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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
/X/ Annual Report pursuant to Section 13 or 15(d)of the Securities Exchange Act
of 1934 (Fee required).
/ / Transaction report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 (No fee required).
For the fiscal year ended _______December 31, 1996________________________
Commission file number _______0-20766_____________________________________
HCC Insurance Holdings, Inc.
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(Exact name of registrant as specified in its charter)
Delaware 76-0336636
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(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
13403 Northwest Freeway, Houston, Texas 77040-6094
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(Address of principal executive offices) (Zip Code)
(713) 690-7300
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(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12 (b) of the Act: NONE
Securities registered pursuant to Section 12 (g) of the Act:
TITLE OF EACH CLASS
COMMON STOCK, $1.00 PAR VALUE
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes __X__ No _____
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K (Section229.405 of this chapter) is not contained herein, and
will not be contained, to the best of registrant's knowledge, in definitive
proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K. / /
The aggregate market value on March 24, 1997, of the voting stock held by
non-affiliates of the registrant was approximately $620.4 million. For purposes
of the determination of the above stated amount, only directors and executive
officers are presumed to be affiliates.
The number of shares outstanding of each of the registrant's classes of common
stock as of March 24, 1997:
CLASS SHARES OUTSTANDING
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Common Stock, $1.00 par value............................................. 36,167,935
Documents incorporated by reference: Information called for in Part III of this
Form 10-K is incorporated by reference to the Registrant's definitive Proxy
Statement to be filed within 120 days of the close of the Registrant's fiscal
year in connection with the Registrant's annual meeting of shareholders.
TABLE OF CONTENTS
HCC INSURANCE HOLDINGS, INC.
PAGE
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PART I.
ITEM 1. Business......................................................................... 3
ITEM 2. Properties....................................................................... 20
ITEM 3 Legal Proceedings................................................................ 20
ITEM 4. Submission of Matters to a Vote of Security Holders.............................. 20
PART II.
ITEM 5. Market for the Registrant's Common Equity and Related Stockholder Matters........ 21
ITEM 6. Selected Financial Data.......................................................... 22
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of
Operations....................................................................... 24
ITEM 8. Financial Statements and Supplementary Data...................................... 29
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosures...................................................................... 30
PART III.
ITEM 10. Directors and Executive Officers of the Registrant............................... 30
ITEM 11. Executive Compensation........................................................... 30
ITEM 12. Security Ownership of Certain Beneficial Owners and Management................... 30
ITEM 13. Certain Relationships and Related Transactions................................... 30
PART IV.
ITEM 14. Exhibits, Financial Statements, Schedules and Reports on Form 8-K................ 30
SIGNATURES.............................................................................................. 31
Forward-looking statements in this Form 10-K are made pursuant to the safe
harbor provisions of the Private Securities Litigation Reform Act of 1995.
Investors are cautioned that all forward-looking statements involve risks and
uncertainty, including without limitation, the risk of a significant natural
disaster, the inability of the Company to reinsure certain risks, the adequacy
of its loss reserves, expansion or contraction in its various lines of business,
the impact of inflation, changing regulations in foreign countries, the effect
of pending acquisitions, as well as general market conditions, competition,
licensing and pricing. Please refer to the Company's Securities and Exchange
Commission filings, copies of which are available from the Company without
charge, for further information.
2
PART I
ITEM 1. BUSINESS
GENERAL
HCC Insurance Holdings, Inc. ("HCCH" or the "Company") is a Delaware
corporation with principal and executive offices located at 13403 Northwest
Freeway, Houston, Texas 77040. HCCH and its consolidated subsidiaries are
collectively referred to as the "Company". HCCH, through its subsidiaries,
provides specialized property and casualty insurance to commercial customers,
underwritten on both a direct and reinsurance basis, and, to a lesser extent,
insurance agency services. The Company's principal insurance company
subsidiaries are Houston Casualty Company ("HCC") and Trafalgar Insurance
Company ("TIC") in Houston, Texas and IMG Insurance Company Ltd. ("IMG") in
Amman, Jordan. The Company's principal agency subsidiaries are LDG Management
Company, Incorporated ("LDG") in Wakefield, Massachusetts; HCC Underwriters, A
Texas Corporation ("HCCU") in Houston, Texas; North American Special Risk
Associates, Inc. ("NASRA") in Northbrook, Illinois and Middle East Insurance
Brokers, Ltd. ("MEIB") in Amman, Jordan.
The Company's underwriting activities are focused on providing aviation,
marine, property, offshore energy and accident and health insurance on a
worldwide basis and international reinsurance on these same lines of business.
The Company also specializes in marketing and servicing complicated, high value,
structured insurance and reinsurance programs placed on behalf of domestic and
foreign clients which cover large, ocean marine fleets; complex, multinational,
energy and industrial businesses; international aviation operations; large
international property accounts; and a variety of accident and health related
risks. The Company derives substantially the same amount of its business
domestically and internationally. The Company operates primarily on a surplus
lines or a non-admitted basis and is licensed in Texas and Oklahoma.
Since its founding in 1974, the Company and its predecessor companies have
been consistently profitable, generally reporting annual increases in gross
written premium ("GWP"), net written premium ("NWP") and total revenue. During
the period 1992 through 1996, the Company had an average combined ratio of 78.1%
versus the less favorable 109.3% recorded by the U.S. property and casualty
insurance industry overall (1992-1995). During the same period, the Company's
GWP increased from $75.1 million to $230.8 million, an increase of 207% and net
earnings increased from $5.3 million to $29.3 million, an increase of 454%.
HCC and TIC are rated "A"(Excellent) by A.M. Best and HCC is rated "Aq" by
S&P. An A.M. Best or S&P rating is intended to provide an independent opinion of
an insurer's ability to meet its obligations to policyholders and should not be
considered an investment recommendation.
STRATEGY
The Company's operating philosophy is to maximize underwriting profit while
preserving the integrity of shareholders' equity. The Company concentrates its
writings in selected, narrowly defined lines of business in which it believes
there is a substantial opportunity to achieve underwriting profits. The Company
primarily underwrites first party, physical damage coverages and lines of
business which have relatively short lead times between the occurrence of an
insured event and the reporting of claims to the Company. With respect to the
underwriting management, marketing and related services, the Company seeks to
offer quality underwriting, decision-making, support and reinsurance capacity
and financial and other resources to take advantage of market opportunities for
the development of new products.
The property and casualty insurance underwriting business has historically
been cyclical (though not seasonal). Within the overall cycle of the industry,
particular lines of business experience their own cycles.
3
These cycles are characterized by periods of excess capital and significant
competition in policy pricing, terms and conditions, followed by periods of
capital shortages, typically resulting from adverse loss experience, which leads
to decreased competition, higher premium rates and stricter underwriting
standards.
The position of a particular line of business in its respective underwriting
cycle depends on prevailing premium rates, availability and cost of reinsurance,
and other market conditions. The Company considers each of these factors in
determining when to increase or decrease premium volume in each line. With this
approach, the Company focuses on increasing net earnings rather than premium
volume or market share.
The Company purchases a substantial amount of reinsurance to limit its net
loss from both individual and catastrophic risks. The degree to which the
Company reinsures varies by, among other things, the particular risks inherent
in the policies underwritten.
The Company's business plan is to expand its underwriting activities and
continue the growth of its insurance agency operations. However, the Company's
business plan is shaped by its underlying operating philosophy, which is to
maximize underwriting profit opportunities, while preserving the integrity of
shareholders' equity and to seek to acquire complementary businesses with
established management and reputation in the insurance agency field, whose
business, the Company believes, can be enhanced through the synergism created by
the Company's underwriting capabilities and other owned insurance businesses. As
a result, the Company's primary interests are not in expanding market share or
necessarily, GWP, but rather in increasing net earnings. To accomplish this
objective, the Company: (i) has been and is prepared to emphasize or reduce
underwritings in certain lines as premium rates, the availability and cost of
reinsurance and other market conditions warrant; and (ii) will continue to
attempt to limit its downside net loss exposure through the effective, prudent
and conservative use of reinsurance.
The Company believes its operational flexibility, experienced underwriting
personnel, and access to and expertise in the reinsurance marketplace allow the
Company to implement its strategy of emphasizing more profitable lines of
business during periods of increased premium rates and de-emphasizing less
profitable lines of business during periods of severe competition. In addition,
through its acquisition and ownership of insurance agency businesses, the
Company believes it has additional lines of business that can complement its
underwriting activities.
RECENT ACQUISITIONS
Effective January 1, 1994, HCCU acquired a 25% interest in MEIB, a wholesale
insurance and reinsurance broker based in Amman, Jordan. Concurrent with the
purchase of IMG on October 1, 1994, HCCH acquired the remaining 75% of interest
in MEIB and HCCU transferred its 25% interest in MEIB to HCCH, thereby making
MEIB a wholly owned subsidiary of HCCH. To acquire 100% of MEIB, the Company
issued 109,524 shares (pre split) of its Common Stock and paid a total of $3.9
million in cash.
Effective October 1, 1994, HCCH acquired 100% of the stock of IMG, a
property and casualty insurance company based in Amman, Jordan. IMG specializes
in insuring large commercial risks. In exchange for IMG's stock, the Company
issued 838,095 shares (pre split) of its Common Stock and paid $4.4 million in
cash.
These acquisitions were made in order to expand the Company's international
business operations, principally in the Middle East, Asia and Africa.
On May 24, 1996, the Company issued 6,250,000 shares of its common stock to
acquire all of the outstanding shares of LDG. LDG acts on behalf of insurance
and reinsurance companies and conducts its business in two areas: (i) insurance
underwriting management and (ii) reinsurance underwriting management and
intermediary services. LDG underwrites insurance and/or reinsurance in the
following lines of business: medical stop-loss insurance for employer sponsored
self-insured health plans, accident and health special risk, workers'
compensation, alternative workers' compensation, and specialty aviation. LDG
4
generally concentrates on lines of business that have relatively short lead
times between the occurrence of an insured event and the reporting of claims.
On November 27, 1996, the Company issued 1,136,400 shares of its Common
Stock and paid $1.7 million in cash to acquire all of the outstanding shares of
North American Special Risk Associates, Inc. group of companies ("NASRA"). NASRA
provides underwriting and claims management services to insurance and
reinsurance companies primarily in occupational accident insurance for
self-employed truckers.
On January 24, 1997, the Company issued 266,667 shares of its Common Stock
and paid $6.55 million in cash to acquire all of the occupational accident
business of TRM International, Inc.
These acquisitions were made in order to increase the agency (non-risk
bearing) operations of the Company.
PENDING ACQUISITIONS
On January 6, 1997, the Company announced that it had agreed in principal to
acquire all of the outstanding shares of Interworld Inc. group of companies
("Interworld") in exchange for 725,000 shares of the Company's Common Stock.
Interworld, through its subsidiaries, acts as a managing general agency that
specializes in underwriting general aviation risks throughout the United States,
with special emphasis on private and corporate aircraft as well as small to
medium size airports and commercial operators.
On January 17, 1997, the Company and AVEMCO Corporation ("AVEMCO") jointly
announced that they had signed a letter of intent to merge in a stock-for-stock
transaction, each share of AVEMCO common stock to be exchanged for one share of
HCCH's Common Stock. The Companies executed definitive agreements on February
28, 1997. AVEMCO provides specialized property and casualty insurance products
and services, principally involving aviation. Non-aviation specialty lines
include lenders single interest, short-term health and pleasure marine.
Insurance products are distributed on a direct basis nationally and in Canada
(except Quebec) and through agency and brokerage networks nationwide. AVEMCO's
insurance services businesses offer management and related subrogation and
salvage services, short-term health and travel insurance programs,
administration and availability of short-term health programs primarily for
foreign students resident in the United States, worldwide multilingual emergency
assistance services for individuals who become ill or are injured while
traveling abroad and computer software and related products and services for
property and casualty insurance companies in the United States.
The merger is subject to approval by each of the Company's shareholders and
additional approval by certain regulatory agencies. The Companies have filed
with the Securities and Exchange Commission a Join Proxy Statement/Prospectus
relating to each of their respective Company's special shareholder's meeting.
The Company anticipates that its Special Meeting of Shareholders will be held
prior to May 31, 1997, and the merger will be consummated as soon thereafter as
all other conditions to the merger are satisfied. There can be no assurance that
the conditions to the proposed merger will be satisfied or that the shareholders
will approve the transaction and the merger will consummated.
These acquisitions are expected to expand and strengthen the Company's
existing lines of business.
INSURANCE COMPANY OPERATIONS
The Company's property and casualty insurance business specializes in the
direct, including facultative reinsurance, underwriting of aviation, marine,
offshore energy, property and accident and health risks, as well as treaty
reinsurance in the same lines of business.
5
LINES OF BUSINESS
The following table sets forth the Company's GWP by line of business and the
percent to total GWP for the periods indicated:
FOR THE YEARS ENDED DECEMBER 31,
(DOLLARS IN THOUSANDS)
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1996 1995 1994
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Direct
Aviation...................................... $ 71,697 31% $ 63,615 27% $ 38,743 20%
Marine........................................ 28,061 12 33,797 14 29,230 15
Offshore Energy............................... 8,496 4 14,893 6 20,123 11
Property...................................... 118,149 51 124,331 52 100,832 52
Accident and Health........................... 2,756 1 -- -- -- --
Reinsurance
Excess of Loss................................ 734 .5 1,877 1 2,019 1
Proportional.................................. 862 .5 445 -- 1,931 1
---------- --- ---------- --- ---------- ---
Total gross written premium..................... $ 230,755 100% $ 238,958 100% $ 192,878 100%
---------- --- ---------- --- ---------- ---
---------- --- ---------- --- ---------- ---
The following table sets forth the Company's NWP by line of business and the
percent to total NWP for the periods indicated:
FOR THE YEARS ENDED DECEMBER 31,
(DOLLARS IN THOUSANDS)
------------------------------------------------------------------
1996 1995 1994
---------------------- -------------------- --------------------
Direct
Aviation.......................................... $ 47,619 49% $ 38,788 39% $ 14,344 24%
Marine............................................ 21,670 22 29,410 30 17,229 29
Offshore Energy................................... 3,472 4 5,115 5 8,194 14
Property.......................................... 21,534 22 24,186 24 17,242 29
Accident and Health............................... 2,671 3 -- -- -- --
Reinsurance
Excess of Loss.................................... (1,047) (1) 833 1 759 1
Proportional...................................... 857 1 454 1 1,926 3
--------- --- --------- --- --------- ---
Total net written premium........................... $ 96,776 100% $ 98,786 100% $ 59,694 100%
--------- --- --------- --- --------- ---
--------- --- --------- --- --------- ---
DIRECT AND FACULTATIVE REINSURANCE UNDERWRITING
AVIATION--The Company insures predominantly foreign general aviation risks
including fixed base, rotor wing and cargo operations and commuter airlines. The
Company does not generally insure major domestic trunk airlines, satellites,
corporate aircraft or United States passenger liabilities. The coverages
underwritten include hull (including engines, avionics and other systems),
liabilities, war, cargo and various ancillary coverages.
The Company has been underwriting aviation risks since 1981. GWP has risen
rapidly since 1992, increasing to $71.7 million in 1996 from $4.3 million in
1992. This growth has occurred due to a dramatic increase in rates as a result
of extremely adverse worldwide underwriting results in prior years and the
Company's ability to respond quickly to the opportunity to write new business in
a rising market. In addition, the Company resumed writing domestic general
aviation risks late in 1996. Rates have now reached very acceptable levels of
profitability but the Company expects the increase in GWP and NWP to slow during
1997 as recent competition is beginning to effect this line of business.
6
Treaty reinsurance is maintained on an excess of loss basis to protect the
Company against individual risk severity of loss and the relatively low level of
catastrophe exposure that exists on this book of business.
MARINE--The Company underwrites marine risks for ocean going vessels ("Blue
Water"), inland and coastal trading vessels ("Brown Water") and fishing vessels.
The coverages written include hull and machinery, liabilities (including
protection and indemnity), marine cargo and various ancillary coverages.
The Company has underwritten marine risks since 1984. Rates increased
substantially between 1991 and 1993 and maintained an acceptable level of
profitability. However, recent competition has caused downward pressure on the
rates which has caused a reduction in GWP from $33.8 million in 1995 to $28.1
million in 1996. The Company believes rates will continue to soften during 1997.
Treaty reinsurance is maintained on an excess of loss basis to protect the
Company against individual risk severity of loss and the relatively low level of
catastrophe exposure that exists on this book of business.
OFFSHORE ENERGY--The Company has been underwriting offshore energy risks
since 1988. Offshore energy risks include drilling rigs, production and
gathering platforms, and pipelines. Coverages underwritten include physical
damage, liabilities, business interruption and various ancillary coverages.
Rates have declined significantly during the past few years to levels where
profitability is unlikely. Underwriting has been on a very selective basis,
striving for quality rather than quantity, which has resulted in a continued
reduction in GWP from $20.1 million in 1994 to $8.5 million in 1996. The Company
anticipates a further decline in GWP and NWP during 1997 and continues to
evaluate the viability of this line of business.
Treaty reinsurance is maintained on both a proportional and an excess of
loss basis to protect the Company against individual risk severity of loss and
the catastrophic exposure that exists, for example, from a hurricane in the Gulf
of Mexico.
PROPERTY--The Company specializes in writing catastrophe exposed risks in
general and the property risks of large multinational corporations covering such
commercial risks as hotels, office buildings, retail locations, factories,
industrial plants, utilities, refineries, and natural gas and petrochemical
plants. Coverage includes business interruption and physical damage, including
flood and earthquake.
The Company has written property business since 1986. GWP grew rapidly
beginning in 1993 as the Company expanded its underwriting into international
business, often in the same countries where it already wrote aviation and/or
marine business. Dramatic rate increases occurred during the period 1993 to 1995
due to the severe lack of catastrophe capacity resulting from the effects of
Hurricane Andrew and the Northridge Earthquake on the world's reinsurance
markets. With support from its reinsurers, the Company moved quickly to take
advantage of the changing market. During 1996, premium rates began to soften
toward the end of the year.
GWP grew from $14.9 million in 1992 to $124.3 million in 1995, with a slight
decrease to $118.1 million in 1996. NWP also grew rapidly but substantial
reinsurance costs will always keep the actual premium retained significantly
smaller than GWP. In the absence of a major industry catastrophe loss, the
Company expects both GWP and NWP to decline during 1997 as premium rates
continue to soften.
Treaty reinsurance is maintained on both a proportional and an excess of
loss basis to ensure adequate protection, particularly against catastrophe
exposures. The Company conservatively estimates its aggregate exposure in any
individual catastrophe zone and maintains catastrophe reinsurance to cover its
exposure to any one occurrence.
ACCIDENT AND HEALTH--The Company began reinsuring accident and health risks
during 1996 which are produced by the agencies acquired during the year. The
risks underwritten include medical stop-loss insurance for employer sponsored
self-insured health plans; reinsurance in the medical, accident and health
special risk, workers' compensation and alternative workers' compensation areas;
and occupational
7
accident insurance for self-employed truckers. The Company underwrites
reinsurance in this area on both a proportional and excess of loss basis. The
Company expects GWP and NWP to increase significantly during 1997.
REINSURANCE UNDERWRITING
The Company engages in reinsurance underwriting on a periodic basis when
market rates and other conditions make it profitable to do so. The Company began
writing treaty reinsurance in 1984, but has been dramatically reducing its book
of business, particularly excess of loss business, due to the lack of adequate
reinsurance protection available at any reasonable cost.
EXCESS OF LOSS--The Company previously wrote excess of loss reinsurance,
typically aviation, marine and non-marine catastrophe exposures. In 1992, due to
a general market contraction of available reinsurance for excess of loss
business, the Company was unable to purchase adequate protection at a reasonable
cost and, therefore, elected not to continue writing this class other than
selectively on a net basis. The run off of this line of business continues
profitably.
PROPORTIONAL--The Company underwrites proportional reinsurance on a
selective basis. The exposures reinsured are typically the same type of risks
that the Company underwrites on a direct basis. The Company provides this
reinsurance to obtain a more diversified cross section of business which it
might not otherwise have access to and for reciprocity with companies with whom
it has an ongoing business relationship.
FACULTATIVE--The Company underwrites facultative reinsurance in all of its
lines of business. Typically, this is on international business in order to
comply with local licensing requirements or as reinsurance of captives and
usually can be considered direct business, as the Company maintains underwriting
and claims control. However, all of this business is recorded under the caption
of "Reinsurance Assumed".
HOUSTON CASUALTY COMPANY
HCC, the Company's principal insurance company subsidiary, operates
worldwide in all of the lines of business in which the Company specializes.
HCC's business is produced by independent agents and brokers, the group's agency
subsidiaries, TIC, IMG and other insurance and reinsurance companies worldwide.
HCC has a highly experienced staff of underwriters trained to deal with the high
value, complicated exposures prevailing in the lines of business in which the
Company specializes. As of December 31, 1996, HCC had statutory policyholders'
surplus of $150.7 million.
TRAFALGAR INSURANCE COMPANY
HCC formed a wholly owned subsidiary, TIC, in 1993. TIC is an Oklahoma
domiciled property and casualty insurance company which currently underwrites
only domestic property risks and allows HCC to offer insurance on a surplus
lines basis in certain jurisdictions where HCC is not permitted to do so.
Applications for surplus lines approval are pending in many additional states
and TIC will expand its operations as approvals are received. As of December 31,
1996, TIC had statutory policyholders' surplus of $27.6 million.
8
IMG INSURANCE COMPANY LTD.
Organized in September, 1991, as a Jordanian Exempt Company ("JEC"), IMG
conducts substantially all of its business outside of Jordan and is principally
engaged in insuring and reinsuring large commercial risks in substantially the
same lines of business as HCC. In connection with IMG's business, the Company
has agreed to unconditionally guarantee certain of the insurance and reinsurance
business of IMG. As of December 31, 1996, IMG had policyholders' surplus of
$59.3 million.
AGENCY OPERATIONS
The Company's agency subsidiaries act on behalf of insurance and reinsurance
companies, conducting business in the areas of insurance and reinsurance
underwriting management and intermediary services. The agency subsidiaries do
not assume any insurance or reinsurance risk themselves. LDG, the largest of
these subsidiaries, manages and markets medical stop-loss and excess coverage
insurance products principally to employer sponsored self-insured health plans.
Other areas of LDG's business include medical, accident and health special risk,
workers' compensation and alternative workers' compensation and specialty
aviation reinsurance. NASRA acts as an insurance and reinsurance underwriting
manager in the area of occupational accident insurance (similar to workers'
compensation) to self-employed truckers. In addition, LDG and NASRA produce all
of the Company's accident and health business.
HCCU and MEIB specialize in marketing and servicing large, complicated
insurance and reinsurance programs placed on behalf of multinational clients
operating in the same lines of business that the Company underwrites. Such
business is placed with domestic and international insurance companies,
including HCC, TIC, and IMG, on a direct basis and through intermediaries. In
addition, LDG, HCCU and MEIB act as reinsurance intermediaries on behalf of HCC,
TIC, IMG and other insurance companies, placing both facultative and treaty
reinsurance. The Company's revenue is composed of fee and commission income
which increased to $38.5 million in 1996 from $17.0 million in 1992. Management
expects continued growth in agency revenues in 1997, both from existing
operations and pending acquisitions.
REINSURANCE CEDED
The Company principally utilizes reinsurance to reduce its net liability on
individual risks, to protect against catastrophic losses and to achieve a
desired ratio of NWP to policyholders' surplus. Various intermediaries,
including LDG, HCCU and MEIB, facilitate the placement of this reinsurance
coverage on behalf of the Company and are compensated, directly or indirectly,
by the reinsurers.
Reinsurance is ceded under treaties on both a proportional (where the
reinsurer shares proportionately in premiums and losses) and an excess of loss
basis (where only losses above a fixed point are reinsured). The Company also
reinsures on a facultative (individual policy) basis on large individual risks.
Management believes that the Company reinsures its risks to a greater extent
than most of its competitors and most other insurance companies. This strategy
greatly reduces the likelihood of a significant net loss from insurance company
operations and protects the integrity of the Company's shareholders' equity.
Under its current reinsurance protections, the Company has limited its net
retained loss, across any single line of business, to a maximum of approximately
$1.0 million for any one risk, but significantly less on most risks.
The type, cost and limits of reinsurance purchased can vary from year to
year based upon the Company's desired retention levels and the availability of
adequate reinsurance at a reasonable price. The majority of the Company's
reinsurance programs are renewed on a calendar year basis. For 1997, the Company
has been successful in renewing its reinsurance protections at reduced costs to
1996 and was able to expand its underwriting capacity. This expanded capacity
will assist the Company in taking advantage of underwriting opportunities as
they present themselves.
9
The Company structures a specific reinsurance program for each line of
business it underwrites. This reinsurance is placed to protect the Company from
any foreseeable event; proportionally to cover frequency and for catastrophe
coverage; excess of loss to cover severity on an individual risk; and
catastrophe to cover losses involving multiple risks, such as those resulting
from a hurricane or an earthquake. The Company does not expose itself to a net
loss from an individual risk in excess of its reinsurance protection.
The Company writes business in areas exposed to catastrophic losses and has
significant exposures to this type of loss in California, certain Gulf Coast
states and Mexico. The Company carefully assesses its overall exposures to a
single catastrophic event and applies procedures, that it believes are more
conservative than is typically used by the industry, to ascertain the Company's
probable maximum loss ("PML") from any single event. The Company maintains
reinsurance protection which it believes is sufficient to cover any foreseeable
event.
The Company receives an overriding (ceding) commission on the premium ceded
to reinsurers which compensates the Company for the direct costs associated with
the production of the premium, the servicing of the business during the term of
the policies ceded, and the costs associated with the placement of the related
reinsurance. In addition, certain of the Company's reinsurance treaties allow
for a sharing with the Company by the reinsurers of the net profits generated
under such treaties.
The ceding of reinsurance does not discharge the Company from liability to
its policyholders. The Company is required to pay losses even if the reinsurer
fails to meet its obligations under the reinsurance contract. To minimize its
exposure to reinsurance credit risk, the Company places its reinsurance with a
diverse group of financially sound reinsurers. The Company's 1997 treaty
reinsurance program was placed with more than 56 domestic and foreign
reinsurers. As of December 31, 1996, the total amount recoverable from
reinsurers was approximately $123.2 million, of which $21.7 million represents
paid losses recoverable and $103.9 million represents outstanding losses
recoverable less a $2.4 million reserve for uncollectible reinsurance. In
addition, ceded unearned premium was $65.8 million. The Company held $67.9
million of irrevocable letters of credit and $9.1 million in cash to
collateralize a portion of the total amount recoverable and had other payable
balances due to its reinsurers of $89.6 million as potential offsets against
reinsurance recoverables.
The following table sets forth the reinsurers with a total recoverable
balance greater than $10.0 million and the collateral and potential offsets held
by the Company as of December 31, 1996 (dollars in thousands):
LETTERS OF
REINSURANCE CREDIT,
RECOVERABLES AND CASH DEPOSITS
CEDED UNEARNED AND
REINSURER LOCATION PREMIUM OTHER PAYABLES
- ----------------------------------------------------- ---------------------- ---------------- ----------------
Underwriters at Lloyd's.............................. London, England $ 28,962 $ 18,446
GIO Insurance Limited................................ Sydney, Australia 25,204 26,106
Reinsurance Australia Corporation, Ltd. ............. Sydney, Australia 20,562 19,332
Underwriters Indemnity Company....................... Houston, TX 12,531 5,934
SCOR Reinsurance Company............................. New York, NY 11,105 2,428
AXA Reinsurance Company.............................. Wilmington, DE 10,402 2,759
Due to the Company's financial analysis of active and potential reinsurers
and its conservative strategy of diversifying its reinsurers, the Company has
never incurred a significant loss on recoverables from reinsurers. The Company
has established a reserve of $2.4 million as of December 31, 1996, to reduce the
effects of any recoverable problem.
10
OPERATING RATIOS
PREMIUM TO SURPLUS RATIO
The following table shows, for the periods indicated, the ratio of GWP and
NWP to statutory policyholders' surplus for the Company's property and casualty
insurance company subsidiaries:
FOR THE YEARS ENDED DECEMBER 31,
(DOLLARS IN THOUSANDS)
---------------------------------------------------------
1996 1995 1994 1993 1992
---------- ---------- ---------- ---------- ---------
GWP.......................................... $ 230,755 $ 238,958 $ 192,878 $ 123,650 $ 75,119
NWP.......................................... 96,776 98,786 59,694 38,556 25,618
Policyholders' surplus....................... 212,194 177,317 134,464 102,803 39,146
GWP Ratio.................................... 108.7% 134.8% 143.4% 120.3% 191.9%
GWP Industry Average(1)...................... * 194.0 221.8 224.4 238.0
NWP Ratio.................................... 45.6% 55.7% 44.4% 37.5% 65.4%
NWP Industry average (1)..................... * 113.0 129.7 132.6 139.6
- ------------------------
* Industry average not yet available
(1) Source: A.M. Best Company.
While there is no statutory requirement regarding a permissible premium to
surplus ratio, guidelines established by the National Association of Insurance
Commissioners ("NAIC") provide that a property and casualty insurer's annual
statutory GWP should not exceed 900% and NWP should not exceed 300% of its
policyholders' surplus. In keeping with its philosophy of protecting its
shareholders' equity and limiting its aggregate loss exposure, the Company
maintains premium to surplus ratios significantly lower than such guidelines,
and, as indicated above, below industry norms.
COMBINED RATIO
The underwriting experience of a property and casualty insurance company is
indicated by its combined ratio. The Company's insurance subsidiaries' loss
ratio, expense ratio and combined ratio, determined on the basis of statutory
accounting principles ("SAP"), are shown in the following table:
1996 1995 1994 1993 1992
--------- --------- --------- --------- ---------
Loss ratio............................................................... 56.4% 63.4% 64.6% 66.7% 66.2%
Expense ratio............................................................ 15.6 11.5 10.2 14.4 21.7
--- --------- --------- --------- ---------
Combined ratio........................................................... 72.0% 74.9% 74.8% 81.1% 87.9%
--- --------- --------- --------- ---------
--- --------- --------- --------- ---------
Industry Average(1)...................................................... * 106.4% 108.4% 106.9% 115.7%
- ------------------------
* Industry average not yet available
(1) Source: A.M. Best Company.
RESERVES
Applicable insurance laws and regulations, under which the Company operates,
require that reserves be maintained for the payment of loss and loss adjustment
expense ("LAE") with respect to both reported and incurred but not reported
("IBNR") claims under insurance and reinsurance policies issued by the Company.
The Company establishes reserves through an evaluation of each individual claim
rather than by any average reserving method. In the case of direct and
facultative reinsurance business, loss reserves are determined by evaluating
reported claims on the basis of the type of loss, jurisdiction of the
occurrence, knowledge of the circumstances surrounding the claim, severity of
injury or damage, potential for ultimate
11
exposure, experience with the insured and the line of business and policy
provisions relating to the particular type of claim. The Company establishes
loss reserves for excess of loss and proportional reinsurance claims based on
information and reports received from ceding companies. Loss reserves for IBNR
losses are determined in part on the basis of statistical information and in
part on industry experience with respect to the probable number and nature of
claims arising from occurrences which have not been reported. The Company does
not discount any of its loss reserves.
The period of time between the occurrence of an insured event and the final
settlement of a claim may be many years, and during this period it often becomes
necessary to adjust the claim estimates either upward or downward. Certain
classes of marine and offshore energy insurance underwritten by the Company have
historically had long lead times between the occurrence of an insured event,
reporting of the claim to the Company, and final settlement. In such cases, the
Company is forced to estimate reserves over long periods of time, with the
possibility of several adjustments to reserves. Other classes of insurance, such
as property, historically have shorter lead times between the occurrence of an
insured event, reporting of the claim to the Company, and final settlement. The
reserves with respect to such property classes are, therefore, less likely to be
adjusted.
The reserving process is intended to provide implicit recognition of the
impact of inflation and other factors affecting loss payments by taking into
account changes in historical payment patterns and perceived probable trends.
However, there is no precise method for the subsequent evaluation of the
adequacy of the consideration given to inflation, or to any other specific
factor, some of which are interdependent.
The Company underwrites, directly and through reinsurance, risks which are
denominated in a number of foreign currencies, and therefore establishes and
maintains loss reserves with respect to these policies in the respective
currencies. These reserves are subject to exchange rate fluctuations, which may
have an effect on the Company's earnings. The Company continues to limit its
exposure to future currency fluctuations through the use of foreign currency
forward contracts.
The following loss development triangle shows changes in reserves in
subsequent years from the prior loss estimates based on experience as of the end
of each succeeding year on the basis of generally accepted accounting principles
("GAAP"). The estimate is increased or decreased as more information becomes
known about the frequency and severity of losses for individual years. A
redundancy means the original estimate was higher than the current estimate; a
deficiency means that the current estimate is higher than the original estimate.
12
The first line of each loss development triangle presents, for each of the
years indicated, the gross reserve liability including the reserve for IBNR
losses. The first section of each table shows, by year, the cumulative amounts
of loss and LAE paid as of the end of each succeeding year. The second section
sets forth the re-estimates in later years of incurred losses, including
payments, for the years indicated. The "cumulative redundancy (deficiency)"
represents, as of December 31, 1996, the difference between the latest
re-estimated reserves and the reserves as originally estimated.
The following loss development triangle shows development in loss reserves
on a gross basis:
FOR THE YEARS ENDED DECEMBER 31,
(DOLLARS IN THOUSANDS)
----------------------------------------------------------
1996 1995 1994 1993 1992
---------- ---------- ---------- ---------- ----------
Balance Sheet Reserves:.............................. $ 185,822 $ 158,451 $ 129,755 $ 98,399 $ 81,997
Cumulative Paid as of:
One year later..................................... 91,910 72,077 54,385 58,367
Two years later.................................... 109,912 90,994 89,519
Three years later.................................. 118,551 115,487
Four years later................................... 136,931
Re-estimated liability as of:
End of year........................................ 185,822 158,451 129,755 98,399 81,997
One year later..................................... 204,262 148,168 121,428 116,007
Two years later.................................... 168,444 140,080 131,317
Three years later.................................. 160,180 148,748
Four years later................................... 169,450
Cumulative redundancy (deficiency)................... $ (45,811) $ (38,689) $ (61,781) $ (87,453)
[THE REMAINDER OF THIS PAGE LEFT INTENTIONALLY BLANK]
13
The following loss development triangle shows development in loss reserves
on a net basis:
FOR THE YEARS ENDED DECEMBER 31,
(DOLLARS IN THOUSANDS)
------------------------------------------------------------------------------
1996 1995 1994 1993 1992 1991 1990
---------- ---------- ---------- --------- --------- --------- ---------
Gross reserves for loss and LAE.............. 185,822 158,451 129,755 98,399 81,997 83,889 64,287
Less reinsurance recoverables................ 103,888 92,125 85,214 66,468 60,232 69,325 49,600
---------- ---------- ---------- --------- --------- --------- ---------
Reserves for loss and LAE net of
reinsurance................................ $ 81,934 $ 66,326 $ 44,541 $ 31,931 $ 21,765 $ 14,564 $ 14,687
Cumulative paid, net reinsurance as of
One year later............................. 19,731 15,714 12,361 6,715 4,279 7,100
Two years later............................ 22,231 18,402 13,471 5,533 11,049
Three years later.......................... 20,900 15,238 10,112 11,396
Four years later........................... 15,923 10,812 15,050
Five years later........................... 11,018 15,453
Six years later............................ 15,317
Seven years later..........................
Eight years later..........................
Nine years later...........................
Ten years later............................
Re-estimated liability, net of reinsurance as
of
End of year................................ 81,934 66,326 44,541 31,931 21,765 14,564 14,687
One year later............................. 62,523 42,923 32,648 21,513 14,951 17,514
Two years later............................ 43,316 32,544 22,061 14,590 17,707
Three years later.......................... 33,610 23,180 15,290 16,785
Four years later........................... 25,709 16,346 17,230
Five years later........................... 18,975 18,421
Six years later............................ 20,263
Seven years later..........................
Eight years later..........................
Nine years later...........................
Ten years later............................
Cumulative redundancy (deficiency)........... $ 3,803 $ 1,225 $ (1,679) $ (3,944) $ (4,411) $ (5,576)
1989 1988 1987 1986
--------- --------- --------- ---------
Gross reserves for loss and LAE.............. 48,948 30,680 32,066 22,357
Less reinsurance recoverables................ 36,586 22,253 25,106 17,118
--------- --------- --------- ---------
Reserves for loss and LAE net of
reinsurance................................ $ 12,362 $ 8,427 $ 6,960 $ 5,239
Cumulative paid, net reinsurance as of
One year later............................. 5,515 725 2,544 2,316
Two years later............................ 8,182 2,334 2,490 3,845
Three years later.......................... 10,791 3,558 3,337 3,642
Four years later........................... 11,207 4,149 4,250 4,041
Five years later........................... 13,434 4,223 4,454 4,561
Six years later............................ 13,361 4,138 4,646 4,957
Seven years later.......................... 13,101 4,476 4,082 5,215
Eight years later.......................... 4,475 4,335 5,516
Nine years later........................... 4,379 5,670
Ten years later............................ 5,678
Re-estimated liability, net of reinsurance as
of
End of year................................ 12,362 8,427 6,960 5,239
One year later............................. 13,330 7,215 7,820 5,060
Two years later............................ 14,367 6,980 6,526 6,481
Three years later.......................... 14,621 6,339 5,815 5,472
Four years later........................... 14,426 6,406 5,871 5,825
Five years later........................... 13,975 6,278 5,842 5,578
Six years later............................ 13,994 5,893 5,752 5,520
Seven years later.......................... 14,991 5,830 5,272 5,457
Eight years later.......................... 6,408 5,290 6,009
Nine years later........................... 5,944 6,032
Ten years later............................ 6,181
Cumulative redundancy (deficiency)........... $ (2,629) $ 2,019 $ 1,016 $ (942)
14
The following table provides a reconciliation of the gross liability of loss
and LAE on a GAAP basis at the beginning and end of 1996, 1995 and 1994:
FOR THE YEARS ENDED DECEMBER 31,
(DOLLARS IN THOUSANDS)
----------------------------------
1996 1995 1994
---------- ---------- ----------
Reserves for loss and LAE at beginning of year............................... $ 158,451 $ 129,755 $ 98,399
Reserves acquired with purchase of subsidiary, net of eliminations........... -- -- 1,059
Provision for loss and LAE for claims occurring in the current year.......... 109,262 128,073 83,194
Increase in estimated loss and LAE for claims occurring in prior years (1)... 45,811 18,413 23,029
---------- ---------- ----------
Incurred loss and LAE........................................................ 155,073 146,486 106,223
---------- ---------- ----------
Loss and LAE payments for claims occurring during:
Current year............................................................... 35,792 45,713 21,541
Prior years................................................................ 91,910 72,077 54,385
---------- ---------- ----------
Loss and LAE payments........................................................ 127,702 117,790 75,926
---------- ---------- ----------
Reserves for loss and LAE at end of the year................................. $ 185,822 $ 158,451 $ 129,755
---------- ---------- ----------
---------- ---------- ----------
- ------------------------
(1) Changes in loss and LAE reserves on a GAAP basis, for losses occurring in
prior years, reflect the gross effect of the resolution of losses for other
than the reserve value and the subsequent adjustments of loss reserves.
The following table provides a reconciliation of the liability for loss and
LAE, net of reinsurance ceded, on a GAAP basis at the beginning and end of 1996,
1995 and 1994:
FOR THE YEARS ENDED DECEMBER
31,
(DOLLARS IN THOUSANDS)
-------------------------------
1996 1995 1994
--------- --------- ---------
Reserves for loss and LAE at beginning of year................................... $ 66,326 $ 44,541 $ 31,931
Reserves acquired with purchase of subsidiary, net of eliminations............... -- -- 1,769
Provision for loss and LAE for claims occurring in the current year.............. 55,045 51,387 28,871
Increase in estimated loss and LAE for claims occurring in prior years (2)....... (3,803) (1,618) 717
--------- --------- ---------
Incurred loss and LAE............................................................ 51,242 49,769 29,588
--------- --------- ---------
Loss and LAE payments for claims occurring during:
Current year................................................................... 15,903 12,268 6,386
Prior years.................................................................... 19,731 15,716 12,361
--------- --------- ---------
Loss and LAE payments............................................................ 35,634 27,984 18,747
--------- --------- ---------
Reserves for loss and LAE at end of the year..................................... $ 81,934 $ 66,326 $ 44,541
--------- --------- ---------
--------- --------- ---------
- ------------------------
(2) Changes in loss and LAE reserves on a GAAP basis, for losses occurring in
prior years, reflect the net effect of the resolution of losses for other
than the reserve value and the subsequent adjustments of loss reserves.
During 1996, the Company had gross loss and LAE deficiency of $45.8 million.
The gross deficiency comes from two primary sources. The first source is the
development of several large claims on individual policies which were
substantially reinsured. These losses were either reported late or reserves were
increased as subsequent information became available. However, because these
policies were substantially reinsured, there is no material effect on a net
basis. The second source is the run-off of the excess of loss
15
"spiral" business the Company ceased writing in 1991. This development is due to
the delay in reporting of catastrophe losses by the London insurance market,
coupled with the unprecedented number of catastrophes and subsequent insurance
company insolvencies. As the Company did not have enough representative years'
underwriting experience to base a more accurate estimate on, significant gross
development has been experienced. However, this business is substantially
reinsured, thereby not having a material effect on the Company's current
operations or shareholders' equity.
During 1996, the Company had net loss and LAE redundancy of $3.8 million
relating to prior year losses compared to a redundancy of $1.6 million in 1995.
The redundancies have been reflected in the statements of earnings for each year
as they occur.
The Company has no material exposure to environmental pollution losses, as
the Company only began writing business in 1981 and policies issued by the
Company normally contain pollution exclusion clauses which limit pollution
coverage to "sudden and accidental" losses only, thus excluding intentional
(dumping) and seepage claims. Therefore, the Company should not experience any
material development in reserves from environmental pollution claims.
INVESTMENTS
Insurance company investments must comply with applicable laws and
regulations which prescribe the kind, quality and concentration of investments.
In general, these laws and regulations permit investments, within specified
limits and subject to certain qualifications, in Federal, state and municipal
obligations, corporate bonds, preferred and common equity securities, real
estate mortgages and real estate. As of December 31, 1996, the Company had
$320.3 million of investment assets, the majority of which were held by HCC.
The Company's investment policy is determined by the Company's Board of
Directors and is reviewed on a regular basis. Pursuant to its investment policy,
the Company concentrates its investments in obligations of states,
municipalities and political subdivisions, the interest income from which is
predominantly exempt from Federal income tax. The interest rates on these
securities are normally lower than rates on comparable taxable securities. The
Company's portfolio of fixed income securities available for sale principally
consists of intermediate term, tax-exempt securities. The Company generally
intends to hold such securities to maturity. However, the Company regularly
re-evaluates its position based upon market conditions, which may cause the
Company to restructure its portfolio and realize gains or losses in order to
maximize its total return on investments. Accordingly, all fixed income
securities are classified as available for sale and are recorded at market
value.
The Company's financial statements reflect an unrealized ("mark-to-market")
gain on fixed income securities available for sale as of December 31, 1996, of
$2.1 million. Since the Company's intention is to hold these securities until
maturity, it does not currently expect to realize any significant gain or loss
on these investments.
The Company has maintained a substantial level of cash and liquid short-term
instruments in order to maintain the ability to fund large physical damage
losses of the Company's insureds, should they occur. As of December 31, 1996,
the Company had cash and short-term investments of approximately $56.3 million.
The Company also maintains credit facilities which provide for $23 million in
bank lines of credit for the issuance of letters of credit and short-term
borrowings.
From time to time the Company enters into foreign currency forward contracts
as a hedge against foreign currency fluctuations, primarily British Pound
Sterling. The Company's balances denominated in foreign currency fluctuate as
transactions are recorded and settled. During 1996, the average Sterling
liability, for subsidiaries whose functional currency was the United States
dollar, was approximately L907,000 ($1.6 million at December 31, 1996, rate of
exchange) which was hedged by an average open forward contract balance of
approximately L460,000 ($785,000 at the December 31, 1996, rate of
16
exchange). There was one open foreign currency forward contract as of December
31, 1996, to purchase L500,000 ($856,000 at the December 31, 1996, rate of
exchange) with a maturity of January, 1997. During January, 1997, the Company
entered into a foreign currency forward contact totaling L500,000 ($856,000 at
the December 31, 1996, rate of exchange). The Company expects to continue to
limit its exposure to currency fluctuations through the use of foreign currency
forward contracts.
The Company utilizes these foreign currency forward contracts strictly as a
hedge against existing exposure to foreign currency fluctuations and it does not
do so as any form of speculative or trading investment.
The following tables reflect the investments of the Company (dollars are
expressed in thousands). The table set forth below reflects the average amount
of investments, income earned, and the yield thereon for the years ended
December 31, 1996, 1995, and 1994 respectively:
1996 1995 1994
---------- ---------- ----------
Average investments................................................... $ 312,773 $ 258,584 $ 192,397
Net investment income................................................. 15,372 13,250 9,533
Average yield (1)..................................................... 4.9% 5.1% 5.0%
Average tax equivalent yield (1)...................................... 6.7 6.7 6.7
- ------------------------
(1) Excluding realized and unrealized capital gains and losses.
The table set forth below summarizes, by type, the investments of the
Company as of December 31, 1996:
AMOUNT PERCENT OF TOTAL
---------- -----------------
Short-term investments................................................................ $ 53,100 16%
U.S. Treasury securities.............................................................. 3,604 1
Obligations of states, municipalities and political subdivisions...................... 261,123 82
Marketable equity securities.......................................................... 2,433 1
---------- ---
Total investments................................................................... $ 320,260 100%
---------- ---
---------- ---
The table set forth below indicates the expected maturity distribution of
the Company's fixed income securities as of December 31, 1996:
AMOUNT PERCENT OF TOTAL
---------- -----------------
One year or less...................................................................... $ 4,276 2%
One year to five years................................................................ 67,383 25
Five years to ten years............................................................... 80,876 31
Ten years to fifteen years............................................................ 61,408 23
More than fifteen years............................................................... 50,784 19
---------- ---
Total fixed income securities....................................................... $ 264,727 100%
---------- ---
---------- ---
COMPETITION
The insurance business is generally highly competitive. The Company faces
competition from domestic and foreign insurers, some of whom are larger and have
greater financial, marketing and management resources than the Company. The
Company's profitability is affected by many other factors, including rate
competition, severity and frequency of claims, interest rates, state
regulations, court decisions, the judicial climate and general business
conditions, all of which are outside the control of the Company. The Company's
medical stop-loss business involves a diversified field of participants from
small start-up
17
operations to large, well-established organizations. While the medical stop-loss
business has been historically competitive, during the past several years there
has been significant growth in the number of medical stop-loss insurance
underwriters. The Company also faces intense and growing pressure from
alternatives to employer sponsored self-insured health plans, such as
fully-insured plans, HMOs and Point of Service plans, as well as from large well
established direct insurers and competing underwriting managers providing
similar medical stop-loss products to those offered by the Company to employer
sponsored self-insured health plans. Competition in the reinsurance marketplace
is primarily due to an increase in the number of reinsurers participating in the
market as well as a tendency by reinsureds to retain a greater percentage of
their own risk. The Company competes with other reinsurance underwriting
managers and domestic and international reinsurance companies. The Company's
results of operations may also be affected by the competition for reinsurance
business between broker reinsurance markets and direct reinsurance writers. The
Company also competes with many reinsurance intermediaries in the broker
reinsurance market, some of which are affiliated with primary insurance brokers
with substantial financial resources. In each of the above business areas, a
significant number of the Company's competitors have financial resources,
employees, facilities, market recognition, marketing, management, experience,
and other resources substantially greater than those of the Company.
REGULATION
The operations of the Company are subject to state insurance laws and
regulations which require the licensing of insurance agents, brokers,
reinsurance intermediaries, reinsurance underwriting managers, and managing
general agents which regulate certain aspects of their business. These laws and
regulations are intended primarily for the protection of policyholders, rather
than shareholders of the licensed entities, and may include requirements for
certain provisions in contracts entered into between the Company and various
insurers or reinsurers, certain record keeping and reporting requirements,
advertising and business practice rules, and other matters. The Company's
business depends on obtaining and maintaining licenses and approvals pursuant to
which it operates, as well as compliance with pertinent regulations. In addition
to the regulatory supervision of the insurance subsidiaries of the Company, the
Company is subject to regulation under the Texas Insurance Holding Company
System Regulatory Act, which contains certain reporting requirements including
registration and the filing of annual reports. In such registration and annual
reports, the Company is required to provide current information regarding its
capital structure, general financial condition, ownership, management, and the
identity of each member of its insurance holding company system. The Company is
also required in such registration and annual reports to disclose certain
agreements and transactions between the Company and its affiliates, which must
satisfy certain standards set forth in the Texas Insurance Code. There can be no
assurance given that the Company has all such required licenses, approvals of
complying contracts or that such licenses, approvals or complying contracts can
always be obtained or continued. In all jurisdictions, the applicable laws and
regulations are subject to amendment or interpretation by regulatory
authorities. Generally, such authorities are vested with relatively broad
discretion to grant, renew and revoke licenses and approvals, and to implement
regulations, and licenses may be denied or revoked for various reasons,
including the violations of such regulations, conviction of crimes and the like.
In some instances, the Company follows practices based on its interpretations,
or those that it believes may be generally followed by the industry, which may
be different from the requirements or interpretations of regulatory authorities.
Accordingly, the possibility exists that the Company may be precluded or
temporarily suspended from carrying on some or all of its activities or
otherwise penalized in a given jurisdiction. Such preclusion or suspension could
have a materially adverse effect on the business and results of operations of
the Company.
HCC is licensed as an admitted insurer in Texas, is an approved surplus
lines insurer and an accredited reinsurer in Oklahoma and Maryland, is an
approved surplus lines insurer in 32 states, and is otherwise permitted to write
surplus lines insurance in nine more states, the District of Columbia, Guam and
Puerto Rico. All surplus lines insurance is written through licensed surplus
lines insurance brokers, who are required to ensure that no licensed admitted
insurer will write a particular risk prior to placing that risk
18
with a surplus lines insurer. TIC is licensed as an admitted insurer in
Oklahoma, is an approved surplus lines insurer and an accredited reinsurer in
Texas, is a surplus line insurer in seven states and is otherwise permitted to
write surplus lines insurance in nine more states and the District of Columbia.
IMG is a JEC licensed as a property and casualty insurance company. Due to its
status as a JEC, IMG cannot write Jordanian domiciled business directly, but can
write reinsurance of Jordanian risks.
Under the laws of its domiciliary state (Texas), HCC may only pay dividends
out of its statutory earned surplus. The maximum amount of dividends that HCC
may pay without prior regulatory approval in any twelve month period is the
greater of its statutory net investment income for the prior year, or 10% of its
statutory policyholders' surplus as of the prior year end, which at December 31,
1996, was $15.1 million. Under the laws of the State of Oklahoma, TIC may only
pay dividends out of surplus funds. The maximum amount TIC may pay without prior
regulatory approval is the greater of statutory net income excluding realized
capital gains or 10% of statutory capital and surplus, which at December 31,
1996 was $2.8 million. As of December 31, 1996, HCC's total adjusted capital was
1,332% of the NAIC authorized control level risk-based capital and TIC's total
adjusted capital was 17,928% of the NAIC authorized control level risk-based
capital.
PENDING LEGISLATION
In recent years state legislatures have considered or enacted laws that
alter and, in many cases, increase state authority to regulate insurance
companies and insurance holding company systems. In addition, the NAIC and state
insurance regulators, as part of the NAIC's state insurance department
accreditation program, have re-examined existing laws and regulations,
specifically focusing on insurance company investments, issues relating to the
solvency of insurance companies, licensing and market conduct issues,
interpretations of existing laws, the development of new laws, and the
definition of extraordinary dividends. In addition, Congress and certain Federal
agencies have conducted investigations of the current condition of the insurance
industry in the United States to determine whether to impose Federal regulation
of insurers and reinsurers. From time to time, Congress and certain states have
considered various legislative proposals which would provide for governmental
earthquake insurance coverage. Legislation has been introduced in Congress that
could result in the Federal government's assuming some role in the regulation of
the insurance industry. The Company does not know at this time the extent to
which such Federal or state legislative or regulatory initiatives will be
adopted, and no assurance can be given that they would not have a material
adverse effect on the Company.
EMPLOYEES
As of December 31, 1996, the Company had 331 employees, which included seven
executive, seventeen senior management and 45 other management personnel. The
average experience in the insurance industry and tenure with the Company of the
executive and senior management personnel was 21 and eight years, respectively.
The Company is not a party to any collective bargaining agreement and has not
experienced work stoppages or strikes as a result of labor disputes. The Company
considers relations with its employees to be good.
19
ITEM 2. PROPERTIES
HCC owns the building which houses the Company's principal and executive
offices in Houston, Texas. The building contains approximately 54,000 square
feet, substantially all of which are used by the Company. LDG's principal
facility is leased office space in Wakefield, Massachusetts consisting of
approximately 34,000 square feet. The lease terminates on October 31, 2001.
Principal activities conducted at the Wakefield office include corporate
management, finance and administration, marketing and actuarial services for all
areas of LDG's business, and medical stop-loss insurance underwriting
management, reinsurance underwriting management, claims, and reinsurance
intermediary activities. LDG's Medical Stop-Loss Division maintains sales and
administration offices in Atlanta, Georgia, Overland Park, Kansas, Portland,
Maine, and Minneapolis, Minnesota. LDG maintains a reinsurance underwriting and
sales office in New York, New York. LDG also maintains an office in London,
England. NASRA's principal facility is newly leased office space in Northbrook,
Illinois, consisting of approximately 18,000 square feet. The lease terminates
on November 30, 2005. Principal activities conducted at the Northbrook office
include corporate management, finance and administration, marketing,
underwriting, customer service and claims activities.
ITEM 3. LEGAL PROCEEDINGS
The Company is a party to numerous lawsuits arising in the normal course of
business. All pending lawsuits involve claims under policies underwritten or
reinsured by the Company, which management believes have been adequately
included in its established loss reserves. The Company believes the resolution
of these lawsuits will not have a material adverse effect on its financial
condition, results of operations or cash flows.
ITEM 4. SUBMISSION OF MATTER TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the
fourth quarter of 1996.
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20
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER
MATTERS
MARKET INFORMATION
The Company's Common Stock began trading on the NASDAQ--National Market
System ("NASDAQ") under the symbol HCCH on October 28, 1992, and traded on
NASDAQ until June 19, 1995. On June 20, 1995, the Company's Common Stock began
trading on the New York Stock Exchange ("NYSE") under the symbol HCC and
currently trades on the NYSE.
The high and low bid prices for quarterly periods during the period January
1, 1995 through June 19, 1995, as reported by NASDAQ and the high and low
closing sales prices for the quarterly periods during the period June 20, 1995
through December 31, 1996, as reported by the NYSE were as follows:
1996 (1)
-----------------
HIGH LOW
------ ------
First Quarter................................................................... $23 1/4 $14 1/2
Second Quarter.................................................................. 25 1/2 19 1/8
Third Quarter................................................................... 32 3/4 22 1/8
Fourth Quarter.................................................................. 29 1/4 23 1/8
1995 (1)
-----------------
HIGH LOW
------ ------
First Quarter................................................................... $10 1/4 $7 7/8
Second Quarter.................................................................. 11 8 3/4
Third Quarter................................................................... 13 3/4 10 1/8
Fourth Quarter.................................................................. 15 1/4 12 1/4
- ------------------------
(1) The above prices have been retroactively adjusted to reflect the effects of
the five-for-two stock split, payable as a 150% stock dividend to
shareholders of record April 30, 1996. On March 24, 1997, the closing sales
price of one share of HCCH's Common Stock as reported by the NYSE was
$25.00.
SHAREHOLDERS
The Company has one class of authorized capital stock: 100,000,000 shares of
Common Stock, par value $1.00 per share. As of March 24, 1997, there were
36,167,935 shares of issued and outstanding Common Stock held by 130
shareholders of record; however, the Company believes there are in excess of
5,000 beneficial owners.
DIVIDENDS
On April 19, 1996 the Company announced that the Board of Directors had
declared a five-for-two stock split in the form of a 150% stock dividend,
payable to shareholders of record April 30, 1996. In connection with this, the
Company announced it would purchase, for cash, any fractional shares issued in
connection with this split.
On June 18, 1996, the Company announced its first cash dividend of $0.02 per
share payable to shareholders of record July 1, 1996. The Company has paid a
cash dividend of $0.02 per share in each succeeding quarter. On March 24, 1997,
the Company declared a cash dividend of $0.03 per share and plans to continue to
pay $0.03 per share dividend in future quarters. The Board of Directors may
review the Company's dividend policy from time to time, and any determination
with respect thereto will be made in light of regulatory and other conditions
then existing, including the Company's earnings, financial condition, capital
requirements, loan covenants, and other related factors.
21
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial data set forth below has been derived
from the Consolidated Financial Statements. All information contained herein
should be read in conjunction with the Consolidated Financial Statements, the
related notes thereto and Management's Discussion and Analysis included
elsewhere in this document.
FOR THE YEARS ENDED DECEMBER 31,
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)(5)
-----------------------------------------------------
1996 1995 1994(4) 1993 1992
--------- --------- --------- --------- ---------
STATEMENT OF EARNINGS DATA
Revenue
Net earned premium................................... $ 93,314 $ 80,011 $ 46,834 $ 32,663 $ 24,483
Fee and commission income............................ 38,462 32,887 28,456 24,073 16,998
Net investment income................................ 15,372 13,250 9,533 5,454 2,814
Net realized investment gain......................... 5,097 1,061 682 949 17
--------- --------- --------- --------- ---------
Total revenue.................................... 152,245 127,209 85,505 63,139 44,312
Expense
Loss and LAE......................................... 51,242 49,769 29,588 21,210 16,834
Operating expense
Policy acquisition costs........................... 34,110 29,748 21,729 12,747 9,238
Compensation expense............................... 20,353 26,790 23,900 16,258 13,330
Other operating expense............................ 12,855 12,591 8,660 7,261 4,191
Ceding commissions................................. (30,268) (27,228) (20,210) (11,166) (6,276)
--------- --------- --------- --------- ---------
Net operating expense............................ 37,050 41,901 34,079 25,100 20,483
Compensatory stock grant and merger related expenses... 26,160 -- -- -- --
Interest expense....................................... 1,166 2,247 1,972 1,175 607
--------- --------- --------- --------- ---------
Total expense.................................... 115,618 93,917 65,639 47,485 37,924
--------- --------- --------- --------- ---------
Earnings before income tax provision................... 36,627 33,292 19,866 15,654 6,388
Income tax provision................................... 7,329 8,955 4,598 2,966 1,098
--------- --------- --------- --------- ---------
Net earnings..................................... $ 29,298 $ 24,337 $ 15,268 $ 12,688 5,290
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
Increase in redemption value of redeemable common stock
(1).................................................. (1,124)
---------
Net earnings applicable to nonredeemable common
stock.......................................... 4,166
---------
---------
EARNINGS PER SHARE DATA
Primary:
Earnings per share applicable to nonredeemable common
stock (2).......................................... $ 0.81 $ 0.75 $ 0.55 $ 0.53 $ 0.28
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
Weighted average shares outstanding (2).............. 35,965 32,667 27,910 23,999 14,863
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
Fully diluted:
Earnings per share applicable to nonredeemable common
stock (2).......................................... $ 0.81 $ 0.74 $ 0.55 $ 0.52 $ 0.27
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
Weighted average shares outstanding (2).............. 35,986 32,804 27,998 24,199 15,260
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
Cash dividends declared, per share..................... $ 0.06
---------
---------
PRO FORMA INFORMATION (6):
Net earnings........................................... $ 43,655
---------
Earnings per share..................................... $ 1.21
---------
---------
22
DECEMBER 31,
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)(5)
-----------------------------------------------------
1996 1995 1994(4) 1993 1992
--------- --------- --------- --------- ---------
BALANCE SHEET DATA:
Total investments.................................... $ 320,260 $ 305,287 $ 211,881 $ 172,913 $ 78,755
Reinsurance recoverables............................. 123,181 103,408 99,462 73,057 62,089
Premium, claims and other receivables................ 139,109 130,384 113,704 54,781 46,517
Ceded unearned premium............................... 65,845 73,282 60,671 26,177 9,830
Total assets......................................... 745,779 681,676 549,490 352,506 213,905
Loss and LAE payable................................. 185,822 158,451 129,755 98,399 81,997
Unearned premium..................................... 114,758 118,732 87,346 37,382 15,142
Total debt........................................... 16,500 16,661 44,908 28,944 3,673
Shareholders' equity................................. 240,690 195,459 114,374 93,451 43,168
Net tangible book value per share (2) (3)............ $ 6.41 $ 5.33 $ 3.50 $ 3.50 $ 2.01
Book value per share (2) (3)......................... $ 6.71 $ 5.65 $ 3.89 $ 3.50 $ 2.01
- --------------------------
(1) In a 1987 private placement, the Company sold shares of redeemable common
stock, which incorporated a redemption obligation requiring the Company to
repurchase such shares at a specified multiple of the then current book
value. Prior to its October, 1992 initial public offering, the Company
executed an agreement with the holders of the redeemable common stock
whereby the redemption obligation would terminate upon the effective date of
the initial public offering. During the period in which the redemption
obligation was in force, the Company was required to reduce its earnings by
an amount equal to the increase in the redemption value of the redeemable
common stock and concurrently increase the book value of the redeemable
common stock by a like amount. On October 28, 1992, the effective date of
the Company's initial public offering, the redemption obligation terminated.
(2) These amounts have been adjusted to reflect the effects of the three-for-two
stock split payable as a 50% stock dividend to shareholders of record March
15, 1994, and the five-for-two stock split payable as a 150% stock dividend
to shareholders of record April 30, 1996.
(3) Book value per share is calculated by dividing shares outstanding into total
shareholders' equity. Net tangible book value per share uses total
shareholders' equity less goodwill as the numerator.
(4) Effective October 1, 1994, the Company acquired 100% of the stock of IMG and
MEIB. Both acquisitions were accounted for using the purchase method.
Therefore, the results of operations from both companies are included in the
consolidated statements of earnings beginning October 1, 1994 and assets and
liabilities of IMG and MEIB have been included in the consolidated balance
sheets beginning October 1, 1994.
(5) On May 24, 1996, the Company acquired 100% of the outstanding common stock
of LDG. This business combination has been accounted for as a
pooling-of-interests and, accordingly, the consolidated financial data shown
in this table has been restated to include the accounts and operations of
LDG for all periods presented. On November 27, 1996, the Company acquired
100% of the outstanding shares of NASRA. This combination has been accounted
for as a pooling-of-interests. However, the Company's consolidated financial
statements have not been restated due to immateriality.
(6) The pro forma amounts shown include the following adjustments relating to
the merger of LDG and HCCH: a) to eliminate the non-recurring compensatory
stock grant and expenses related to the merger, and b) to reflect
appropriate Federal income tax expense on LDG's earnings for the period LDG
was an S Corporation.
23
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS
FORWARD-LOOKING STATEMENTS IN THIS FORM 10-K ARE MADE PURSUANT TO THE SAFE
HARBOR PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995.
INVESTORS ARE CAUTIONED THAT ALL FORWARD-LOOKING STATEMENTS INVOLVE RISKS AND
UNCERTAINTY, INCLUDING WITHOUT LIMITATION, THE RISK OF A SIGNIFICANT NATURAL
DISASTER, THE INABILITY OF THE COMPANY TO REINSURE CERTAIN RISKS, THE ADEQUACY
OF ITS LOSS RESERVES, EXPANSION OR CONTRACTION IN ITS VARIOUS LINES OF BUSINESS,
THE IMPACT OF INFLATION, CHANGING REGULATIONS IN FOREIGN COUNTRIES, THE EFFECT
OF PENDING ACQUISITIONS, AS WELL AS GENERAL MARKET CONDITIONS, COMPETITION,
LICENSING AND PRICING. PLEASE REFER TO THE COMPANY'S SECURITIES AND EXCHANGE
COMMISSION FILINGS, COPIES OF WHICH ARE AVAILABLE FROM THE COMPANY WITHOUT
CHARGE, FOR FURTHER INFORMATION.
GENERAL
The Company's primary sources of revenue are earned premium and investment
income derived from its insurance operations, and fee and commission income from
its insurance agency operations. The Company's core underwriting activities
involve providing aviation, marine, offshore energy, property, and accident and
health insurance, which is underwritten on both a direct and a reinsurance
basis. The Company concentrates on first party, physical damage coverages and
lines of business which have relatively short lead times between the occurrence
of an insured event and the reporting of claims to the Company. The Company also
selectively underwrites a small amount of excess treaty reinsurance. The
Company's agencies market and service medical stop-loss, occupational accident
and excess coverage insurance products plus large complicated insurance and
reinsurance programs on behalf of multinational clients. They also place
reinsurance for the Company's insurance operations and other insurance
companies.
During recent years, the Company has substantially increased its capital and
surplus through the issuance of equity securities, incurrence of debt, and
earnings, thereby enabling it to increase its underwriting capacity. The Company
has utilized this additional capital by increasing underwriting activity across
many of its core lines of business, emphasizing lines of business and individual
opportunities with the most favorable underwriting characteristics at a
particular point in time. In each line of business, the Company also cedes
premiums through the purchase of reinsurance in types and amounts appropriate to
the line of business, market conditions and the Company's desired net risk
retention profile. Accordingly, the Company has substantially increased both its
GWP and NWP, although with different relative increases in each line of
business. In addition, because the Company's operating expense and loss and LAE
have not increased as quickly as its premium volume, the Company has been able
to substantially expand its operating margins.
24
RESULTS OF OPERATIONS
The following table sets forth certain premium revenue information for the
periods indicated (dollars in thousands):
FOR THE YEARS ENDED DECEMBER 31,
----------------------------------
1996 1995 1994
---------- ---------- ----------
Direct.................................................................... $ 84,166 $ 111,466 $ 97,585
Reinsurance assumed....................................................... 146,589 127,492 95,293
---------- ---------- ----------
Gross written premium............................................... 230,755 238,958 192,878
Reinsurance ceded......................................................... (133,979) (140,172) (133,184)
---------- ---------- ----------
Net written premium................................................. 96,776 98,786 59,694
Increase in unearned premium.............................................. (3,462) (18,775) (12,860)
---------- ---------- ----------
Net earned premium.................................................. $ 93,314 $ 80,011 $ 46,834
---------- ---------- ----------
---------- ---------- ----------
The following table sets forth the relationships of certain income statement
items as a percent of total revenue for the periods indicated:
FOR THE YEARS ENDED DECEMBER
31,
-------------------------------
1996 1995 1994
--------- --------- ---------
Net earned premium............................................................. 61.3% 62.9% 54.8%
Fee and commission income...................................................... 25.3 25.9 33.3
All other income............................................................... 13.4 11.2 11.9
--------- --------- ---------
Total revenue............................................................ 100.0 100.0 100.0
Loss and LAE................................................................... 33.7 39.1 34.6
Net operating expense.......................................................... 24.3 32.9 39.9
All other expense.............................................................. 17.9 1.8 2.3
--------- --------- ---------
Earnings before taxes.................................................... 24.1 26.2 23.2
Income taxes................................................................... 4.9 7.1 5.3
--------- --------- ---------
Net earnings............................................................. 19.2% 19.1% 17.9%
--------- --------- ---------
--------- --------- ---------
YEAR ENDED DECEMBER 31, 1996 VERSUS YEAR ENDED DECEMBER 31, 1995
Total revenue during 1996 increased 20% to $152.2 million from $127.2
million in 1995. 1996 GWP decreased to $230.8 million from $239.0 million in
1995, while 1996 NWP decreased from $98.8 million to $96.8 million. The decrease
in written premium was a result of the planned exit from the offshore energy
business as a result of increased competition that has driven rates below
acceptable levels, as well as the softening in marine rates and, more recently,
property rates. Net earned premium in 1996 increased from $80.0 million to $93.3
million, reflecting the large increase in written premium during 1995.
Fee and commission (non-risk bearing) income in 1996 increased 17% to $38.5
million from $32.9 million in 1995, reflecting increased agency activities. Net
investment income increased 16% to $15.4 million in 1996 from $13.3 million in
1995 reflecting a higher level of investment assets.
Realized investment gains from sales of marketable equity securities were
$5.3 million during 1996 compared to $1.1 million during 1995. Realized
investment losses from dispositions of fixed income securities were $201,000
during 1996, compared to losses of $11,000 during 1995. During 1996, the Company
liquidated most of its equity security portfolio and redeployed those investment
assets into fixed income securities.
Loss and LAE increased $1.5 million in 1996, to $51.2 million, reflecting
the overall increase in business. During 1996, the Company had net loss and LAE
redundancy of $3.8 million relating to prior
25
year losses compared to a redundancy of $1.6 million in 1995. However, during
1996, the Company had gross loss and LAE deficiency of $45.8 million. The gross
deficiency comes from two primary sources. The first source is the development
of several large claims on individual policies which were substantially
reinsured. These losses were either reported late or reserves were increased as
subsequent information became available. However, because these policies were
substantially reinsured, there is no material effect on a net basis. The second
source is the run-off of the excess of loss "spiral" business which the Company
ceased writing in 1991. This development is due to the delay in reporting of
catastrophe losses by the London market, coupled with the unprecedented number
of catastrophes and subsequent insurance company insolvencies. As the Company
did not have enough representative years' underwriting experience upon which to
base a more accurate estimate, significant gross development has been
experienced. However, this business is substantially reinsured, thereby not
having a material effect on the Company's current operations or shareholders'
equity. The Company continues to believe it has materially provided for all net
incurred losses.
Compensation expense decreased $6.4 million or 24% in 1996, to $20.4 million
due primarily to changes in compensation to LDG's previous principal
shareholders.
Interest expense during 1996 decreased 48% to $1.2 million from $2.2 million
during 1995 due to the reduced level of indebtedness as a portion of the
proceeds of a June, 1995, public offering of Common Stock which was used to
retire debt.
Income tax expense decreased to $7.3 million in 1996, compared to $9.0
million in 1995. The decrease in income tax expense was a result of a deferred
tax benefit of $9.6 million which was recorded in connection with the
compensatory stock grant to certain LDG employees. Also, as an S corporation,
LDG was exempt from Federal income taxes through May 21, 1996. Had LDG been
subject to Federal income taxes for both years, additional income tax expense of
$2.3 million and $722,000 would have been recorded during the years ended
December 31, 1996 and 1995, respectively.
Net earnings increased 20% to $29.3 million in 1996 from $24.3 million in
1995. Included in these amounts were merger related expenses of $2.1 million and
a non-recurring compensation expense of $14.4 million (net of a $9.6 million tax
benefit) recorded by LDG in connection with a compensatory stock grant from
LDG's majority shareholder to certain key employees prior to the Company's May,
1996, acquisition of LDG. The compensation expense was a non-cash item however,
$9.6 million of actual cash tax savings will be recognized. Earnings per share
increased 8% to $0.81 in 1996 from $0.75 in 1995. Excluding the non-recurring
compensation charge and the merger related expenses, net earnings in 1996 would
have been $43.7 million, an increase of 56% over comparable 1995 amounts and
earnings per share would have been $1.21, a 41% increase over comparable 1995
amounts. The non-recurring compensation expense also caused the net loss for the
agency segment during 1996.
The Company's insurance company subsidiaries' statutory combined ratio was
72.0% for 1996 compared to 74.9% in 1995. The Company's combined ratio remains
significantly better than the industry average.
YEAR ENDED DECEMBER 31, 1995 VERSUS YEAR ENDED DECEMBER 31, 1994
Total revenue during 1995 increased 49% to $127.2 million from $85.5 million
in 1994. GWP increased 24% to $239.0 million from $192.9 million in 1994, while
1995 NWP increased 65% from $59.7 million to $98.8 million. Accordingly, net
earned premium in 1995 increased 71% from $46.8 million to $80.0 million. These
increases were due to substantial new business, rate increases on some renewals,
particularly property and aviation, and increased retentions.
Fee and commission (non-risk bearing) income in 1995 increased 16% to $32.9
million from $28.5 million in 1994, reflecting increased agency activities. Net
investment income increased 39% to $13.3 million in 1995 from $9.5 million in
1994 reflecting a substantially higher level of investment assets due to
increased operating cash flow and the deployment of the proceeds from a public
offering of the Company's Common Stock.
26
Realized investment gains from sales of marketable equity securities were
$1.1 million during 1995 compared to $775,000 during 1994. Realized investment
losses from sales of fixed income securities were $11,000 during 1995, compared
to losses of $89,000 during 1994.
Loss and LAE increased $20.2 million in 1995, to $49.8 million, reflecting
the overall increase in business written. During 1995, the Company had net loss
and LAE redundancy of $1.6 million relating to prior year losses compared to a
deficiency of $717,000 in 1994. However, during 1995, the Company had gross loss
and LAE deficiency of $18.4 million. A substantial portion of this gross
deficiency relates to the run-off of the excess of loss "spiral" business which
the Company ceased writing in 1991. This development is due to the delay in
reporting of catastrophe losses by the London market, coupled with the
unprecedented number of catastrophes and subsequent insurance company
insolvencies. As the Company did not have enough representative years'
underwriting experience to base a more accurate estimate on, significant gross
development has been experienced. However, this business is substantially
reinsured, thereby not having a material effect on the Company's current
operations or shareholders' equity. The Company continues to believe it has
materially provided for all net incurred losses.
Interest expense during 1995 increased 14% to $2.2 million from $2.0 million
during 1994 due to the increased level of indebtedness during the first six
months of 1995, which was incurred during late 1994 to fund the acquisitions of
IMG and MEIB.
Net earnings increased 59% to $24.3 million from $15.3 million in 1994. This
increase was principally a result of more efficient and continued profitable
underwriting plus higher investment income and fee and commission income.
Earnings per share in 1995 increased 36% to $0.75 from $0.55 in 1994. This
reflects the 59% increase in net earnings partially offset by the 17% increase
in weighted average shares outstanding as a result of HCCH's 1994 acquisitions
and 1995 public stock offering.
HCCH's insurance company subsidiaries' statutory combined ratio was 74.9%
for 1995 compared to 74.8% in 1994. HCCH's combined ratio remains significantly
better than the industry average.
LIQUIDITY AND CAPITAL RESOURCES
HCCH completed an initial public offering of 1,437,500 shares (pre splits)
of Common Stock during October, 1992 and secondary public offerings of 1,254,200
shares (pre splits) of Common Stock in September, 1993 and 2,012,500 shares (pre
split) of Common Stock in June, 1995. The offerings dramatically improved the
capital resources of the Company. The net proceeds of the offerings have been
used to reduce the Company's indebtedness and to contribute capital to the
insurance company subsidiaries. HCC now has more than $150 million in
policyholders' surplus and IMG has more than $59 million. This additional
capital enables both HCC and IMG to write significantly more premium income. The
initial public offering also resulted in the termination of all redemption
rights previously held by certain shareholders.
The Company receives substantial cash from premiums and reinsurance
recoverables, and, to a lesser extent, investment income, proceeds from sales
and redemptions of investment assets and fee and commission income. The
principal cash outflows are for the payment of claims, payment of premiums to
reinsurers, purchase of investments, debt service, LAE, policy acquisition
costs, operating expense, income and other taxes and dividends.
During 1996, HCC renewed its existing credit facility which provides for a
$12 million bank line of credit for the issuance of letters of credit and for
short-term borrowings at the prime rate of interest. This line is collateralized
by securities with a market value equal to 125% of the total sum of the letters
of credit issued and cash advances outstanding. This facility matures on April
30, 1997. As of December 31, 1996, letters of credit in the amount of $4.6
million were issued on behalf of the HCC to collateralize certain reinsurance
obligations, however no cash advances were outstanding under this line and,
therefore, $7.4 million is available for short-term borrowings under this
facility.
27
In January, 1997, the Company obtained an additional bank line of credit for
$10.0 million. This credit facility provides for short-term borrowings and
matures April 30, 1998. Interest is payable quarterly at either (i) variable at
the banks prime rate; or (ii) fixed at the London Interbank Offering Rate
("LIBOR") plus 1 1/2%, at the option of the Company. The line of credit is
collateralized by a pledge of all capital stock of HCC. This new line of credit
improves the Company's short term liquidity.
On September 14, 1993, HCCH borrowed $29.25 million from a bank. HCCH used
the proceeds to retire previous indebtedness and make a $10.0 million capital
contribution to HCC. The principal terms of the note, which matures on October
1, 1998 are (i) quarterly principal repayments of $1.5 million, increasing to
$1.75 million; (ii) interest at the prime lending rate; (iii) collateralization
by a pledge of all capital stock of HCC and substantially all of the common
stock of IMG; and (iv) certain restrictive terms and conditions including
restrictions on certain transactions in the Company's Common Stock or the
capital stock of HCC and IMG and the maintenance of required financial ratios.
During February, 1994, the note was amended by fixing the interest rate at 6.5%
until February 7, 1997. Thereafter, the rate reverts to the prime lending rate
or LIBOR plus 2.25%, at the Company's option. Additionally, the loan agreement
prohibits the payment of dividends by the Company without the bank's approval.
During 1995, the Company prepaid the first two installments of $1.5 million due
in 1996. The bank deferred the second two installments due in 1996 until
maturity. The Company paid the first 1997 quarterly payment of $1.5 million in
January, 1997.
The Company maintains a substantial level of cash and liquid short-term
investments which are used to meet anticipated payment obligations. As of
December 31, 1996, the Company had cash and short-term investments of
approximately $56.3 million. The Company's consolidated investment portfolio of
$320.3 million as of December 31, 1996, is available to provide additional
liquidity and cash for operations.
Property and casualty insurance companies domiciled in the State of Texas
are limited in the payment of dividends to its shareholders in any 12 month
period, without the prior written consent of the Commissioner of Insurance, to
the greater of net investment income or 10% of statutory policyholders' surplus.
HCC paid no dividends in 1996 to HCCH. During 1997, HCC's ordinary dividend
capacity will be approximately $15.1 million.
The Company believes that its operating cash flows, short-term investments
and the bank lines of credit will provide sufficient sources of liquidity to
meet its anticipated needs for the foreseeable future.
At December 31, 1996, the Company had a net deferred tax asset of $11.5
million. Due to the Company's history of consistent earnings, strong operating
cash flows, expectations for the future and the ability to hold investments to
maturity, it is more likely than not that the Company will be able to realize
the benefit of its deferred tax asset.
As of December 31, 1996, HCC's total adjusted capital was $150.7 million,
which is 1,332% of the NAIC authorized control level risk-based capital while
TIC's total adjusted capital was $27.6 million, which is 17,928% of the NAIC
authorized control level risk-based capital.
Industry and regulatory guidelines suggest that a property and casualty
insurer's annual statutory GWP should not exceed 900% of its statutory
policyholders' surplus and NWP should not exceed 300% of its statutory
policyholders' surplus. The Company maintains a premium to surplus ratio
significantly lower than such guidelines, and for the year ended December 31,
1996, its annual statutory GWP was 108.8% of its statutory policyholders'
surplus and NWP was 45.6% of its statutory policyholders' surplus.
IMPACT OF INFLATION
The Company's operations, like those of other property and casualty
insurers, are susceptible to the effects of inflation, as premiums are
established before the ultimate amounts of loss and LAE are known. Although
management considers the potential effects of inflation when setting premiums,
for competitive reasons, such premiums may not adequately compensate the Company
for the effects of inflation. However, as the majority of the Company's business
is comprised of lines which have short lead times
28
between the occurrence of an insured event, reporting of the claims to the
Company and the final settlement of the claims, the effects of inflation are
minimized.
A significant portion of the Company's revenue is related to healthcare
insurance and reinsurance products which are subject to the effects of the
underlying inflation of medical costs. Such inflation in the costs of healthcare
tends to generate increases in premiums for medical stop-loss coverage,
resulting in greater revenue, but also higher claim payments. Inflation may have
a negative impact on insurance and reinsurance operations by causing higher
claim settlements than may originally have been estimated without an immediate
increase in premiums to a level necessary to maintain profit margins being
possible. No express provision for inflation is made, although trends are
considered when setting underwriting terms and claim reserves for purposes of
determining revenue from underwriting profit commission. Such reserves are
subject to a continuing review process to assess their adequacy and are adjusted
as deemed appropriate. In addition, the market value of the investments held by
the Company varies depending on economic and market conditions and interest
rates, which are highly sensitive to the policies of governmental and regulatory
authorities. Any significant change in interest rates could therefore have a
material adverse effect on the market value of the Company's investments.
EXCHANGE RATE FLUCTUATIONS
The Company underwrites risks which are denominated in a number of foreign
currencies. It establishes and maintains loss reserves with respect to these
policies in their respective currencies. These reserves are subject to exchange
rate fluctuations which can have an effect on the Company's net earnings. The
Company's principal area of exposure is with respect to fluctuation in the
exchange rate between the British Pound Sterling and the United States Dollar.
For the years ended December 31, 1996, 1995 and 1994, the gain (loss) from
currency conversion was ($181,000), ($209,000) and $203,000, respectively.
From time to time the Company enters into foreign currency forward contracts
as a hedge against foreign currency fluctuations, primarily British Pound
Sterling. The Company's balances denominated in foreign currency fluctuate as
transactions are recorded and settled. During 1996, the average Sterling
liability, for subsidiaries whose functional currency was the United States
dollar, was approximately L907,000 ($1.6 million at the December 31, 1996, rate
of exchange) which was hedged by an average open forward contract balance of
approximately L460,000 ($785,000 at the December 31, 1996, rate of exchange).
There was one open foreign currency forward contract as of December 31, 1996, to
purchase L500,000 ($856,000 at the December 31, 1996, rate of exchange) with a
maturity of January, 1997. During January, 1997, the Company entered into a
foreign currency forward contract totaling L500,000 ($856,000 at the December
31, 1996, rate of exchange). The Company expects to continue to limit its
exposure to currency fluctuations through the use of foreign currency forward
contracts.
The Company utilizes these foreign currency forward contracts strictly as a
hedge against existing exposure to foreign currency fluctuations and it does not
do so as any form of speculative or trading investment.
EFFECTS OF RECENT ACCOUNTING PRONOUNCEMENTS
In February, 1997, the Financial Accounting Standards Board issued SFAS
No.128 "Earnings Per Share". SFAS No.128 is effective for fiscal years ending
after December 15, 1997. Early application is not permitted. SFAS No.128
modifies the denominator to be used in the earnings per share calculations, and
requires additional disclosures of the calculations. However, the statement will
have no effect on the Company's net earnings, shareholders' equity or cash
flows.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements required in response to this section
are submitted as part of Item 14 of this report.
29
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURES
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
For information regarding Directors and Executive Officers of the
Registrant, reference is made to the Registrant's definitive proxy statement for
its Annual Meeting of Shareholders, which will be filed with the Securities and
Exchange Commission within 120 days after December 31, 1996, and which is
incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
For information regarding Executive Compensation, reference is made to the
Registrant's definitive proxy statement for its Annual Meeting of Shareholders,
which will be filed with the Securities and Exchange Commission within 120 days
after December 31, 1996, and which is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
For information regarding Security Ownership of Certain Beneficial Owners
and Management, reference is made to the Registrant's definitive proxy statement
for its Annual Meeting of Shareholders, which will be filed with the Securities
and Exchange Commission within 120 days after December 31, 1996, and which is
incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
For information regarding Certain Relationships and Related Transactions,
reference is made to the Registrant's definitive proxy statement for its Annual
Meeting of Shareholders, which will be filed with the Securities and Exchange
Commission within 120 days after December 31, 1996, and which is incorporated
herein by reference.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K
FINANCIAL STATEMENTS AND SCHEDULES
The financial statements and schedules listed in the accompanying index on
page 32 are filed as part of this report.
EXHIBITS
The exhibits listed on the accompanying Index to Exhibits on page 33 are
filed as part of this report.
REPORTS ON FORM 8-K
On December 11, 1996, the Registrant filed a report on Form 8-K reporting
the consummation of the acquisition of all the outstanding shares of common
stock of NASRA.
30
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
HCC INSURANCE HOLDINGS, INC.
(Registrant)
By: /s/ STEPHEN L. WAY
------------------------------------------
Stephen L. Way
CHAIRMAN OF THE BOARD
Dated: March 27, 1997 AND CHIEF EXECUTIVE OFFICER
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
NAME TITLE DATE
- ------------------------------ --------------------------- -------------------
Chairman of the Board of
/s/ STEPHEN L. WAY Directors and Chief
- ------------------------------ Executive Officer March 27, 1997
(Stephen L. Way) (Principal Executive
Officer)
/s/ STEPHEN J. LOCKWOOD*
- ------------------------------ Director, President March 27, 1997
(Stephen J. Lockwood)
Executive Vice President,
Secretary and Chief
/s/ FRANK J. BRAMANTI Financial Officer
- ------------------------------ (Principal Financial March 27, 1997
(Frank J. Bramanti) Officer and Principal
Accounting Officer)
/s/ JAMES M. BERRY*
- ------------------------------ Director March 27, 1997
(James M. Berry)
/s/ PATRICK B. COLLINS*
- ------------------------------ Director March 27, 1997
(Patrick B. Collins)
/s/ J. ROBERT DICKERSON*
- ------------------------------ Director March 27, 1997
(J. Robert Dickerson)
/s/ EDWIN H. FRANK, III*
- ------------------------------ Director March 27, 1997
(Edwin H. Frank, III)
/s/ JOHN L. KAVANAUGH*
- ------------------------------ Director March 27, 1997
(John L. Kavanaugh)
/s/ WALTER J. LACK*
- ------------------------------ Director March 27, 1997
(Walter J. Lack)
/s/ HUGH T. WILSON*
- ------------------------------ Director March 27, 1997
(Hugh T. Wilson)
*By: /s/ FRANK J. BRAMANTI
-------------------------
Frank J. Bramanti, March 27, 1997
ATTORNEY-IN-FACT
31
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES
Reports of Independent Accountants................................................... F-1
Consolidated Balance Sheets at December 31, 1996 and 1995............................ F-3
Consolidated Statements of Earnings for each of the years in the three-year period
ended December 31, 1996............................................................ F-4
Consolidated Statements of Changes in Shareholders' Equity for each of the years in
the three-year period ended December 31, 1996...................................... F-5
Consolidated Statements of Cash Flows for each of the years in the three-year period
ended December 31, 1996............................................................ F-8
Notes to Consolidated Financial Statements........................................... F-9
SCHEDULES:
Report of Independent Accountants......................................... S-1
Schedule 1 Summary of Investments other than Investments in Related Parties........ S-2
Schedule 2 Condensed Financial Information of Registrant........................... S-3
Schedule 3 Supplementary Insurance Information..................................... S-7
Schedule 4 Reinsurance............................................................. S-8
Schedules other than those listed above have been omitted because they are
either not required, not applicable, or the required information is shown in the
Consolidated Financial Statements and related notes thereto.
32
INDEX TO EXHIBITS
(ITEMS DENOTED BY A LETTER ARE INCORPORATED BY REFERENCE TO OTHER DOCUMENTS
PREVIOUSLY FILED WITH THE SECURITIES AND EXCHANGE COMMISSION AS SET FORTH AT THE
END OF THIS INDEX. ITEMS NOT DENOTED BY A LETTER ARE BEING FILED HEREWITH.)
EXHIBIT
NUMBER
- ------------
(A)3.4 --Bylaws of HCC Insurance Holdings, Inc., as amended.
(J)3.7 --Restated Certificate of Incorporation of HCC Holdings, Inc., filed with the Delaware Secretary of
State on July 23, 1996.
(A)4.1 --Specimen of Common Stock Certificate, $1.00 par value, of HCC Insurance Holdings, Inc.
(A)10.17 --Cost Allocation Agreement dated September 1, 1991, by and among HCC Holdings, A Texas Corporation,
Houston Casualty Company, Trafalgar Reinsurance Company Ltd., Houston Re Corporation and HCC
Underwriters, A Texas Corporation
(A)10.19 --Agreement for Allocation of Federal Income Tax dated November 29, 1991, by and among HCC Holdings,
Inc., Houston Casualty Company, SBS Insurance Holdings, Trafalgar Reinsurance Company, Ltd., HCC
Underwriters and Houston Re Corporation
(A)10.22 --Investment Advisory Agreement dated January 10, 1992 between Houston Casualty Company and William
Blair & Company relating to investment services to be provided by William Blair & Company
(A)10.23 --HCC Insurance Holdings, Inc. 1992 Incentive Stock Option Plan
(A)10.24 --Program License Agreement dated April 29, 1992, by and between EPG America, Inc., and HCC Holdings,
Inc. pertaining to license for the computer services described therein
(B)10.227 --Loan Agreement dated August 24, 1993 in the original principal amount of $29,250,000 executed by HCC
Insurance Holdings, Inc., payable to First Interstate Bank of Texas, N.A. together with Promissory
Note and Commercial Pledge Agreement relating thereto.
(B)10.227.1 --Change in Loan Agreement dated February 7, 1994 between HCC Insurance Holdings, Inc. and First
Interstate Bank of Texas, N.A. relating to the $29,250,000 loan.
(B)10.228 --Promissory Note dated February 25, 1994 in the original principal amount of $12,000,000 executed by
Houston Casualty Company, payable to First Interstate Bank of Texas, N.A. together with Commercial
Pledge Agreement relating thereto.
(C)10.302 --Aircraft Dry Lease Agreement effective January 4, 1995 between SLW Aviation, Inc. and HCC Insurance
Holdings, Inc.
(C)10.303 --Stock Purchase Agreement effective January 1, 1994 between River Investments Limited and HCC
Underwriters, A Texas Corporation related to the acquisition of 25% of Middle East Insurance Brokers
Ltd.
(C)10.304 --Stock Purchase Agreement effective October 1, 1994 between various shareholders of Middle East
Insurance Brokers Ltd. and HCC Insurance Holdings, Inc. related to the acquisition of 75% of Middle
East Insurance Brokers Ltd.
(C)10.305 --Stock Purchase Agreement effective October 1, 1994 between various shareholders of International
Marine & General Insurance Company Ltd. and HCC Insurance Holdings, Inc. related to the acquisition
of 100% of International Marine & General Insurance Company Ltd.
33
EXHIBIT
NUMBER
- ------------
(C)10.306 --Loan Agreement dated November 29, 1994 in the original principal amount of $20,000,000 executed by
HCC Insurance Holdings, Inc., payable to First Interstate Bank of Texas, N.A. together with the
Promissory Note.
(D)10.320 --Promissory note dated April 30, 1995, in the original principal amount of $12,000,000 executed by
Houston Casualty Company, payable to First Interstate Bank of Texas, N.A.
(E)10.324 --HCC Insurance Holdings, Inc. 1994 Nonemployee Director Stock Option Plan.
(F)10.325 --HCC Insurance Holdings, Inc. 1995 Flexible Stock Option Plan.
(H)10.326 --Agreement and Plan of Reorganization dated February 22, 1996 between various shareholders of LDG
Management Company Incorporated and affiliated companies and HCC Insurance Holdings, Inc. related to
the acquisition of 100% of the common stock of LDG Management Company Incorporated and affiliated
companies.
(I)10.327 --Agreement and Plan of Reorganization dated February 28, 1997 between AVEMCO Corporation and HCC
Insurance Holdings, Inc. related to the intent to merge in a stock for stock transaction.
(J)10.328 --HCC Insurance Holdings, Inc. 1996 Nonemployee Director Stock Option Plan.
(K)10.329 --HCC Insurance Holdings, Inc. 1995 Flexible Incentive Plan.
10.330 --Agreement and Plan of Reorganization dated November 27, 1996 between various shareholders of North
American Special Risk Associates and affiliated companies and HCC Insurance Holdings, Inc. related to
the acquisition of 100% of the common stock of North American Special Risk Associates, Inc. and
affiliated companies.
10.331 --Agreement of Purchase and Sale dated January 23, 1997, between TRM International, Inc., Unicover
Manager, Inc., North American Special Risk Associates, Inc. and HCC Insurance Holdings, Inc.
10.332 --Revolving Line of Credit Note dated October 7, 1996, in the original principal amount of $12,000,000
executed by Houston Casualty Company, payable to Wells Fargo Bank (Texas), National Association
together with Credit Agreement and General Pledge Agreement and Amendment relating thereto.
10.333 --Revolving Line of Credit Note dated January 10, 1997, in the original principal amount of $10,000,000
executed by HCC Insurance Holdings, Inc., payable to Wells Fargo Bank (Texas), National Association
together with Credit Agreement and General Pledge Agreement relating thereto.
11 --Statement Regarding Computation of Earnings Per Share
12 --Statement Regarding Computation of Ratios
21 --Subsidiaries of HCC Insurance Holdings, Inc.
(G)24 --Powers of Attorney
27 --EDGAR Financial Data Schedule
28 --Information from reports furnished to the State Boards of Insurance
34
INDEX TO EXHIBITS
(A) Incorporated by reference to the Exhibits to HCC Insurance Holdings,
Inc.'s Registration Statement (Registration No. 33-48737) filed October 27,
1992.
(B) Incorporated by reference to the Exhibits to HCC Insurance Holdings,
Inc.'s Form 10K for the fiscal year ended December 31, 1993 filed March 30,
1994.
(C) Incorporated by reference to the Exhibits to HCC Insurance Holdings,
Inc.'s Form 10K for the fiscal year ended December 31, 1994 filed March 30,
1995.
(D) Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Form 10Q for the fiscal quarter ended March 31, 1995 filed May 16, 1995.
(E) Incorporated by reference to the Exhibits to HCC Insurance Holdings,
Inc.'s Registration Statement on Form S-8 (Registration No. 33-94472) filed
July 11, 1995.
(F) Incorporated by reference to the Exhibits to HCC Insurance Holdings,
Inc.'s Registration Statement on Form S-8 (Registration No. 33-94468) filed
July 11, 1995.
(G) Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Form 10K for fiscal year ended December 31, 1995 filed March 28, 1996.
(H) Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Registration Statement (Registration No. 333-3652) filed April 15, 1996.
(I) Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.
Preliminary Registration Statement filed March 7, 1997.
(J) Incorporated by reference to the Exhibits to HCC Insurance Holdings,
Inc.'s Registration Statement on Form S-8 (Registration No. 333-14479) filed
October 18, 1996.
(K) Incorporated by reference to the Exhibits to HCC Insurance Holdings,
Inc.'s Registration Statement on Form S-8 (Registration No. 333-14471) filed
October 18, 1996.
35
REPORT OF INDEPENDENT ACCOUNTANTS
The Board of Directors and Shareholders
HCC Insurance Holdings, Inc.
We have audited the accompanying consolidated balance sheets of HCC
Insurance Holdings, Inc. and Subsidiaries as of December 31, 1996 and 1995, and
the related consolidated statements of earnings, changes in shareholders'
equity, and cash flows for each of the three years in the period ended December
31, 1996. These financial statements are the responsibility of HCC Insurance
Holdings, Inc.'s management. Our responsibility is to express an opinion on
these financial statements based on our audits. We did not audit the 1994
financial statements of LDG Management Company Incorporated and Affiliates,
which statements reflect total revenues constituting 30 percent and net earnings
constituting 12 percent of the related consolidated financial statement totals
for the year ended December 31, 1994. Those statements were audited by other
auditors whose report has been furnished to us, and our opinion, insofar as it
relates to data included for LDG Management Company Incorporated and Affiliates
for 1994, is based solely on the report of the other auditors.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits and the report of the other auditors provide a
reasonable basis for our opinion.
In our opinion, based on our audits and the report of the other auditors,
the consolidated financial statements referred to above present fairly, in all
material respects, the consolidated financial position of HCC Insurance
Holdings, Inc. and Subsidiaries as of December 31, 1996 and 1995, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 1996, in conformity with generally
accepted accounting principles.
COOPERS & LYBRAND L.L.P.
Houston, Texas
March 27, 1997
F-1
REPORT OF INDEPENDENT ACCOUNTANTS
The Board of Directors and Shareholders
LDG Management Company Incorporated and Affiliates
Wakefield, Massachusetts
We have audited the combined statements of earnings, changes in
shareholders' equity, and cash flow of LDG Management Company Incorporated (an S
corporation) and Affiliates (S corporations) for the year ended December 31,
1994. These combined financial statements are the responsibility of the
Companies' management. Our responsibility is to express an opinion on these
combined financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the combined financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the combined financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audit provides a reasonable basis
for our opinion.
In our opinion, the combined financial statements referred to above present
fairly, in all material respects, the combined results of operations of LDG
Management Company Incorporated and Affiliates and their cash flows for the year
ended December 31, 1994, in conformity with generally accepted accounting
principles.
TONNESON & COMPANY C.P.A.'s P.C.
Wakefield, Massachusetts
April 6, 1995
F-2
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31,
------------------------------
1996 1995
-------------- --------------
ASSETS
Investments:
Securities available for sale:
Fixed income securities, at market (cost: 1996 $262,667,000; 1995
$231,807,000).............................................................. $ 264,727,000 $ 234,881,000
Marketable equity securities, at market (cost: 1996 $2,481,000 ; 1995
$10,097,000)............................................................... 2,433,000 13,812,000
Mortgage loans, at unpaid principal balance, net............................... -- 81,000
Short-term investments, at cost, which approximates market..................... 53,100,000 56,513,000
-------------- --------------
Total investments.......................................................... 320,260,000 305,287,000
Cash............................................................................. 3,212,000 3,574,000
Restricted cash and short-term investments....................................... 44,363,000 23,495,000
Reinsurance recoverables......................................................... 123,181,000 103,408,000
Premium, claims and other receivables............................................ 139,109,000 130,384,000
Ceded unearned premium........................................................... 65,845,000 73,282,000
Deferred policy acquisition costs................................................ 16,843,000 16,431,000
Property and equipment, net...................................................... 9,135,000 9,440,000
Deferred income tax.............................................................. 11,524,000 2,921,000
Other assets, net................................................................ 12,307,000 13,454,000
-------------- --------------
Total assets............................................................... $ 745,779,000 $ 681,676,000
-------------- --------------
-------------- --------------
LIABILITIES
Loss and loss adjustment expense payable......................................... $ 185,822,000 $ 158,451,000
Reinsurance balances payable..................................................... 43,900,000 68,463,000
Unearned premium................................................................. 114,758,000 118,732,000
Deferred ceding commissions...................................................... 15,418,000 17,497,000
Premium and claims payable....................................................... 119,524,000 96,122,000
Notes payable.................................................................... 16,500,000 16,661,000
Accounts payable and accrued liabilities......................................... 9,167,000 10,291,000
-------------- --------------
Total liabilities.......................................................... 505,089,000 486,217,000
SHAREHOLDERS' EQUITY
Common Stock, $1.00 par value; 100,000,000 shares authorized; (issued and
outstanding: 1996 35,850,832 shares; 1995 13,838,802 shares)................... 35,851,000 13,839,000
Additional paid-in capital....................................................... 131,240,000 123,257,000
Retained earnings................................................................ 72,169,000 53,950,000
Unrealized investment gain, net.................................................. 1,303,000 4,417,000
Foreign currency translation adjustment.......................................... 127,000 (4,000)
-------------- --------------
Total shareholders' equity................................................. 240,690,000 195,459,000
-------------- --------------
Total liabilities and shareholders' equity................................. $ 745,779,000 $ 681,676,000
-------------- --------------
-------------- --------------
See Notes to Consolidated Financial Statements.
F-3
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF EARNINGS
FOR THE YEARS ENDED DECEMBER 31,
-------------------------------------------
1996 1995 1994
------------- ------------- -------------
REVENUE
Net earned premium.................................................. $ 93,314,000 $ 80,011,000 $ 46,834,000
Fee and commission income........................................... 38,462,000 32,887,000 28,456,000
Net investment income............................................... 15,372,000 13,250,000 9,533,000
Net realized investment gain........................................ 5,097,000 1,061,000 682,000
------------- ------------- -------------
Total revenue................................................. 152,245,000 127,209,000 85,505,000
EXPENSE
Loss and loss adjustment expense.................................... 51,242,000 49,769,000 29,588,000
Operating expense:
Policy acquisition costs.......................................... 34,110,000 29,748,000 21,729,000
Compensation expense.............................................. 20,353,000 26,790,000 23,900,000
Other operating expense........................................... 12,855,000 12,591,000 8,660,000
Ceding commissions................................................ (30,268,000) (27,228,000) (20,210,000)
------------- ------------- -------------
Net operating expense......................................... 37,050,000 41,901,000 34,079,000
Compensatory stock grant and merger related expenses................ 26,160,000 -- --
Interest expense.................................................... 1,166,000 2,247,000 1,972,000
------------- ------------- -------------
Total expense................................................. 115,618,000 93,917,000 65,639,000
------------- ------------- -------------
Earnings before income tax provision.......................... 36,627,000 33,292,000 19,866,000
Income tax provision................................................ 7,329,000 8,955,000 4,598,000
------------- ------------- -------------
Net earnings.................................................. $ 29,298,000 $ 24,337,000 $ 15,268,000
------------- ------------- -------------
------------- ------------- -------------
EARNINGS PER SHARE DATA:
Earnings per share.................................................. $ 0.81 $ 0.75 $ 0.55
------------- ------------- -------------
------------- ------------- -------------
Weighted average shares outstanding................................. 35,965,000 32,667,000 27,910,000
------------- ------------- -------------
------------- ------------- -------------
PRO FORMA INFORMATION (SEE NOTE 2):
Net earnings........................................................ $ 43,655,000
-------------
-------------
Earnings per share.................................................. $ 1.21
-------------
-------------
See Notes to Consolidated Financial Statements.
F-4
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
ADDITIONAL UNREALIZED
COMMON PAID-IN RETAINED INVESTMENT
STOCK CAPITAL EARNINGS GAIN (LOSS)
------------- -------------- ------------- -------------
BALANCE AS OF DECEMBER 31, 1993............................... $ 10,691,000 $ 61,721,000 $ 18,029,000 $ 3,035,000
128,588 shares of Common Stock issued for exercise of options,
including tax benefit of $659,000............................ 128,000 1,216,000 -- --
947,619 shares of Common Stock issued to acquire subsidiaries,
net of 64,950 shares of Common Stock acquired as treasury
stock........................................................ 948,000 11,983,000 -- --
Capital contributions to LDG prior to merger.................. -- 313,000 -- --
Net earnings.................................................. -- -- 15,268,000 --
Dividends to shareholders of LDG prior to merger.............. -- -- (1,855,000) --
Unrealized investment loss on fixed income securities, net of
deferred tax benefit of $4,270,000........................... -- -- -- (8,017,000)
Unrealized investment loss on marketable equity securities,
net of deferred tax benefit of $148,000...................... -- -- -- (319,000)
Sale of 64,950 shares of treasury stock....................... -- 1,247,000 -- --
Other......................................................... -- -- -- --
------------- -------------- ------------- -------------
BALANCE AS OF DECEMBER 31, 1994........................... $ 11,767,000 $ 76,480,000 $ 31,442,000 $ (5,301,000)
FOREIGN
CURRENCY TOTAL
TRANSLATION SHAREHOLDERS'
ADJUSTMENT EQUITY
----------- --------------
BALANCE AS OF DECEMBER 31, 1993............................... $ (25,000) $ 93,451,000
128,588 shares of Common Stock issued for exercise of options,
including tax benefit of $659,000............................ -- 1,344,000
947,619 shares of Common Stock issued to acquire subsidiaries,
net of 64,950 shares of Common Stock acquired as treasury
stock........................................................ -- 12,931,000
Capital contributions to LDG prior to merger.................. -- 313,000
Net earnings.................................................. -- 15,268,000
Dividends to shareholders of LDG prior to merger.............. -- (1,855,000)
Unrealized investment loss on fixed income securities, net of
deferred tax benefit of $4,270,000........................... -- (8,017,000)
Unrealized investment loss on marketable equity securities,
net of deferred tax benefit of $148,000...................... -- (319,000)
Sale of 64,950 shares of treasury stock....................... -- 1,247,000
Other......................................................... 11,000 11,000
----------- --------------
BALANCE AS OF DECEMBER 31, 1994........................... $ (14,000) $ 114,374,000
See Notes to Consolidated Financial Statements.
F-5
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY--(CONTINUED)
FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
ADDITIONAL UNREALIZED
COMMON PAID-IN RETAINED INVESTMENT
STOCK CAPITAL EARNINGS GAIN (LOSS)
------------- -------------- ------------- -------------
BALANCE AS OF DECEMBER 31, 1994............................... $ 11,767,000 $ 76,480,000 $ 31,442,000 $ (5,301,000)
58,876 shares of Common Stock issued for exercise of options,
including tax benefit of $252,000............................ 59,000 770,000 -- --
2,012,500 shares of Common Stock issued in public offering,
net of costs................................................. 2,013,000 45,957,000 -- --
Capital contribution to LDG prior to merger................... -- 50,000 -- --
Net earnings.................................................. -- -- 24,337,000 --
Dividends to shareholders of LDG prior to merger.............. -- -- (1,829,000) --
Unrealized investment gain on fixed income securities, net of
deferred tax charge of $4,293,000............................ -- -- -- 7,973,000
Unrealized investment gain on marketable equity securities,
net of deferred tax charge of $934,000....................... -- -- -- 1,745,000
Other......................................................... -- -- -- --
------------- -------------- ------------- -------------
BALANCE AS OF DECEMBER 31, 1995........................... $ 13,839,000 $ 123,257,000 $ 53,950,000 $ 4,417,000
FOREIGN
CURRENCY TOTAL
TRANSLATION SHAREHOLDERS'
ADJUSTMENT EQUITY
----------- --------------
BALANCE AS OF DECEMBER 31, 1994............................... $ (14,000) $ 114,374,000
58,876 shares of Common Stock issued for exercise of options,
including tax benefit of $252,000............................ -- 829,000
2,012,500 shares of Common Stock issued in public offering,
net of costs................................................. -- 47,970,000
Capital contribution to LDG prior to merger................... -- 50,000
Net earnings.................................................. -- 24,337,000
Dividends to shareholders of LDG prior to merger.............. -- (1,829,000)
Unrealized investment gain on fixed income securities, net of
deferred tax charge of $4,293,000............................ -- 7,973,000
Unrealized investment gain on marketable equity securities,
net of deferred tax charge of $934,000....................... -- 1,745,000
Other......................................................... 10,000 10,000
----------- --------------
BALANCE AS OF DECEMBER 31, 1995........................... $ (4,000) $ 195,459,000
See Notes to Consolidated Financial Statements.
F-6
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY--(CONTINUED)
FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
ADDITIONAL UNREALIZED
COMMON PAID-IN RETAINED INVESTMENT
STOCK CAPITAL EARNINGS GAIN (LOSS)
------------- -------------- ------------- -------------
BALANCE AS OF DECEMBER 31, 1995............................... $ 13,839,000 $ 123,257,000 $ 53,950,000 $ 4,417,000
20,758,172 shares of Common Stock issued for 150% stock
dividend (see note 1)........................................ 20,758,000 (20,758,000) -- --
117,458 shares of Common Stock issued for exercise of options,
including tax benefit of $366,000............................ 118,000 725,000 -- --
Net earnings.................................................. -- -- 29,298,000 --
Cash dividends declared, $0.06 per share...................... -- -- (2,104,000) --
Compensatory grant of LDG stock prior to merger............... -- 23,682,000 -- --
Dividends to shareholders of LDG prior to merger.............. -- -- (3,683,000) --
Capitalize undistributed earnings of LDG upon conversion from
S Corporation................................................ -- 3,840,000 (3,840,000) --
1,136,400 shares of Common Stock issued for NASRA
combination.................................................. 1,136,000 -- (1,452,000) --
Unrealized investment loss on fixed income securities, net of
deferred tax benefit of $355,000............................. -- -- -- (659,000)
Unrealized investment loss on marketable equity securities,
net of deferred tax benefit of $1,307,000.................... -- -- -- (2,455,000)
Other......................................................... -- 494,000 -- --
------------- -------------- ------------- -------------
BALANCE AS OF DECEMBER 31, 1996........................... $ 35,851,000 $ 131,240,000 $ 72,169,000 $ 1,303,000
------------- -------------- ------------- -------------
------------- -------------- ------------- -------------
FOREIGN
CURRENCY TOTAL
TRANSLATION SHAREHOLDERS'
ADJUSTMENT EQUITY
----------- --------------
BALANCE AS OF DECEMBER 31, 1995............................... $ (4,000) $ 195,459,000
20,758,172 shares of Common Stock issued for 150% stock
dividend (see note 1)........................................ -- --
117,458 shares of Common Stock issued for exercise of options,
including tax benefit of $366,000............................ -- 843,000
Net earnings.................................................. -- 29,298,000
Cash dividends declared, $0.06 per share...................... -- (2,104,000)
Compensatory grant of LDG stock prior to merger............... -- 23,682,000
Dividends to shareholders of LDG prior to merger.............. -- (3,683,000)
Capitalize undistributed earnings of LDG upon conversion from
S Corporation................................................ -- --
1,136,400 shares of Common Stock issued for NASRA
combination.................................................. -- (316,000)
Unrealized investment loss on fixed income securities, net of
deferred tax benefit of $355,000............................. -- (659,000)
Unrealized investment loss on marketable equity securities,
net of deferred tax benefit of $1,307,000.................... -- (2,455,000)
Other......................................................... 131,000 625,000
----------- --------------
BALANCE AS OF DECEMBER 31, 1996........................... $ 127,000 $ 240,690,000
----------- --------------
----------- --------------
See Notes to Consolidated Financial Statements.
F-7
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31,
--------------------------------------------
1996 1995 1994
------------- -------------- -------------
Cash flows from operating activities:
Net earnings..................................................... $ 29,298,000 $ 24,337,000 $ 15,268,000
Adjustments to reconcile net earnings to net cash provided by
operating activities:
Change in reinsurance recoverables............................. (19,773,000) (3,946,000) (25,233,000)
Change in premium, claims and other receivables................ (8,725,000) (16,680,000) (56,061,000)
Change in ceded unearned premium............................... 7,437,000 (12,611,000) (34,926,000)
Change in deferred policy acquisition costs, net............... (2,491,000) (419,000) 1,115,000
Change in deferred income tax, net of tax effect of unrealized
gain or loss................................................... (6,941,000) (1,545,000) (1,181,000)
Change in loss and loss adjustment expense payable............. 27,371,000 28,696,000 28,746,000
Change in reinsurance balances payable......................... (24,563,000) 403,000 32,922,000
Change in unearned premium..................................... (3,974,000) 31,386,000 47,786,000
Change in premium and claims payable, net of restricted cash... 2,534,000 7,577,000 21,258,000
Change in accounts payable and accrued liabilities............. (1,841,000) 4,027,000 645,000
Net realized investment gain................................... (5,097,000) (1,061,000) (682,000)
Noncash compensation expense................................... 24,176,000 -- --
Depreciation and amortization expense.......................... 2,318,000 1,700,000 1,284,000
Other, net..................................................... 3,126,000 767,000 328,000
------------- -------------- -------------
Cash provided by operating activities........................ 22,855,000 62,631,000 31,269,000
Cash flows from investing activities:
Sales of fixed income securities................................. 3,465,000 21,388,000 24,002,000
Maturity or call of fixed income securities...................... 8,285,000 8,162,000 25,000
Sales of equity securities....................................... 18,211,000 9,458,000 9,104,000
Net cash (paid) received in combinations......................... (1,753,000) -- 1,979,000
Cost of investments acquired..................................... (48,807,000) (107,639,000) (73,738,000)
Purchases of property and equipment.............................. (1,724,000) (3,269,000) (1,438,000)
Other, net....................................................... 81,000 1,229,000 826,000
------------- -------------- -------------
Cash used by investing activities............................ (22,242,000) (70,671,000) (39,240,000)
Cash flows from financing activities:
Proceeds from notes payable...................................... 250,000 -- 20,110,000
Sale of Common Stock, net of costs............................... 843,000 48,799,000 1,344,000
Sales of treasury stock.......................................... -- -- 1,247,000
Capital contributions to LDG..................................... -- -- 313,000
Payments on notes payable........................................ (411,000) (28,247,000) (4,146,000)
Dividends paid................................................... (5,070,000) (1,507,000) (1,855,000)
------------- -------------- -------------
Cash provided (used) by financing activities................. (4,388,000) 19,045,000 17,013,000
------------- -------------- -------------
Net change in cash and short-term investments................ (3,775,000) 11,005,000 9,042,000
Cash and short-term investments at beginning of year......... 60,087,000 49,082,000 40,040,000
------------- -------------- -------------
Cash and short-term investments at end of year............... $ 56,312,000 $ 60,087,000 $ 49,082,000
------------- -------------- -------------
------------- -------------- -------------
See Notes to Consolidated Financial Statements.
F-8
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) GENERAL INFORMATION AND SIGNIFICANT ACCOUNTING AND REPORTING POLICIES
HCC Insurance Holdings, Inc. and its subsidiaries (collectively, "the
Company" or "HCCH"), include domestic and foreign property and casualty
insurance companies and managing general agents, surplus lines insurance brokers
and wholesale insurance and reinsurance brokers. HCCH, through its subsidiaries,
provides specialized property and casualty insurance to commercial customers
worldwide, underwritten on both a direct and reinsurance basis, in the areas of
aviation, marine, property, offshore energy and accident and health. The
principal insurance company subsidiaries are Houston Casualty Company ("HCC")
and Trafalgar Insurance Company ("TIC") in Houston, Texas and IMG Insurance
Company Ltd. ("IMG") in Amman, Jordan. The agency subsidiaries provide
underwriting management and intermediary services for insurance and reinsurance
companies, primarily in the accident and health area, but also in the same lines
of business that the insurance subsidiaries operate. The principal agency
subsidiaries are LDG Management Company Incorporated ("LDG") in Wakefield,
Massachusetts, HCC Underwriters, A Texas Corporation ("HCCU") in Houston, Texas;
North American Special Risk Associates, Inc. ("NASRA") in Northbrook, Illinois
and Middle East Insurance Brokers, Ltd. ("MEIB") in Amman, Jordan.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions. This affects amounts reported in the financial statements and the
disclosure of contingent assets and liabilities. Actual results could differ
from those estimates.
A description of the significant accounting and reporting policies utilized
by the Company in preparing the consolidated financial statements is as follows:
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries. All significant intercompany balances and
transactions have been eliminated in consolidation. The business combinations
with LDG and NASRA have been recorded as poolings-of-interests. The Company's
financial statements have been restated to include the accounts and operations
of LDG for all periods presented. The financial statements have not been
restated to include NASRA due to immateriality. (see note 2).
INVESTMENTS
Fixed income securities and marketable equity securities are classified as
available for sale and are carried at quoted market value, if readily
marketable, or at management's estimated fair value, if not readily marketable.
The change in unrealized gain or loss with respect to these securities is
recorded as a direct increase or decrease to shareholders' equity, net of
related deferred income tax, if any. Fixed income securities available for sale
are purchased with the original intent to hold to maturity, but which may be
available for sale if market conditions warrant, or if the Company's investment
policies dictate, in order to maximize the Company's investment yield. Mortgage
loans on real estate are stated at the aggregate unpaid principal balance less
unamortized fees. Short-term investments and restricted short-term investments
are carried at cost which approximates market value.
The realized gain or loss on investment transactions is determined on an
average cost basis and included in earnings on the trade date. When impairment
of the value of an investment is considered other than temporary, the decrease
in value is reported in earnings as a realized investment loss and a new cost
basis is established.
F-9
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(1) GENERAL INFORMATION AND SIGNIFICANT ACCOUNTING AND REPORTING POLICIES
(CONTINUED)
PROPERTY AND EQUIPMENT
Property and equipment are carried at cost, net of accumulated depreciation.
Depreciation expense is provided using the straight-line method over the
estimated useful lives of the related assets. Amortization of leasehold
improvements is provided using the straight-line method over the term of the
respective lease. Upon disposal of assets, the cost and related accumulated
depreciation are removed from the accounts and the resulting gain or loss is
included in earnings.
Costs incurred in developing or purchasing management information systems
are capitalized and included in property and equipment. These costs are
amortized over their estimated useful lives from the dates the systems are
placed in service.
EARNED PREMIUM, DEFERRED POLICY ACQUISITION COSTS AND CEDING COMMISSIONS OF
INSURANCE COMPANY SUBSIDIARIES
Written premium, net of reinsurance, is generally included in earnings on a
pro rata basis over the lives of the related policies. Policy acquisition costs
related to unearned premium, which include commissions, taxes, fees and other
direct costs of underwriting policies and ceding commissions allowed by
reinsurers, which include expense allowances, are deferred and charged or
credited to earnings on the same basis. Historical and current loss and loss
adjustment expense experience are considered in determining the recoverability
of deferred policy acquisition costs.
FEE AND COMMISSION INCOME
Fee and commission income is recognized on the revenue recognition date,
which is the later of the effective date of the policy, the date when the
premium can be reasonably estimated, or the date when substantially all required
services relating to the insurance placement have been rendered to the client.
Commission income relating to additional or return premiums or other policy
adjustments is recognized when the events occur and the amounts become known or
can be estimated.
PREMIUM AND OTHER RECEIVABLES
The Company has adopted the gross method for reporting receivables and
payables on brokered transactions.
Management considers all premium and other receivables to be collectable
and, therefore, has not recorded an allowance for doubtful accounts.
LOSS AND LOSS ADJUSTMENT EXPENSE OF INSURANCE COMPANY SUBSIDIARIES
Loss and loss adjustment expense is based on undiscounted estimates of
payments to be made for reported and incurred but not reported losses ("IBNR"),
net of reinsurance and anticipated salvage and subrogation receipts. Estimates
for reported losses are based on all available information, including reports
received from ceding companies on assumed business. Estimates for IBNR are based
both on the Company's and industry experience. While management believes that
amounts included in the accompanying financial statements are adequate, such
estimates may be more or less than the amounts ultimately
F-10
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(1) GENERAL INFORMATION AND SIGNIFICANT ACCOUNTING AND REPORTING POLICIES
(CONTINUED)
paid when the claims are settled. The estimates are continually reviewed and any
changes are reflected in current operations.
REINSURANCE
The Company records all reinsurance recoverables and ceded unearned premiums
as assets and deferred ceding commissions as a liability. All such amounts are
estimated and recorded in a manner consistent with the underlying reinsured
contracts. Management has recorded a reserve for uncollectible reinsurance based
on estimates of collectability.
GOODWILL
In connection with the Company's acquisitions of subsidiaries during 1994,
the excess of cost over fair value of net assets acquired is being amortized
using the straight-line method over forty years. Management of the acquired
businesses have successfully operated in the Companies' insurance markets for a
number of years and, with the additional capital provided by the Company, will
be positioned to take advantage of increased underwriting opportunities.
The Company has no reason to expect major changes in the business conditions
in which the acquired companies operate which might affect the recoverability of
the recorded intangibles. However, in the event business conditions change, the
recoverability will be re-evaluated based upon revised projections of future
undiscounted operating income and cash flows and, if impaired, the balances will
be adjusted accordingly. Amortization charged to income for the years ended
December 31, 1996, 1995 and 1994, was $289,000, $289,000 and $72,000,
respectively.
CASH AND CASH EQUIVALENTS
For purposes of the consolidated statements of cash flows, the Company
considers certificates of deposit, corporate demand notes receivable and
commercial paper with original maturities of three months or less and money
market funds as cash equivalents. These amounts are shown as short-term
investments in the consolidated balance sheets. In conjunction with the
management of reinsurance pools, the Company's agency subsidiaries withhold
premium funds for the payment of claims which are shown as restricted cash and
short-term investments on the consolidated balance sheets.
The Company generally invests its excess cash with major banks and in
investment grade commercial paper and repurchase agreements. These securities
typically mature within 90 days and, therefore, bear minimal risk. The Company
has not experienced any losses on these investments.
FOREIGN CURRENCY TRANSLATION
The functional currency of most foreign subsidiaries is the United States
dollar. Assets and liabilities recorded in foreign currencies are translated
into United States dollars at exchange rates in effect at the balance sheet
date. Transactions in foreign currencies are translated at the rates of exchange
in effect on the date the transaction occurs. The Company's foreign currency
transactions are principally denominated in British Pound Sterling. From time to
time the Company enters into foreign currency forward contracts as a hedge
against foreign currency fluctuations. Gains or losses in the market value of
foreign currency forward contracts are recognized in the statements of earnings
concurrently with the gains and losses on
F-11
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(1) GENERAL INFORMATION AND SIGNIFICANT ACCOUNTING AND REPORTING POLICIES
(CONTINUED)
the hedged balances. For the years ended December 31, 1996, 1995 and 1994, the
gain (loss) from currency conversion was ($181,000), ($209,000) and $203,000,
respectively.
One subsidiary has a functional currency of the British Pound Sterling
("GBP"). Cumulative translation adjustment, representing the effect of
translating this subsidiary's assets and liabilities into United States dollars
is included in the foreign currency translation adjustment within shareholders'
equity.
INCOME TAX
The domestic companies and the foreign insurance company subsidiaries (which
have all elected to be taxed as domestic companies) file a single consolidated
Federal income tax return and include the foreign subsidiaries' income to the
extent required by law. Deferred income tax is accounted for using the liability
method, which reflects the tax impact of temporary differences between the bases
of assets and liabilities for financial reporting purposes and such bases as
measured by tax laws and regulations. LDG was an S Corporation prior to its
reorganization and merger with the Company. Therefore, Federal income tax
expense was not provided for LDG's earnings until the S Corporation election was
terminated. LDG is included in the Company's consolidated Federal income tax
return beginning May 24, 1996.
EARNINGS PER SHARE
Earnings per share are based on the weighted average number of common and
common equivalent shares outstanding during the year divided into net earnings.
The shares issued in connection with the combination with LDG are included in
outstanding shares for all periods presented. Outstanding common stock options,
when dilutive, are considered to be common stock equivalents for the purpose of
this calculation. The treasury stock method is used to calculate common stock
equivalents due to options. The difference between primary and fully diluted
earnings per share is not material.
STOCK SPLITS
In February, 1994, the Board of Directors declared a three-for-two stock
split in the form of a 50% stock dividend on its shares of $1.00 par value
Common Stock payable to shareholders of record March 15, 1994. This stock split
was recorded retroactively as of December 31, 1993. In April, 1996, the Board of
Directors declared a five-for-two stock split in the form of a 150% stock
dividend on the Company's $1.00 par value Common Stock, payable to shareholders
of record April 30, 1996. The par value of the Company's Common Stock remains
unchanged. All per share, weighted average shares outstanding and option data
presented in the consolidated financial statements and the notes thereto have
been retroactively adjusted to reflect the effects of the splits.
EFFECTS OF RECENT ACCOUNTING PRONOUNCEMENTS
In February, 1997, the Financial Accounting Standards Board issued SFAS No.
128 "Earnings Per Share". SFAS No. 128 is effective for fiscal years ending
after December 15, 1997. Early application is not permitted. SFAS No. 128
modifies the denominator to be used in the earnings per share calculations, and
requires additional disclosures of the calculations. However, the statement will
have no effect on the Company's net earnings, shareholders' equity or cash
flows.
F-12
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(1) GENERAL INFORMATION AND SIGNIFICANT ACCOUNTING AND REPORTING POLICIES
(CONTINUED)
RECLASSIFICATIONS
Certain amounts in the 1995 and 1994 consolidated financial statements have
been reclassified to conform with the 1996 presentation. Such reclassifications
had no effect on the Company's shareholders' equity, net earnings or cash flows.
(2) ACQUISITIONS
IMG AND MEIB
Effective January 1, 1994, the Company acquired a 25% interest in MEIB.
Concurrent with the purchase of IMG on October 1, 1994, the Company acquired the
remaining 75% interest, thereby making MEIB a wholly-owned subsidiary of the
Company. To acquire 100% interest of MEIB the Company issued 109,524 shares (pre
split) of its Common Stock and paid a total of $3.9 million. During the first
nine months of 1994, the Company accounted for its 25% interest using the equity
method and beginning October 1, 1994, MEIB's results of operations have been
included in the consolidated statements of earnings.
Effective October 1, 1994, the Company acquired 100% of the stock of IMG.
IMG specializes in insuring large commercial risks, with an emphasis on energy
related business. In exchange for IMG's stock, the Company issued 838,095 shares
(pre split) of its Common Stock and paid $4.4 million. IMG's results of
operations have been included in the consolidated statements of earnings
beginning October 1, 1994.
Both acquisitions were accounted for using the purchase method. In each case
the purchase price was allocated to assets acquired based on their estimated
fair values. On a combined basis, the fair value of assets acquired was
approximately $29.0 million and the fair value of liabilities assumed was
approximately $18.3 million. This resulted in a combined total cost in excess of
net assets acquired (goodwill) of approximately $11.6 million from both
acquisitions. The resulting goodwill is being amortized on a straight-line basis
over forty years.
The following unaudited pro forma summary presents information for the year
ended December 31, 1994, as if the acquisitions of IMG and MEIB had occurred at
the beginning of the year after giving effect to certain adjustments including
amortization of goodwill, increased interest expense from debt issued to fund
the acquisitions and Federal income taxes. The pro forma summary is for
information purposes only, does not necessarily reflect the actual results that
would have occurred, nor is it necessarily indicative of future results of the
combined Company.
UNAUDITED PRO FORMA INFORMATION 1994
- ------------------------------------------------------------------------------- -------------
Total revenue.................................................................. $ 89,110,000
Net earnings................................................................... 15,892,000
Earnings per share............................................................. 0.54
LDG
On May 24, 1996, the Company issued 6,250,000 shares of its Common Stock to
acquire all of the outstanding common stock of LDG. The former principal
shareholder of LDG is a director of the Company. This business combination has
been accounted for as a pooling-of-interests. The Company's
F-13
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(2) ACQUISITIONS (CONTINUED)
consolidated financial statements have been restated to include the accounts and
operations of LDG for all periods presented.
The consolidated financial statements include adjustments made to conform
LDG's accounting policies for fee and commission income to that of HCCH. HCCH's
policy is to recognize fee and commission income on the revenue recognition date
(the later of the effective date of the policy, the date when premium can be
reasonably estimated, or the date when substantially all required services
relating to the placement have been rendered to the client), and subsequent
policy adjustments and contingent profit commissions are recognized when events
occur and amounts are known or can be reasonably estimated. LDG previously
recognized fee and commission income on the later of the effective date or the
reporting date, subsequent adjustments were recognized when they became due, and
contingent profit commission was recognized when received. For the years ended
December 31, 1995 and 1994, these adjustments decreased net income $119,000 and
$844,000, respectively.
Separate total revenue and net earnings (loss) amounts of the merged
entities are presented for the periods prior to merger in the following table:
FOR THE FIVE FOR THE YEAR ENDED DECEMBER
MONTHS 31,
ENDED MAY 31, -----------------------------
1996 1995 1994
------------------ -------------- -------------
Total revenue:
HCCH........................................................ $ 48,771,000 $ 99,197,000 $ 59,869,000
LDG......................................................... 12,893,000 28,012,000 25,636,000
------------------ -------------- -------------
Total revenue........................................... $ 61,664,000 $ 127,209,000 $ 85,505,000
------------------ -------------- -------------
------------------ -------------- -------------
Net earnings (loss):
HCCH........................................................ $ 12,144,000 $ 22,273,000 $ 13,409,000
LDG......................................................... (9,919,000) 2,064,000 1,859,000
------------------ -------------- -------------
Net earnings.............................................. $ 2,225,000 $ 24,337,000 $ 15,268,000
------------------ -------------- -------------
------------------ -------------- -------------
Certain nonrecurring expenses were incurred during the first six months of
1996. Of the nonrecurring expenses, approximately $24.0 million was related to
the compensatory grant of LDG stock to certain key employees by LDG's majority
shareholder immediately prior to the combination. Other nonrecurring expenses,
which totalled approximately $2.1 million, included legal, accounting and
investment banking fees in connection with the merger. The following table
presents pro forma net income and earnings per share amounts which reflect the
elimination of nonrecurring compensation and merger related expenses in 1996,
pro forma adjustments to all years to present Federal income taxes on LDG's
earnings prior to its reorganization and merger with the Company and pro forma
adjustments to reduce 1995 and 1994
F-14
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(2) ACQUISITIONS (CONTINUED)
compensation expense based on employment arrangements in effect during 1996, for
LDG's previous principal shareholders.
1996 1995 1994
-------------- ------------- -------------
Net earnings....................................................... $ 29,298,000 $ 24,337,000 $ 15,268,000
Nonrecurring expenses.............................................. 26,160,000 -- --
Compensation adjustment, net of state income tax................... -- 6,534,000 5,910,000
Pro forma Federal income tax....................................... (11,803,000) (2,923,000) (2,641,000)
-------------- ------------- -------------
Pro forma net earnings......................................... $ 43,655,000 $ 27,948,000 $ 18,537,000
-------------- ------------- -------------
-------------- ------------- -------------
Pro forma earnings per share................................... $ 1.21 $ 0.86 $ 0.66
-------------- ------------- -------------
-------------- ------------- -------------
NASRA
On November 27, 1996, the Company acquired all of the outstanding shares of
NASRA by issuing 1,136,400 shares of its Common Stock and a payment of $1.7
million in cash to one dissenting shareholder. This combination has been
accounted for as a pooling-of-interests. However, the Company's consolidated
financial statements have not been restated due to immateriality.
TRM
On November 11, 1996, the Company announced that it had agreed to acquire
all of the occupational accident business of the TRM International, Inc. group
of companies ("TRM") in exchange for 266,667 shares of its Common Stock and
$6.55 million in cash. The acquisition was finalized on January 24, 1997 and
will be accounted for as a purchase.
AMIG
On January 6, 1997, the Company announced that it had agreed in principal to
acquire all of the outstanding shares of Interworld Inc. Group ("Interworld") in
exchange for 725,000 shares of its Common Stock. The transaction will be
accounted for as a pooling-of-interests.
AVEMCO
On January 17, 1997, HCCH and AVEMCO Corporation ("AVEMCO") jointly
announced that the Companies had signed a letter of intent to merge in a stock
for stock transaction, each share of AVEMCO common stock to be exchanged for one
share of HCCH's Common Stock. The Companies executed definitive agreements on
February 28, 1997. This transaction will be accounted for as a pooling-of-
interests. The merger is still subject to approval by the shareholders of both
Companies and to certain regulatory approvals. As of March 1, 1997, there were
8.4 million shares of AVEMCO common stock outstanding.
F-15
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(3) INVESTMENTS
Substantially all of the Company's fixed income securities are investment
grade; most are A rated or better. No high-yield corporate bonds are owned or
contemplated. The amortized cost, gross unrealized gain or loss and estimated
market value of securities available for sale are as follows:
GROSS GROSS ESTIMATED
AMORTIZED UNREALIZED UNREALIZED MARKET
COST GAIN LOSS VALUE
-------------- ------------ ------------- --------------
December 31, 1996:
Marketable equity securities...................... $ 2,481,000 $ 256,000 $ (304,000) $ 2,433,000
US Treasury securities............................ 3,527,000 83,000 (6,000) 3,604,000
Obligations of states, municipalities and
political subdivisions.......................... 259,140,000 3,078,000 (1,095,000) 261,123,000
-------------- ------------ ------------- --------------
Total securities available for sale............. $ 265,148,000 $ 3,417,000 $ (1,405,000) $ 267,160,000
-------------- ------------ ------------- --------------
-------------- ------------ ------------- --------------
December 31, 1995:
Marketable equity securities...................... $ 10,097,000 $ 3,866,000 $ (151,000) $ 13,812,000
US Treasury securities............................ 3,914,000 44,000 (10,000) 3,948,000
Obligations of states, municipalities and
political subdivisions.......................... 227,893,000 3,872,000 (832,000) 230,933,000
-------------- ------------ ------------- --------------
Total securities available for sale............. $ 241,904,000 $ 7,782,000 $ (993,000) $ 248,693,000
-------------- ------------ ------------- --------------
-------------- ------------ ------------- --------------
The amortized cost and estimated market value of fixed income securities
available for sale at December 31, 1996, by contractual maturity, are shown
below. Expected maturities may differ from contractual maturities because
borrowers may have the right to call or prepay obligations with or without call
or prepayment penalties.
ESTIMATED
AMORTIZED MARKET
COST VALUE
-------------- --------------
Due in 1 year or less............................................................ $ 4,229,000 $ 4,276,000
Due after 1 year through 5 years................................................. 66,362,000 67,383,000
Due after 5 years through 10 years............................................... 80,119,000 80,876,000
Due after 10 years through 15 years.............................................. 60,990,000 61,408,000
Due after 15 years............................................................... 50,967,000 50,784,000
-------------- --------------
Total fixed income securities available for sale............................. $ 262,667,000 $ 264,727,000
-------------- --------------
-------------- --------------
As of December 31, 1996, the Company's insurance company subsidiaries had
deposited fixed income securities available for sale with an amortized cost of
approximately $9.1 million (market: $9.1 million) to meet the deposit
requirements of the insurance departments of certain states.
F-16
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(3) INVESTMENTS (CONTINUED)
The sources of net investment income for the years ended December 31, 1996,
1995 and 1994, are detailed below:
1996 1995 1994
------------- ------------- ------------
Fixed income securities.............................................. $ 12,524,000 $ 10,172,000 $ 7,604,000
Short-term investments............................................... 2,817,000 2,952,000 1,633,000
Equity securities.................................................... 130,000 136,000 308,000
Other................................................................ 18,000 152,000 317,000
------------- ------------- ------------
Total investment income.......................................... 15,489,000 13,412,000 9,862,000
Investment expense................................................... (117,000) (162,000) (329,000)
------------- ------------- ------------
Net investment income............................................ $ 15,372,000 $ 13,250,000 $ 9,533,000
------------- ------------- ------------
------------- ------------- ------------
There were no investments in fixed income securities available for sale that
were non-income producing for the twelve months preceding December 31, 1996.
F-17
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(3) INVESTMENTS (CONTINUED)
Realized pre-tax gain (loss) on the sale of investments is as follows:
GAIN LOSS NET
------------ ------------- ------------
For the year ended December 31, 1996:
Fixed income securities available for sale........................... $ 20,000 $ (221,000) $ (201,000)
Equity securities available for sale................................. 5,635,000 (337,000) 5,298,000
------------ ------------- ------------
Realized gain (loss)............................................... $ 5,655,000 $ (558,000) $ 5,097,000
------------ ------------- ------------
------------ ------------- ------------
For the year ended December 31, 1995:
Fixed income securities available for sale........................... $ 513,000 $ (524,000) $ (11,000)
Equity securities available for sale................................. 1,767,000 (697,000) 1,070,000
Other................................................................ 2,000 -- 2,000
------------ ------------- ------------
Realized gain (loss)............................................... $ 2,282,000 $ (1,221,000) $ 1,061,000
------------ ------------- ------------
------------ ------------- ------------
For the year ended December 31, 1994:
Fixed income securities available for sale........................... $ 152,000 $ (241,000) $ (89,000)
Equity securities available for sale................................. 1,156,000 (381,000) 775,000
Other................................................................ -- (4,000) (4,000)
------------ ------------- ------------
Realized gain (loss)............................................... $ 1,308,000 $ (626,000) $ 682,000
------------ ------------- ------------
------------ ------------- ------------
(4) PROPERTY AND EQUIPMENT
The following table summarizes property and equipment at December 31, 1996
and 1995:
ESTIMATED
1996 1995 USEFUL LIFE
------------- ------------- -------------
Building and improvements........................................... $ 6,150,000 $ 6,067,000 31.5 years
Furniture, fixtures and equipment................................... 5,753,000 4,875,000 3 to 5 years
Management information systems...................................... 5,356,000 4,847,000 3 to 7 years
------------- -------------
Total property and equipment.................................... 17,259,000 15,789,000
Less accumulated depreciation and amortization...................... (8,124,000) (6,349,000)
------------- -------------
Property and equipment, net..................................... $ 9,135,000 $ 9,440,000
------------- -------------
(5) NOTES PAYABLE
Notes payable at December 31, 1996 and 1995 are shown in the table below.
The estimated fair value of the notes payable at December 31, 1996 and 1995,
which is based on current rates offered to the company for debt with similar
terms, approximates the carrying value.
1996 1995
------------- -------------
First note......................................................................... $ 16,250,000 $ 16,250,000
Second note........................................................................ -- 411,000
Line of credit..................................................................... 250,000 --
------------- -------------
Total notes payable............................................................ $ 16,500,000 $ 16,661,000
------------- -------------
------------- -------------
F-18
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(5) NOTES PAYABLE (CONTINUED)
The first note is payable to a bank in quarterly installments of $1.5
million plus interest increasing to quarterly installments of $1.75 million plus
interest as of October 1, 1997. Interest is payable quarterly at the prime rate
(8 1/4% at December 31, 1996). During February, 1994, the first note was amended
changing the interest rate to a fixed rate of 6 1/2% until February 7, 1997. The
rate reverts back to the prime rate after such date or can be set at London
Interbank Offering Rate ("LIBOR") plus 2 1/4% at the Company's discretion. The
note is collateralized by all of the Common Stock of HCC. The loan agreement
contains certain restrictive covenants, including restrictions on certain
transactions in the Company's capital stock or the capital stock of HCC and the
maintenance of required financial ratios. Additionally, the loan agreement
prohibits the payment of dividends by the Company without the bank's approval.
The bank has approved the Company's current dividend policy. During 1995, the
Company prepaid the first two installments of $1.5 million due in 1996. The bank
deferred the second two installments due in 1996 until maturity on October 1,
1998. The Company paid the first 1997 quarterly payment of $1.5 million in
January, 1997.
The second note was payable to a bank in monthly installments of $21,000
plus interest. This note was repaid in full during 1996.
The outstanding advance at December 31, 1996, on a revolving line of credit,
is owed to a bank and represents the maximum available on that line of credit.
Interest is payable quarterly beginning March 20, 1997, at a variable rate which
is the bank's prime rate plus one percent (9 1/4% at December 31, 1996). The
principal is due in one payment upon maturity on December 20, 1998. The loan is
collateralized by a certificate of deposit.
At December 31, 1996, HCC maintained a revolving line of credit with a bank
in the maximum amount of $12 million available through April 30, 1997. Advances
under the line of credit are limited to amounts required to fund draws, if any,
on letters of credit issued by the bank on behalf of HCC and short-term direct
cash advances. The line of credit is collateralized by securities having an
aggregate market value of up to $15 million, the actual amount of collateral at
any one time being 125% of the aggregate amount outstanding. Interest on the
line is payable at the bank's prime rate of interest (8 1/4% at December 31,
1996). At December 31, 1996, letters of credit totaling $4.6 million had been
issued to insurance companies by the bank on behalf of HCC, with total
securities collateralizing the line of $5.8 million. As of December 31, 1996,
there were no cash advances outstanding under this line of credit, therefore,
$7.4 million is available for short-term borrowings under this facility.
Principal payments due on the note payable and the line of credit at
December 31, 1996, are shown in the table below:
FOR THE YEARS ENDED DECEMBER 31, AMOUNT DUE
- --------------------------------------------------------------------------------------------------- -------------
1997..................................................................................... $ 6,250,000
1998..................................................................................... 10,250,000
-------------
Total principal payments due....................................................................... $ 16,500,000
-------------
-------------
(6) INCOME TAX
Several of the Company's foreign subsidiaries are not subject to foreign
income taxes and no foreign income tax expense was incurred for the three years
ended December 31, 1996. United States Federal
F-19
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(6) INCOME TAX (CONTINUED)
income taxes are provided on all foreign earnings. As of December 31, 1996 and
1995, the Company had income taxes payable of $1.9 million and $702,000,
respectively. For Federal income tax purposes, LDG has approximately $19.1
million of net operating loss carryforwards which will expire in the year 2010.
The components of the income tax provision for the years ended December 31,
1996, 1995 and 1994, are as follows:
1996 1995 1994
------------- ------------- -------------
Current............................................................. $ 14,655,000 $ 10,500,000 $ 5,782,000
Deferred:
Change in net deferred tax at current enacted tax rate............ (7,326,000) (1,528,000) (1,201,000)
Change in deferred tax valuation allowance........................ -- (17,000) 17,000
------------- ------------- -------------
Total income tax provision...................................... $ 7,329,000 $ 8,955,000 $ 4,598,000
------------- ------------- -------------
------------- ------------- -------------
The composition of deferred tax assets and liabilities and the related tax
effects as of December 31, 1996 and 1995, are as follows:
1996 1995
------------- ------------
Tax net operating loss carryforward.................................................. $ 7,820,000 $ --
Excess of financial unearned premium over tax........................................ 3,930,000 3,714,000
Effect of loss reserve discounting and salvage and subrogation accrual for tax....... 3,199,000 2,746,000
Bad debt expense, deducted for financial over tax.................................... 845,000 838,000
Accrued expenses and other items deductible when paid for tax........................ 510,000 677,000
------------- ------------
Total assets..................................................................... 16,304,000 7,975,000
Excess of financial over currently taxable earnings from foreign subsidiaries........ 421,000 --
Unrealized gain on increase in value of securities available for sale (shareholders'
equity)............................................................................ 707,000 2,372,000
Deferred policy acquisition costs, net of ceding commissions, deductible for tax..... 3,027,000 2,240,000
Property and equipment depreciation and other items.................................. 625,000 442,000
------------- ------------
Total liabilities................................................................ 4,780,000 5,054,000
------------- ------------
Net deferred tax asset........................................................... $ 11,524,000 $ 2,921,000
------------- ------------
------------- ------------
Changes in the valuation allowance account applicable to the net deferred
tax asset are as follows:
1996 1995 1994
--------- ---------- ---------
Balance, beginning of year...................................................... $ -- $ 17,000 $ --
Increase charged (decrease credited) to income.................................. -- (17,000) 17,000
Valuation allowance acquired.................................................... 54,000 -- --
--------- ---------- ---------
Balance, end of year........................................................ $ 54,000 $ 0 $ 17,000
--------- ---------- ---------
--------- ---------- ---------
During 1994, the Company's statutory Federal income tax rate changed from
34% to 35%. This change resulted in a deferred tax benefit of approximately
$70,000. The rate change also resulted in an
F-20
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(6) INCOME TAX (CONTINUED)
increase in the current income tax provision of approximately $135,000. The
following table summarizes the differences between the Company's effective tax
rate for financial statement purposes and the Federal statutory rate:
1996 1995 1994
------------- ------------- ------------
Statutory tax rate............................................ 35.0% 35.0% 35.0%
Federal tax at statutory rate................................. $ 12,819,000 $ 11,652,000 $ 6,953,000
Nontaxable municipal bond interest and dividends received
deduction................................................... (3,670,000) (2,624,000) (2,176,000)
State income taxes............................................ (234,000) 397,000 349,000
Tax exempt status of S Corporation............................ (1,617,000) (722,000) (651,000)
Deferred taxes at date of S Corporation conversion............ (680,000) -- --
Other, net.................................................... 711,000 252,000 123,000
------------- ------------- ------------
Income tax provision...................................... $ 7,329,000 $ 8,955,000 $ 4,598,000
------------- ------------- ------------
------------- ------------- ------------
Effective tax rate........................................ 20.0% 26.9% 23.1%
------------- ------------- ------------
------------- ------------- ------------
(7) SEGMENT AND GEOGRAPHIC DATA
The Company classifies its activities into two core business segments: 1)
property and casualty insurance company operations and 2) insurance agency and
brokerage operations. Corporate includes general corporate items and
intersegment eliminations. The following table shows information by business
segment and geographic location:
COMPANY AGENCY CORPORATE TOTAL
-------------- ------------- ------------- --------------
For the year ended December 31, 1996:
Revenue:
Domestic........................................ $ 94,507,000 $ 36,418,000 $ 41,000 $ 130,966,000
Foreign......................................... 17,836,000 3,443,000 -- 21,279,000
Intersegment.................................... 600,000 763,000 (1,363,000) --
-------------- ------------- ------------- --------------
Total revenue................................. $ 112,943,000 $ 40,624,000 $ (1,322,000) $ 152,245,000
-------------- ------------- ------------- --------------
-------------- ------------- ------------- --------------
Net earnings:
Domestic........................................ $ 28,340,000 $ (766,000) $ (2,853,000) $ 24,721,000
Foreign......................................... 5,254,000 (677,000) -- 4,577,000
-------------- ------------- ------------- --------------
Total net earnings............................ $ 33,594,000 $ (1,443,000) $ (2,853,000) $ 29,298,000
-------------- ------------- ------------- --------------
-------------- ------------- ------------- --------------
Depreciation and amortization..................... $ 1,509,000 $ 780,000 $ 29,000 $ 2,318,000
-------------- ------------- ------------- --------------
-------------- ------------- ------------- --------------
Capital expenditures.............................. $ 598,000 $ 1,126,000 $ -- $ 1,724,000
-------------- ------------- ------------- --------------
-------------- ------------- ------------- --------------
F-21
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(7) SEGMENT AND GEOGRAPHIC DATA (CONTINUED)
COMPANY AGENCY CORPORATE TOTAL
-------------- ------------- ------------- --------------
For the year ended December 31, 1995:
Revenue:
Domestic........................................ $ 79,209,000 $ 30,766,000 $ 36,000 $ 110,011,000
Foreign......................................... 13,889,000 3,309,000 -- 17,198,000
Intersegment.................................... 474,000 383,000 (857,000) --
-------------- ------------- ------------- --------------
Total revenue................................. $ 93,572,000 $ 34,458,000 $ (821,000) $ 127,209,000
-------------- ------------- ------------- --------------
-------------- ------------- ------------- --------------
Net earnings:
Domestic........................................ $ 17,192,000 $ 3,608,000 $ (1,824,000) $ 18,976,000
Foreign......................................... 4,508,000 853,000 -- 5,361,000
-------------- ------------- ------------- --------------
Total net earnings............................ $ 21,700,000 $ 4,461,000 $ (1,824,000) $ 24,337,000
-------------- ------------- ------------- --------------
-------------- ------------- ------------- --------------
Depreciation and amortization..................... $ 932,000 $ 758,000 $ 10,000 $ 1,700,000
-------------- ------------- ------------- --------------
-------------- ------------- ------------- --------------
Capital expenditures.............................. $ 2,399,000 $ 684,000 $ 186,000 $ 3,269,000
-------------- ------------- ------------- --------------
-------------- ------------- ------------- --------------
For the year ended December 31, 1994:
Revenue:
Domestic........................................ $ 54,060,000 $ 28,552,000 $ -- $ 82,612,000
Foreign......................................... 1,996,000 897,000 -- 2,893,000
Intersegment.................................... 674,000 376,000 (1,050,000) --
-------------- ------------- ------------- --------------
Total revenue................................. $ 56,730,000 $ 29,825,000 $ (1,050,000) $ 85,505,000
-------------- ------------- ------------- --------------
-------------- ------------- ------------- --------------
Net earnings:
Domestic........................................ $ 12,475,000 $ 3,959,000 $ (1,377,000) $ 15,057,000
Foreign......................................... 725,000 (514,000) -- 211,000
-------------- ------------- ------------- --------------
Total net earnings............................ $ 13,200,000 $ 3,445,000 $ (1,377,000) $ 15,268,000
-------------- ------------- ------------- --------------
-------------- ------------- ------------- --------------
Depreciation and amortization..................... $ 632,000 $ 652,000 $ -- $ 1,284,000
-------------- ------------- ------------- --------------
-------------- ------------- ------------- --------------
Capital expenditures.............................. $ 1,033,000 $ 405,000 $ -- $ 1,438,000
-------------- ------------- ------------- --------------
-------------- ------------- ------------- --------------
Identifiable assets by business segment and geographic location are shown in
the following table:
COMPANY AGENCY CORPORATE TOTAL
-------------- -------------- ------------- --------------
December 31, 1996:
Domestic....................................... $ 494,870,000 $ 119,628,000 $ 14,418,000 $ 628,916,000
Foreign........................................ 92,033,000 24,830,000 -- 116,863,000
-------------- -------------- ------------- --------------
Total identifiable assets.................... $ 586,903,000 $ 144,458,000 $ 14,418,000 $ 745,779,000
-------------- -------------- ------------- --------------
-------------- -------------- ------------- --------------
December 31, 1995:
Domestic....................................... $ 466,366,000 $ 95,917,000 $ 11,917,000 $ 574,200,000
Foreign........................................ 89,078,000 18,398,000 -- 107,476,000
-------------- -------------- ------------- --------------
Total identifiable assets.................... $ 555,444,000 $ 114,315,000 $ 11,917,000 $ 681,676,000
-------------- -------------- ------------- --------------
-------------- -------------- ------------- --------------
F-22
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(7) SEGMENT AND GEOGRAPHIC DATA (CONTINUED)
During 1996 and 1995, one broker in London, England, produced gross written
premium to the Company of approximately $25.7 million and $31.2 million,
respectively. This represents 11% and 13% of the Company's total gross written
premium for those years. Approximately 55% of the gross written premium by the
domestic insurance subsidiaries is for insureds located outside the United
States.
(8) REINSURANCE
In the normal course of business the Company's insurance company
subsidiaries cede a substantial portion of their premium to unrelated domestic
and foreign reinsurers through quota share, surplus, excess of loss and
facultative reinsurance agreements. Although the ceding of reinsurance does not
discharge the primary insurer from liability to its policyholder, the
subsidiaries participate in such agreements for the purpose of limiting their
loss exposure and diversifying their business. Substantially all of the
reinsurance assumed by the Company's insurance company subsidiaries was
underwritten directly by the subsidiaries but issued by other unrelated
companies in order to satisfy local licensing or other requirements,
predominantly on foreign business or as reinsurance of captives. The following
table represents the effect of such reinsurance transactions on net premium and
loss and loss adjustment expense:
LOSS AND LOSS
WRITTEN EARNED ADJUSTMENT
PREMIUM PREMIUM EXPENSE
--------------- --------------- ---------------
For the year ended December 31, 1996:
Direct business............................................ $ 84,166,000 $ 99,436,000 $ 57,768,000
Reinsurance assumed........................................ 146,589,000 135,294,000 97,305,000
Reinsurance ceded.......................................... (133,979,000) (141,416,000) (103,831,000)
--------------- --------------- ---------------
Net amounts.............................................. $ 96,776,000 $ 93,314,000 $ 51,242,000
--------------- --------------- ---------------
--------------- --------------- ---------------
For the year ended December 31, 1995:
Direct business............................................ $ 111,466,000 $ 97,675,000 $ 81,425,000
Reinsurance assumed........................................ 127,492,000 110,344,000 65,061,000
Reinsurance ceded.......................................... (140,172,000) (128,008,000) (96,717,000)
--------------- --------------- ---------------
Net amounts.............................................. $ 98,786,000 $ 80,011,000 $ 49,769,000
--------------- --------------- ---------------
--------------- --------------- ---------------
For the year ended December 31, 1994:
Direct business............................................ $ 97,585,000 $ 68,174,000 $ 45,386,000
Reinsurance assumed........................................ 95,293,000 76,895,000 60,837,000
Reinsurance ceded.......................................... (133,184,000) (98,235,000) (76,635,000)
--------------- --------------- ---------------
Net amounts.............................................. $ 59,694,000 $ 46,834,000 $ 29,588,000
--------------- --------------- ---------------
--------------- --------------- ---------------
F-23
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(8) REINSURANCE (CONTINUED)
The table below represents the composition of reinsurance recoverables in
the accompanying consolidated balance sheets:
1996 1995
-------------- --------------
Reinsurance recoverable on paid losses....................... $ 21,708,000 $ 13,678,000
Reinsurance recoverable on outstanding losses................ 96,247,000 83,847,000
Reinsurance recoverable on IBNR.............................. 7,641,000 8,278,000
Reserve for uncollectible reinsurance........................ (2,415,000) (2,395,000)
-------------- --------------
Total reinsurance recoverables........................... $ 123,181,000 $ 103,408,000
-------------- --------------
-------------- --------------
The insurance company subsidiaries require reinsurers not authorized by
their respective states of domicile to collateralize their reinsurance
obligations to the Company with letters of credit or cash deposits. At December
31, 1996, the Company held letters of credit and cash deposits in the amounts of
$67.9 million and $9.1 million, respectively, to collateralize certain
reinsurance balances. The Company has established a reserve of $2.4 million as
of December 31, 1996, to reduce the effects of any recoverable problem.
In order to minimize their exposure to reinsurance credit risk, the Company
evaluates the financial condition of their reinsurers and place their
reinsurance with a diverse group of financially sound companies. The following
table shows reinsurance balances relating to the reinsurers with a total
recoverable balance greater than $10.0 million and the collateral and potential
offsets held by the Company as of each year end:
REINSURANCE
RECOVERABLES AND LETTERS OF CREDIT,
CEDED UNEARNED CASH DEPOSITS AND
REINSURER LOCATION PREMIUM OTHER PAYABLES
- ------------------------------------------------------ ------------------- ---------------- ------------------
December 31, 1996:
Underwriters at Lloyd's............................. London, England $ 28,962,000 $ 18,446,000
GIO Insurance Limited............................... Sydney, Australia 25,204,000 26,106,000
Reinsurance Australia Corporation, Ltd.............. Sydney, Australia 20,562,000 19,332,000
Underwriters Indemnity Company...................... Houston, TX 12,531,000 5,934,000
SCOR Reinsurance Company............................ New York, NY 11,105,000 2,428,000
AXA Reinsurance Company............................. Wilmington, DE 10,402,000 2,759,000
December 31, 1995:
GIO Insurance Limited............................... Sydney, Australia $ 30,160,000 $ 31,202,000
Underwriters at Lloyd's............................. London, England 24,518,000 25,916,000
Reinsurance Australia Corporation, Ltd.............. Sydney, Australia 16,620,000 14,198,000
AXA Reinsurance Company............................. Wilmington, DE 13,096,000 5,586,000
Approximately $1.9 million in recoverables is due from reinsurers that are
either under regulatory supervision or insolvent. The Company holds letters of
credit and cash deposits totaling $1.9 million to collateralize these balances
plus other credits of $1.1 million available for potential offset. The Company
is involved in a dispute with two reinsurers over coverage and other issues. The
Company believes the reinsurers' positions are without merit and all amounts due
from the reinsurers will be recovered. The total amount in dispute is
approximately $3.4 million.
F-24
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(9) COMMITMENTS AND CONTINGENCIES
LITIGATION
The Company is a party to numerous lawsuits arising in the normal course of
business. All pending lawsuits involve claims under policies underwritten or
reinsured by the Company, which management believes have been adequately
included in its established loss reserves. The Company believes the resolution
of these lawsuits will not have a material adverse effect on its financial
condition, results of operations or cash flows.
FOREIGN CURRENCY FORWARD CONTRACTS
From time to time the Company enters into foreign currency forward contracts
as a hedge against foreign currency fluctuations, primarily British Pound
Sterling. The Company's balances denominated in foreign currency fluctuate as
transactions are recorded and settled. During 1996, the average Sterling
liability, for subsidiaries whose functional currency was the United States
dollar, was approximately L907,000 ($1.6 million at the December 31, 1996, rate
of exchange) which was hedged by an average open forward contract balance of
approximately L460,000 ($785,000 at the December 31, 1996, rate of exchange).
There was one open foreign currency forward contract as of December 31, 1996 to
purchase L500,000 ($856,000 at the December 31, 1996, rate of exchange) with a
maturity of January, 1997. As of December 31, 1996, the open foreign currency
contract had a gain of $37,000. During January, 1997, the Company entered into a
foreign currency forward contract for L500,000 ($856,000 at December 31, 1996,
rate of exchange). The Company expects to continue to limit its exposure to
currency fluctuations through the use of foreign currency forward contracts.
The Company utilizes these foreign currency forward contracts strictly as a
hedge against existing exposure to foreign currency fluctuations and it does not
do so as any form of speculative or trading investment.
LEASES
The Company leases administrative office facilities under long-term
noncancelable operating lease agreements expiring at various dates through
October, 2001. The agreements generally require the payment of utilities, real
estate taxes, insurance and repairs. The Company has recognized rent expense on
a straight-line basis over the terms of these leases. In addition, the Company
leases computer equipment and automobiles under operating leases expiring at
various dates through the year 1999. Rent expense under these leases amounted to
$1,495,000, $1,095,000 and $895,000 for the years ended December 31, 1996, 1995
and 1994, respectively.
At December 31, 1996, future minimum annual rental payments required under
the long-term noncancelable operating leases, excluding certain expenses payable
by the Company, are as follows:
FOR THE YEARS ENDED DECEMBER 31, AMOUNT DUE
- ---------------------------------------------------------------------------------------------------- ------------
1997...................................................................................... $ 1,125,000
1998...................................................................................... 877,000
1999...................................................................................... 815,000
2000...................................................................................... 789,000
2001...................................................................................... 575,000
------------
Total future minimum annual rental payments due..................................................... $ 4,181,000
------------
------------
F-25
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(10) RELATED PARTY TRANSACTIONS
Certain of the Company's directors are officers, directors or owners of
business entities with which the Company transacts business. Balances with these
business entities and other related parties included in the accompanying
consolidated balance sheets are as follows:
1996 1995
------------ ------------
Marketable equity securities.......................................................... $ 773,000 $ --
Reinsurance recoverables.............................................................. 3,472,000 590,000
Ceded unearned premium................................................................ 9,059,000 4,786,000
Reinsurance balances payable.......................................................... 3,780,000 3,903,000
Premium payable....................................................................... 1,532,000 --
Loss and loss adjustment expense payable.............................................. 663,000 9,000
Accounts payable and accrued liabilities.............................................. -- 7,000
Transactions with these business entities and other related parties included
in the accompanying consolidated statements of earnings are as follows:
1996 1995 1994
------------- ------------ ------------
Gross earned premium.................................................. $ 871,000 $ -- $ --
Commission income..................................................... 1,249,000 -- --
Ceded earned premium.................................................. 12,050,000 1,194,000 1,017,000
Gross loss and loss adjustment expense................................ 661,000 106,000 157,000
Ceded loss and loss adjustment expense................................ 5,852,000 185,000 866,000
Other operating expense............................................... 1,011,000 758,000 104,000
During 1995, $63,000 was paid to a related party for construction management
services related to improvements to the Company's offices in Houston, Texas.
Also, during 1994, real estate acquired with the acquisition of IMG was sold to
a related party for $788,000. There was no gain or loss recorded on this sale.
(11) EMPLOYEE BENEFIT PLANS
The Company has defined contribution retirement plans under Section 401(k)
of the Internal Revenue Code which cover substantially all of the domestic
employees who meet specified service requirements. The Company's contributions
of these plans are based on varying percentages of the employees' contributions,
up to varying maximum levels. The Company contributed $506,000, $693,000 and
$646,000 to the plans for the years ended December 31, 1996, 1995 and 1994,
respectively, which is included in compensation expense in the accompanying
consolidated statements of earnings.
(12) SHAREHOLDERS' EQUITY
Under the Texas Insurance Code, HCC must maintain minimum statutory capital
of $1,000,000 and minimum statutory surplus of $1,000,000, and can only pay
dividends out of surplus funds. In addition, HCC is limited in the amount of
dividends which it may pay in any twelve month period, without prior regulatory
approval, to the greater of statutory net investment income for the prior
calendar year or ten percent (10%)of statutory capital and surplus as of the
prior calendar year end. During 1997, HCC's ordinary dividend capacity will be
approximately $15.1 million. As of December 31, 1996, HCC's and TIC's total
adjusted capital greatly exceeded the NAIC authorized control level risk-based
capital.
F-26
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(12) SHAREHOLDERS' EQUITY (CONTINUED)
Under Jordanian Law, IMG and MEIB must transfer 10% of their earnings before
income tax each year to a statutory reserve until the reserve balance equals the
paid up capital balance. This reserve is not available for the payment of
dividends. As of December 31, 1996, IMG and MEIB had combined capital plus
statutory reserves totaling $17.0 million included as part their combined
shareholders' equity totaling $61.1 million.
(13) STOCK OPTIONS
The Company has four option plans, the 1994 Nonemployee Director Stock
Option Plan, the 1996 Nonemployee Director Stock Option Plan, the 1992 Incentive
Stock Option Plan, and the 1995 Flexible Incentive Plan. All plans are
administered by the Compensation Committee of the Board of Directors. Each
option may be used to purchase one share of Common Stock of the Company. As of
December 31, 1996, 4,004,669 shares of Common Stock were reserved for issuance
of options, of which 1,748,276 shares were reserved for future issuances of
options.
Options generally vest over a one, three or five year period and expire ten
years after grant date. All options have been granted at fixed exercise prices,
generally at the market price of the Company's Common Stock on the grant date.
Any excess of the market price on the grant date over the exercise price is
recognized as compensation expense in the accompanying financial statements.
During 1996, such compensation expense amounted to $494,000. If the fair value
method of valuing compensation related to options would have been used, pro
forma net earnings and pro forma earnings per share would have been $28.3
million, or $0.79 per share, for the year ended December 31, 1996. The pro forma
compensation cost for the year ended December 31, 1995, is immaterial. The fair
value of each option grant was estimated on the grant date using the
Black-Scholes single option pricing model with the following assumptions: a)
risk free interest rate of 5.6% for 1996 and 6.6% for 1995, b) expected
volatility factor of .3, c) dividend yield of .3% for 1996 and 0% for 1995, and
d) expected option life of six years.
Stock option activity is shown below after adjustment for the effects of the
three-for-two stock split payable as a 50% stock dividend to shareholders of
record March 15, 1994, and for the effects of the five-for-two stock split
payable as a 150% stock dividend to shareholders of record April 30, 1996. (See
note 1).
1996 1995 1994
---------------------------------- ------------------------------------ ----------
AVERAGE AVERAGE AVERAGE AVERAGE
NUMBER OF EXERCISE FAIR NUMBER OF EXERCISE FAIR NUMBER OF
SHARES PRICE VALUE SHARES PRICE VALUE SHARES
---------- ----------- --------- ---------- ----------- ----------- ----------
Outstanding, beginning of year....... 2,036,563 $ 9.29 1,166,187 $ 5.75 1,146,562
Granted at market value.............. 292,500 23.63 $ 9.87 1,078,751 12.29 $ 4.99 371,250
Granted above market value........... -- -- -- -- -- -- 59,000
Granted below market value........... 60,000 13.01 11.51 16,000 7.70 5.70 --
Cancelled............................ (12,250) 11.51 (77,184) 7.54 (89,155)
Exercised............................ (120,420) 4.52 (147,191) 3.92 (321,470)
---------- ----------- ---------- ----------- ----------
Outstanding, end of year............. 2,256,393 $ 11.49 2,036,563 $ 9.29 1,166,187
---------- ----------- ---------- ----------- ----------
---------- ----------- ---------- ----------- ----------
Exercisable, end of year............. 722,142 $ 8.12 420,142 $ 4.49 387,021
---------- ----------- ---------- ----------- ----------
---------- ----------- ---------- ----------- ----------
AVERAGE
EXERCISE
PRICE
-----------
Outstanding, beginning of year....... $ 3.77
Granted at market value.............. 7.87
Granted above market value........... 8.47
Granted below market value........... --
Cancelled............................ 3.93
Exercised............................ 2.14
-----
Outstanding, end of year............. $ 5.75
-----
-----
Exercisable, end of year............. $ 3.87
-----
-----
F-27
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(13) STOCK OPTIONS (CONTINUED)
Options outstanding at December 31, 1996, are shown on the following
schedule:
OPTIONS EXERCISABLE
OPTIONS OUTSTANDING
---------------------------------------- ------------------------
AVERAGE
REMAINING AVERAGE AVERAGE
RANGE OF NUMBER OF CONTRACTUAL EXERCISE NUMBER OF EXERCISE
EXERCISE PRICES SHARES LIFE PRICE SHARES PRICE
- ----------------------------------------------------------- ---------- --------------- ----------- ----------- -----------
Under $4.00................................................ 239,842 3.33 years $ 3.73 225,782 $ 3.73
$4.00--$10.00.............................................. 619,050 6.33 7.19 200,927 6.90
$10.01--$15.00............................................. 1,105,001 8.78 12.37 295,433 12.31
$15.01--$21.00............................................. -- -- -- -- --
Over $21.00................................................ 292,500 8.98 23.63 -- --
---------- --------------- ----------- ----------- -----------
Total Options.......................................... 2,256,393 7.55 years $ 11.49 722,142 $ 8.12
---------- --------------- ----------- ----------- -----------
---------- --------------- ----------- ----------- -----------
(14) STATUTORY TO GAAP RECONCILIATIONS
Reconciliations of statutory policyholders' surplus as of December 31, 1996
and 1995, and net income for the years ended December 31, 1996, 1995 and 1994,
of the Company's insurance company subsidiaries included in those companies'
respective filings with regulatory authorities to the amounts shown in the
F-28
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(14) STATUTORY TO GAAP RECONCILIATIONS (CONTINUED)
accompanying consolidated financial statements on the basis of generally
accepted accounting principles ("GAAP") are as follows:
1996 1995
-------------- --------------
Statutory policyholders' surplus................................................. $ 212,194,000 $ 177,317,000
Difference in carrying value of fixed income securities.......................... 1,652,000 2,467,000
Assets non-admitted for statutory reporting...................................... 2,174,000 2,973,000
Deferred policy acquisition costs and deferred ceding commissions capitalized for
GAAP........................................................................... 820,000 (1,569,000)
Deferred income taxes recorded for GAAP.......................................... 4,519,000 3,199,000
Statutory provisions for reinsurance, net of GAAP reserve for uncollectible
reinsurance.................................................................... 1,587,000 4,224,000
Other............................................................................ (133,000) --
-------------- --------------
Shareholder's equity of insurance company subsidiaries on basis of GAAP...... 222,813,000 188,611,000
Equity attributable to non-insurance company parent and subsidiaries, net of
elimination entries in consolidation........................................... 17,877,000 6,848,000
-------------- --------------
Total shareholders' equity per accompanying consolidated financial
statements................................................................. $ 240,690,000 $ 195,459,000
-------------- --------------
-------------- --------------
1996 1995 1994
------------- ------------- -------------
Statutory net income................................................ $ 34,640,000 $ 23,004,000 $ 15,711,000
Deferred income tax benefit (expense) not recorded for statutory
purposes.......................................................... (250,000) 1,650,000 1,318,000
Change in deferred policy acquisition costs and deferred ceding
commissions capitalized for GAAP.................................. 2,390,000 (165,000) (1,065,000)
Provision for reinsurance not expensed for statutory purposes....... 100,000 (900,000) (600,000)
Other, net.......................................................... (18,000) (10,000) (4,000)
------------- ------------- -------------
Net income of insurance company subsidiaries on basis of GAAP... 36,862,000 23,579,000 15,360,000
Net income (loss) attributable to non-insurance parent and
subsidiaries...................................................... (7,564,000) 758,000 (92,000)
------------- ------------- -------------
Net earnings per accompanying consolidated financial
statements.................................................... $ 29,298,000 $ 24,337,000 $ 15,268,000
------------- ------------- -------------
------------- ------------- -------------
(15) SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental cash flow information for the three years ended December 31,
1996, is summarized below:
1996 1995 1994
------------ ------------ ------------
Interest paid........................................................... $ 1,109,000 $ 2,313,000 $ 1,876,000
Income tax paid......................................................... 13,740,000 9,803,000 5,139,000
F-29
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(15) SUPPLEMENTAL CASH FLOW INFORMATION (CONTINUED)
The unrealized gain or loss on securities available for sale, deferred taxes
related thereto, and the issuance of the Company's Common Stock for the purchase
of subsidiaries are noncash transactions which have been included as direct
increases or decreases in shareholders' equity. During the year ended December
31, 1995, non-cash contributions to LDG's additional paid-in capital of $50,000
was recorded by a reduction in certain payable balances.
(16) LIABILITY FOR UNPAID LOSS AND LOSS ADJUSTMENT EXPENSE
The following table provides a reconciliation of the liability of loss and
loss adjustment expense, for the years ended December 31, 1996, 1995 and 1994:
1996 1995 1994
-------------- -------------- --------------
Reserves for loss and loss adjustment expense at beginning of
the year...................................................... $ 158,451,000 $ 129,755,000 $ 98,399,000
Less reinsurance recoverables................................... 92,125,000 85,214,000 66,468,000
-------------- -------------- --------------
Net reserves at beginning of the year....................... 66,326,000 44,541,000 31,931,000
Net reserves acquired with purchase of subsidiary............... -- -- 1,769,000
Provision for loss and loss adjustment expense for claims
occurring in the current year................................. 55,045,000 51,387,000 28,871,000
Increase (decrease) in estimated loss and loss adjustment
expense for claims occurring in prior years................... (3,803,000) (1,618,000) 717,000
-------------- -------------- --------------
Incurred loss and loss adjustment expense, net of
reinsurance............................................... 51,242,000 49,769,000 29,588,000
-------------- -------------- --------------
Loss and loss adjustment expense payments for claims occurring
during:
Current year.................................................... 15,903,000 12,268,000 6,386,000
Prior years..................................................... 19,731,000 15,716,000 12,361,000
-------------- -------------- --------------
Loss and loss adjustment expense payments, net of
reinsurance............................................... 35,634,000 27,984,000 18,747,000
-------------- -------------- --------------
Net reserves at end of the year................................. 81,934,000 66,326,000 44,541,000
Plus reinsurance recoverables................................... 103,888,000 92,125,000 85,214,000
-------------- -------------- --------------
Reserves for loss and loss adjustment expense at end of
the year................................................ $ 185,822,000 $ 158,451,000 $ 129,755,000
-------------- -------------- --------------
-------------- -------------- --------------
F-30
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(17) QUARTERLY FINANCIAL DATA (UNAUDITED)
FOURTH QUARTER THIRD QUARTER SECOND QUARTER FIRST QUARTER
1996 1996 1996 1996
-------------- ------------- -------------- -------------
Net earned premium................................ $ 27,212,000 $20,145,000 $ 22,459,000 $ 23,498,000
Fee and commission income......................... 8,428,000 9,981,000 10,536,000 9,517,000
Total revenue..................................... 41,424,000 35,569,000 37,768,000 37,484,000
Loss and loss adjustment expense.................. 14,367,000 10,508,000 12,128,000 14,239,000
Total expense..................................... 23,683,000 19,308,000 47,430,000 25,197,000
Earnings (loss) before income tax provision....... 17,741,000 16,261,000 (9,662,000) 12,287,000
Income tax provision (benefit).................... 5,177,000 4,931,000 (5,602,000) 2,823,000
-------------- ------------- -------------- -------------
Net earnings (loss)............................... $ 12,564,000 $11,330,000 $ (4,060,000) $ 9,464,000
-------------- ------------- -------------- -------------
-------------- ------------- -------------- -------------
Earnings per share data:
Earnings per share................................ $ 0.35 $ 0.31 $ (0.11) $ 0.27
-------------- ------------- -------------- -------------
-------------- ------------- -------------- -------------
Weighted average shares outstanding............... 36,387,000 35,993,000 35,785,000 35,638,000
-------------- ------------- -------------- -------------
-------------- ------------- -------------- -------------
FOURTH QUARTER THIRD QUARTER SECOND QUARTER FIRST QUARTER
1995 1995 1995 1995
-------------- ------------- -------------- -------------
Net earned premium................................ $ 21,160,000 $20,254,000 $ 20,532,000 18,065,000
Fee and commission income......................... 9,437,000 7,860,000 8,182,000 7,408,000
Total revenue..................................... 35,000,000 31,535,000 32,186,000 28,488,000
Loss and loss adjustment expense.................. 12,749,000 12,517,000 13,227,000 11,276,000
Total expense..................................... 23,445,000 23,566,000 24,232,000 22,674,000
Earnings before income tax provision.............. 11,555,000 7,969,000 7,954,000 5,814,000
Income tax provision.............................. 3,208,000 2,333,000 1,987,000 1,427,000
-------------- ------------- -------------- -------------
Net earnings...................................... $ 8,347,000 $ 5,636,000 $ 5,967,000 $ 4,387,000
-------------- ------------- -------------- -------------
-------------- ------------- -------------- -------------
Earnings per share data:
Earnings per share................................ $ 0.24 $ 0.16 $ 0.20 $ 0.15
-------------- ------------- -------------- -------------
-------------- ------------- -------------- -------------
Weighted average shares outstanding............... 35,156,000 34,999,000 30,506,000 29,906,000
-------------- ------------- -------------- -------------
-------------- ------------- -------------- -------------
All amounts have been restated to include the accounts and operations of LDG
(see note 2). All share and per share data have been retroactively adjusted to
reflect the effects of the five-for-two stock split and the shares issued in
connection with the combination with LDG (see note 1). Nonrecurring expenses of
$25.0 million were incurred in the second quarter of 1996. (see note 2).
F-31
REPORT OF INDEPENDENT ACCOUNTANTS
Our report on the consolidated financial statements of HCC Insurance
Holdings, Inc. and Subsidiaries is included on page F-1 of this Form 10-K. Such
report states that for the year ended December 31, 1994, our opinion, insofar as
it relates to data included for LDG Management Company Incorporated and
Affiliates for 1994, is based solely on the report of the other auditors. In
connection with our audits and the report of other auditors of such financial
statements, we have also audited the related financial statement schedules
listed in the index on page 32 of this Form 10-K. Our opinion on the financial
statement schedules, insofar as it relates to data included for LDG Management
Company Incorporated and Affiliates for 1994, is based solely on the report of
the other auditors.
In our opinion, based on our audits and the report of other auditors, the
financial statement schedules referred to above, when considered in relation to
the basic financial statements taken as a whole, present fairly, in all material
respects, the information required to be included therein.
COOPERS & LYBRAND L.L.P.
Houston, Texas
March 27, 1997
S-1
SCHEDULE 1
HCC INSURANCE HOLDINGS, INC.
SUMMARY OF INVESTMENTS
OTHER THAN INVESTMENTS IN RELATED PARTIES
DECEMBER 31, 1996
COLUMN A COLUMN B COLUMN C COLUMN D
- ---------------------------------------------------------------- -------------- -------------- --------------
AMOUNT AT
WHICH
SHOWN IN THE
BALANCE
TYPE OF INVESTMENT COST VALUE SHEET
- ---------------------------------------------------------------- -------------- -------------- --------------
Fixed maturities available for sale:
Bonds--United States government and government agencies and
authorities................................................. $ 3,527,000 $ 3,604,000 $ 3,604,000
Bonds--states, municipalities and political subdivisions...... 126,256,000 127,552,000 127,552,000
Bonds--special revenue........................................ 132,884,000 133,571,000 133,571,000
-------------- -------------- --------------
Total fixed maturities available for sale................... 262,667,000 $ 264,727,000 264,727,000
-------------- -------------- --------------
--------------
Equity securities available for sale:
Common stocks--banks, trusts & insurance companies............ 1,154,000 1,219,000 1,219,000
Common stocks--industrial..................................... 1,133,000 1,019,000 1,019,000
Nonredeemable preferred stocks................................ 194,000 195,000 195,000
-------------- -------------- --------------
Total equity securities available for sale.................. 2,481,000 $ 2,433,000 2,433,000
-------------- -------------- --------------
--------------
Short-term investments.......................................... 53,100,000 53,100,000
-------------- --------------
Total investments........................................... $ 318,248,000 $ 320,260,000
-------------- --------------
-------------- --------------
S-2
SCHEDULE 2
HCC INSURANCE HOLDINGS, INC.
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
BALANCE SHEETS
DECEMBER 31,
------------------------
1996 1995
----------- -----------
ASSETS
Cash and short-term investments.................................. $ 4,192,000 $ 1,055,000
Investment in subsidiaries....................................... 253,680,000 208,006,000
Receivable from subsidiaries..................................... -- 630,000
Deferred Federal income tax...................................... 9,999,000 2,914,000
Other assets..................................................... 205,000 312,000
----------- -----------
Total assets................................................. $268,076,000 $212,917,000
----------- -----------
----------- -----------
LIABILITIES AND SHAREHOLDERS' EQUITY
Notes payable.................................................... $16,250,000 $16,250,000
Payable to subsidiaries.......................................... 8,636,000 --
Accounts payable and accrued liabilities......................... 2,500,000 1,208,000
----------- -----------
Total liabilities............................................ 27,386,000 17,458,000
Total shareholders' equity................................... 240,690,000 195,459,000
----------- -----------
Total liabilities and shareholders' equity................... $268,076,000 $212,917,000
----------- -----------
----------- -----------
See Note to Condensed Financial Information.
S-3
SCHEDULE 2
HCC INSURANCE HOLDINGS, INC.
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF EARNINGS
FOR THE YEARS ENDED DECEMBER 31,
-------------------------------------------
1996 1995 1994
------------- ------------- -------------
Equity in earnings of subsidiaries.................................. $ 32,621,000 $ 26,558,000 $ 16,881,000
Interest income..................................................... 41,000 36,000 --
Interest expense.................................................... 1,110,000 2,196,000 1,901,000
Merger related expenses............................................. 907,000 -- --
Other operating expense............................................. 1,832,000 784,000 341,000
------------- ------------- -------------
Earnings before income tax benefit.............................. 28,813,000 23,614,000 14,639,000
------------- ------------- -------------
Income tax benefit.................................................. 485,000 723,000 629,000
------------- ------------- -------------
Net earnings.................................................... $ 29,298,000 $ 24,337,000 $ 15,268,000
------------- ------------- -------------
------------- ------------- -------------
See Note to Condensed Financial Information.
S-4
SCHEDULE 2
HCC INSURANCE HOLDINGS, INC.
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31,
----------------------------------------------
1996 1995 1994
-------------- -------------- --------------
Cash flows from operating activities:
Net earnings................................................... $ 29,298,000 $ 24,337,000 $ 15,268,000
Adjustment to reconcile net earnings to net cash provided
(used) by operating activities:
Undistributed net income of subsidiaries....................... (32,621,000) (26,558,000) (16,881,000)
Change in deferred Federal income tax, net of tax effect of
unrealized gain or loss........................................ (5,423,000) (1,546,000) (1,216,000)
Amortization and other non-cash expenses....................... 29,000 10,000 116,000
Change in payable to subsidiaries and other.................... 8,971,000 230,000 210,000
-------------- -------------- --------------
Cash provided (used) by operating activities................. 254,000 (3,527,000) (2,503,000)
Cash flows from investing activities:
Cash contributions to subsidiaries............................. -- (24,072,000) (15,959,000)
Purchase of subsidiaries....................................... (1,753,000) -- (8,375,000)
Cash dividends from subsidiaries............................... 5,180,000 7,102,000 10,003,000
-------------- -------------- --------------
Cash provided (used) by investing activities................. 3,427,000 (16,970,000) (14,331,000)
Cash flows from financing activities:
Proceeds from note payable..................................... -- -- 20,000,000
Payments on notes payable...................................... -- (28,000,000) (4,000,000)
Sale of Common Stock, net of costs............................. 843,000 48,799,000 1,344,000
Dividends paid................................................. (1,387,000) -- --
-------------- -------------- --------------
Cash provided (used) by financing activities................. (544,000) 20,799,000 17,344,000
-------------- -------------- --------------
Net increase in cash and short-term investments.............. 3,137,000 302,000 510,000
Cash and short-term investments at beginning of year......... 1,055,000 753,000 243,000
-------------- -------------- --------------
Cash and short-term investments at end of year............... $ 4,192,000 $ 1,055,000 $ 753,000
-------------- -------------- --------------
-------------- -------------- --------------
See Note to Condensed Financial Information.
S-5
HCC INSURANCE HOLDINGS, INC.
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
NOTE TO CONDENSED FINANCIAL INFORMATION
The accompanying condensed financial information should be read in
conjunction
with the consolidated financial statements and the related notes thereto of HCC
Insurance Holdings, Inc. and Subsidiaries. Investments in subsidiaries are
accounted for using the equity method.
S-6
SCHEDULE 3
HCC INSURANCE HOLDINGS, INC.
SUPPLEMENTARY INSURANCE INFORMATION
(DOLLARS IN THOUSANDS)
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN F COLUMN G COLUMN H
------------ --------------- ------------- ----------- ----------- --------------- -----------
(1) (1) (2)
DECEMBER 31,
------------------------------------------- FOR THE YEARS ENDED DECEMBER 31,
FUTURE POLICY -----------------------------------------
BENEFITS, BENEFITS,
LOSSES, CLAIMS,
DEFERRED POLICY CLAIMS LOSSES AND
ACQUISITION AND LOSS UNEARNED PREMIUM NET INVESTMENT SETTLEMENT
SEGMENTS COSTS EXPENSES PREMIUMS REVENUE INCOME EXPENSES
------------ --------------- ------------- ----------- ----------- --------------- -----------
1996 Company...................... $ 1,425 $ 185,822 $ 114,758 $ 93,314 $ 13,932 $ 51,242
Agency....................... 1,399
Corporate.................... 41
------- ------------- ----------- ----------- ------- -----------
Total........................ $ 1,425 $ 185,822 $ 114,758 $ 93,314 $ 15,372 $ 51,242
------- ------------- ----------- ----------- ------- -----------
------- ------------- ----------- ----------- ------- -----------
1995 Company...................... $ (1,066) $ 158,451 $ 118,732 $ 80,011 $ 12,031 49,769
Agency....................... 1,183
Corporate.................... 36
------- ------------- ----------- ----------- ------- -----------
Total........................ $ (1,066) $ 158,451 $ 118,732 $ 80,011 $ 13,250 $ 49,769
------- ------------- ----------- ----------- ------- -----------
------- ------------- ----------- ----------- ------- -----------
1994 Company...................... $ (1,485) $ 129,755 $ 87,346 $ 46,834 $ 8,351 $ 29,588
Agency....................... 1,182
Corporate....................
------- ------------- ----------- ----------- ------- -----------
Total........................ $ (1,485) $ 129,755 $ 87,346 $ 46,834 $ 9,533 $ 29,588
------- ------------- ----------- ----------- ------- -----------
------- ------------- ----------- ----------- ------- -----------
COLUMN I COLUMN J COLUMN K
------------- --------------- -----------
(2)
AMORTIZATION
OF DEFERRED
POLICY
ACQUISITION OTHER OPERATING PREMIUMS
COSTS EXPENSES WRITTEN
------------- --------------- -----------
1996 $ 3,842 $ 10,815 $ 96,776
20,561
1,832
------ ------- -----------
$ 3,842 $ 33,208 $ 96,776
------ ------- -----------
------ ------- -----------
1995 $ 2,520 $ 11,010 $ 98,786
27,586
785
------ ------- -----------
$ 2,520 $ 39,381 $ 98,786
------ ------- -----------
------ ------- -----------
1994 $ 1,519 $ 7,765 $ 59,694
24,454
341
------ ------- -----------
$ 1,519 $ 32,560 $ 59,694
------ ------- -----------
------ ------- -----------
- ------------------------
(1) Columns C and D are shown ignoring the effects of reinsurance.
(2) Net investment income was allocated to the company, and therefore the
segment, on which the related investment asset was recorded. Other operating
expenses were allocated to the company, and therefore the corresponding
segment, which actually incurred those expenses.
Note: Column E is omitted because the Company has no other policy claims and
benefits payable.
S-7
SCHEDULE 4
HCC INSURANCE HOLDINGS, INC.
REINSURANCE
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F
- ---------------------------------------------- ------------- -------------- -------------- -------------- --------------
(1)
ASSUMED FROM PERCENT OF
CEDED TO OTHER OTHER AMOUNT
EARNED PREMIUM GROSS AMOUNT COMPANIES COMPANIES NET AMOUNT ASSUMED TO NET
- ---------------------------------------------- ------------- -------------- -------------- -------------- --------------
For the year ended December 31, 1996:
Property and liability insurance.............. $ 99,211,000 $ 141,331,000 $ 133,095,000 $ 90,975,000 146%
Accident and health insurance................. 225,000 85,000 2,199,000 2,339,000 94%
------------- -------------- -------------- --------------
Total..................................... $ 99,436,000 $ 141,416,000 $ 135,294,000 $ 93,314,000 145%
------------- -------------- -------------- -------------- -------
------------- -------------- -------------- -------------- -------
For the year ended December 31, 1995:
Property and liability insurance.............. $ 97,675,000 $ 128,008,000 $ 110,344,000 $ 80,011,000 138%
------------- -------------- -------------- -------------- -------
------------- -------------- -------------- -------------- -------
For the year ended December 31, 1994:
Property and liability insurance.............. $ 68,174,000 $ 98,235,000 $ 76,895,000 $ 46,834,000 164%
------------- -------------- -------------- -------------- -------
------------- -------------- -------------- -------------- -------
- ------------------------
(1) Substantially all of the reinsurance assumed by the Company's insurance
company subsidiaries was underwritten directly by the subsidiaries but
issued by other unrelated companies in order to satisfy local licensing or
other requirements, predominantly on foreign business or as reinsurance of
captives.
S-8