HCC INSURANCE HOLDINGS INC/DE/ - 10-Q Quarterly Report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q


þ		Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the Quarter Ended June 30, 2004.


o		Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 from _______ to __________

Commission file number 001-13790

HCC Insurance Holdings, Inc.

(Exact name of registrant as specified in its charter)


Delaware		76-0336636

(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)

13403 Northwest Freeway, Houston, Texas		77040-6094

(Address of principal executive offices)		(Zip Code)


(713) 690-7300

(Registrant’s telephone number, including area code)

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

Yes þ No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12B-2 of the Act).

Yes þ No o

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

On July 30, 2004, there were approximately 64.7 million shares of common stock, $1.00 par value issued and outstanding.

HCC INSURANCE HOLDINGS, INC.
INDEX


			Page No.
Part I.	FINANCIAL INFORMATION
	Item 1.	Financial Statements
		Condensed Consolidated Balance Sheets June 30, 2004 and December 31, 2003		3
		Condensed Consolidated Statements of Earnings For the six months and three months ended June 30, 2004 and 2003		4
		Condensed Consolidated Statement of Changes in Shareholders’ Equity For the six months ended June 30, 2004		5
		Condensed Consolidated Statements of Cash Flows For the six months and three months ended June 30, 2004 and 2003		6
		Notes to Condensed Consolidated Financial Statements		7
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		21
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk		33
	Item 4.	Controls and Procedures		33
Part II.	OTHER INFORMATION
	Item 1.	Legal Proceedings		34
	Item 4.	Submission of Matters to a Vote of Security Holders		35
	Item 6.	Exhibits and Reports on Form 8-K		35
Signatures				36
Certification by Chief Executive Officer
Certification by Chief Financial Officer
Certification with respect to quarterly report

This report on Form 10-Q contains certain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934, which are intended to be covered by the safe harbors created by those laws. We have based these forward-looking statements on our current expectations and projections about future events. These forward-looking statements include information about possible or assumed future results of our operations. All statements, other than statements of historical facts, included or incorporated by reference in this report that address activities, events or developments that we expect or anticipate may occur in the future, including such things as future capital expenditures, business strategy, competitive strengths, goals, growth of our business and operations, plans and references to future successes may be considered forward-looking statements. Also, when we use words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “plan,” “probably” or similar expressions, we are making forward-looking statements. Many risks and uncertainties may impact the matters addressed in these forward-looking statements.

Many possible events or factors could affect our future financial results and performance. These could cause our results or performance to differ materially from those we express in our forward-looking statements. Although we believe that the assumptions underlying our forward-looking statements are reasonable, any of these assumptions, and therefore also the forward-looking statements based on these assumptions, could themselves prove to be inaccurate. In light of the significant uncertainties inherent in the forward-looking statements which are included in this report, our inclusion of this information is not a representation by us or any other person that our objectives and plans will be achieved.

Our forward-looking statements speak only as of the date made and we will not update these forward-looking statements unless the securities laws require us to do so. In light of these risks, uncertainties and assumptions, any forward-looking events discussed in this report may not occur.

HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

(unaudited, in thousands, except per share data)


	June 30, 2004		December 31, 2003
ASSETS
Investments:
Fixed income securities, at market (cost: 2004 — $1,395,833; 2003 — $1,134,128)	$	1,401,867	$	1,164,166
Marketable equity securities, at market (cost: 2004 — $12,007; 2003 — $12,007)		12,055		12,002
Short-term investments, at cost, which approximates market		570,024		518,482
Other investments, at cost, which approximates fair value		17,506		8,696

Total investments		2,001,452		1,703,346

Cash		37,968		96,416
Restricted cash and cash investments		188,087		210,301
Premium, claims and other receivables		969,851		899,031
Reinsurance recoverables		985,677		916,190
Ceded unearned premium		301,193		291,591
Ceded life and annuity benefits		75,412		77,548
Deferred policy acquisition costs		136,584		106,943
Goodwill		400,795		386,507
Other assets		188,255		176,423

Total assets	$	5,285,274	$	4,864,296

LIABILITIES
Loss and loss adjustment expense payable	$	1,720,050	$	1,535,288
Life and annuity policy benefits		75,412		77,548
Reinsurance balances payable		269,842		296,916
Unearned premium		705,572		592,311
Deferred ceding commissions		88,311		88,129
Premium and claims payable		797,450		745,559
Notes payable		322,396		310,404
Accounts payable and accrued liabilities		177,551		171,221

Total liabilities		4,156,584		3,817,376

SHAREHOLDERS’ EQUITY
Common stock, $1.00 par value; 250.0 million shares authorized (shares issued and outstanding: 2004 — 64,643; 2003 — 63,964)		64,643		63,964
Additional paid-in capital		463,937		447,671
Retained earnings		590,458		509,159
Accumulated other comprehensive income		9,652		26,126

Total shareholders’ equity		1,128,690		1,046,920

Total liabilities and shareholders’ equity	$	5,285,274	$	4,864,296

See Notes to Condensed Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Statements of Earnings

(unaudited, in thousands, except per share data)


	For the six months ended June 30,					For the three months ended June 30,
	2004			2003		2004		2003
REVENUE
Net earned premium	$	469,133		$	345,914	$	252,070	$	183,492
Fee and commission income		89,945			63,715		46,102		38,063
Net investment income		29,402			22,865		14,967		11,868
Net realized investment gain		569			184		51		205
Other operating income		6,239			5,134		4,080		4,240

Total revenue		595,288			437,812		317,270		237,868
EXPENSE
Loss and loss adjustment expense, net		273,762			220,112		147,898		120,080
Operating expense:
Policy acquisition costs, net		98,641			65,964		55,422		34,001
Compensation expense		46,438			38,611		23,625		19,865
Other operating expense		33,175			26,038		17,796		12,939

Total operating expense		178,254			130,613		96,843		66,805
Interest expense		3,958			3,596		1,746		1,914

Total expense		455,974			354,321		246,487		188,799

Earnings from continuing operations before income tax provision		139,314			83,491		70,783		49,069
Income tax provision from continuing operations		48,132			30,037		24,403		17,955

Earnings from continuing operations		91,182			53,454		46,380		31,114
Earnings (loss) from discontinued operations, net of income taxes (benefit) of $(110), $1,905, $36 and $1,165		(199	)		3,281		35		1,854

Net earnings	$	90,983		$	56,735	$	46,415	$	32,968

Basic earnings per share data:
Earnings from continuing operations	$	1.42		$	0.85	$	0.72	$	0.49
Earnings (loss) from discontinued operations		(0.01	)		0.05		—		0.03

Net earnings	$	1.41		$	0.90	$	0.72	$	0.52

Weighted average shares outstanding		64,399			62,753		64,538		62,867

Diluted earnings per share data:
Earnings from continuing operations	$	1.39		$	0.84	$	0.71	$	0.49
Earnings from discontinued operations		—			0.05		—		0.03

Net earnings	$	1.39		$	0.89	$	0.71	$	0.52

Weighted average shares outstanding		65,557			63,667		65,686		63,990

Cash dividends declared, per share	$	0.15		$	0.13	$	0.075	$	0.065

See Notes to Condensed Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Statement of Changes in Shareholders’ Equity

For the six months ended June 30, 2004

(unaudited, in thousands, except per share data)


								Accumulated
			Additional					other			Total
	Common		paid-in		Retained			comprehensive			shareholders'
	stock		capital		earnings			income			equity
Balance as of December 31, 2003	$	63,964	$	447,671	$	509,159		$	26,126		$	1,046,920
Net earnings		—		—		90,983			—			90,983
Other comprehensive loss		—		—		—			(16,474	)		(16,474	)

Comprehensive income												74,509
645 shares of common stock issued upon exercise of options, including tax benefit of $2,715		645		15,140		—			—			15,785
34 shares of common stock issued to acquire strategic investment		34		1,126		—			—			1,160
Cash dividends declared, $0.15 per share		—		—		(9,684	)		—			(9,684	)

Balance as of June 30, 2004	$	64,643	$	463,937	$	590,458		$	9,652		$	1,128,690

See Notes to Condensed Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(unaudited, in thousands, except per share data)


	For the six months ended						For the three months ended
	June 30,						June 30,
	2004			2003			2004			2003
Cash flows from operating activities:
Net earnings	$	90,983		$	56,735		$	46,415		$	32,968
Adjustments to reconcile net earnings to net cash provided by operating activities:
Change in premium, claims and other receivables		(65,155	)		(169,946	)		37,833			(107,729	)
Change in reinsurance recoverables		(64,772	)		(64,084	)		(21,154	)		(17,052	)
Change in ceded unearned premium		(6,642	)		(65,813	)		1,724			(41,382	)
Change in loss and loss adjustment expense payable		169,225			149,833			75,602			70,912
Change in reinsurance balances payable		(28,803	)		64,265			(28,840	)		35,430
Change in unearned premium		86,183			166,720			58,551			110,496
Change in premium and claims payable, net of restricted cash		74,105			58,845			(23,340	)		18,965
Depreciation and amortization expense		7,368			5,564			3,978			2,588
Other, net		(48,858	)		(2,847	)		(38,000	)		(7,795	)

Cash provided by operating activities		213,634			199,272			112,769			97,401
Cash flows from investing activities:
Sales of fixed income securities		133,694			123,181			30,602			27,952
Maturity or call of fixed income securities		72,340			69,086			39,224			41,728
Sales of equity securities		4,671			1,165			4,371			182
Other proceeds		—			16,846			—			16,846
Change in short-term investments		(8,807	)		(89,563	)		50,238			58,636
Cost of securities acquired		(406,263	)		(407,875	)		(192,909	)		(243,638	)
Payments for purchase of subsidiaries, net of cash received		(71,038	)		(4,079	)		(27,731	)		(4,079	)
Other, net		72			(3,135	)		(2,194	)		(1,612	)

Cash used by investing activities		(275,331	)		(294,374	)		(98,399	)		(103,985	)
Cash flows from financing activities:
Issuance of notes payable, net of costs		2,000			134,845			2,000			—
Sale of common stock		13,070			11,969			3,146			8,238
Payments on notes payable		(2,185	)		(67,622	)		(2,094	)		(95	)
Dividends paid		(9,636	)		(8,137	)		(4,836	)		(4,076	)

Cash provided (used) by financing activities		3,249			71,055			(1,784	)		4,067

Net change in cash		(58,448	)		(24,047	)		12,586			(2,517	)
Cash at beginning of period		96,416			40,306			25,382			18,776

Cash at end of period	$	37,968		$	16,259		$	37,968		$	16,259

See Notes to Condensed Consolidated Financial Statements

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, in thousands, except per share data)

(1) GENERAL INFORMATION

HCC Insurance Holdings, Inc. and its subsidiaries (“we,” “us” and “our”) provide specialized property and casualty, surety and accident and health insurance coverages and related agency and brokerage services to commercial customers. Our lines of business include group life, accident and health; diversified financial products (which includes directors’ and officers’ liability, errors and omissions, employment practices liability and surety); our London market account (which includes energy, marine, property and accident and health); aviation; and other specialty lines of insurance. We operate primarily in the United States, the United Kingdom, Spain and Bermuda, although some of our operations have a broader international scope. We market our products both directly to customers and through a network of independent and affiliated agents and brokers.

Basis of Presentation

The unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and include all adjustments which are, in our opinion, necessary for a fair presentation of the results of the interim periods. All adjustments made to the interim periods are of a normal recurring nature. The condensed consolidated financial statements include the accounts of HCC Insurance Holdings, Inc. and those of our wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated. The condensed consolidated financial statements for periods reported should be read in conjunction with the annual audited consolidated financial statements and related notes. The condensed consolidated balance sheet as of December 31, 2003 was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America.

During the third quarter of 2003, we completed one acquisition. The results of operations of this entity are included in our consolidated financial statements beginning on the effective date of the transaction. Thus, our condensed consolidated statements of earnings and cash flows for the six months and three months ended June 30, 2003 do not contain any activity generated by this entity. See Note (2) for discussion of our 2004 acquisition.

In the second quarter of 2004, we completed our annual assessment of the impairment of goodwill. Based upon this test, the fair value of each of our reporting units exceeded its carrying amount by a satisfactory margin.

Income Tax

For the six months and three months ended June 30, 2004 and 2003, the income tax provision has been calculated based on an estimated effective tax rate for each of the fiscal years. The difference between our effective tax rate and the United States federal statutory rate is primarily the result of state income taxes and tax exempt municipal bond interest.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, in thousands, except per share data, continued)

(1) GENERAL INFORMATION, continued

Stock Options

We account for stock options granted to employees using the intrinsic value method of APB Opinion No. 25 entitled “Accounting for Stock Issued to Employees”. All options have been granted at fixed exercise prices at the market price of our common stock at the grant date. Because of that, no stock-based employee compensation cost is reflected in our reported net income. However, the Financial Accounting Standards Board has issued an exposure draft of a pronouncement that, if adopted in its present form, will require stock-based employee compensation to be deducted from net income beginning in 2005. Options vest over a period of up to seven years and expire four to ten years after grant date. The following table illustrates the effects on net income and earnings per share if we had used the fair value method of SFAS No. 123 entitled “Accounting for Stock-Based Compensation”.


	For the six months ended						For the three months ended
	June 30,						June 30,
	2004			2003			2004			2003
Reported net earnings	$	90,983		$	56,735		$	46,415		$	32,968
Stock-based compensation using fair value method, net of income tax		(2,453	)		(3,871	)		(1,233	)		(1,932	)

Pro forma net earnings	$	88,530		$	52,864		$	45,182		$	31,036

Reported basic earnings per share	$	1.41		$	0.90		$	0.72		$	0.52
Fair value stock-based compensation		(0.04	)		(0.06	)		(0.02	)		(0.03	)

Pro forma basic earnings per share	$	1.37		$	0.84		$	0.70		$	0.49

Reported diluted earnings per share	$	1.39		$	0.89		$	0.71		$	0.52
Fair value stock-based compensation		(0.04	)		(0.06	)		(0.02	)		(0.03	)

Pro forma diluted earnings per share	$	1.35		$	0.83		$	0.69		$	0.49

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, in thousands, except per share data, continued)

(1) GENERAL INFORMATION, continued

Discontinued Operations

In December 2003, we sold the business of our retail brokerage subsidiary HCC Employee Benefits, Inc. In the fourth quarter of 2003, we began reporting this business as discontinued operations and prior year financial information has been reclassified to reflect this presentation. Summarized financial data for discontinued operations is shown below. Earnings before income tax provision exclude allocated general corporate overhead expenses of $0.8 million and $0.4 million, respectively, for the six months and three months ended June 30, 2003.


	For the six months ended					For the three months ended
	June 30,					June 30,
	2004			2003		2004		2003
Revenue	$	(197	)	$	10,499	$	—	$	6,050
Earnings (loss) before income tax provision		(309	)		5,186		71		3,019

Reclassifications

Certain amounts in our 2003 condensed consolidated financial statements have been reclassified to conform to the 2004 presentation. Such reclassifications had no effect on our net earnings, shareholders’ equity or cash flows.

(2) ACQUISITION

On January 31, 2004, we acquired all of the shares of Surety Associates Holding Co., Inc., the parent company of American Contractors Indemnity Company, a California surety company specializing in court, specialty contract, license and permit bonds. American Contractors Indemnity Company will further expand our diversified financial products segment. We paid $46.9 million in cash. This business combination has been recorded using the purchase method of accounting. The results of operations of American Contractors Indemnity Company have been included in our consolidated financial statements beginning on the effective date of the transaction. We are still in the process of completing the purchase price allocation for this acquisition, as we are still gathering some of the information, including information related to litigation contingencies, needed to make the required calculations. Goodwill resulting from this acquisition will not be deductible for United States federal income tax purposes.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, in thousands, except per share data, continued)

(2) ACQUISITION, continued

The following table summarizes the combined estimated fair values of assets acquired and liabilities assumed at the acquisition date.


	January 31, 2004
Total investments	$	87,873
Premium, claims and other receivables		5,665
Reinsurance recoverables		4,715
Other policy related assets		15,118
Goodwill and intangible assets		14,618
All other assets		1,587

Total assets acquired		129,576
Loss and loss adjustment expense payable		15,537
Unearned premium		27,078
Other policy related liabilities		1,729
All other liabilities		38,323

Total liabilities assumed		82,667

Assets acquired in excess of liabilities assumed	$	46,909

The following unaudited pro forma summary presents information as if this acquisition had occurred at the beginning of 2004 and 2003 after giving effect to certain adjustments, including estimated amortization of intangible assets, presumed interest expense from debt issued to fund the acquisition and 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 companies. American Contractors Indemnity Company incurred $2.6 million in acquisition related expenses, primarily for bonuses and other incentive compensation and related employment taxes immediately prior to the completion of the acquisition.


	For the six months				For the three months
	ended June 30,				ended June 30,
Unaudited Pro forma Information	2004		2003		2004		2003
Revenue	$	599,135	$	459,149	$	317,270	$	249,114
Net earnings		90,007		59,971		46,415		34,398
Basic earnings per share		1.40		0.96		0.72		0.55
Diluted earnings per share		1.37		0.94		0.71		0.54

In the first six months of 2004, we paid $27.7 million related to year end accruals for consideration based on the terms of prior acquisition agreements.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, in thousands, except per share data, continued)

(3) REINSURANCE

In the normal course of business our insurance companies cede a portion of their premium to domestic and foreign reinsurers through treaty and facultative reinsurance agreements. Although the ceding of reinsurance does not discharge the primary insurer from liability to its policyholder, our insurance companies participate in such agreements for the purpose of limiting their loss exposure, protecting them against catastrophic loss and diversifying their business. The following table represents the effect of such reinsurance transactions on premium and loss and loss adjustment expense:


							Loss and Loss
	Written			Earned			Adjustment
	Premium			Premium			Expense
For the six months ended June 30, 2004:
Direct business	$	828,804		$	743,736		$	416,885
Reinsurance assumed		151,967			148,911			129,621
Reinsurance ceded		(435,955	)		(423,514	)		(272,744	)

Net amounts	$	544,816		$	469,133		$	273,762

For the six months ended June 30, 2003:
Direct business	$	654,610		$	538,255		$	335,912
Reinsurance assumed		202,117			153,833			168,660
Reinsurance ceded		(413,135	)		(346,174	)		(284,460	)

Net amounts	$	443,592		$	345,914		$	220,112

For the three months ended June 30, 2004:
Direct business	$	456,843		$	385,657		$	205,777
Reinsurance assumed		64,347			74,685			71,632
Reinsurance ceded		(212,329	)		(208,272	)		(129,511	)

Net amounts	$	308,861		$	252,070		$	147,898

For the three months ended June 30, 2003:
Direct business	$	357,830		$	282,384		$	168,696
Reinsurance assumed		119,449			91,885			116,833
Reinsurance ceded		(226,188	)		(190,777	)		(165,449	)

Net amounts	$	251,091		$	183,492		$	120,080

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, in thousands, except per share data, continued)

(3) REINSURANCE, continued

The table below represents the composition of reinsurance recoverables in our condensed consolidated balance sheets:


	June 30, 2004			December 31, 2003
Reinsurance recoverable on paid losses	$	97,916		$	101,013
Reinsurance recoverable on outstanding losses		436,614			425,609
Reinsurance recoverable on incurred but not reported losses		468,102			404,479
Reserve for uncollectible reinsurance		(16,955	)		(14,911	)

Total reinsurance recoverables	$	985,677		$	916,190

Our insurance companies require their reinsurers not authorized by the respective states of domicile of our insurance companies to collateralize the reinsurance obligations due to us. The table below shows amounts held by us as collateral plus other credits available for potential offset.


	June 30, 2004		December 31, 2003
Payables to reinsurers	$	398,709	$	393,214
Letters of credit		238,525		195,329
Cash deposits		10,224		11,195

Total credits	$	647,458	$	599,738

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


	June 30, 2004			December 31, 2003
Loss and loss adjustment expense payable	$	1,720,050		$	1,535,288
Reinsurance recoverable on outstanding losses		(436,614	)		(425,609	)
Reinsurance recoverable on incurred but not reported losses		(468,102	)		(404,479	)

Net loss and loss adjustment expense payable	$	815,334		$	705,200

Unearned premium	$	705,572		$	592,311
Ceded unearned premium		(301,193	)		(291,591	)

Net unearned premium	$	404,379		$	300,720

Deferred policy acquisition costs	$	136,584		$	106,943
Deferred ceding commissions		(88,311	)		(88,129	)

Net deferred policy acquisition costs	$	48,273		$	18,814

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, in thousands, except per share data, continued)

(3) REINSURANCE, continued

We have a reserve of $17.0 million as of June 30, 2004 for potential collectibility issues and associated expenses related to reinsurance recoverables. This includes the exposure we have with respect to disputed amounts. While we believe that the reserve is adequate based on currently available information, conditions may change or additional information might be obtained which may result in a future change in the reserve. We periodically review our financial exposure to the reinsurance market and the level of our reserve and continue to take actions in an attempt to mitigate our exposure to possible loss.

Certain reinsurers have delayed or suspended the payment of amounts recoverable under reinsurance contracts to which we are a party. Such delays have not materially affected the investment income of our insurance companies nor to any extent their liquidity. We limit our liquidity exposure by holding funds, letters of credit or other security such that net balances due are significantly less than the gross balances shown in our consolidated balance sheets. We generally expect to collect the full amounts recoverable and are currently in negotiations with most of these parties, but if such negotiations do not result in a satisfactory resolution of the matters in question, we may seek or be involved in a judicial or arbitral determination. In some cases, the final resolution of such disputes through arbitration or litigation may extend over several years. Our insurance companies had an aggregate amount of $3.2 million which had not been paid to us under contracts that are subject to arbitration proceedings we initiated and we estimate that there could be up to an additional $11.0 million of incurred losses and loss expenses and other balances due under the subject contracts.

(4) SEGMENT AND GEOGRAPHIC INFORMATION

The performance of each segment is evaluated based upon net earnings and is calculated after tax and after all corporate expense and purchase price allocations have been charged or credited to the individual segments. The following tables show information by business segment and geographic location. Geographic location is determined by physical location of our offices and does not represent the location of insureds or reinsureds from whom the business was generated. In December 2003, we sold our retail brokerage subsidiary that was a significant portion of our intermediary segment. As a result, operationally we have combined the underwriting agency and intermediary segments (excluding the former retail brokerage subsidiary, which is now shown as discontinued operations) to form the agency segment, and we have reflected this change in our 2003 presentation.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, in thousands, except per share data, continued)

(4) SEGMENT AND GEOGRAPHIC INFORMATION, continued


	Insurance				Other
	Company		Agency		Operations		Corporate			Total
For the six months ended June 30, 2004
Revenue:
Domestic	$	402,632	$	42,466	$	4,827	$	824		$	450,749
Foreign		120,388		24,151		—		—			144,539
Inter-segment		351		44,207		—		—			44,558

Total segment revenue	$	523,371	$	110,824	$	4,827	$	824			639,846

Inter-segment revenue											(44,558	)

Consolidated total revenue										$	595,288

Net earnings:
Domestic	$	48,451	$	16,794	$	2,857	$	(861	)	$	67,241
Foreign		18,319		8,671		—		—			26,990

Total segment net earnings (loss)	$	66,770	$	25,465	$	2,857	$	(861	)		94,231

Inter-segment eliminations											(3,049	)
Loss from discontinued operations											(199	)

Consolidated net earnings										$	90,983

Other items:
Net investment income	$	27,354	$	1,508	$	186	$	354		$	29,402
Depreciation and amortization		2,125		4,572		238		433			7,368
Interest expense (benefit)		366		4,062		377		(847	)		3,958
Capital expenditures		1,527		745		16		1,535			3,823

Income tax provision (benefit)		31,819		17,128		906		359			50,212
Inter-segment eliminations											(2,080	)

Consolidated income tax provision from continuing operations										$	48,132

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, in thousands, except per share data, continued)

(4) SEGMENT AND GEOGRAPHIC INFORMATION, continued


	Insurance				Other
	Company		Agency		Operations		Corporate			Total
For the six months ended June 30, 2003
Revenue:
Domestic	$	284,796	$	28,846	$	4,654	$	786		$	319,082
Foreign		101,273		17,457		—		—			118,730
Inter-segment		—		48,004		—		—			48,004

Total segment revenue	$	386,069	$	94,307	$	4,654	$	786			485,816

Inter-segment revenue											(48,004	)

Consolidated total revenue										$	437,812

Net earnings:
Domestic	$	31,960	$	19,348	$	1,933	$	478		$	53,719
Foreign		7,201		4,940		—		—			12,141

Total segment net earnings (loss)	$	39,161	$	24,288	$	1,933	$	478			65,860

Inter-segment eliminations											(12,406	)
Earnings from discontinued operations											3,281

Consolidated net earnings										$	56,735

Other items:
Net investment income	$	20,227	$	1,827	$	8	$	803		$	22,865
Depreciation and amortization (1)		1,617		2,457		327		1,080			5,481
Interest expense (benefit)		25		5,201		387		(2,017	)		3,596
Capital expenditures (1)		1,231		1,408		—		348			2,987


Income tax provision (benefit)		19,201		15,203		868		1,085			36,357
Inter-segment eliminations											(6,320	)

Consolidated income tax provision from continuing operations										$	30,037

(1)

Excludes immaterial amounts related to discontinued operations.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, in thousands, except per share data, continued)

(4) SEGMENT AND GEOGRAPHIC INFORMATION, continued


	Insurance				Other
	Company		Agency		Operations		Corporate			Total
For the three months ended June 30, 2004:
Revenue:
Domestic	$	212,731	$	23,479	$	2,673	$	426		$	239,309
Foreign		66,592		11,369		—		—			77,961
Inter-segment		351		22,511		—		—			22,862

Total segment revenue	$	279,674	$	57,359	$	2,673	$	426			340,132

Inter-segment revenue											(22,862	)

Consolidated total revenue										$	317,270

Net earnings:
Domestic	$	23,821	$	9,898	$	1,664	$	(130	)	$	35,253
Foreign		9,429		3,480		—		—			12,909

Total segment net earnings (loss)	$	33,250	$	13,378	$	1,664	$	(130	)		48,162

Inter-segment eliminations											(1,782	)
Earnings from discontinued operations											35

Consolidated net earnings										$	46,415

Other items:
Net investment income	$	14,001	$	668	$	97	$	201		$	14,967
Depreciation and amortization		1,314		2,137		112		415			3,978
Interest expense (benefit)		18		2,022		187		(481	)		1,746
Capital expenditures		674		614		12		894			2,194

Income tax provision (benefit)		16,097		8,928		488		(258	)		25,255
Inter-segment eliminations											(852	)

Consolidated income tax provision from continuing operations										$	24,403

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, in thousands, except per share data, continued)

(4) SEGMENT AND GEOGRAPHIC INFORMATION, continued


	Insurance				Other
	Company		Agency		Operations		Corporate			Total
For the three months ended June 30, 2003:
Revenue:
Domestic	$	147,560	$	17,806	$	4,207	$	785		$	170,358
Foreign		56,951		10,559		—		—			67,510
Inter-segment		—		21,010		—		—			21,010

Total segment revenue	$	204,511	$	49,375	$	4,207	$	785			258,878

Inter-segment revenue											(21,010	)

Consolidated total revenue										$	237,868

Net earnings:
Domestic	$	15,987	$	10,227	$	2,523	$	697		$	29,434
Foreign		3,814		2,612		—		—			6,426

Total segment net earnings (loss)	$	19,801	$	12,839	$	2,523	$	697			35,860

Inter-segment eliminations											(4,746	)
Earnings from discontinued operations											1,854

Consolidated net earnings										$	32,968

Other items:
Net investment income	$	10,197	$	895	$	4	$	772		$	11,868
Depreciation and amortization (1)		796		821		88		841			2,546
Interest expense (benefit)		16		2,751		194		(1,047	)		1,914
Capital expenditures (1)		791		660		—		83			1,534

Income tax provision (benefit)		10,440		7,929		1,150		327			19,846
Inter-segment eliminations											(1,891	)

Consolidated income tax provision from continuing operations										$	17,955

(1)

Excludes immaterial amounts related to discontinued operations.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, in thousands, except per share data, continued)

(4) SEGMENT AND GEOGRAPHIC INFORMATION, continued

The following table presents selected revenue items by line of business for the periods indicated:


	For the six months ended				For the three months ended
	June 30,				June 30,
	2004		2003		2004		2003
Group life, accident and health	$	159,890	$	147,509	$	80,501	$	75,526
Diversified financial products		130,113		44,818		73,714		26,512
London market account		61,522		66,457		35,408		37,081
Aviation		57,267		48,237		32,998		24,355
Other specialty lines of business		28,291		207		15,720		153

		437,083		307,228		238,341		163,627
Discontinued lines of business		32,050		38,686		13,729		19,865

Net earned premium	$	469,133	$	345,914	$	252,070	$	183,492

Group life, accident and health	$	29,595	$	30,963	$	16,603	$	15,484
Property and casualty		60,350		32,752		29,499		22,579

Fee and commission income	$	89,945	$	63,715	$	46,102	$	38,063

(5) EARNINGS PER SHARE

Basic earnings per share is based on the weighted average number of common shares outstanding during the period divided into net earnings. Diluted earnings per share is based on the weighted average number of common shares outstanding plus the potential common shares outstanding during the period divided into net earnings. Outstanding common stock options, when dilutive, are considered to be potential common shares for the purpose of the diluted calculation. The treasury stock method is used to calculate potential common shares due to options. The dilutive effect of our contingently convertible notes is not included in the diluted earnings per share computation until the market price trigger requirement is met.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, in thousands, except per share data, continued)

(5) EARNINGS PER SHARE, continued

The following table provides a reconciliation of the denominators used in the earnings per share calculations:


	For the six months ended				For the three months ended
	June 30,				June 30,
	2004		2003		2004		2003
Net earnings	$	90,983	$	56,735	$	46,415	$	32,968

Weighted average common shares outstanding		64,399		62,753		64,538		62,867
Additional dilutive effect of outstanding options (as determined by the application of the treasury stock method)		1,158		914		1,148		1,123

Weighted average common shares and potential common shares outstanding		65,557		63,667		65,686		63,990

Anti-dilutive stock options not included in treasury stock method computation		—		499		—		174

(6) SUPPLEMENTAL INFORMATION


	For the six months ended				For the three months ended
	June 30,				June 30,
	2004		2003		2004		2003
Interest paid	$	3,522	$	2,721	$	252	$	290
Income tax paid		72,009		32,102		40,451		26,171
Comprehensive income		74,509		63,584		24,928		40,640
Ceding commissions netted with policy acquisition costs		53,680		54,313		23,788		29,934

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, in thousands, except per share data, continued)

(7) COMMITMENTS AND CONTINGENCIES

We are party to lawsuits, arbitrations and other proceedings that arise in the normal course of our business. Many of such lawsuits, arbitrations and other proceedings involve claims under policies that we underwrite as an insurer or reinsurer, the liabilities for which we believe have been adequately included in our loss reserves. Also, from time to time, we are a party to lawsuits, arbitrations and other proceedings which relate to disputes over contractual relationships with third parties, or which involve alleged errors and omissions on the part of our subsidiaries.

A subsidiary has been named along with several other defendants in legal proceedings by certain insurance company members of a discontinued workers’ compensation reinsurance facility commonly known as the Unicover Pool. During 1997 and 1998, our subsidiary was one of two co-intermediaries for the facility. Other defendants in the current proceedings include the other reinsurance intermediary, the former managing underwriter for the facility and various individuals, none of whom are affiliated with us. It is claimed in the proceedings that the actions of the various defendants resulted in the recission of certain reinsurance contracts in an arbitration to which we were not a party and include allegations of breach of fiduciary duty, negligence, fraud and other allegations. The claims in the proceedings are for unspecified or substantial compensatory and punitive damages. We believe that we have meritorious defenses to the allegations and intend to vigorously defend against the claims made in the proceedings. The current court proceedings have been subjected to an indefinite judicial stay pending the resolution of an arbitration among the managing underwriter of the facility and the various facility members. We are not a party to such arbitration.

In addition, we are presently engaged in litigation initiated by the appointed liquidator of a former reinsurer concerning payments made to us prior to the date of the appointment of the liquidator. The disputed payments were made by the now insolvent reinsurer in connection with a commutation agreement. Our understanding is that such litigation is one of a number of similar actions brought by the liquidator. We intend to vigorously contest the action.

Although the ultimate outcome of these matters may not be determined at this time, based upon present information, the availability of insurance coverage and advice received from our outside legal counsel, we do not believe the resolution of any of these matters, some of which include allegations of damages in material amounts, will have a material adverse effect on our financial condition, results of operations or cash flows.

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

Overview

We primarily receive our revenue from earned premium derived from our insurance company operations, fee and commission income generated by our agency operations, proceeds from ceded reinsurance (ceding commissions in excess of acquisition costs) earned by our insurance company subsidiaries, investment income from all of our operations and other operating income. Our core underwriting activities involve providing insurance products in the group life, accident and health, diversified financial products, London market account, aviation and other specialty lines of business, each of which is marketed by our insurance companies and our agencies either directly to customers or through a network of agents, third party administrators and brokers.

The results of operations of Surety Associates Holding Co., Inc. and its subsidiary American Contractors Indemnity Company, which were acquired in the first quarter of 2004, and Covenant Underwriters Limited and Continental Underwriters Limited, which were acquired in the third quarter of 2003, are included in our condensed consolidated financial statements beginning on the respective effective dates of their acquisitions. Thus, our condensed consolidated statements of earnings and cash flows for the six months and three months ended June 30, 2003 do not include the operations of these companies.

Results of Operations

The following table sets forth the relationships of certain income statement items as a percent of total revenue:


	For the six months						For the three months
	ended June 30,						ended June 30,
	2004			2003			2004			2003
Net earned premium		78.8	%		79.0	%		79.5	%		77.1	%
Fee and commission income		15.1			14.6			14.5			16.0
Net investment income		4.9			5.2			4.7			5.0
Net realized investment gain		0.1			—			—			0.1
Other operating income		1.1			1.2			1.3			1.8

Total revenue		100.0			100.0			100.0			100.0
Loss and loss adjustment expense, net		46.0			50.3			46.6			50.5
Total operating expense		29.9			29.8			30.5			28.1
Interest expense		0.7			0.8			0.6			0.8

Earnings from continuing operations before income tax provision		23.4			19.1			22.3			20.6
Income tax provision		8.1			6.9			7.7			7.5

Earnings from continuing operations		15.3	%		12.2	%		14.6	%		13.1	%

Six months ended June 30, 2004 versus six months ended June 30, 2003

Total revenue increased 36% to $595.3 million for 2004 driven by significant increases in net earned premium, fee and commission income and investment income. Most of this growth was either organic or resulted from increased retentions. In addition, $27.5 million came from subsidiaries acquired in the past twelve months. We expect revenue growth to continue for the rest of 2004 and into 2005.

Fee and commission income increased 41% to $89.9 million in 2004 due principally to organic growth in our agency subsidiaries. Additionally, 2003 fee and commission income included a charge of $6.5 million due to the cumulative effect on prior years of our 2003 restatement to change our accounting for certain fee and commission income. The table below shows the composition of fee and commission income for the six months ended June 30, 2004 and 2003 (amounts in thousands):


	2004		2003
Continuing subsidiaries	$	86,295	$	70,243
Subsidiaries acquired during past year		3,650		—
2003 charge		—		(6,528	)

Total fee and commission income	$	89,945	$	63,715

Net investment income increased 29% to $29.4 million in 2004. This increase was due to higher investment assets, which increased to $2.0 billion as of June 30, 2004 compared to $1.7 billion as of December 31, 2003 resulting primarily from significant cash flow from operations and to a lesser extent the acquisition of American Contractors Indemnity Company in January 2004. Net investment income increased despite low yields on our fixed income and short-term investments. We expect investment assets to continue to increase and produce additional growth in investment income for the balance of 2004. If market interest rates were to rise, the growth in investment income would be expected to accelerate as our current portfolio has a relatively short duration and would become available to be invested on a longer-term basis to take advantage of higher rates. Our weighted average tax equivalent yield was 3.7% in 2004 and 4.3% in 2003. As of June 30, 2004, the weighted average duration of our fixed income portfolio was 3.88 years and the weighted average maturity was 4.67 years.

Compensation expense increased as a result of acquisitions and a slight increase in staffing levels to manage growth and additional reporting requirements under Sarbanes-Oxley. However, the rate of increase in compensation expense is less than the rate of increase in revenue, thereby contributing to higher margins and increased net earnings. Compensation expense for the six months ended June 30, 2004 and 2003 (amounts in thousands) and the number of employees as of June 30 of each year are shown below:


Compensation Expense	2004		2003
Continuing subsidiaries	$	41,479	$	38,611
Subsidiaries acquired during past year		4,959		—

Total compensation expense	$	46,438	$	38,611


Number of Employees
Continuing subsidiaries	1,075	1,051
Subsidiaries acquired during past year	165	—
Subsidiaries sold during past year	—	58

Total number of employees	1,240	1,109

Other operating expense increased during 2004 compared to 2003, as shown in the following table (amounts in thousands). During 2003 there was a one-time currency gain of $1.3 million from the settlement of an advance of funds to an unaffiliated entity.


	2004		2003
Subsidiaries acquired during past year	$	3,623	$	—
2003 currency conversion transaction gain		—		(1,287	)
Litigation accruals		1,775		245
Other expense		27,777		27,080

	$	33,175	$	26,038

Income tax expense from continuing operations was $48.1 million in 2004 compared to $30.0 million in 2003. Our effective tax rate was 34.5% in 2004 compared to 36.0% in 2003. We expect a decrease in our income tax rate in 2004 compared to 2003 because a higher percentage of our pre-tax income is earned by our insurance company subsidiaries and is not subject to State income taxes and our tax exempt interest income is increasing.

Net earnings increased 60% to $91.0 million, or $1.39 per diluted share, in 2004 from $56.7 million, or $0.89 per diluted share, in 2003. Growth in net earned premium, fee and commission income and investment income and continuing favorable underwriting results caused the increase in 2004 net earnings. Net earnings in 2004 include $3.5 million from subsidiaries acquired during the past year. Also included in 2003 net earnings is a charge of $3.9 million, or $0.06 per share, due to the cumulative effect on prior years of our 2003 restatement to change our accounting for certain fee and commission income.

At June 30, 2004, book value per share was $17.46, up from $17.12 as of March 31, 2004 and $16.37 as of December 31, 2003 (despite a reduction of $0.22 per share since year end 2003 due to the reduction in net after tax unrealized gains on our investments as a result of rising interest rates). Total assets were $5.3 billion and shareholders’ equity was $1.1 billion, up from $4.9 billion and $1.0 billion, respectfully, at December 31, 2003.

SEGMENTS

Insurance Companies

The following table sets forth certain premium amounts and percentages of gross written premium for the six months ended June 30, 2004 and 2003 (amounts in thousands):


	2004						2003
	Amount			Percentage			Amount			Percentage
Direct	$	828,804			85	%	$	654,610			76	%
Reinsurance assumed		151,967			15			202,117			24

Gross written premium		980,771			100			856,727			100
Reinsurance ceded		(435,955	)		(44	)		(413,135	)		(48	)

Net written premium		544,816			56			443,592			52
Change in unearned premium		(75,683	)		(8	)		(97,678	)		(12	)

Net earned premium	$	469,133			48	%	$	345,914			40	%

The following tables provide information by line of business (amounts in thousands):


	Gross Written Premium							Net Written Premium							Net Earned Premium
					%							%							%
	2004		2003		Change			2004		2003		Change			2004		2003		Change
Group life, accident & health	$	293,855	$	283,482		4	%	$	161,312	$	157,353		3	%	$	159,890	$	147,509		8	%
Diversified financial products		391,663		250,426		56			167,814		82,214		104			130,113		44,818		190
London market account		117,344		140,152		(16	)		81,886		102,554		(20	)		61,522		66,457		(7	)
Aviation		96,993		108,960		(11	)		75,081		51,204		47			57,267		48,237		19
Other specialty lines of business		63,994		6,845	nm				38,809		2,222	nm				28,291		207	nm

		963,849		789,865		22			524,902		395,547		33			437,083		307,228		42
Discontinued lines of business		16,922		66,862	nm				19,914		48,045	nm				32,050		38,686	nm

	$	980,771	$	856,727		14	%	$	544,816	$	443,592		23	%	$	469,133	$	345,914		36	%

nm-Not meaningful

Gross written premium increased 14% to $980.8 million in the first six months of 2004. Net written premium increased 23% to $544.8 million and net earned premium increased 36% to $469.1 million, both due principally to organic growth and increased retentions on some lines. The increase in premium is expected to continue into 2005. The growth in gross written premium results principally from the following factors:

• The largest growth was in our diversified financial products line of business primarily as a result of organic growth in directors’ and officers’ and errors and omissions business, as well as an increase in surety business due to our acquisition of American Contractors Indemnity Company in January 2004. We are seeing some softness in premium rates but no change in deductibles or policy conditions. The underwriting profit margins are all still very adequate.

• Our other specialty lines of business increased significantly due to new business activities commenced during the past year. These activities include underwriting of marine insurance on the Gulf Coast of the United States, our quota-share reinsurance participation in a book of surplus lines insurance and our participation in a Lloyds syndicate writing UK liability insurance.

• Our London market account experienced somewhat reduced premium writings due to more selective underwriting, as premium rates softened.

The tables below show the composition of net and gross incurred loss and loss adjustment expense for the six months ended June 30, 2004 and 2003 (amounts in thousands):


	2004						2003
	Amount			Loss Ratio			Amount		Loss Ratio
Net
Deficiency	$	2,852			0.6	%	$	9,830		2.8	%
All other net incurred loss and loss adjustment expense		270,910			57.8			210,282		60.8

Net incurred loss and loss adjustment expense	$	273,762			58.4	%	$	220,112		63.6	%

Gross
Discontinued line of business adjustments	$	34,212			3.8	%	$	76,100		11.0	%
Reduce incurred but not reported losses		(17,300	)		(1.9	)		—		—
All other gross incurred loss and loss adjustment expense		529,594			59.3			428,472		61.9

Gross incurred loss and loss adjustment expense	$	546,506			61.2	%	$	504,572		72.9	%

We have no material exposure to environmental or asbestos losses and believe we have provided for all material net incurred losses.

Our gross loss ratio was 61.2% for 2004 compared to 72.9% for 2003. We continue to experience gross development on certain business included in the discontinued line of business, but at a slower pace than in 2003. Also, during 2004, we reduced gross incurred but not reported losses on prior accident years on certain of our London market account business. Since all of these contracts were substantially reinsured, the effect on our net losses was not material.

The following table provides comparative net loss ratios by line of business for the six months ended June 30, 2004 and 2003 (amounts in thousands):


	2004					2003
	Net		Net			Net		Net
	Earned		Loss			Earned		Loss
	Premium		Ratio			Premium		Ratio
Group life, accident and health	$	159,890		62.7	%	$	147,509		63.7	%
Diversified financial products		130,113		45.7			44,818		47.9
London market accounts		61,522		45.5			66,457		52.8
Aviation		57,267		59.1			48,237		63.6
Other specialty lines of business		28,291		60.4			207		54.6

		437,083		54.6			307,228		59.0
Discontinued lines of business		32,050		109.7			38,686		100.4

Totals	$	469,133		58.4	%	$	345,914		63.6	%

Expense ratio				26.6					25.3

Combined ratio				85.0	%				88.9	%

Comments on net loss ratios by line of business are below:

• Group life, accident and health — The 2004 loss ratio is slightly lower than expected because of a reduction in reserves for redundancies from prior accident years.

• Diversified financial products — The decrease in loss ratio is due to changes in overall mix of business. The surety business of American Contractors Indemnity Company, acquired in January 2004, has a lower loss ratio compared to the other business in this line.

• London market accounts — Underwriting results generally improved due to more selective underwriting and we have moved to excess business where there is less loss frequency.

• Aviation — Underwriting results improved.

• Other specialty lines — The current loss ratio is as expected for new business activities commenced during the past year.

• Discontinued lines of business — Both periods have been affected by reserve additions resulting from our ongoing review of outstanding claims. Additionally, given the limited amount of earned premium in this line of business, a minor adjustment to the reserves can significantly impact the loss ratio.

Policy acquisition costs, which are net of the related portion of commissions on reinsurance ceded, increased to $98.6 million during the first six months of 2004, from $66.0 million in the same period in 2003. This increase is due to the increase in net earned premium. The increase in the expense ratio is due to the reduction in ceding commissions as a result of higher retentions plus the addition of surety business at American Contractors Indemnity Company, acquired in January 2004, which, as is common to the surety business, has a higher expense ratio than the rest of our business, although a much lower expected loss ratio.

Net earnings of our insurance companies increased 71% to $66.8 million in 2004 due to increased premium volume, continuing profitable underwriting results and increased investment income. We expect growth in the net earnings of our insurance companies to continue through 2005. Our increasingly profitable underwriting results are reflected in a 2004 combined ratio of 85.0% compared to 88.9% in 2003.

Agency

Revenue from our agency segment increased 18% to $110.8 million in 2004. This results primarily from increased new business and an acquisition made in 2003 which accounted for $5.3 million of the increased revenue. Net earnings of our agency segment increased 5% to $25.5 million in 2004 for the same reasons. Higher corporate cost allocations in 2004 caused the increase in segment net earnings to be less than the comparable increase in segment revenue. Also, in 2004 a discontinued agency operation recorded a $1.6 million (before tax) accrual for certain pending litigation.

Other Operations

The increase in other operating income in 2004 is primarily due to income from strategic investments. Period to period comparisons may vary substantially depending on other operating investments or dispositions of such investments in any given period.

Three months ended June 30, 2004 versus three months ended June 30, 2003

Total revenue increased 33% to $317.3 million for 2004 driven by significant increases in net earned premium, fee and commission income and investment income. Most of this growth was either organic or resulted from increased retentions. In addition, $18.3 million came from subsidiaries acquired in the past twelve months. We expect revenue growth to continue for the rest of 2004 and into 2005.

Fee and commission income increased 21% to $46.1 million in 2004 due principally to organic growth in our agency subsidiaries. The table below shows the composition of fee and commission income for the three months ended June 30, 2004 and 2003 (amounts in thousands):


	2004		2003
Continuing subsidiaries	$	43,766	$	38,063
Subsidiaries acquired during past year		2,336		—

Total fee and commission income	$	46,102	$	38,063

Net investment income increased 26% to $15.0 million in 2004. This increase was due to higher investment assets, which increased to $2.0 billion as of June 30, 2004 compared to $1.7 billion as of December 31, 2003 resulting primarily from significant cash flow from operations and to a lesser extent the acquisition of American Contractors Indemnity Company in January 2004. Net investment income increased despite low yields on our fixed income and short-term investments. We expect investment assets to continue to increase and produce additional growth in investment income for the balance of 2004. If market interest rates were to rise, the growth in investment income would be expected to accelerate as our current portfolio has a relatively short duration and would become available to be invested on a longer-term basis to take advantage of higher rates. Our weighted average tax equivalent yield was 3.6% in 2004 and 4.4% in 2003.

Compensation expense increased as a result of acquisitions and a slight increase in staffing levels to manage growth and additional reporting requirements under Sarbanes-Oxley. However, the rate of increase in compensation expense is less than the rate of increase in revenue, thereby contributing to higher margins and increased net earnings. Compensation expense for the three months ended June 30, 2004 and 2003 (amounts in thousands):


	2004		2003
Continuing subsidiaries	$	20,509	$	19,865
Subsidiaries acquired during past year		3,116		—

Total compensation expense	$	23,625	$	19,865


	2004		2003
Subsidiaries acquired during past year	$	2,024	$	—
2003 currency conversion transaction gain		—		(1,287	)
Litigation accruals (reversal)		1,775		(355	)
Other expense		13,997		14,581

	$	17,796	$	12,939

Income tax expense from continuing operations was $24.4 million in 2004 compared to $18.0 million in 2003. Our effective tax rate was 34.5% in 2004 compared to 36.6% in 2003. We expect a decrease in our income tax rate in 2004 compared to 2003 because a higher percentage of our pre-tax income is earned by our insurance company subsidiaries and is not subject to State income taxes and our tax exempt interest income is increasing.

Net earnings increased 41% to $46.4 million, or $0.71 per diluted share, in 2004 from $33.0 million, or $0.52 per diluted share, in 2003. Growth in net earned premium, fee and commission income and investment income and continuing favorable underwriting results increased 2004 net earnings. Net earnings in 2004 include $2.6 million from subsidiaries acquired during the past year.

SEGMENTS

Insurance Companies

The following table sets forth certain premium amounts and percentages of gross written premium for the three months ended June 30, 2004 and 2003 (amounts in thousands):


	2004						2003
	Amount			Percentage			Amount			Percentage
Direct	$	456,843			88	%	$	357,830			75	%
Reinsurance assumed		64,347			12			119,449			25

Gross written premium		521,190			100			477,279			100
Reinsurance ceded		(212,329	)		(41	)		(226,188	)		(47	)

Net written premium		308,861			59			251,091			53
Change in unearned premium		(56,791	)		(11	)		(67,599	)		(15	)

Net earned premium	$	252,070			48	%	$	183,492			38	%

The following tables provide information by line of business (amounts in thousands):


	Gross Written Premium							Net Written Premium							Net Earned Premium
					%							%							%
	2004		2003		Change			2004		2003		Change			2004		2003		Change
Group life, accident & health	$	147,201	$	144,162		2	%	$	83,345	$	81,168		3	%	$	80,501	$	75,526		7	%
Diversified financial products		220,797		143,106		54			96,306		48,907		97			73,714		26,512		178
London market account		60,644		79,434		(24	)		49,169		65,322		(25	)		35,408		37,081		(5	)
Aviation		53,860		64,429		(16	)		54,131		30,525		77			32,998		24,355		35
Other specialty lines of business		32,974		5,381	nm				19,904		2,183	nm				15,720		153	nm

		515,476		436,512		18			302,855		228,105		33			238,341		163,627		46
Discontinued lines of business		5,714		40,767	nm				6,006		22,986	nm				13,729		19,865	nm

	$	521,190	$	477,279		9	%	$	308,861	$	251,091		23	%	$	252,070	$	183,492		37	%

nm-Not meaningful

Gross written premium increased 9% to $521.2 million in the second quarter of 2004. Net written premium increased 23% to $308.9 million and net earned premium increased 37% to $252.1 million, both due principally to organic growth and increased retentions on some lines. The increase in premium is expected to continue into 2005. The growth in gross written premium results principally from the following factors:

The tables below show the composition of net and gross incurred loss and loss adjustment expense for the three months ended June 30, 2004 and 2003 (amounts in thousands):


	2004						2003
	Amount			Loss Ratio			Amount		Loss Ratio
Net
Deficiency	$	699			0.3	%	$	8,535		4.6	%
All other net incurred loss and loss adjustment expense		147,199			58.4			111,545		60.8

Net incurred loss and loss adjustment expense	$	147,898			58.7	%	$	120,080		65.4	%

Gross
Discontinued line of business adjustments	$	19,212			4.2	%	$	61,100		16.3	%
Reduce incurred but not reported losses		(17,300	)		(3.8	)		—		—
All other gross incurred loss and loss adjustment expense		275,497			59.9			224,429		60.0

Gross incurred loss and loss adjustment expense	$	277,409			60.3	%	$	285,529		76.3	%

We have no material exposure to environmental or asbestos losses and believe we have provided for all material net incurred losses.

Our gross loss ratio was 60.3% for 2004 compared to 76.3% for 2003. We continue to experience gross development on certain business included in the discontinued line of business, but at a slower pace than in 2003. Also, during 2004, we reduced gross incurred but not reported losses on prior accident years on certain of our London market account business. Since all of these contracts were substantially reinsured, the effect on our net losses was not material.

The following table provides comparative net loss ratios by line of business for the three months ended June 30, 2004 and 2003 (amounts in thousands):


	2004					2003
	Net		Net			Net		Net
	Earned		Loss			Earned		Loss
	Premium		Ratio			Premium		Ratio
Group life, accident and health	$	80,501		62.5	%	$	75,526		63.7	%
Diversified financial products		73,714		45.2			26,512		50.8
London market accounts		35,408		57.2			37,081		61.3
Aviation		32,998		56.6			24,355		61.9
Other specialty lines of business		15,720		59.8			153		58.2

		238,341		55.4			163,627		60.8
Discontinued lines of business		13,729		115.8			19,865		103.8

Totals	$	252,070		58.7	%	$	183,492		65.4	%

Expense ratio				27.6					23.7

Combined ratio				86.3	%				89.1	%

Comments on net loss ratios by line of business are below:

• Group life, accident and health — The 2004 loss ratio is slightly lower than expected because of a reduction in reserves for redundancies from prior accident years.

• Diversified financial products — The decrease in loss ratio is due to changes in overall mix of business. The surety business of American Contractors Indemnity Company, acquired in January 2004, has a lower loss ratio compared to the other business in this line.

• London market accounts — Underwriting results generally improved due to more selective underwriting and we have moved to excess business where there is less loss frequency.

• Aviation — Underwriting results improved.

• Other specialty lines — The current loss ratio is as expected for new business activities commenced during the past year.

• Discontinued lines of business — Both quarters have been affected by reserve additions resulting from our ongoing review of outstanding claims. Additionally, given the limited amount of earned premium in this line of business, a minor adjustment to the reserves can significantly impact the loss ratio.

Policy acquisition costs, which are net of the related portion of commissions on reinsurance ceded, increased to $55.4 million during the second quarter of 2004, from $34.0 million in the same period in 2003. This increase is due to the increase in net earned premium. The increase in the expense ratio is due to the reduction in ceding commissions as a result of higher retentions plus the addition of surety business at American Contractors Indemnity Company, acquired in January 2004, which, as is common to the surety business, has a higher expense ratio than the rest of our business, although a much lower expected loss ratio.

Net earnings of our insurance companies increased 68% to $33.3 million in 2004 due to increased premium volume, continuing profitable underwriting results and increased investment income. We expect growth in the net earnings of our insurance companies to continue through 2005. Our increasingly profitable underwriting results are reflected in a 2004 combined ratio of 86.3% compared to 89.1% in 2003.

Agency

Revenue from our agency segment increased 16% to $57.4 million in 2004. This results primarily from increased new business and an acquisition made in 2003 which accounted for $2.7 million of the increased revenue. Net earnings of our agency segment increased 4% to $13.4 million in 2004 for the same reasons. Higher corporate cost allocations in 2004 caused the increase in segment net earnings to be less than the comparable increase in segment revenue. Also, in 2004 a discontinued agency operation recorded a $1.6 million (before tax) accrual for certain pending litigation.

Other Operations

The decrease in other operating income in 2004 is primarily due to less gains on securities trading activities. Quarter to quarter comparisons may vary substantially depending on other operating investments or dispositions of such investments in any given quarter.

Liquidity and Capital Resources

We receive substantial cash from premiums, reinsurance recoverables, fee and commission income and, to a lesser extent, investment income and proceeds from sales and redemptions of investments and other assets. Our principal cash outflows are for the payment of claims and loss adjustment expenses, payment of premiums to reinsurers, purchases of investments, debt service, policy acquisition costs, operating expenses, income and other taxes and dividends. Variations in operating cash flows can occur due to timing differences in either the payment of claims and the collection of related recoverables or the collection of receivables and the payment of related payable amounts.

We maintain a substantial level of cash and liquid short-term investments which are used to meet anticipated payment obligations. Our consolidated cash and investment portfolio increased $239.7 million, or 13%, during the first six months of 2004 and totaled $2.0 billion as of June 30, 2004, of which $608.0 million was cash and short-term investments. The increase resulted primarily from operating cash flows and the acquisition of American Contractors Indemnity Company. Included in short-term investments as of June 30, 2004 is $190.0 million of funds held by underwriting agencies for the benefit of insurance or reinsurance clients. We earn the interest income on these funds.

During the first six months of 2004, due primarily to changes in market interest rates, the net after tax unrealized gain on our investments recorded in other comprehensive income decreased $14.2 million. However, during the month of July we estimate that our net after tax unrealized gain increased approximately $1.5 million, again primarily due to changes in market interest rates.

We have filed registration statements with the United States Securities and Exchange Commission, which provide shelf registrations for an aggregate of $750.0 million of our securities, of which we have $625.0 million available to be issued. These securities may be debt securities, equity securities or a combination thereof.

Notes payable as of June 30, 2004 and December 31, 2003 are shown in the table below (amounts in thousands):


	2004			2003
1.3% Convertible notes	$	125,000		$	125,000
2% Convertible notes		172,451			172,451
Other debt		24,945			12,953

Total notes payable	$	322,396		$	310,404

Debt to total capital		22.2	%		22.9	%

Our $200.0 million Revolving Loan Facility, which had no outstanding borrowings as of June 30, 2004, expires on December 17, 2004. We expect to replace the facility with another facility.

Holders of our 2% Convertible Notes due in 2021 may require us to repurchase the notes at par on September 1, 2004. Because the recent market price of these notes ($110.00 as of August 4, 2004) is in excess of the par value, we do not expect that any of the notes will be tendered for repurchase. In the event that any such notes are tendered for repurchase we would expect to use funds from our revolving loan facility to repurchase the notes for cash.

The following table shows the composition of our gross, ceded and net reserves at the respective balance sheet dates (amounts in thousands):


	Gross		Ceded		Net
As of June 30, 2004:
Reported losses	$	879,290	$	436,614	$	442,676
Incurred but not reported losses		840,760		468,102		372,658

Total loss and loss adjustment expense payable	$	1,720,050	$	904,716	$	815,334

As of December 31, 2003:
Reported losses	$	721,979	$	425,609	$	296,370
Incurred but not reported losses		813,309		404,479		408,830

Total loss and loss adjustment expense payable	$	1,535,288	$	830,088	$	705,200

Reserves and recoverables continue to grow primarily due to our large account directors’ and officers’ liability business and our professional indemnity business. These claims have a longer duration and tend to be more highly reinsured than our other lines of business due to their potential volatility.

We have a reserve of $17.0 million as of June 30, 2004 for potential collectibility issues and associated expenses related to reinsurance recoverables. This includes the exposure we have with respect to disputed amounts. While we believe that the reserve is adequate based on currently available information, conditions may change or additional information might be obtained which may result in a future change in the reserve. We periodically review our financial exposure to the reinsurance market and the level of our reserve and continue to take actions in an attempt to mitigate our exposure to possible loss.

Certain reinsurers have delayed or suspended the payment of amounts recoverable under reinsurance contracts to which we are a party. Such delays have not materially affected the investment income of our insurance companies nor to any extent their liquidity. We limit our liquidity exposure by holding funds, letters of credit or other security such that net balances due are significantly less than the gross balances shown in our consolidated balance sheets. We generally expect to collect the full amounts recoverable and are currently in negotiations with most of these parties, but if such negotiations do not result in a satisfactory resolution of the matters in question, we may seek or be involved in a judicial or arbitral determination. In some cases, the final resolution of such disputes through arbitration or litigation may extend over several years. Our insurance companies had an aggregate amount of $3.2 million which had not been paid to us under contracts that are subject to arbitration proceedings we initiated and we estimate that there could be up to an additional $11.0 million of incurred losses and loss expenses and other balances due under the subject contracts.

We believe that our operating cash flows, short-term investments, bank facility and shelf registrations on file with the United States Securities and Exchange Commission will provide sufficient sources of liquidity to meet our operating needs for the foreseeable future.

Critical Accounting Policies

We have made no changes in our methods of application of our critical accounting policies from the information provided in our Annual Report on Form 10-K for the year ended December 31, 2003.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

There have been no material changes in market risk from the information provided in Item 7A. “Quantitative and Qualitative Disclosures About Market Risk” in our Annual Report on Form 10-K for the year ended December 31, 2003.

Item 4. Controls and Procedures

a. Evaluation of disclosure controls and procedures.

The term “disclosure controls and procedures” is defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, or the Exchange Act. This term refers to the controls and procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commission. Our management, including our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this quarterly report. Based upon the evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.

b. Changes in internal controls.

There were no changes to our internal control over financial reporting during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Part II — Other Information

Item 1. Legal Proceedings

We are party to lawsuits, arbitrations and other proceedings that arise in the normal course of our business. Many of such lawsuits, arbitrations and other proceedings involve claims under policies that we underwrite as an insurer or reinsurer, the liabilities for which we believe have been adequately included in our loss reserves. Also, from time to time, we are a party to lawsuits, arbitrations and other proceedings which relate to disputes over contractual relationships with third parties, or which involve alleged errors and omissions on the part of our subsidiaries.

A subsidiary has been named along with several other defendants in legal proceedings by certain insurance company members of a discontinued workers’ compensation reinsurance facility commonly known as the Unicover Pool. During 1997 and 1998, our subsidiary was one of two co-intermediaries for the facility. Other defendants in the current proceedings include the other reinsurance intermediary, the former managing underwriter for the facility and various individuals, none of whom are affiliated with us. It is claimed in the proceedings that the actions of the various defendants resulted in the recission of certain reinsurance contracts in an arbitration to which we were not a party and include allegations of breach of fiduciary duty, negligence, fraud and other allegations. The claims in the proceedings are for unspecified or substantial compensatory and punitive damages. We believe that we have meritorious defenses to the allegations and intend to vigorously defend against the claims made in the proceedings. The current court proceedings have been subjected to an indefinite judicial stay pending the resolution of an arbitration among the managing underwriter of the facility and the various facility members. We are not a party to such arbitration.

In addition, we are presently engaged in litigation initiated by the appointed liquidator of a former reinsurer concerning payments made to us prior to the date of the appointment of the liquidator. The disputed payments were made by the now insolvent reinsurer in connection with a commutation agreement. Our understanding is that such litigation is one of a number of similar actions brought by the liquidator. We intend to vigorously contest the action.

Although the ultimate outcome of these matters may not be determined at this time, based upon present information, the availability of insurance coverage and advice received from our outside legal counsel, we do not believe the resolution of any of these matters, some of which include allegations of damages in material amounts, will have a material adverse effect on our financial condition, results of operations or cash flows.

Item 4. Submission of Matters to a Vote of Security Holders

On May 13, 2004, we held our 2004 Annual Meeting of Shareholders. At such time the following items were submitted to a vote of shareholders through the solicitation of proxies:

(a) Election of Directors.

The following persons were elected to serve on the Board of Directors until the 2005 Annual Meeting of Shareholders or until their successors have been duly elected and qualified. The Directors received the votes set forth opposite their respective names:


NAME	FOR		VOTES WITHHELD
Stephen L. Way		53,840,774		1,450,428
Frank J. Bramanti		53,930,974		1,360,228
Patrick B. Collins		54,074,925		1,216,277
James R. Crane		54,897,259		393,943
J. Robert Dickerson		53,928,464		1,362,738
Edward H. Ellis, Jr.		53,293,378		1,997,824
James C. Flagg, Ph.D.		54,078,105		1,213,097
Allan W. Fulkerson		53,828,372		1,462,830
Walter J. Lack		54,167,420		1,123,782
Michael A. F. Roberts		54,897,509		393,693

(b) Adoption of the 2004 Flexible Incentive Plan.

Shareholders were requested to approve the adoption of the 2004 Flexible Incentive Plan. The plan was approved by the shareholders, who voted 39,347,051 shares in favor, 11,238,598 against, and 60,024 abstained.

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits

31.1
31.2
32.1 Certification by Chief Executive Officer.
Certification by Chief Financial Officer.
Certification with respect to quarterly report.

(b) Reports on Form 8-K

On May 4, 2004, we furnished on Form 8-K our announcement of financial results for the first quarter of 2004.

On May 5, 2004, we furnished on Form 8-K the text materials used for presentations at various investor conferences.

On June 23, 2004, we furnished on Form 8-K the text materials used for presentations at various investor conferences.


		HCC Insurance Holdings, Inc. (Registrant)


August 6, 2004 (Date)		/s/ Stephen L. Way Stephen L. Way, Chairman of the Board Chief Executive Officer and President


August 6, 2004 (Date)		/s/ Edward H. Ellis, Jr. Edward H. Ellis, Jr., Executive Vice President and Chief Financial Officer

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(1)		GENERAL INFORMATION

		HCC Insurance Holdings, Inc. and its subsidiaries (“we,” “us” and “our”) provide specialized property and casualty, surety and accident and health insurance coverages and related agency and brokerage services to commercial customers. Our lines of business include group life, accident and health; diversified financial products (which includes directors’ and officers’ liability, errors and omissions, employment practices liability and surety); our London market account (which includes energy, marine, property and accident and health); aviation; and other specialty lines of insurance. We operate primarily in the United States, the United Kingdom, Spain and Bermuda, although some of our operations have a broader international scope. We market our products both directly to customers and through a network of independent and affiliated agents and brokers.

		Basis of Presentation

		The unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and include all adjustments which are, in our opinion, necessary for a fair presentation of the results of the interim periods. All adjustments made to the interim periods are of a normal recurring nature. The condensed consolidated financial statements include the accounts of HCC Insurance Holdings, Inc. and those of our wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated. The condensed consolidated financial statements for periods reported should be read in conjunction with the annual audited consolidated financial statements and related notes. The condensed consolidated balance sheet as of December 31, 2003 was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America.

		During the third quarter of 2003, we completed one acquisition. The results of operations of this entity are included in our consolidated financial statements beginning on the effective date of the transaction. Thus, our condensed consolidated statements of earnings and cash flows for the six months and three months ended June 30, 2003 do not contain any activity generated by this entity. See Note (2) for discussion of our 2004 acquisition.

		In the second quarter of 2004, we completed our annual assessment of the impairment of goodwill. Based upon this test, the fair value of each of our reporting units exceeded its carrying amount by a satisfactory margin.

		Income Tax

		For the six months and three months ended June 30, 2004 and 2003, the income tax provision has been calculated based on an estimated effective tax rate for each of the fiscal years. The difference between our effective tax rate and the United States federal statutory rate is primarily the result of state income taxes and tax exempt municipal bond interest.

(1)		GENERAL INFORMATION, continued

		Stock Options

		We account for stock options granted to employees using the intrinsic value method of APB Opinion No. 25 entitled “Accounting for Stock Issued to Employees”. All options have been granted at fixed exercise prices at the market price of our common stock at the grant date. Because of that, no stock-based employee compensation cost is reflected in our reported net income. However, the Financial Accounting Standards Board has issued an exposure draft of a pronouncement that, if adopted in its present form, will require stock-based employee compensation to be deducted from net income beginning in 2005. Options vest over a period of up to seven years and expire four to ten years after grant date. The following table illustrates the effects on net income and earnings per share if we had used the fair value method of SFAS No. 123 entitled “Accounting for Stock-Based Compensation”.

(1)		GENERAL INFORMATION, continued

		Discontinued Operations

		In December 2003, we sold the business of our retail brokerage subsidiary HCC Employee Benefits, Inc. In the fourth quarter of 2003, we began reporting this business as discontinued operations and prior year financial information has been reclassified to reflect this presentation. Summarized financial data for discontinued operations is shown below. Earnings before income tax provision exclude allocated general corporate overhead expenses of $0.8 million and $0.4 million, respectively, for the six months and three months ended June 30, 2003.

		Reclassifications

		Certain amounts in our 2003 condensed consolidated financial statements have been reclassified to conform to the 2004 presentation. Such reclassifications had no effect on our net earnings, shareholders’ equity or cash flows.

(2)		ACQUISITION

		On January 31, 2004, we acquired all of the shares of Surety Associates Holding Co., Inc., the parent company of American Contractors Indemnity Company, a California surety company specializing in court, specialty contract, license and permit bonds. American Contractors Indemnity Company will further expand our diversified financial products segment. We paid $46.9 million in cash. This business combination has been recorded using the purchase method of accounting. The results of operations of American Contractors Indemnity Company have been included in our consolidated financial statements beginning on the effective date of the transaction. We are still in the process of completing the purchase price allocation for this acquisition, as we are still gathering some of the information, including information related to litigation contingencies, needed to make the required calculations. Goodwill resulting from this acquisition will not be deductible for United States federal income tax purposes.

(2)		ACQUISITION, continued

		The following table summarizes the combined estimated fair values of assets acquired and liabilities assumed at the acquisition date.

(3)		REINSURANCE

		In the normal course of business our insurance companies cede a portion of their premium to domestic and foreign reinsurers through treaty and facultative reinsurance agreements. Although the ceding of reinsurance does not discharge the primary insurer from liability to its policyholder, our insurance companies participate in such agreements for the purpose of limiting their loss exposure, protecting them against catastrophic loss and diversifying their business. The following table represents the effect of such reinsurance transactions on premium and loss and loss adjustment expense:

(3)		REINSURANCE, continued

		The table below represents the composition of reinsurance recoverables in our condensed consolidated balance sheets:

(4)		SEGMENT AND GEOGRAPHIC INFORMATION, continued

		The following table presents selected revenue items by line of business for the periods indicated:

(5)		EARNINGS PER SHARE

		Basic earnings per share is based on the weighted average number of common shares outstanding during the period divided into net earnings. Diluted earnings per share is based on the weighted average number of common shares outstanding plus the potential common shares outstanding during the period divided into net earnings. Outstanding common stock options, when dilutive, are considered to be potential common shares for the purpose of the diluted calculation. The treasury stock method is used to calculate potential common shares due to options. The dilutive effect of our contingently convertible notes is not included in the diluted earnings per share computation until the market price trigger requirement is met.

(5)		EARNINGS PER SHARE, continued

		The following table provides a reconciliation of the denominators used in the earnings per share calculations:

(7)		COMMITMENTS AND CONTINGENCIES

		We are party to lawsuits, arbitrations and other proceedings that arise in the normal course of our business. Many of such lawsuits, arbitrations and other proceedings involve claims under policies that we underwrite as an insurer or reinsurer, the liabilities for which we believe have been adequately included in our loss reserves. Also, from time to time, we are a party to lawsuits, arbitrations and other proceedings which relate to disputes over contractual relationships with third parties, or which involve alleged errors and omissions on the part of our subsidiaries.

		A subsidiary has been named along with several other defendants in legal proceedings by certain insurance company members of a discontinued workers’ compensation reinsurance facility commonly known as the Unicover Pool. During 1997 and 1998, our subsidiary was one of two co-intermediaries for the facility. Other defendants in the current proceedings include the other reinsurance intermediary, the former managing underwriter for the facility and various individuals, none of whom are affiliated with us. It is claimed in the proceedings that the actions of the various defendants resulted in the recission of certain reinsurance contracts in an arbitration to which we were not a party and include allegations of breach of fiduciary duty, negligence, fraud and other allegations. The claims in the proceedings are for unspecified or substantial compensatory and punitive damages. We believe that we have meritorious defenses to the allegations and intend to vigorously defend against the claims made in the proceedings. The current court proceedings have been subjected to an indefinite judicial stay pending the resolution of an arbitration among the managing underwriter of the facility and the various facility members. We are not a party to such arbitration.

		In addition, we are presently engaged in litigation initiated by the appointed liquidator of a former reinsurer concerning payments made to us prior to the date of the appointment of the liquidator. The disputed payments were made by the now insolvent reinsurer in connection with a commutation agreement. Our understanding is that such litigation is one of a number of similar actions brought by the liquidator. We intend to vigorously contest the action.

		Although the ultimate outcome of these matters may not be determined at this time, based upon present information, the availability of insurance coverage and advice received from our outside legal counsel, we do not believe the resolution of any of these matters, some of which include allegations of damages in material amounts, will have a material adverse effect on our financial condition, results of operations or cash flows.

	•		The largest growth was in our diversified financial products line of business primarily as a result of organic growth in directors’ and officers’ and errors and omissions business, as well as an increase in surety business due to our acquisition of American Contractors Indemnity Company in January 2004. We are seeing some softness in premium rates but no change in deductibles or policy conditions. The underwriting profit margins are all still very adequate.

	•		Our other specialty lines of business increased significantly due to new business activities commenced during the past year. These activities include underwriting of marine insurance on the Gulf Coast of the United States, our quota-share reinsurance participation in a book of surplus lines insurance and our participation in a Lloyds syndicate writing UK liability insurance.

	•		Our London market account experienced somewhat reduced premium writings due to more selective underwriting, as premium rates softened.

	•		Group life, accident and health — The 2004 loss ratio is slightly lower than expected because of a reduction in reserves for redundancies from prior accident years.

	•		Diversified financial products — The decrease in loss ratio is due to changes in overall mix of business. The surety business of American Contractors Indemnity Company, acquired in January 2004, has a lower loss ratio compared to the other business in this line.

	•		London market accounts — Underwriting results generally improved due to more selective underwriting and we have moved to excess business where there is less loss frequency.

	•		Aviation — Underwriting results improved.

	•		Other specialty lines — The current loss ratio is as expected for new business activities commenced during the past year.

	•		Discontinued lines of business — Both quarters have been affected by reserve additions resulting from our ongoing review of outstanding claims. Additionally, given the limited amount of earned premium in this line of business, a minor adjustment to the reserves can significantly impact the loss ratio.

Item 4.		Submission of Matters to a Vote of Security Holders

		On May 13, 2004, we held our 2004 Annual Meeting of Shareholders. At such time the following items were submitted to a vote of shareholders through the solicitation of proxies:

			On May 4, 2004, we furnished on Form 8-K our announcement of financial results for the first quarter of 2004.

			On May 5, 2004, we furnished on Form 8-K the text materials used for presentations at various investor conferences.

			On June 23, 2004, we furnished on Form 8-K the text materials used for presentations at various investor conferences.


31.1		Certification by Chief Executive Officer.
31.2		Certification by Chief Financial Officer.
32.1		Certification with respect to quarterly report.