 $ 136,294 $ 85,163 =============== =============== =============== For the three months ended September 30, 2001: Direct business $ 199,047 $ 203,301 $ 223,449 Reinsurance assumed 43,852 51,240 202,920 Reinsurance ceded (149,724) (161,070) (307,195) --------------- --------------- --------------- NET AMOUNTS $ 93,175 $ 93,471 $ 119,174 =============== =============== ===============
13 HCC Insurance Holdings, Inc. and Subsidiaries -------- Notes to Condensed Consolidated Financial Statements (unaudited, in thousands) (continued) (3) REINSURANCE, CONTINUED The table below represents the composition of reinsurance recoverables in our condensed consolidated balance sheets:
September 30, 2002 December 31, 2001 ------------------ ------------------ Reinsurance recoverable on paid losses $ 129,154 $ 86,653 Reinsurance recoverable on outstanding losses 331,643 414,428 Reinsurance recoverable on incurred but not reported losses 394,950 403,223 Reserve for uncollectible reinsurance (9,588) (5,176) ------------------ ------------------ TOTAL REINSURANCE RECOVERABLES $ 846,159 $ 899,128 ================== ==================
The tables below present the calculation of net reserves, net unearned premium and net deferred policy acquisition costs:
September 30, 2002 December 31, 2001 ------------------ ------------------ Loss and loss adjustment expense payable $ 1,084,443 $ 1,130,748 Reinsurance recoverable on outstanding losses (331,643) (414,428) Reinsurance recoverable on incurred but not reported losses (394,950) (403,223) ------------------ ------------------ NET RESERVES $ 357,850 $ 313,097 ================== ================== Unearned premium $ 280,330 $ 179,530 Ceded unearned premium (135,033) (71,140) ------------------ ------------------ NET UNEARNED PREMIUM $ 145,297 $ 108,390 ================== ================== Deferred policy acquisition costs $ 61,916 $ 32,071 Deferred ceding commissions (41,762) (16,681) ------------------ ------------------ NET DEFERRED POLICY ACQUISITION COSTS $ 20,154 $ 15,390 ================== ==================
14 HCC Insurance Holdings, Inc. and Subsidiaries -------- Notes to Condensed Consolidated Financial Statements (unaudited, in thousands) (continued) (3) REINSURANCE, CONTINUED Our insurance companies require their reinsurers not authorized by the respective states of domicile of our insurance companies to collateralize the reinsurance obligations due to us. The table below shows amounts held by us as collateral plus other credits available for potential offset.
September 30, 2002 December 31, 2001 ------------------ ----------------- Payables to reinsurers $ 207,171 $ 199,581 Letters of credit 145,805 145,796 Cash deposits 11,691 14,851 ------------------ ----------------- TOTAL CREDITS $ 364,667 $ 360,228 ================== =================
We have a reserve of $9.6 million as of September 30, 2002 for potential collectibility issues related to reinsurance recoverables and associated expenses. The reserve for uncollectible reinsurance increased due to provisions of $5.3 million and $1.6 million for the nine and three months, respectively, ended September 30, 2002. The adverse economic environment in the worldwide insurance industry in recent years and the terrorist attacks on September 11, 2001 have placed great pressure on reinsurers and the results of their operations. Ultimately, these conditions could affect reinsurers' solvency. Historically, there have been insolvencies following a period of competitive pricing in the industry, such as the marketplace has experienced for the last several years. While we believe that our overall reserve is adequate based on currently available information, conditions may change or additional information might be obtained which may result in a future change in the reserve. We periodically review our financial exposure to the reinsurance market and the level of our reserve and continue to take actions in an attempt to mitigate our risk. A number of reinsurers have delayed or suspended the payment of amounts recoverable under certain reinsurance contracts to which we are a party. Such delays have affected, although not materially to date, the investment income of our insurance companies, but not to any extent their liquidity. We limit our liquidity exposure by holding funds, letters of credit or other security such that net balances due to us are significantly less than the gross balances shown in our consolidated balance sheets. In some instances, the reinsurers have withheld payment without reference to a substantive basis for the delay or suspension. In other cases, the reinsurers have claimed they are not liable for payment to us of all or part of the amounts due under the applicable reinsurance agreement. We believe these claims are without merit and expect to collect a substantial portion of the amounts recoverable. We are currently in negotiations with most of these parties, but if such negotiations do not result in a satisfactory resolution of the matters in question, we may seek or be involved in a judicial or arbitral determination of these matters. In some cases, the final resolution of such disputes through arbitration or litigation may extend over several years. 15 HCC Insurance Holdings, Inc. and Subsidiaries -------- Notes to Condensed Consolidated Financial Statements (unaudited, in thousands) (continued) (3) REINSURANCE, CONTINUED In this regard, as of September 30, 2002, our insurance companies had initiated three litigation or arbitration proceedings against reinsurers and were involved in one arbitration proceeding initiated by a reinsurer. These proceedings primarily concern the collection of amounts owing under reinsurance agreements. As of such date, our insurance companies had an aggregate amount of $16.2 million which had not been paid to us under the agreements and we estimate that there could be up to an additional $14.3 million of incurred losses and loss expenses and other balances due under the subject agreements. During the nine months ended September 30, 2002, we negotiated the settlement of two arbitrations with reinsurers under which the reinsurers agreed to pay the full amounts due to us, which we estimate to be $27.5 million in the aggregate. In addition, because our insurance companies, principally Houston Casualty Company, participated in facilities or pools of companies which were managed by one of our underwriting agencies, they are indirectly involved in any proceedings involving collections which affect the applicable facilities or pools of companies. As of September 30, 2002, Houston Casualty Company's allocated portion of these actions was $3.0 million and we estimate that there could be up to an additional $2.4 million of incurred losses and loss expenses. Neither Houston Casualty Company nor its affiliated underwriting agency has any net exposure on the portion of the amounts which are due to the non-affiliated companies who also participated in the applicable facilities or pool of companies. (4) SEGMENT AND GEOGRAPHIC INFORMATION The performance of each segment is evaluated based upon net earnings and is calculated after tax and after all corporate expense allocations, purchase price allocations and intercompany eliminations have been charged or credited to the individual segments. The following tables show information by business segment and geographic location. Geographic location is determined by physical location of our offices and does not represent the location of insureds or reinsureds from whom the business was generated. Effective January 1, 2001 and 2002, we consolidated the operations of three and one of our underwriting agencies, respectively, into the operations of our insurance companies. Policies incepting on or after the effective dates, along with associated expenses, will be reported in the insurance company segment. The administration of all policies incepting before the effective dates, which are now in run off, along with associated expenses, will continue to be reported in the underwriting agency segment. This consolidation will affect the comparability of segment information between periods. SFAS No. 142, which we adopted effective January 1, 2002, required the discontinuance of the amortization of goodwill and indefinite lived intangible assets on a prospective basis. This will affect the comparability of certain segment information between periods. Pro forma segment information is shown in the tables for the nine and three months ended September 30, 2001, as if we had adopted SFAS No. 142 as of January 1, 2001. 16 HCC Insurance Holdings, Inc. and Subsidiaries -------- Notes to Condensed Consolidated Financial Statements (unaudited, in thousands) (continued) (4) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED
Insurance Underwriting Other Company Agency Intermediary Operations Corporate Total ----------- ------------ ------------ ---------- --------- --------- For the nine months ended September 30, 2002: Revenue: Domestic $ 324,746 $ 58,918 $ 18,535 $ 1,335 $ 774 $ 404,308 Foreign 64,648 510 13,827 -- -- 78,985 Inter-segment -- 20,457 746 -- -- 21,203 ----------- --------- --------- --------- --------- --------- TOTAL SEGMENT REVENUE $ 389,394 $ 79,885 $ 33,108 $ 1,335 $ 774 504,496 =========== ========= ========= ========= ========= Inter-segment revenue (21,203) --------- CONSOLIDATED TOTAL REVENUE $ 483,293 ========= Net earnings: Domestic $ 42,873 $ 17,270 $ 4,658 $ 750 $ 1,309 $ 66,860 Foreign 5,137 300 2,406 -- -- 7,843 ----------- --------- --------- --------- --------- --------- TOTAL SEGMENT NET EARNINGS $ 48,010 $ 17,570 $ 7,064 $ 750 $ 1,309 74,703 =========== ========= ========= ========= ========= Inter-segment eliminations (370) --------- CONSOLIDATED NET EARNINGS $ 74,333 ========= Other items: Net investment income $ 24,713 $ 2,144 $ 731 $ 376 $ 159 $ 28,123 Depreciation and amortization 2,241 4,585 256 77 774 7,933 Interest expense (benefit) 127 5,748 1,931 -- (914) 6,892 Capital expenditures 1,510 1,155 1,041 -- 242 3,948 Income tax provision 23,375 11,682 5,165 364 631 41,217 Inter-segment eliminations (189) --------- CONSOLIDATED INCOME TAX PROVISION $ 41,028 =========
During the first nine months of 2002, the insurance company segment recorded a charge of $5.0 million (net of income tax) related to a discontinued line of business. 17 HCC Insurance Holdings, Inc. and Subsidiaries -------- Notes to Condensed Consolidated Financial Statements (unaudited, in thousands) (continued) (4) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED
Insurance Underwriting Other Company Agency Intermediary Operations Corporate Total ----------- ------------ ------------ ----------- ----------- ----------- For the nine months ended September 30, 2001: Revenue: Domestic $ 242,219 $ 46,402 $ 18,184 $ 14,374 $ 715 $ 321,894 Foreign 31,363 1,561 18,451 -- -- 51,375 Inter-segment -- 15,585 395 1,954 -- 17,934 ----------- ----------- ----------- ----------- ----------- ----------- TOTAL SEGMENT REVENUE $ 273,582 $ 63,548 $ 37,030 $ 16,328 $ 715 391,203 =========== =========== =========== =========== =========== Inter-segment revenue (17,934) ----------- CONSOLIDATED TOTAL REVENUE $ 373,269 =========== Net earnings (loss): Domestic $ (15,823) $ 12,184 $ 3,454 $ 6,746 $ 764 $ 7,325 Foreign (5,530) 808 2,766 -- -- (1,956) ----------- ----------- ----------- ----------- ----------- ----------- TOTAL SEGMENT NET EARNINGS (LOSS) $ (21,353) $ 12,992 $ 6,220 $ 6,746 $ 764 5,369 =========== =========== =========== =========== =========== Inter-segment eliminations 991 ----------- CONSOLIDATED NET EARNINGS $ 6,360 =========== SFAS No. 142 pro forma adjustments: Net effect of goodwill and intangible asset amortization $ 1,623 $ 4,494 $ 2,635 $ -- $ -- $ 8,752 ----------- ----------- ----------- ----------- ----------- ----------- Pro forma segment net earnings (loss) $ (19,730) $ 17,486 $ 8,855 $ 6,746 $ 764 14,121 =========== =========== =========== =========== =========== Inter-segment eliminations 991 ----------- PRO FORMA CONSOLIDATED NET EARNINGS $ 15,112 =========== Other items: Net investment income $ 23,248 $ 4,305 $ 2,336 $ 73 $ 651 $ 30,613 Depreciation, amortization and impairments 19,295 6,903 2,918 203 463 29,782 Interest expense 33 3,466 2,803 12 317 6,631 Capital expenditures 2,380 480 903 107 767 4,637 Income tax provision (benefit) (6,282) 10,865 4,552 4,052 2,352 15,539 Inter-segment eliminations 606 ----------- CONSOLIDATED INCOME TAX PROVISION $ 16,145 ===========
During the first nine months of 2001, the insurance company segment recorded two large unusual items: 1) a $22.8 million (net of income tax) loss due to the terrorist attacks on September 11 and 2) a $29.4 million charge (net of income tax) related to lines of business being exited. Of the latter amount, $15.0 million was an impairment of goodwill which was not deductible for income tax purposes. 18 HCC Insurance Holdings, Inc. and Subsidiaries -------- Notes to Condensed Consolidated Financial Statements (unaudited, in thousands) (continued) (4) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED
Insurance Underwriting Other Company Agency Intermediary Operations Corporate Total ----------- ------------ ------------ ---------- --------- --------- For the three months ended September 30, 2002: Revenue: Domestic $ 114,667 $ 19,001 $ 6,033 $ 730 $ (16) $ 140,415 Foreign 30,700 (81) 4,638 -- -- 35,257 Inter-segment -- 7,579 391 -- -- 7,970 ----------- --------- --------- --------- --------- --------- TOTAL SEGMENT REVENUE $ 145,367 $ 26,499 $ 11,062 $ 730 $ (16) 183,642 =========== ========= ========= ========= ========= Inter-segment revenue (7,970) --------- CONSOLIDATED TOTAL REVENUE $ 175,672 ========= Net earnings: Domestic $ 12,634 $ 5,871 $ 1,774 $ 455 $ 13 $ 20,747 Foreign 2,397 43 1,138 -- -- 3,578 ----------- --------- --------- --------- --------- --------- TOTAL SEGMENT NET EARNINGS $ 15,031 $ 5,914 $ 2,912 $ 455 $ 13 24,325 =========== ========= ========= ========= ========= Inter-segment eliminations (56) --------- CONSOLIDATED NET EARNINGS $ 24,269 ========= Other items: Net investment income $ 8,739 $ 814 $ 267 $ 155 $ (30) $ 9,945 Depreciation and amortization 723 1,474 86 11 261 2,555 Interest expense (benefit) 54 1,868 643 -- (514) 2,051 Capital expenditures 503 355 346 -- (94) 1,110 Income tax provision (benefit) 7,361 4,377 1,584 312 (161) 13,473 Inter-segment eliminations (11) --------- CONSOLIDATED INCOME TAX PROVISION $ 13,462 =========
During the third quarter of 2002, the insurance company segment recorded a charge of $5.0 million (net of income tax) related to a discontinued line of business. 19 HCC Insurance Holdings, Inc. and Subsidiaries -------- Notes to Condensed Consolidated Financial Statements (unaudited, in thousands) (continued) (4) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED
Insurance Underwriting Other Company Agency Intermediary Operations Corporate Total ----------- ------------ ------------ ---------- --------- --------- For the three months ended September 30, 2001: Revenue: Domestic $ 88,015 $ 14,610 $ 5,220 $ 9,953 $ 617 $ 118,415 Foreign 14,061 240 4,905 -- -- 19,206 Inter-segment -- 5,152 260 665 -- 6,077 ----------- --------- --------- --------- --------- --------- TOTAL SEGMENT REVENUE $ 102,076 $ 20,002 $ 10,385 $ 10,618 $ 617 143,698 =========== ========= ========= ========= ========= Inter-segment revenue (6,077) --------- CONSOLIDATED TOTAL REVENUE $ 137,621 ========= Net earnings (loss): Domestic $ (36,482) $ 4,082 $ 692 $ 5,860 $ 392 $ (25,456) Foreign (5,237) 160 1,268 -- -- (3,809) ----------- --------- --------- --------- --------- --------- TOTAL SEGMENT NET EARNINGS (LOSS) $ (41,719) $ 4,242 $ 1,960 $ 5,860 $ 392 (29,265) =========== ========= ========= ========= ========= Inter-segment eliminations 189 --------- CONSOLIDATED NET EARNINGS (LOSS) $ (29,076) ========= SFAS No. 142 pro forma adjustments: Net effect of goodwill and intangible asset amortization $ 549 $ 1,624 $ 878 $ -- $ -- $ 3,051 ----------- --------- --------- --------- --------- --------- Pro forma segment net earnings (loss) $ (41,170) $ 5,866 $ 2,838 $ 5,860 $ 392 (26,214) =========== ========= ========= ========= ========= Inter-segment eliminations 189 --------- PRO FORMA CONSOLIDATED NET EARNINGS (LOSS) $ (26,025) ========= Other items: Net investment income $ 7,924 $ 1,072 $ 619 $ 14 $ 476 $ 10,105 Depreciation, amortization and impairments 16,561 2,618 971 94 239 20,483 Interest expense (benefit) 16 964 769 12 (291) 1,470 Capital expenditures 702 29 534 41 340 1,646 Income tax provision (benefit) (15,187) 3,644 234 3,498 1,004 (6,807) Inter-segment eliminations 129 --------- CONSOLIDATED INCOME TAX PROVISION (BENEFIT) $ (6,678) =========
During the third quarter of 2001, the insurance company segment recorded two large unusual items: 1) a $22.8 million (net of income tax) loss due to the terrorist attacks on September 11 and 2) a $29.4 million charge (net of income tax) related to lines of business being exited. Of the latter amount, $15.0 million was an impairment of goodwill which was not deductible for income tax purposes. 20 HCC Insurance Holdings, Inc. and Subsidiaries -------- Notes to Condensed Consolidated Financial Statements (unaudited, in thousands) (continued) (4) SEGMENT AND GEOGRAPHIC INFORMATION, CONTINUED The following tables present revenue by line of business within each operating segment for the periods indicated:
For the nine months ended For the three months ended September 30, September 30, 2002 2001 2002 2001 ----------- ----------- ----------- ----------- Insurance company: Group life, accident and health $ 214,595 $ 137,369 $ 85,484 $ 50,716 Aviation 76,599 65,675 25,845 23,397 Property, marine and energy 27,795 15,640 10,636 6,503 Other specialty lines of business 27,364 10,831 11,105 4,007 ----------- ----------- ----------- ----------- Subtotal 346,353 229,515 133,070 84,623 Discontinued lines of business 16,046 19,565 3,224 8,848 ----------- ----------- ----------- ----------- TOTAL NET EARNED PREMIUM $ 362,399 $ 249,080 $ 136,294 $ 93,471 =========== =========== =========== =========== Underwriting agency: Group life, accident and health $ 36,347 $ 36,519 $ 11,321 $ 11,493 Property and casualty 20,705 7,149 6,736 2,540 ----------- ----------- ----------- ----------- TOTAL MANAGEMENT FEES $ 57,052 $ 43,668 $ 18,057 $ 14,033 =========== =========== =========== =========== Intermediary: Group life, accident and health $ 24,373 $ 26,621 $ 7,893 $ 7,118 Property and casualty 7,258 7,678 2,510 2,389 ----------- ----------- ----------- ----------- TOTAL COMMISSION INCOME $ 31,631 $ 34,299 $ 10,403 $ 9,507 =========== =========== =========== ===========
Goodwill assigned to our operating segments after our adoption of SFAS No. 142 effective January 1, 2002 was as follows: Insurance company $ 130,504 Underwriting agency 107,598 Intermediary 77,216 ------------ TOTAL GOODWILL $ 315,318 ============
21 HCC Insurance Holdings, Inc. and Subsidiaries -------- Notes to Condensed Consolidated Financial Statements (unaudited, in thousands) (continued) (5) EARNINGS PER SHARE Basic earnings per share is based on the weighted average number of common shares outstanding during the period divided into net earnings. Diluted earnings per share is based on the weighted average number of common shares outstanding plus the potential common shares outstanding during the period divided into net earnings. Outstanding common stock options, when dilutive, are considered to be potential common shares for the purpose of the diluted calculation. The treasury stock method is used to calculate potential common shares due to options. Contingent shares to be issued are included in the earnings per share computation only when the underlying conditions for issuance have been met. The following table provides a reconciliation of the denominators used in the earnings per share calculations:
For the nine months ended For the three months ended September 30, September 30, 2002 2001 2002 2001 ------------ ------------ ------------ ------------ Net earnings (loss) $ 74,333 $ 6,360 $ 24,269 $ (29,076) ============ ============ ============ ============ Reconciliation of shares outstanding: Shares of common stock outstanding at period end 62,294 59,791 62,294 59,791 Effect of common shares issued during the period (176) (2,563) (11) (575) Contingent shares to be issued -- 28 -- 28 Common shares contractually issuable in the future 52 155 52 155 ------------ ------------ ------------ ------------ Weighted average common shares outstanding 62,170 57,411 62,335 59,399 Additional dilutive effect of outstanding options (as determined by the application of the treasury stock method) 671 1,344 536 -- ------------ ------------ ------------ ------------ Weighted average shares and potential common shares outstanding 62,841 58,755 62,871 59,399 ============ ============ ============ ============ Anti-dilutive shares not included in computation 415 158 1,216 1,360 ============ ============ ============ ============
22 HCC Insurance Holdings, Inc. and Subsidiaries -------- Notes to Condensed Consolidated Financial Statements (unaudited, in thousands) (continued) (6) SUPPLEMENTAL INFORMATION Supplemental information is summarized below:
For the nine months ended For the three months ended September 30, September 30, 2002 2001 2002 2001 ------------- ------------- ------------- ------------- Interest paid $ 4,568 $ 7,776 $ 2,151 $ 491 Income tax paid 23,045 27,171 10,025 18,574 Comprehensive income (loss) 90,921 12,688 35,789 (25,557) Ceding commissions netted with policy acquisition costs 102,822 146,456 36,658 45,818
(7) NOTES PAYABLE The table below shows the composition of our notes payable as shown in our condensed consolidated balance sheet.
September 30, 2002 December 31, 2001 ------------------ ----------------- 2% Convertible notes $ 172,451 $ 172,500 Bank facility 30,000 -- Acquisition notes 961 3,365 Mortgage note and other 3,617 6,063 ---------------- --------------- TOTAL NOTES PAYABLE $ 207,029 $ 181,928 ================ ===============
During April 2002, we drew down $40.0 million on our bank facility as partial funding for a $50.0 million capital contribution to our largest insurance company, Houston Casualty Company, to support its growth and increased business opportunities. Since that time, we have repaid $10.0 million on our bank facility using funds generated from operating cash flows. As of September 30, 2002, the weighted average interest rate on our bank facility outstanding debt was 2.8%. Under the terms of the related indenture agreement, our outstanding 2% convertible notes could have been put, or sold back, to us on September 1, 2002 at the option of the note holders. On September 4, 2002, we paid $49,000 in cash for the notes which were so tendered. Under the indenture agreement, the next available date for the remaining noteholders to exercise their put rights is September 1, 2004. 23 HCC Insurance Holdings, Inc. and Subsidiaries -------- Notes to Condensed Consolidated Financial Statements (unaudited, in thousands) (continued) (8) COMMITMENTS AND CONTINGENCIES In addition to the matters discussed in Note (3), Reinsurance, we are party to numerous lawsuits and other proceedings that arise in the normal course of our business. Many of these lawsuits 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 party to lawsuits and other proceedings which relate to disputes over contractual relationships with third parties, or which involve alleged errors and omissions on the part of our subsidiaries. In addition, we are presently engaged in litigation initiated by the appointed liquidator of a former reinsurer concerning payments made to us prior to the date of the appointment of the liquidator. The disputed payments were made by the now insolvent reinsurer in connection with a commutation agreement. Our understanding is that such litigation is one of a number of similar actions brought by the liquidator. We intend to vigorously contest the action. We believe the resolution of the lawsuits in which we are a party will not have a material adverse effect on our financial position, results of operations or cash flows. 24 MANAGEMENT'S DISCUSSION AND ANALYSIS Statement of Financial Accounting Standards ("SFAS") No. 142 entitled "Goodwill and Other Intangible Assets" became effective for us on January 1, 2002 and required the discontinuance of the amortization of goodwill and indefinite lived intangible assets on a prospective basis. This will affect the comparability of financial results between periods. See "Effects of Recent Accounting Pronouncements" for additional information. NINE MONTHS ENDED SEPTEMBER 30, 2002 VERSUS NINE MONTHS ENDED SEPTEMBER 30, 2001 Results of Operations Total revenue increased 29% to $483.3 million for the first nine months of 2002 from $373.3 million for the same period in 2001. The revenue increase in the insurance company segment resulted from organic growth in our existing lines of business, the addition of new specialty lines of business and increased retention levels. The revenue in the underwriting agency segment increased due to organic growth and two acquisitions made in late 2001, but was offset by reduced revenue in the intermediary and other operations segments as a result of market conditions and the sale or other disposition of various operations in 2001. Net investment income decreased to $28.1 million for the first nine months of 2002 from $30.6 million for the same period in 2001. This decrease was due to the decrease in interest rates partially offset by the higher level of invested assets which resulted from cash flow provided by operating activities and capital contributions made to our insurance company segment. Although we expect investment assets to continue to increase, investment income is unlikely to show much growth until interest rates rise. Compensation expense increased to $58.7 million during the first nine months of 2002 from $51.1 million for the same period in 2001. Much of this increase was due to the two underwriting agency subsidiaries acquired in late 2001, somewhat offset by a decrease from operations sold or otherwise disposed of during the same period. The first nine months of 2001 were adversely affected as we experienced the largest loss to our insurance company operations in our history due to the terrorist attack on September 11, with incurred net losses of $35.0 million. In 2001, we also recorded a charge totaling $37.3 million related to our primary workers' compensation line of business and other lines that we had decided to cease writing. Included in this charge was $15.0 million related to the impairment of goodwill associated with the primary workers' compensation line of business. Other operating expense decreased to $36.6 million during the first nine months of 2002 compared to the $55.3 million for the same period in 2001. As compared to the prior period, current expense increased as a result of the two acquisitions made in 2001 and the increase in the provision for uncollectible reinsurance, offset by the reduction in the amortization of goodwill, operations sold or disposed of and the charge for lines of business being exited in 2001. Interest expense was $6.9 million for the first nine months of 2002 compared to $6.6 million for the same period in 2001. Included in the current period is $2.9 million representing the amortization of underwriting discounts and other costs of our August 2001 issuance of 2% convertible notes. These costs were fully amortized by the end of August 2002. Income tax expense was $41.0 million for the first nine months of 2002 compared to $16.1 million for the same period in 2001. Our effective tax rate was 35.6% in the current period. The unusual tax rate for 2001 results from the write off related to the impairment of goodwill, which was not deductible for income tax purposes. Net earnings increased to $74.3 million, or $1.18 per diluted share, for the first nine months of 2002 from $6.4 million, or $0.11 per diluted share, for the same period in 2001. The increase in net earnings resulted from increased revenue and an improved underwriting performance by the insurance company segment, net of a charge in 2002 related to a discontinued line of business ($5.0 million or $0.08 per share). Other events affecting the comparison include losses from the September 11 terrorist attacks recorded during 2001 ($22.8 million or $0.39 per share), the charge for lines of business being 25 exited during 2001 ($29.6 million or $0.50 per share) and from the non-amortization of goodwill in accordance with SFAS No. 142 ($8.8 million or $0.15 per share). Our book value per share was $13.72 as of September 30, 2002, up from $12.40 as of December 31, 2001. Net earnings and the unrealized gain on available for sale securities contributed to the increase in book value per share. SEGMENTS Insurance Companies The following tables provide information by line of business (in thousands):
Gross Net Net Net written written earned loss premium premium premium ratio ------------ ------------ ------------ --------- For the nine months ended September 30, 2002: Group life, accident and health $ 461,699 $ 220,803 $ 214,595 62.8% Aviation 153,908 75,741 76,599 51.5 Property, marine and energy 98,379 57,443 27,795 23.9 Other specialty lines of business 130,147 41,847 27,364 76.5 ------------ ------------ ------------ --------- Subtotal 844,133 395,834 346,353 58.3 Discontinued lines of business 7,951 6,394 16,046 120.9 ------------ ------------ ------------ --------- TOTALS $ 852,084 $ 402,228 $ 362,399 61.1% ============ ============ ============ Expense ratio 26.2 --------- Combined ratio 87.3% ========= For the nine months ended September 30, 2001: Group life, accident and health $ 474,695 $ 139,379 $ 137,369 86.2% Aviation 137,123 67,460 65,675 65.0 Property, marine and energy 65,825 22,906 15,640 61.2 Other specialty lines of business 11,285 10,075 10,831 81.3 ------------ ------------ ------------ --------- Subtotal 688,928 239,820 229,515 78.2 Discontinued lines of business 77,679 31,444 19,565 187.9 ------------ ------------ ------------ --------- TOTALS $ 766,607 $ 271,264 $ 249,080 86.8% ============ ============ ============ Expense ratio 26.2 --------- Combined ratio 113.0% =========
26 Gross written premium increased 11% to $852.1 million for the first nine months of 2002 from $766.6 million for the same period in 2001. This increase was 23% before the reduction due to discontinued lines of business. The increase resulted from organic growth and premium rate increases in our aviation and property, marine and energy lines of business, plus other specialty lines of business not previously written, offset by the decrease in discontinued lines. Gross written premium is expected to continue to increase into 2003. Net written premium for the first nine months of 2002 increased 48% to $402.2 million from $271.3 million for the same period in 2001, as our insurance companies have increased retentions on the group life, accident and health and the property, marine and energy segments, in addition to the effect of the changes in gross premium described above. Net earned premium also increased 45% to $362.4 million for the same reasons. Increases in net written and net earned premiums were 65% and 51%, respectively, before the reduction in discontinued lines of business. Increases in net written and net earned premium are expected to continue. Loss and loss adjustment expense was $221.2 million for the first nine months of 2002 compared to $216.1 million for the same period in 2001. The 2001 net loss expense included $35.0 million from the September 11 terrorist attacks and $18.8 million from the charge for lines of business being exited. Prior year net reserve redundancies included in loss and loss adjustment expense approximated $4.1 million and $6.9 million for the first nine months of 2002 and 2001, respectively. The redundancies resulted from the settlement of claims for less than amounts previously reserved. Because of these items, and generally better underwriting results in 2002 as a result of higher pricing and improved policy terms and conditions, the net loss ratio was greatly improved at 61.1% for the first nine months of 2002 compared to 86.8% for the same period in 2001, on substantially increased earned premiums. During the first nine months of 2002 we also recorded incurred losses in the amount of $7.7 million related to certain business included in discontinued lines. This business was acquired as part of our purchase of Centris in 1999 and was subsequently sold. The business was of a type that we have not historically written. Based on our current evaluations, we do not expect any further development from this business in future periods. The gross loss ratio was 61.5% in the first nine months of 2002 compared to 112.7% for the same period in 2001. During the first nine months of 2001, we recorded gross losses of $55.0 million due to the Petrobras production platform, $141.0 million due to the September 11 terrorist attacks and $49.0 million due to the Total Oil Company loss. Additionally, in 2002, as a result of further evaluation, we reduced our gross losses from the September 11 terrorist attacks by $21.5 million and reduced the gross losses from the Total loss by $14.0 million. 27 The tables below show the composition of net and gross incurred loss and loss adjustment expense (amounts in thousands):
Net Incurred Loss and Loss Adjustment Expense 2002 2001 ----------------------------- -------------------------------- Amount Loss Ratio Amount Loss Ratio ------------- ------------ ------------- ------------ September 11 terrorist attacks $ -- -- % $ 35,000 14.1% 2001 workers' compensation exit charge -- -- 18,799 7.5 2002 discontinued line charge 7,674 2.1 -- -- All other incurred loss and loss adjustment expense 213,572 59.0 162,344 65.2 -------------- ----------- ------------- ----------- Net incurred loss and loss adjustment expense $ 221,246 61.1% $ 216,143 86.8% ============== =========== ============= ===========
Gross Incurred Loss and Loss Adjustment Expense 2002 2001 ----------------------------- -------------------------------- Amount Loss Ratio Amount Loss Ratio ------------- ------------ ------------- ------------ September 11 terrorist attacks $ (21,500) (2.9)% $ 140,962 18.5% Petrobras production platform -- -- 55,000 7.2 Total Oil Company loss (14,000) (1.9) 49,000 6.5 2001 workers' compensation exit charge -- -- 36,784 4.8 2002 discontinued line charge 7,674 1.0 -- -- All other incurred loss and loss adjustment expense 488,506 65.3 575,683 75.7 ------------- ------------ ------------- ----------- Gross incurred loss and loss adjustment expense $ 460,680 61.5% $ 857,429 112.7% ============= ============ ============= ===========
Policy acquisition costs, which are net of commissions on reinsurance ceded, increased to $44.5 million during the first nine months of 2002, from $21.5 million in the same period in 2001. This increase is due to the higher earned premium and the reduction in ceding commissions as a result of our retaining more business. The expense ratio was unchanged at 26.2% for the first nine months of 2002 compared to the same period in 2001. Because of our improved loss ratio, our combined ratio improved substantially to 87.3% for the first nine months of 2002, compared to 113.0% for the same period in 2001. Net earnings of our insurance companies increased to $48.0 million in the first nine months of 2002 from a net loss of $21.4 million for the same period in 2001, due to increased revenue, improved underwriting results and the charge to exit primary workers' compensation and other lines in 2001. Barring future catastrophic events, we expect this trend to continue into 2003. Only $1.6 million of the increase was due to the adoption of SFAS No. 142. Underwriting Agencies Management fees increased 31% to $57.1 million for the first nine months of 2002, compared to $43.7 million for the same period in 2001. The underwriting agencies acquired in late 2001 accounted for much of the increase, partially offset by a decrease in management fees from our other underwriting agencies as we continued the consolidation of other pre-existing underwriting agency operations into our insurance companies. Net earnings of our underwriting agencies increased to $17.6 million for the first nine months of 2002 from $13.0 million in 2001 as a result of increased revenue and the adoption of SFAS No. 142. There was $4.5 million (net of income tax) of goodwill amortization recorded in 2001. We expect further improvement in 2003 due to our recent acquisition of MAG Global Financial Products, LLC during the fourth quarter of 2002 and organic growth. Intermediaries Commission income decreased to $31.6 million for the first nine months of 2002, compared to $34.3 million for the same period in 2001 due to general market conditions and less ceded reinsurance being placed on behalf of our insurance companies as they increased their retentions. Net earnings of our intermediaries increased to $7.1 million for the first nine months of 2002 compared to $6.2 million for the same period in 2001 due to the 28 adoption of SFAS No. 142. There was $2.6 million (net of income tax) of goodwill amortization recorded in 2001. Other Operations The decrease in other operating income to $2.9 million during the first nine months of 2002 from $15.8 million for the same period in 2001 was principally from the disposition or closure of certain operations during 2001 and the resultant gains totaling $8.2 million from these dispositions. Net earnings of other operations decreased to $0.8 million in 2002 from $6.7 million in 2001 for the same reasons. Period to period comparisons may vary substantially depending on other operating investments or dispositions thereof in any given period. Recent investments and future dispositions should have a positive effect on this segment's revenue and earnings in future periods. Corporate The net income of the corporate segment was $1.3 million for the first nine months of 2002 compared to $0.8 million for the same period in 2001. This improvement resulted from the reduction of interest expense allocated to the corporate segment. THREE MONTHS ENDED SEPTEMBER 30, 2002 VERSUS THREE MONTHS ENDED SEPTEMBER 30, 2001 Results of Operations Total revenue increased 28% to $175.7 million for the third quarter of 2002 from $137.6 million for the same period in 2001. The revenue increase in the insurance company segment resulted from organic growth in our existing lines of business, the addition of new specialty lines of business, and increased retention levels. Also, the revenue in the underwriting agency segment increased due to organic growth and two acquisitions made in late 2001, but was offset by reduced revenue in the other operations segment as a result of the sale or other disposition of various operations in 2001. Net investment income for the third quarter of 2002 was flat at $9.9 million compared to $10.1 million for the same period in 2001. The lack of growth was due to the decrease in interest rates partially offset by the higher level of invested assets which resulted from cash flow provided by operating activities and capital contributions made to our insurance company segment. Although we expect investment assets to continue to increase, investment income is unlikely to show much growth until interest rates rise. Compensation expense increased to $19.2 million during the third quarter of 2002 from $15.7 million for the same period in 2001. Much of this increase was due to the two underwriting agency subsidiaries acquired in late 2001, somewhat offset by a decrease from operations sold or otherwise disposed of during the same period. The third quarter of 2001 was adversely affected as we experienced the largest loss to our insurance company operations in our history due to the terrorist attack on September 11, with incurred net losses of $35.0 million. In 2001, we also recorded a charge totaling $37.3 million related to our primary workers' compensation line of business and other lines that we had decided to cease writing. Included in this charge was $15.0 million related to the impairment of goodwill associated with the primary workers' compensation line of business. Other operating expense decreased to $12.6 million during the third quarter of 2002 compared to $27.8 million in 2001. As compared to the prior period, current expense increased as a result of the two acquisitions made in 2001 and the increase in the provision for uncollectible reinsurance, offset by the reduction in the amortization of goodwill, operations sold or disposed of and the charge for lines of business being exited in 2001. Interest expense was $2.1 million for the third quarter of 2002 compared to $1.5 million for the same period in 2001. Included in the current period is $0.7 million representing the amortization of underwriting discounts and other costs of our August 2001 issuance of 2% convertible notes. These costs were fully amortized by the end of August 2002. 29 Income tax expense was $13.5 million for the third quarter of 2002 compared to a $6.7 million tax benefit for the same period in 2001. Our effective tax rate was 35.7% in the current period. The unusual tax rate for 2001 results from the impairment of goodwill, which was not deductible for income tax purposes. Net earnings increased to $24.3 million, or $0.39 per diluted share, for the third quarter of 2002 from a loss of $29.1 million, or $0.49 per diluted share, for the same period in 2001. The increase in net earnings resulted from increased revenue and an improved underwriting performance by the insurance company segment, net of a charge in 2002 related to a discontinued line of business ($5.0 million or $0.08 per share). Other events affecting the comparison include losses from the September 11 terrorist attacks during 2001 ($22.8 million or $0.39 per share), the charge for lines of business being exited during 2001 ($29.6 million or $0.50 per share) and from the non-amortization of goodwill in accordance with SFAS No. 142 ($3.1 million or $0.05 per share). Our book value per share was $13.72 as of September 30, 2002, up from $13.21 as of June 30, 2002. Net earnings and unrealized gain on available for sale securities contributed to the increase in book value per share. SEGMENTS Insurance Companies The following tables provide information by line of business (in thousands):
Gross Net Net written written earned Net loss premium premium premium ratio ------------ ------------ ------------ -------- For the three months ended September 30, 2002: Group life, accident and health $ 162,953 $ 90,642 $ 85,484 61.7% Aviation 49,804 23,687 25,845 48.5 Property, marine and energy 22,120 10,868 10,636 6.3 Other specialty lines of business 61,894 17,748 11,105 76.2 ------------ ------------ ------------ ------- Subtotal 296,771 142,945 133,070 55.9 Discontinued lines of business 1,693 1,621 3,224 334.5% ------------ ------------ ------------ ------- TOTALS $ 298,464 $ 144,566 $ 136,294 62.5 ------------ ------------ ------------ Expense ratio 27.1 ------- Combined ratio 89.6% =======
30
Gross Net Net written written earned Net loss premium premium premium ratio ------------ ------------ ------------ -------- For the three months ended September 30, 2001: Group life, accident and health $ 154,346 $ 50,511 $ 50,716 118.5% Aviation 43,862 19,232 23,397 80.0 Property, marine and energy 14,684 6,442 6,503 111.9 Other specialty lines of business 3,505 3,251 4,007 107.2 ------------ ------------ ------------ -------- Subtotal 216,397 79,436 84,623 106.8 Discontinued lines of business 26,502 13,739 8,848 325.2 ------------ ------------ ------------ -------- TOTALS $ 242,899 $ 93,175 $ 93,471 127.5% ============ ============ ============ Expense ratio 24.7 -------- Combined ratio 152.2% ========
Gross written premium increased 23% to $298.5 million for the third quarter of 2002 from $242.9 million for the same period in 2001. This increase was 37% before the reduction due to discontinued lines of business. The net increase resulted from organic growth and premium rate increases on all lines of business except for other specialty lines, which we had not previously written, and offset by the decrease in discontinued lines. Gross written premium is expected to continue to increase into 2003. Net written premium for the third quarter of 2002 increased 55% to $144.6 million from $93.2 million for the same period in 2001, as our insurance companies have increased retentions on the group life, accident and health and the property, marine and energy segments, in addition to the effect of the changes in gross premium described above. Net earned premium increased 46% to $136.3 million for the same reasons. Increases in net written and net earned premiums were 80% and 57%, respectively, before the reduction in discontinued lines of business. Increases in net written and net earned premium are expected to continue. Loss and loss adjustment expense was $85.2 million for the third quarter of 2002 compared to $119.2 million for the same period in 2001. The 2001 net loss expense includes $35.0 million from the September 11 terrorist attacks and $18.8 million from the charge for lines of business being exited. Prior year net reserve redundancies included in loss and loss adjustment expense approximated $2.2 million and $2.8 million for the third quarters of 2002 and 2001, respectively. The redundancies resulted from the settlement of claims for less than amounts previously reserved. Because of these items, and generally better underwriting results in 2002 as a result of higher pricing and improved policy terms and conditions, the net loss ratio was greatly improved at 62.5% for the third quarter of 2002 from 127.5% for the same period in 2001, on substantially increased earned premiums. During the third quarter of 2002 we also recorded incurred losses in the amount of $7.7 million related to certain business included in discontinued lines. This business was written by an insurance company which was acquired as part of our purchase of Centris in 1999 and was subsequently sold. The business was of a type that we have not historically written. Based on our current evaluations, we do not expect any further development from this business in future periods. The gross loss ratio was 64.1% in the third quarter of 2002 compared to 167.5% for the same period in 2001. During the third quarter of 2001, we recorded gross losses of $141.0 million due to the September 11 terrorist attacks and $49.0 million due to the Total Oil Company loss. Additionally, in 2002, as a result of further evaluation, we reduced the gross losses from the Total loss by $14.0 million. 31 The tables below show the composition of net and gross incurred loss and loss adjustment expense (amounts in thousands):
Net Incurred Loss and Loss Adjustment Expense 2002 2001 --------------------------- --------------------------- Amount Loss Ratio Amount Loss Ratio ------------ ------------ ------------ ------------ September 11 terrorist attacks $ -- --% $ 35,000 37.4% 2001 workers' compensation exit charge -- -- 18,799 20.1 2002 discontinued line charge 7,674 5.6 -- -- All other incurred loss and loss adjustment expense 77,489 56.9 65,375 70.0 ------------ ------------ ------------ ------------ Net incurred loss and loss adjustment expense $ 85,163 62.5% $ 119,174 127.5% ============ ============ ============ ============
Gross Incurred Loss and Loss Adjustment Expense 2002 2001 --------------------------- --------------------------- Amount Loss Ratio Amount Loss Ratio ------------ ------------ ------------ ------------ September 11 terrorist attacks $ -- --% $ 140,962 55.4% Total Oil Company loss (14,000) (5.3) 49,000 19.2 2001 workers' compensation exit charge -- -- 36,784 14.5 2002 discontinued line charge 7,674 2.9 -- -- All other incurred loss and loss adjustment expense 176,582 66.5 199,623 78.4 ------------ ------------ ------------ ------------ Gross incurred loss and loss adjustment expense $ 170,256 64.1% $ 426,369 167.5% ============ ============ ============ ============
Policy acquisition costs, which are net of commissions on reinsurance ceded, increased to $19.0 million during the third quarter of 2002, from $9.3 million in the same period in 2001. This increase is due to the higher earned premium and the reduction in ceding commissions on business as a result of our retaining more business. The expense ratio was 27.1% for the third quarter of 2002 compared to 24.7% for the same period in 2001. The increase in the expense ratio was caused by the increase in policy acquisition costs. However, because of our improved loss ratio, our combined ratio improved substantially to 89.6% for the third quarter of 2002, compared to 152.2% for the same period in 2001. Net earnings of our insurance companies increased to $15.0 million in the third quarter of 2002 from a net loss of $41.7 million for the same period in 2001, due to increased revenue and improved underwriting results. Barring future catastrophic events, we expect continued improvement into 2003. Only $0.5 million of the increase was due to the adoption of SFAS No. 142. Underwriting Agencies Management fees increased 29% to $18.1 million for the third quarter of 2002, compared to $14.0 million for the same period in 2001. The underwriting agencies acquired in late 2001 accounted for much of the increase, partially offset by a decrease in management fees from our other underwriting agencies as we continued the consolidation of other pre-existing underwriting agency operations into our insurance companies. Net earnings of our underwriting agencies increased to $5.9 million in the third quarter of 2002 from $4.2 million in 2001 as a result of increased revenue and the adoption of SFAS No. 142. There was $1.6 million (net of income tax) of goodwill amortization recorded in 2001. We expect further improvement in 2003 due to our recent acquisition of MAG Global Financial Products, LLC during the fourth quarter of 2002 and organic growth. 32 Intermediaries Commission income increased to $10.4 million for the third quarter of 2002, compared to $9.5 million for the same period in 2001, despite poor market conditions and less ceded reinsurance being placed on behalf of our insurance companies as they increased their retentions. Net earnings of our intermediaries increased to $2.9 million for the third quarter of 2002 compared to $2.0 million for the same period of 2001, primarily due to the adoption of SFAS No. 142. There was $0.9 million (net of income tax) of goodwill amortization recorded in 2001. Other Operations The decrease in other operating income to $1.0 million during the third quarter of 2002 from $10.4 million for the same period in 2001 was principally from the disposition or closure of certain operations during 2001 and the resultant gains totaling $8.2 million from these dispositions. Net earnings of other operations decreased to $0.5 million in 2002 from $5.9 million in 2001 for the same reasons. Quarter to quarter comparisons may vary substantially depending on other operating investments or dispositions thereof in any given period. Recent investments and future dispositions should have a positive effect on this segment's revenue and earnings in future periods. Corporate The net income of the corporate segment was less than $0.1 million for the third quarter of 2002 compared to net income of $0.4 million for the same period in 2001. The difference was due to investment and other income recorded during the third quarter of 2001 which did not occur in 2002. LIQUIDITY AND CAPITAL RESOURCES We receive substantial cash from premiums, collection of reinsurance recoverables, management fees and commission income and, to a lesser extent, investment income and proceeds from sales and redemptions of investments and other assets. Our principal cash outflows are for the payment of claims and loss adjustment expenses, payment of premiums to reinsurers, purchase of investments, debt service, policy acquisition costs, operating expenses, income and other taxes and dividends. Variations in operating cash flows, which were $122.8 million for the first nine months of 2002 compared to $82.0 million for the same period in 2001 ($76.1 million for the third quarter of 2002 compared to $65.4 million for the third quarter of 2001), can occur due to timing differences in either the payment of claims and the collection of related recoverables or the collection of receivables and the payment of related payable amounts. We limit our liquidity exposure by holding funds, letters of credit and other security such that net balances due to us are generally less than the gross balances shown in our condensed consolidated balance sheets. We maintain a substantial level of cash and liquid short-term investments which are used to meet anticipated payment obligations. Our consolidated cash and investment portfolio increased $166.4 million, or 18% during 2002 and totaled $1.1 billion as of September 30, 2002, of which $317.8 million was cash and short-term investments. The increase in investments resulted primarily from the positive operating cash flows and the capital contribution we made to Houston Casualty Company during 2002. During April 2002, we drew down $40.0 million on our bank line of credit as partial funding for a $50.0 million capital contribution to our largest insurance company, Houston Casualty Company, to support its growth and increased business opportunities. Since that time, we have repaid $10.0 million on our bank facility using funds generated from operating cash flows. Because of the utilization of our bank facility, our debt to total capital ratio increased to 19.5% as of September 30, 2002, compared to 19.2% as of December 31, 2001. As of September 30, 2002, the weighted average interest rate on our bank facility outstanding debt was 2.8%. 33 Under the terms of the related indenture agreement, our outstanding 2% convertible notes could have been put, or sold back, to us on September 1, 2002 at the option of the note holders. On September 4, 2002 we paid $49,000 in cash for the notes which were so tendered. Under the indenture agreement, the next available date for the remaining noteholders to exercise their put rights is September 1, 2004. We have a reserve of $9.6 million as of September 30, 2002 for potential collectibility issues related to reinsurance recoverables and associated expenses. The reserve for uncollectible reinsurance increased due to provisions of $5.3 million and $1.6 million during the nine and three months, respectfully, ended September 30, 2002. The adverse economic environment in the worldwide insurance industry in recent years and the terrorist attacks on September 11, 2001 have placed great pressure on reinsurers and the results of their operations. Ultimately, these conditions could affect reinsurers' solvency. Historically, there have been insolvencies following a period of competitive pricing in the industry, such as the marketplace has experienced for the last several years. While we believe that our overall reserve is adequate based on currently available information, conditions may change or additional information might be obtained which may result in a future change in the reserve. We periodically review our financial exposure to the reinsurance market and the level of our reserve and continue to take actions in an attempt to mitigate our risk. The reduction in the gross loss ratio, together with reduction in ceded premium, is causing the reduction in ceded loss and loss adjustment expense and this is having a positive effect on our reinsurance recoverable balances. We are also making payments and collecting the corresponding recoverables on the two catastrophe losses which occurred during the third quarter 2001; the terrorist attacks on September 11 and the Total Oil Company loss. We expect this trend to continue over the next few quarters, barring another catastrophe, despite the reinsurance additions from our new specialty liability lines of business, which are more heavily reinsured than most of our other lines of business. A number of reinsurers have delayed or suspended the payment of amounts recoverable under certain reinsurance contracts to which we are a party. Such delays have affected, although not materially to date, the investment income of our insurance companies, but not to any extent their liquidity. We limit our liquidity exposure by holding funds, letters of credit or other security such that net balances due to us are significantly less than the gross balances shown in our consolidated balance sheets. In some instances, the reinsurers have withheld payment without reference to a substantive basis for the delay or suspension. In other cases, the reinsurers have claimed they are not liable for payment to us of all or part of the amounts due under the applicable reinsurance agreement. We believe these claims are without merit and expect to collect a substantial portion of the amounts recoverable. We are currently in negotiations with most of these parties, but if such negotiations do not result in a satisfactory resolution of the matters in question, we may seek or be involved in a judicial or arbitral determination of these matters. In some cases, the final resolution of such disputes through arbitration or litigation may extend over several years. In this regard, as of September 30, 2002, our insurance companies had initiated three litigation or arbitration proceedings against reinsurers and were involved in one arbitration proceeding initiated by a reinsurer. These proceedings primarily concern the collection of amounts owing under reinsurance agreements. As of such date, our insurance companies had an aggregate amount of $16.2 million which had not been paid to us under the agreements and we estimate that there could be up to an additional $14.3 million of incurred losses and loss expenses and other balances due under the subject agreements. During the nine months ended September 30, 2002, we negotiated the settlement of two arbitrations with reinsurers under which the reinsurers agreed to pay the full amounts due to us, which we estimate to be $27.5 million in the aggregate. In addition, because our insurance companies, principally Houston Casualty Company, participated in facilities or pools of companies which were managed by one of our underwriting agencies, they are indirectly involved in any proceedings involving collections which affect the applicable facilities or pools of companies. As of September 30, 2002, Houston Casualty Company's allocated portion of these actions was $3.0 million and we estimate that there could be up to an additional $2.4 million of incurred losses and loss expenses. Neither Houston Casualty Company nor its affiliated underwriting agency has any net exposure on the portion of the amounts which are due to the non-affiliated companies who also participated in the applicable facilities or pool of companies. We believe that our operating cash flows, short-term investments and bank facility will provide sufficient sources of liquidity to meet our operating needs for the foreseeable future. 34 Effects of Recent Accounting Pronouncements Statement of Financial Accounting Standards ("SFAS") No. 142 entitled "Goodwill and Other Intangible Assets" was issued in June, 2001, and became effective for us on January 1, 2002. SFAS No. 142 requires goodwill to be tested for impairment at a level referred to as a reporting unit. After the initial adoption, goodwill of a reporting unit will be tested for impairment on an annual basis and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. SFAS No. 142 also requires the discontinuance of the amortization of goodwill effective January 1, 2002 and that goodwill recognized for acquisitions which were consummated after July 1, 2001 not be amortized. During the first six months of 2002 we determined our reporting units, completed our initial goodwill impairment testing, completed our first annual impairment testing as of June 30, 2002 and determined we did not have to record an impairment charge. SFAS No. 142 is not expected to have a material effect on our financial position or cash flows. SFAS No. 146 entitled " Accounting for Costs Associated with Exit or Disposal Activities" was issued in July, 2002 and will become effective for us on January 1, 2003. SFAS No. 146 will spread out the reporting of expenses related to restructurings and is a change to existing guidance. The commitment to a plan to exit an activity or dispose of long-lived assets will no longer be enough to record a one-time charge for most anticipated coats. Instead, companies will record exit or disposal costs when they are incurred and can be measured at fair value and the liability will be subsequently adjusted for changes in estimated cash flow. We do not expect the adoption of SFAS No. 146 to have a material effect on our financial position, results of operations or cash flows. Significant Accounting Policies Other than our adoption of SFAS No. 142 described above, we have made no changes in our methods of application of our significant accounting policies from the information provided in our Annual Report on Form 10-K for the year ended December 31, 2001. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK There have been no material changes in market risk from the information provided in Item 7A. "Quantitative and Qualitative Disclosures About Market Risk" of our Annual Report on Form 10-K for the year ended December 31, 2001. CONTROLS AND PROCEDURES a. Evaluation of disclosure controls and procedures. Within the 90 days prior to the date of this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to HCC Insurance Holdings, Inc. and its subsidiaries required to be included in our periodic SEC filings. b. Changes in internal controls. There have been no significant changes in our internal controls or in other factors which could significantly affect internal controls subsequent to the date we carried out our evaluation. 35 PART II - OTHER INFORMATION Item 1. Legal Proceedings In addition to the matters discussed in Note (3), Reinsurance, we are party to numerous lawsuits and other proceedings that arise in the normal course of our business. Many of these lawsuits 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 party to lawsuits and other proceedings which relate to disputes over contractual relationships with third parties, or which involve alleged errors and omissions on the part of our subsidiaries. In addition, we are presently engaged in litigation initiated by the appointed liquidator of a former reinsurer concerning payments made to us prior to the date of the appointment of the liquidator. The disputed payments were made by the now insolvent reinsurer in connection with a commutation agreement. Our understanding is that such litigation is one of a number of similar actions brought by the liquidator. We intend to vigorously contest the action. We believe the resolution of the lawsuits in which we are a party will not have a material adverse effect on our financial position, results of operations or cash flows. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits 99.1 Certification with respect to quarterly report. (b) Reports on Form 8-K On July 10, 2002, we reported on Form 8-K our previously announced authorization to repurchase up to 3.0 million shares of our common stock. On August 6, 2002, we reported on Form 8-K our intention to pay the purchase price in cash of any of our 2% Convertible Notes which might be tendered to us on September 1, 2002. On August 9, 2002, we reported on Form 8-K our announcement of financial results for the second quarter of 2002. On September 4, 2002, we reported on Form 8-K that we paid less than $0.1 million in cash for 2% Convertible Notes which were tendered to us on September 1, 2002. 36 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. HCC Insurance Holdings, Inc. ----------------------------------------------- (Registrant) November 13, 2002 /s/ Stephen L. Way ---------------------- ----------------------------------------------- (Date) Stephen L. Way, Chairman of the Board and Chief Executive Officer November 13, 2002 /s/ Edward H. Ellis, Jr. ---------------------- ----------------------------------------------- (Date) Edward H. Ellis, Jr., Executive Vice President and Chief Financial Officer 37 CERTIFICATIONS I, Stephen L. Way, certify that: 1. I have reviewed this quarterly report on Form 10-Q of HCC Insurance Holdings, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a. designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c. presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a. all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. November 13, 2002 /s/ Stephen L. Way ------------------------- -------------------------------------- (Date) Stephen L. Way, Chairman of the Board and Chief Executive Officer 38 CERTIFICATIONS I, Edward H. Ellis, Jr., certify that: 1. I have reviewed this quarterly report on Form 10-Q of HCC Insurance Holdings, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a. designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c. presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a. all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. November 13, 2002 /s/ Edward H. Ellis, Jr. ---------------------- ---------------------------------------------- (Date) Edward H. Ellis, Jr., Executive Vice President and Chief Financial Officer 39 INDEX TO EXHIBITS
EXHIBIT NUMBER DESCRIPTION ------- ----------- 99.1 Certification with respect to quarterly report.