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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

Commission file number 001-13790

HCC Insurance Holdings, Inc.

(Exact name of registrant as specified in its charter)

(713) 690-7300

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act: None

      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 (the “Act”) 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

      Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes þ          No o

      The aggregate market value on June 30, 2004 (the last business day of the Registrant’s most recently completed second fiscal quarter) of the voting stock held by non-affiliates of the Registrant was approximately $2.1 billion. For purposes of the determination of the above stated amount, only directors and executive officers are presumed to be affiliates, but neither the Registrant nor any such person concede that they are affiliates of the Registrant.

      The number of shares outstanding of the Registrant’s Common Stock, $1.00 par value, at February 28, 2005 was 69,761,591.

DOCUMENTS INCORPORATED BY REFERENCE:

          Information called for in Part III of this Form 10-K is incorporated by reference to the Registrant’s definitive Proxy Statement to be filed within 120 days of the close of the Registrant’s fiscal year in connection with the Registrant’s annual meeting of shareholders.

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HCC INSURANCE HOLDINGS, INC.

TABLE OF CONTENTS

      This report on Form 10-K 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, including, among other things:

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

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

PART I

Terminology

      HCC Insurance Holdings, Inc. is a Delaware corporation, which was formed in 1991. Its predecessor corporation was formed in 1974. Our principal executive offices are located at 13403 Northwest Freeway, Houston, Texas 77040 and our telephone number is (713) 690-7300. We maintain an Internet web-site at www.hcch.com. The reference to our Internet web-site address in this report does not constitute the incorporation by reference of the information contained at this site in this report. We will make available, free of charge through publication on our Internet web-site, a copy of our Annual Report on Form 10-K and quarterly reports on Form 10-Q and any current reports on Form 8-K or amendments to those reports, filed or furnished to the Securities and Exchange Commission as soon as reasonably practicable after we have filed or furnished such materials with the Securities and Exchange Commission.

      As used in this report, unless otherwise required by the context, the terms “we,” “us” and “our” refer to HCC Insurance Holdings, Inc. and its consolidated subsidiaries and the term “HCC” refers only to HCC Insurance Holdings, Inc. All trade names or trademarks appearing in this report are the property of their respective holders.

Risk Factors

      The following factors as well as other information contained in this report should be considered.

      We purchase reinsurance for significant amounts of risk underwritten by our insurance companies, especially volatile and catastrophic risks. Market conditions beyond our control determine the availability and cost of the reinsurance protection we purchase, which may affect the level of our business and profitability. For instance, the natural attrition of reinsurers who exit lines of business, or who curtail their writings, for economic or other reasons, reduces the capacity of the reinsurance market, causing rates to rise. In addition, the historical results of reinsurance programs and the availability of capital also affect the availability of reinsurance. Our reinsurance facilities are generally subject to annual renewal. We cannot assure you that we can maintain our current reinsurance facilities or that we can obtain other reinsurance facilities in adequate amounts and at favorable rates. Further, we cannot determine what effect catastrophic losses will have on the reinsurance market in general and on our ability to obtain reinsurance in adequate amounts and at favorable rates in particular. If we are unable to renew our expiring facilities or to obtain new reinsurance facilities, either our net exposures would increase or, if we are unwilling to bear an increase in net exposures, we would have to reduce the level of our underwriting commitments, especially in catastrophe-exposed risks. Either of these potential developments could have a material adverse effect on our business. The lack of available reinsurance may also adversely affect our ability to generate fee and commission income in our underwriting agency and reinsurance broker operations.

      In some cases, we may determine, based on pricing, availability, loss history and other factors, to increase the level of risk we retain and reduce the amount of reinsurance we purchase or may determine not to purchase reinsurance for a particular risk or line of business. Such determinations have the effect of increasing our exposure to losses associated with such risks or in the subject line of business and could have a material adverse effect on our financial position, results of operations and cash flows in the event of significant losses associated with such risks or lines of business.

      We purchase reinsurance by transferring, or ceding, part of the risk we have assumed to a reinsurance company in exchange for part of the premium we receive in connection with the risk. The part of the risk we retain for our own account is known as the retention. Through reinsurance, we have the contractual right to collect the amount above our retention from our reinsurers. Although reinsurance makes the reinsurer liable to us to the extent the risk is transferred or ceded to the reinsurer, it does not relieve us, the reinsured, of our full liability to our policyholders. Accordingly, we bear credit risk with respect to our reinsurers. We cannot assure you that our reinsurers will pay all of our reinsurance claims, or that they will pay our claims on a timely basis.

      If we become liable for risks we have ceded to reinsurers or if our reinsurers cease to meet their obligations to us, whether because they are in a weakened financial position as a result of incurred losses or otherwise, our financial position, results of operations and cash flows could be materially adversely affected.

      In our specialty insurance operations, we compete in narrowly-defined niche classes of business such as the insurance of private aircraft (aviation), directors’ and officers’ liability (diversified financial products), employer sponsored, self-insured medical plans (medical stop-loss), errors and omissions (diversified financial products) and surety (diversified financial products), as distinguished from such general lines of business as automobile or homeowners insurance. We compete with a large number of other companies in our selected lines of business, including: Lloyd’s, ACE and Zurich Insurance Company in our London market business; American International Group and U.S. Aviation Insurance Group (a subsidiary of Berkshire Hathaway, Inc.) in our aviation line of business; United Health, White Mountain and Hartford Life in our group life, accident and health business; and The Chubb Corporation, ACE, XL and Philadelphia Consolidated in our diversified financial products business. We face competition from specialty insurance companies, underwriting agencies and reinsurance brokers, as well as from diversified financial services companies that are larger than we are and that have greater financial, marketing and other resources than we do. Some of these competitors also have longer experience and more market recognition than we do in certain lines of business. In addition to competition in the operation of our business, we face competition from a variety of sources in attracting and retaining qualified employees.

      We cannot assure you that we will maintain our current competitive position in the markets in which we operate, or that we will be able to expand our operations into new markets. If we fail to do so, our business could be materially adversely affected.

      Property and casualty insurers are subject to claims arising out of catastrophes that may have a significant effect on their results of operations, liquidity and financial condition. Catastrophic losses have had a significant impact on our results. Catastrophes can be caused by various events, including hurricanes, windstorms, earthquakes, hailstorms, explosions, severe winter weather and fires and may include man-made events, such as the September 11, 2001 terrorist attacks. The incidence, frequency and severity of catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. Most catastrophes are restricted to small geographic areas; however, hurricanes, earthquakes and terrorist attacks may produce significant damage in large, heavily populated areas. Catastrophes can cause losses in a variety of our property and casualty lines, and most of our past catastrophe-related claims have resulted from hurricanes and earthquakes; however, as a result of the September 11, 2001 terrorist attack, we experienced the largest single loss to our insurance company operations in our history. We also experienced significant losses during the third quarter of 2004 related to four major hurricanes. Insurance companies

are not permitted to reserve for a catastrophe until it has occurred. In 2005, we estimate that approximately 6% of our current business (based on gross written premium) may be affected by catastrophes. It is therefore possible that a catastrophic event or multiple catastrophic events could have material adverse effect on our results of operations, liquidity and financial condition.

      We underwrite insurance coverages that are denominated in a number of foreign currencies and we establish and maintain our loss reserves with respect to these policies in their respective currencies. Our net earnings could be adversely affected by exchange rate fluctuations, which would adversely affect receivable and payable balances and reserves. Our principal area of exposure relates to fluctuations in exchange rates between the major European currencies (particularly the British pound sterling and the Euro) and the U.S. dollar. Consequently, a change in the exchange rate between the U.S. dollar and the British pound sterling or the Euro could have an adverse effect on our net earnings.

      We are subject to extensive governmental regulation and supervision. Most insurance regulations are designed to protect the interests of policyholders rather than shareholders and other investors. In the United States, this regulation, generally administered by a department of insurance in each state in which we do business, relates to, among other things:

      State insurance departments also conduct periodic examinations of the affairs of insurance companies and require the filing of annual and other reports relating to the financial condition of insurance companies, holding company issues and other matters. Recently, state regulators in many states have initiated or are participating in industry-wide investigations of sales and marketing practices in the insurance industry. Such investigations focused in large part on compensation practices between insurance companies and insurance agents and brokers known as contingent commissions and other non-disclosed fees; and in certain cases with the fraudulent quoting of terms and conditions, known as bid rigging; and more recently in the application and accounting of finite risk insurance. These ongoing investigations have

in some instances already resulted in restitution and settlement payments by some companies and criminal charges against some individuals. These ongoing investigations might lead to changes in the structure of compensation arrangements, the offering of certain products and increased transparency in the marketing of many insurance products.

      Recently adopted federal legislation to modernize financial services may lead to additional federal regulation of the insurance industry in the coming years. Also, foreign governments regulate our international operations. Each foreign jurisdiction has its own unique regulatory framework which applies to our operations in that jurisdiction. Our business depends on compliance with applicable laws and regulations and our ability to maintain valid licenses and approvals for our operations. Some regulatory authorities have relatively broad discretion to grant, renew, or revoke licenses and approvals. Regulatory authorities may deny or revoke licenses for various reasons, including the violation of regulations. In some instances, we follow practices based on our interpretations of regulations, or those we believe to be generally followed by the industry, which may be different from the requirements or interpretations of regulatory authorities. If we do not have the requisite licenses and approvals and do not comply with applicable regulatory requirements, the insurance regulatory authorities could preclude or temporarily suspend us from carrying on some or all of our activities or otherwise penalize us. That type of action could have a material adverse effect on our business. Also, changes in the level of regulation of the insurance industry (whether federal, state or foreign), or changes in laws or regulations themselves or interpretations by regulatory authorities, could have a material adverse effect on our business.

      Ratings have become an increasingly important factor in establishing the competitive position of insurance companies. Our insurance companies are rated by A.M. Best Company, Inc. and Standard & Poor’s Corporation, whose ratings reflect their opinions of an insurance company’s and insurance holding company’s financial strength, operating performance, strategic position and ability to meet its obligations to policyholders and are not evaluations directed to investors. Our ratings are subject to periodic review by those entities and the continued retention of those ratings cannot be assured. If our ratings are reduced from their current levels by those entities, our results of operations could be adversely affected.

      We maintain loss reserves to cover our estimated liability for unpaid losses and loss adjustment expenses, including legal and other fees as well as a portion of our general expenses, for reported and unreported claims incurred at the end of each accounting period. Reserves do not represent an exact calculation of liability. Rather, reserves represent an estimate of what we expect the ultimate settlement and administration of claims will cost. These estimates, which generally involve actuarial projections, are based on our assessment of facts and circumstances then known, as well as estimates of future trends in claims severity, frequency, judicial theories of liability and other factors. These variables are affected by both internal and external events, such as changes in claims handling procedures, inflation, judicial trends and legislative changes. Many of these items are not directly quantifiable in advance. Additionally, there may be a significant reporting delay between the occurrence of the insured event and the time it is reported to us. The inherent uncertainties of estimating reserves are greater for certain types of liabilities, particularly those in which the various considerations affecting the type of claim are subject to change and in which long periods of time may elapse before a definitive determination of liability is made. Reserve estimates are continually refined in a regular and ongoing process as experience develops and further claims are reported and settled. Adjustments to reserves are reflected in our results of operations in the periods in which such estimates are changed. Because setting reserves is inherently uncertain, there can be no assurance that current reserves will prove adequate in light of subsequent events.

      At December 31, 2004, $1.7 billion of our $2.5 billion investment portfolio was invested in fixed income securities. The fair market value of these fixed income securities and the related investment income fluctuate depending on general economic and market conditions. With respect to our investments in fixed income securities, the fair market value of these investments generally increases or decreases in an inverse relationship with fluctuations in interest rates, while net investment income realized by us from future investments in fixed income securities will generally increase or decrease with interest rates. In addition, actual net investment income and/or cash flows from investments that carry prepayment risk (such as mortgage-backed and other asset-backed securities) may differ from those anticipated at the time of investment as a result of interest rate fluctuations. An investment has prepayment risk when there is a risk that the timing of cash flows that result from the repayment of principal might occur earlier than anticipated because of declining interest rates or later than anticipated because of rising interest rates. Although we maintain an investment grade portfolio (99% are rated “A” or better), our fixed income securities are also subject to credit risk. If any of the issuers of our fixed income securities suffer financial setbacks, the ratings on the fixed income securities could fall (with a concurrent fall in market value) and, in a worst case scenario, the issuer could default on its financial obligations. Historically, the impact of market fluctuations has affected our financial statements. Because all of our fixed income securities are classified as available for sale, changes in the fair market value of our securities are reflected in our other comprehensive income. Similar treatment is not available for liabilities. Therefore, interest rate fluctuations could adversely affect our shareholders’ equity, total comprehensive income and/or our cash flows. Unrealized pre-tax net investment gains (losses) on investments in fixed-income securities were $(9.3) million in 2004, $(3.7) million in 2003 and $22.0 million in 2002.

      Our insurance companies are subject to assessments in most states where we are licensed for the provision of funds necessary for the settlement of covered claims under certain policies provided by impaired, insolvent or failed insurance companies or for the issuance of insurance policies to “high risk” or otherwise uninsured individuals. Maximum contributions required by law in any one year vary by state and have historically been between 1% and 2% of annual premiums written. We cannot predict with certainty the amount of future assessments. Significant assessments could have a material adverse effect on our financial condition or results of operations.

      Historically, we have had sufficient cash flow from our non-insurance company subsidiaries to meet our corporate cash flow requirements for paying principal and interest on outstanding debt obligations, dividends to shareholders and corporate expenses. However, in the future we may rely on dividends from our insurance companies to meet these requirements. The payment of dividends by our insurance companies is subject to regulatory restrictions and will depend on the surplus and future earnings of these subsidiaries, as well as the regulatory restrictions. As a result, should our other sources of funds prove to be inadequate, we may not be able to receive dividends from our insurance companies at times and in amounts necessary to meet our obligations.

      Our strategy for growth includes growing through acquisitions of insurance industry related companies. This strategy presents risks that could materially adversely affect our business and financial performance, including:

      We cannot predict whether:

      In addition, future acquisitions by us may result in:

Business Overview

      We provide specialized property and casualty, surety, and group life, accident and health insurance coverages and related agency and reinsurance brokerage services to commercial customers and individuals. We concentrate our activities in selected, narrowly defined, specialty lines of business. We operate primarily in the United States, the United Kingdom, Spain and Bermuda. We underwrite insurance both on a direct basis, where we insure a risk in exchange for a premium, and on a reinsurance basis, where we insure all or a portion of another insurance company’s risk in exchange for all or a portion of the premium. We market our products both directly to customers and through a network of independent brokers and producers, and affiliated agents.

      Since our founding, we have been consistently profitable, generally reporting annual increases in gross written premium and total revenue. During the period 2000 through 2003, which is the latest period for which industry information is available, we had an average statutory combined ratio of 93.9% versus the less favorable 108.4% (source: A.M. Best Company, Inc.) recorded by the U.S. property and casualty insurance industry overall. During the period 2000 through 2004, our gross written premium increased from $967.5 million to $2.0 billion, an increase of 104%, while net written premium increased 290% from $283.8 million to $1.1 billion. During this period, our revenue increased from $474.6 million to $1.3 billion, an increase of 170%.

      During the period December 31, 2000 through December 31, 2004, our shareholders’ equity more than doubled from $530.9 million to $1.3 billion. During the same period, our assets increased 113% from $2.8 billion to $5.9 billion.

      Our insurance companies are risk-bearing and focus their underwriting activities on providing insurance and/or reinsurance in the following lines of business:

      In the United States, American Contractors Indemnity Company, Avemco Insurance Company, HCC Life Insurance Company, U.S. Specialty Insurance Company, and United States Surety Company (acquired in February 2005) operate on an admitted, or licensed, basis. Houston Casualty Company and HCC Specialty Insurance Company operate on a surplus lines basis as a non-admitted, or unlicensed, insurer offering insurance coverage not otherwise available from an admitted insurer in the relevant state. Houston Casualty Company operates a registered branch office in London and offers insurance predominantly in the United Kingdom and reinsurance in countries where it is not licensed. HCC Europe operates from its Madrid, Spain offices and offers insurance throughout the European Union. HCC Reinsurance Company is a Bermuda-domiciled reinsurance company and can write assumed reinsurance worldwide.

      Our operating insurance companies are rated “A+ (Superior)” (2nd of 16 ratings) by A.M. Best Company, Inc. and “AA (Very Strong)” (3rd of 22 ratings) by Standard and Poor’s Corporation, two nationally recognized independent rating agencies. These ratings are intended to provide an independent opinion of an insurer’s ability to meet its obligations to policyholders and are not evaluations directed at investors.

      Our underwriting agencies underwrite on behalf of our insurance companies and in certain situations for other non-affiliated insurance companies. They receive fees for these services and do not bear any of the insurance risk of the companies for which they underwrite. Our underwriting agencies generate revenues based entirely on fee income and profit commissions and specialize in contingency (including contest indemnification, event cancellation and weather coverages); directors’ and officers’ liability; individual disability (for athletes and other high profile individuals); kidnap and ransom; employment practices liability; marine; professional indemnity; mortgage and residual value insurance; and other specialty lines of business. Our principal underwriting agencies are ASU International, Covenant Underwriters, HCC Global Financial Products, HCC Diversified Financial Products, Professional Indemnity Agency and HCC Indemnity Guaranty Agency.

      Our reinsurance and insurance brokers provide reinsurance and insurance brokerage services for our insurance companies and our clients and receive fees for their services. A reinsurance broker structures and arranges reinsurance between insurers seeking to cede insurance risks and reinsurers willing to assume such risks. Our reinsurance brokers do not bear any of the insurance risks of their client companies. They earn commission income, and to a lesser extent, fees for certain services, generally paid by the insurance and reinsurance companies with whom the business is placed. These operations consist of consulting with clients by providing information about insurance coverage and marketing, placing and negotiating particular insurance risks. Our reinsurance brokers specialize in placing reinsurance for group life, accident and health and property and casualty lines of business. Our reinsurance brokers are Rattner Mackenzie and HCC Risk Management. Our insurance broker is Continental Underwriters, which earns commission revenue for the placement of marine business.

Our Strategy

      Our business philosophy as an insurer is to maximize underwriting profits while limiting risk in order to preserve shareholders’ equity and maximize earnings. We concentrate our insurance writings in selected, narrowly defined, specialty lines of business where we believe we can achieve an underwriting profit. We

market our insurance products both directly to customers and through affiliated agents and independent brokers and producers.

      The property and casualty insurance industry and individual lines of business within the industry are cyclical. There are times when a large number of companies offer insurance on certain lines of business, causing premiums to trend downward. During other times, insurance companies limit their writings in certain lines of business due to lack of capital or following periods of excessive losses. This results in an increase in premiums for those companies that continue to write insurance in those lines of business. In our insurance company operations, we believe our operational flexibility, which permits us to shift the focus of our insurance underwriting activity amongst our various lines of business and also to shift the emphasis from our insurance risk-bearing business to our non-insurance, fee-based business, as well as our experienced underwriting personnel and access to and expertise in the reinsurance marketplace, allow us to implement a strategy of emphasizing more profitable lines of business during periods of increased premium rates and de-emphasizing less profitable lines of business during periods of increased competition. In addition, we believe that our underwriting agencies and reinsurance and insurance brokers complement our insurance underwriting activities. Our ability to utilize affiliated insurers, underwriting agencies and reinsurance brokers permits us to retain a greater portion of the gross revenue derived from written premium.

      In the past three years, due to a hardening of the insurance market, premium rates increased in varying amounts across many of our lines of business, substantially improving our overall underwriting profitability. In 2004, premium rates in some of our lines of business began to soften, although generally the rate decreases were more gradual than previous increases and, therefore, the business written in 2004 remains profitable. We anticipate continued underwriting profitability during 2005 and into 2006, assuming premium rate reductions are not excessive. Accordingly, in 2005 we plan to focus our efforts on the underwriting activities in our insurance company operations and retain more of the risks, applicable premiums, and expected underwriting profits.

      Through reinsurance, our insurance companies transfer or cede part of the risk we have underwritten to a reinsurance company in exchange for part of the premium we receive in connection with the risk. We purchase reinsurance to limit the net loss to our insurance companies from both individual and catastrophic risks. The amount of reinsurance we purchase varies by, among other things, the particular risks inherent in the policies underwritten, the pricing of reinsurance and the competitive conditions within the relevant line of business.

      When we determine to retain more underwriting risk in a particular line of business, we do so with the intention of retaining a greater portion of any underwriting profits. In this regard, we may purchase less proportional or quota share reinsurance applicable to that line, thus accepting more of the risk, but possibly replacing it with specific excess of loss reinsurance, where we transfer to reinsurers both premium and losses on a non-proportional basis for individual and catastrophic risks above a retention point. Additionally, we may obtain facultative reinsurance protection on individual risks. In some cases, we may choose not to purchase reinsurance in some of our lines of business where there has been a favorable loss history, our policy limits are relatively low or where we determine there is a low likelihood of catastrophe exposure.

      We also acquire or make strategic investments in companies that present an opportunity for future profits or for enhancement of our business. We expect to continue to acquire complementary businesses. We believe that we can enhance acquired businesses through the synergies created by our underwriting capabilities and our other operations.

      Our business plan is shaped by our underlying business philosophy, which is to maximize underwriting profit and net earnings, while preserving and achieving long-term growth of shareholders’ equity. As a result, our primary objective is to increase net earnings rather than market share or gross written premium.

      In our ongoing operations, we will continue to:

Industry Segment Information

      Financial information concerning our operations by industry segment is included in the Consolidated Financial Statements and the Notes thereto.

Recent Acquisitions

      We have made a series of acquisitions that have furthered our overall business strategy. Our recent major transactions are described below:

      On October 1, 2002, we acquired all of the outstanding member interests of MAG Global Financial Products, LLC, an underwriting agency specializing in directors’ and officers’ liability and professional liability insurance. The total purchase price of the acquisition is based in part on future earnings. We paid an initial $6.9 million for the acquisition in 2002, $4.1 million during 2003, $27.0 million in 2004 and expect to pay $33.8 million in 2005 based on 2004 earnings. We may pay additional amounts in the future based on the attainment of certain earnings benchmarks through September 2007. MAG Global Financial Products, LLC has been renamed HCC Global Financial Products, LLC.

      On December 24, 2002, we acquired all of the outstanding shares of Manchester Dickson Holdings Limited, the parent Company of Dickson Manchester & Company Limited, an underwriting agency and Lloyd’s broker specializing in U.K. professional indemnity products. We paid $17.0 million as an initial amount and paid an additional $12.3 million as final payment for the acquisition. Dickson Manchester & Company Limited’s underwriting operations have been renamed HCC Diversified Financial Products Limited.

      On December 31, 2002, we acquired all of the outstanding shares of St. Paul Holdings Limited, a holding company for a Spanish insurance company, St. Paul España, which we have renamed HCC Europe. We paid $8.1 million for the acquisition. HCC Europe writes surety, directors’ and officers’ liability and professional liability insurance in Spain and other countries in the European Union.

      On July 1, 2003, we acquired all of the outstanding shares of Covenant Underwriters Ltd. and Continental Underwriters Ltd., an underwriting agency and an insurance broker, respectively, specializing in commercial marine insurance. We paid $11.6 million and issued 314,537 shares of our common stock in connection with the acquisition and may pay additional amounts if certain earnings targets are reached through December 31, 2006. We expect to pay $2.1 million in 2005 based on 2004 earnings.

      On January 31, 2004, we acquired all of the shares of Surety Associates Holding Co., Inc., the parent company of American Contractors Indemnity Company, a California-domiciled surety company specializing in court, specialty contract, license and permit bonds. We paid $46.8 million for the acquisition. American Contractors Indemnity Company now operates with our other surety operations as part of our HCC Surety Group.

      On October 1, 2004, we acquired all of the shares of InsPro Corporation, a California underwriting agency specializing in professional indemnity insurance and which does business as RA&MCO Insurance Services. We paid $7.0 million and issued 49,833 shares of our common stock in connection with the acquisition. RA&MCO will operate as a division of Professional Indemnity Agency.

      On February 25, 2005, we completed the acquisition of United States Surety Company through a merger effected with its parent company, USSC Holdings, Inc. We issued 793,650 shares of our common stock in connection with the acquisition. United States Surety Company is a Maryland-domiciled surety company specializing in contract bonds and now operates as a part of our HCC Surety Group.

      We continue to evaluate possible acquisition candidates and we may complete additional acquisitions during 2005. Any future acquisitions will be designed to expand and strengthen our existing lines of business and perhaps provide access to additional specialty sectors, which we expect to contribute to our overall growth.

Recent Disposition

      On December 31, 2003, we sold the business of our retail brokerage subsidiary, HCC Employee Benefits, Inc. We received $62.5 million as initial consideration and expect to receive an additional $6.3 million based on the estimated 2004 earnings of the disposed operations.

Insurance Company Operations

      This table shows our insurance companies’ total premium written, otherwise known as gross written premium, by line of business and the percentage of each line to total gross written premium (dollars in thousands):

      This table shows our insurance companies’ actual premium retained, otherwise known as net written premium, by line of business and the percentage of each line to total net written premium (dollars in thousands):

      This table shows our insurance companies’ net written premium as a percentage of gross written premium, otherwise referred to as percentage retained, for our continuing lines of business:

      We underwrite direct business produced through affiliated underwriting agencies, independent brokers and producers, affiliated reinsurance brokers and by direct marketing efforts. We also write facultative, or individual account, reinsurance, as well as some treaty reinsurance business.

      We write medical stop-loss business for employer-sponsored, self-insured health plans. Our medical stop-loss insurance provides coverages to companies, associations and public entities that elect to self-insure their employee’s medical coverage for losses within specified levels, allowing them to manage the risk of excessive health insurance exposure by limiting aggregate and specific losses to a predetermined amount. We also underwrite a small program of group life insurance offered to our insureds as a complement to our medical stop-loss products. In early 2005, we consolidated the operations of HCC Benefits Corporation, our underwriting agency that underwrites all of our medical stop-loss business, into HCC Life Insurance Company. In the future, HCC Benefits Corporation will operate as a division of HCC Life Insurance Company. We first began writing this business in our insurance companies in 1997. HCC Benefits Corporation began underwriting this business, on behalf of other insurance companies, in 1980 through a predecessor company. This line of business has grown both internally and through acquisitions. We are considered a market leader in medical stop-loss insurance.

      Premiums have risen substantially since 2000 and, although they are now stable to slightly down, underwriting results are still very profitable. In 2005, we determined not to purchase reinsurance on our medical stop-loss line of business and to retain all of the underwriting risk associated with this line of business. This business has relatively low limits, generally at or below $2.0 million, and we believe is relatively stable and predictable and subject to a relatively low level of catastrophe exposure.

      We began writing alternative workers’ compensation and occupational accident insurance in 1996. The business is currently written through U.S. Specialty Insurance Company. We maintain specific reinsurance on an excess of loss basis and we believe there is a relatively low level of catastrophe exposure in this business. The business in this line has relatively low limits, generally below $1.0 million and is relatively stable and predictable.

      We underwrite a variety of financial insurance risks in our diversified financial products line of business. These risks include:

      The following table presents the details of net written premium within the diversified financial products line of business (in thousands):

      We began to underwrite this line of business with our acquisition of Professional Indemnity Agency in October 2001, although Professional Indemnity Agency has written this business since 1977. We have substantially increased our level of business in this area through our October 2002 acquisition of HCC Global Financial Products, our December 2002 acquisitions of Dickson Manchester & Company and HCC Europe, and our October 2004 acquisition of RA&MCO. In January 2004, we acquired American Contractors Indemnity Company, which now operates within our HCC Surety Group along with the surety operations of HCC Europe and the recently acquired United States Surety Company. We acquired United States Surety Company, a Maryland—domiciled surety company in February 2005 and plan to complete the acquisition of DeMontfort Group, a U.K. based surety company, following receipt of required regulatory approval. Each of the acquired entities has substantial experience in their respective specialty within this line of business. In July 2004, we formed HCC Indemnity Guaranty Agency, an underwriting agency based in New York, New York which specializes in mortgage guaranty and title reinsurance and residual value insurance.

      In 2002 and 2003, following several years of substantial insurance industry losses, we experienced substantial rate increases throughout our diversified financial products line of business, particularly directors’ and officers’ liability. We benefited greatly from this significant change despite the fact that we had not been involved in the past losses. Gross written premium in the diversified financial products line rose dramatically to $857.3 million in 2004 compared to $178.7 million in 2002 due to acquisitions, premium rate increases and other organic growth in all products in this line. Rates have softened in 2004 for some of the products in this line, but they are still very profitable as rates had risen so much in the prior two years that the current reductions have only had a small effect on our projected margins.

      We maintain reinsurance on our diversified financial products line of business on both a proportional and excess of loss basis. In 2005, we decided to substantially reduce our proportional reinsurance programs related to the component products within this line of business. Although individual losses, primarily in the directors’ and officers’ United States public company liability business, may have potential severity, there is a relatively low risk of catastrophe exposure in this line of business. Net premium written for United States public company directors’ and officers’ liability was approximately $90.0 million in 2004. The remainder of the business is less volatile with relatively low limits.

      Our London market account business consists of marine, energy, property, and accident and health business and is underwritten by Houston Casualty Company’s London branch office. This line represents most of our catastrophe exposure. We have underwritten these risks for more than 15 years, increasing or decreasing our premium volume depending on market conditions, which can be very volatile in this line.

      The following table presents the details of net written premium within the London market account line of business (in thousands):

      We underwrite marine risks for ocean-going vessels including hull, liabilities, protection and indemnity and marine cargo. We have underwritten marine risks on both a direct and reinsurance basis since 1984 and currently write a relatively small book of business due to the competitive state of the market.

      In our energy business, we underwrite physical damage and business interruption. We have been underwriting both onshore and offshore energy risks since 1988 and are considered a market leader. Risks written include:

      Despite recent increases, rates have been relatively low for an extended period of time at levels where underwriting profitability has been difficult to achieve. As a result, we have underwritten energy risks on a very selective basis, striving for quality rather than quantity.

      We underwrite property business specializing in risks of large, often multinational, corporations, covering a variety of commercial properties including:

      We have written property business since 1986, including business interruption, physical damage and catastrophe risks including flood and earthquake. Rates increased significantly following September 11, 2001, but despite the four hurricanes in 2004 have recently been softening once again. We are reducing our involvement in this business accordingly.

      We began writing London market accident and health risks in 1996, including trip accident, medical and disability. Due to past experiences and other market factors, we decreased premiums in 2003 and 2004 as a result of our re-underwriting this business.

      Our London market account business is reinsured both proportionally and on an excess of loss basis. Catastrophe exposure is closely monitored and reinsurance is purchased accordingly to limit our net exposure to a level that any loss is not expected to impact our capital. Previous catastrophe losses from

Hurricane Andrew in 1992, Northridge Earthquake in 1994, September 11, 2001, and the four hurricanes in 2004 did not exceed net earnings in the effected quarter.

      We are a market leader in the general aviation insurance industry. We insure aviation risks, both domestically and internationally, including:

      We offer coverages that include hulls, engines, avionics and other systems, liabilities, cargo and other ancillary coverages. We do not generally insure major airlines, major manufacturers or satellites. Insurance claims related to general aviation business tend to be seasonal, with the majority of the claims being incurred during the spring and summer months.

      We have been underwriting aviation risks through Houston Casualty Company since 1981 and in 1997 acquired Avemco Insurance Company and U.S. Specialty Insurance Company. Avemco Insurance Company is one of the largest writers of personal aircraft insurance in the United States and has been insuring aviation risks since 1959. Our aviation gross premium has remained relatively stable since 1998, although our retentions have changed. Our aviation net written premium for 2004 was $144.7 million.

      We maintain reinsurance on both a proportional and excess of loss basis and believe that the aviation risks we underwrite carry a relatively low level of catastrophe exposures. The majority of our aviation risks are written with small limits and have proven to be relatively stable and predictable.

      In addition to the above, we underwrite various other specialty lines of business, of which individual premiums by line of business are not at this time significant to our overall results of operations.

      Our operating insurance companies are rated “A+ (Superior)” (2nd of 16 ratings) by A.M. Best Company, Inc. and “AA (Very Strong)” (3rd of 22 ratings) by Standard and Poor’s Corporation, two nationally recognized independent rating agencies. These ratings are intended to provide an independent opinion of an insurer’s ability to meet its obligations to policyholders and are not evaluations directed at investors.

      Houston Casualty Company is our principal insurance company subsidiary. Houston Casualty Company operates worldwide and is domiciled and licensed in Texas and operates on a surplus lines basis in 48 states, three U.S. territories and the District of Columbia. Houston Casualty Company receives business through independent agents and brokers, our underwriting agencies and reinsurance brokers, and other insurance and reinsurance companies. Houston Casualty Company writes aviation, London market account, diversified financial products and other specialty lines of business. Houston Casualty Company’s

2004 gross written premium, including Houston Casualty Company-London, was $927.9 million. Houston Casualty Company is also issuing carrier for our affiliated underwriting agencies.

      Houston Casualty Company operates a full branch office in London, England, in order to more closely align its underwriting operations with the London market, a historical focal point for some of the business that it underwrites. Houston Casualty Company-London underwrites diversified financial products and London market account business, some of which is produced by our affiliated underwriting agencies.

      U.S. Specialty Insurance Company is a Texas-domiciled property and casualty insurance company. It is a direct subsidiary of Houston Casualty Company. U.S. Specialty Insurance Company operates on an admitted basis throughout the United States, primarily writing aviation, accident and health and diversified financial products business. U.S. Specialty Insurance Company acts as an issuing carrier for certain business underwritten by our underwriting agencies. U.S. Specialty Insurance Company’s gross written premium in 2004 was $367.6 million.

      HCC Life Insurance Company is an Indiana-domiciled life insurance company and a subsidiary of Houston Casualty Company. It operates as a group life, accident and health insurer on an admitted basis in 42 states and the District of Columbia. In early 2005, we consolidated the operations of our underwriting agency, HCC Benefits Corporation, into HCC Life Insurance Company. HCC Life Insurance Company’s gross written premium in 2004 was $413.3 million.

      Avemco Insurance Company is a Maryland-domiciled property and casualty insurer and operates as a direct market underwriter of aviation business on an admitted basis throughout the United States. Avemco Insurance Company has also been an issuing carrier for accident and health business underwritten by our underwriting agencies and an unaffiliated underwriting agency. Avemco Insurance Company’s gross written premium in 2004 was $178.2 million.

      American Contractors Indemnity Company was acquired on January 31, 2004 and is a California-domiciled surety company. American Contractors Indemnity Company writes court, specialty contract, license and permit bonds and operates on an admitted basis in 45 states, the District of Columbia and two U.S. Territories. American Contractors Indemnity Company has been in operation since 1990 and operates as a part of our HCC Surety Group. American Contractors Indemnity Company’s 2004 gross written premium since its acquisition was $66.1 million.

      Houston Casualty Company Europe, Seguros y Reaseguros, S.A. is a Spanish insurer and underwrites diversified financial products business throughout the European Union and its surety operations make up a part of our HCC Surety Group. HCC Europe is also an issuing carrier for business underwritten by our underwriting agencies and has been in operation since 1978. HCC Europe’s gross written premium in 2004 was $109.8 million.

      HCC Reinsurance Company Limited is a Bermuda-domiciled reinsurance company which writes assumed reinsurance from our insurance companies and from unaffiliated insurance companies. HCC

Reinsurance Company’s gross written premium in 2004 was $43.5 million. We expect to increase the underwriting activity of HCC Reinsurance Company in 2005.

      HCC Specialty Insurance Company is an Oklahoma-domiciled property and casualty insurance company. HCC Specialty Insurance Company operates on a surplus lines basis in Texas and writes diversified financial products and other specialty lines business produced by our underwriting agencies. HCC Specialty Insurance Company’s gross written premium in 2004 was $14.3 million.

      United States Surety Company was acquired on February 25, 2005 and is a Maryland-domiciled surety company. The results of operations of United States Surety Company will be included in our 2005 financial results beginning on the date of acquisition. United States Surety Company writes contract bonds on an admitted basis in eleven states and the District of Columbia and has been in operation since 1996 and will operate as a part of our HCC Surety Group.

Underwriting Agency Operations

      Our underwriting agencies act on behalf of affiliated and non-affiliated insurance companies and provide insurance underwriting management and claims administration services. Our underwriting agencies do not assume any insurance or reinsurance risk themselves and generate revenues based entirely on fee income and profit commissions. These subsidiaries are in a position to direct and control business that they produce. Our insurance companies serve as policy issuing companies for the majority of the business written by our underwriting agencies. In instances where our insurance companies are not the policy issuing company, our insurance companies may reinsure the business written by the underwriting agencies. Total revenue generated by our underwriting agencies in 2004 amounted to $193.4 million. In early 2005, we consolidated the operations of our underwriting agency, HCC Benefits Corporation, into our insurer, HCC Life Insurance Company.

      Professional Indemnity Agency, Inc., based in Mount Kisco, New York and with branch offices in San Francisco and Concord, California, acts as an underwriting manager for diversified financial products, specializing in directors’ and officers’ liability, errors and omissions liability, kidnap and ransom and other specialty lines of business on behalf of affiliated and unaffiliated insurance companies and has been in operation since 1977.

      ASU International, Inc., with its home office in Wakefield, Massachusetts, acts as an underwriting manager for group life, accident and health and other specialty lines of business on behalf of affiliated and unaffiliated insurance companies and has been in operation since 1982. ASU International formed an entertainment division in late 2004 and now underwrites film completion bonds and entertainment insurance from offices in Los Angeles, California and New York, New York.

      HCC Global Financial Products, LLC has offices in Farmington, Connecticut, Houston, Texas, Jersey City, New Jersey, Barcelona, Spain and London, England. HCC Global Financial Products acts as an underwriting manager for diversified financial products, specializing in directors’ and officers’ liability business on behalf of affiliated insurance companies.

      HCC Diversified Financial Products Limited is an underwriting agency based in London, England and underwrites diversified financial products, specializing in professional indemnity business principally in the United Kingdom on behalf of affiliated insurance companies and has been in operation since 1997.

      We acquired Covenant Underwriters, Ltd. in July 2003. Covenant Underwriters is an underwriting agency based in Covington, Louisiana with an office in New York, New York specializing in commercial marine insurance underwritten on behalf of affiliated and unaffiliated insurance companies. Covenant Underwriters has been in operation through predecessor entities since 1970.

      HCC Indemnity Guaranty Agency, Inc. was formed in 2004 to underwrite mortgage guaranty, title and residual value insurance and reinsurance on behalf of affiliated insurance companies.

Reinsurance and Insurance Broker Operations

      Our reinsurance and insurance brokers provide a variety of services, including marketing, placing, consulting on and servicing insurance risks for their clients, which include medium to large corporations, unaffiliated and affiliated insurance and reinsurance companies, and other risk taking entities. The brokers earn commission income and, to a lesser extent, fees for certain services, generally paid by the underwriters with whom the business is placed. Some of these risks may be initially underwritten by our insurance companies, which may retain a portion of the risk. Total revenue generated by our reinsurance and insurance brokers in 2004 amounted to $32.9 million.

      Rattner Mackenzie Limited is a reinsurance broker based in London, England with other operations in Hamilton, Bermuda and Mt. Kisco, New York. Rattner Mackenzie specializes in group life, accident and health reinsurance and some specialty property and casualty lines of business. Rattner Mackenzie operates as a Lloyd’s broker for reinsurance business placed on behalf of unaffiliated and affiliated insurance companies, reinsurance companies and underwriting agencies and has been in operation since 1989.

      Continental Underwriters Ltd. is an insurance broker based in Covington, Louisiana specializing in commercial marine insurance and has been in operation since 1970.

      HCC Risk Management Corporation, based in Houston, Texas, is a reinsurance broker specializing in placing reinsurance on behalf of affiliated and unaffiliated insurance companies.

Other Operations

      Other operating income consists of equity in the earnings of mainly insurance-related companies in which we invest; dividends and interest from certain other insurance-related investments and gains or losses from the disposition of these investments; income related to two mortgage impairment insurance contracts which, while written as insurance policies, receive accounting treatment as derivative financial instruments; the profit or loss from an inventory of predominantly insurance-related trading securities; and other miscellaneous income. Other operating income was $19.4 million in 2004, but can vary considerably from period to period depending on the amount of investment or disposition activity.

Reinsurance Ceded

      Annually, we analyze our overall threshold for risk in each line of business based upon a number of factors including market conditions, pricing, competition and the inherent risks associated with the business type, then structure a specific reinsurance program for each of our lines of business. Based on our analyses of these factors, we may determine not to purchase reinsurance for some lines of business. We generally purchase reinsurance to reduce our net liability on individual risks, to protect against catastrophe losses and volatility, and to achieve a desired ratio of net written premium to policyholders’ surplus. We purchase reinsurance on a proportional basis to cover loss frequency, individual risk severity and catastrophe exposure. Some of the proportional insurance agreements may have maximum loss limits, which are well above a 100% combined ratio. We also purchase reinsurance on an excess of loss basis to cover individual risk severity and catastrophe exposure. Additionally, we may obtain facultative reinsurance protection on a single risk. The type and amount of reinsurance we purchase varies year to year based on our risk assessment, our desired retention levels based on profitability and other considerations, and the market availability of quality reinsurance at prices we consider acceptable. Our reinsurance programs renew throughout the year and during 2004, some of those renewals contained price increases, which were not material to our underwriting results. Our reinsurance generally does not cover war or terrorism risks, which are excluded from most of our policies.

      We decided for the 2005 underwriting year to retain more underwriting risk in certain lines of business with the intention of retaining a greater proportion of any underwriting profits. In doing so, we will necessarily purchase less reinsurance applicable to that line or choose to restructure the applicable reinsurance programs, obtaining more excess of loss reinsurance and less proportional reinsurance, which significantly reduces the amount of ceded premium. Also, we have chosen not to purchase any reinsurance on other business where volatility or catastrophe risks are considered remote.

      In our proportional reinsurance programs, we generally receive an overriding (ceding) commission on the premium ceded to reinsurers. This compensates our insurance companies for the direct costs associated with the production of the business, the servicing of the business during the term of the policies ceded and the costs associated with the placement of the related reinsurance. In addition, certain of our reinsurance treaties allow us to share with the reinsurers in any net profits generated under such treaties. Various reinsurance brokers, including Rattner Mackenzie and HCC Risk Management, arrange for the placement of this proportional and other reinsurance coverage on our behalf and are compensated, directly or indirectly, by the reinsurers.

      We have a reserve of $20.4 million at December 31, 2004 for potential collectibility issues related to reinsurance recoverables, including disputed amounts and associated expenses. While we believe the reserve is adequate based on information currently available, conditions may change or additional information might be obtained which may require us to change the reserve in the future. We periodically review our financial exposure to the reinsurance market and the level of our reserve and continue to take actions in an attempt to mitigate our exposure to possible loss.

Operating Ratios

      This table shows the ratio of statutory gross written premium and net written premium to statutory policyholders’ surplus for our property and casualty insurance companies (dollars in thousands):

      While there is no statutory requirement regarding a permissible premium to policyholders’ surplus ratio, guidelines established by the National Association of Insurance Commissioners provide that a property and casualty insurer’s annual statutory gross written premium should not exceed 900% and net written premium should not exceed 300% of its policyholders’ surplus. However, industry standards and rating agency criteria place these ratios at 300% and 200%, respectively. Our property and casualty insurance companies have maintained net written premium to surplus ratios lower than such guidelines.

      The underwriting experience of a property and casualty insurance company is indicated by its combined ratio. Under generally accepted accounting principles, the combined ratio is a combination of the loss ratio (the ratio of incurred losses and loss adjustment expenses to net earned premium) and the expense ratio (the ratio of policy acquisition costs and other underwriting expenses, net of ceding commissions, to net earned premium), both calculated in accordance with generally accepted accounting principles. Our insurance companies’ loss ratios, expense ratios and combined ratios in accordance with generally accepted accounting principles are shown in the following table:

      The combined ratio in accordance with statutory accounting principles is a combination of the loss ratio (the ratio of incurred losses and loss adjustment expenses to net earned premium) and the expense ratio (the ratio of policy acquisition costs and other underwriting expenses, net of ceding commissions, to net written premium), both calculated in accordance with statutory accounting principles. Our insurance

companies’ loss ratios, expense ratios and combined ratios in accordance with statutory accounting principles are shown in the following table:

      The ratio data in accordance with statutory accounting principles is not intended to be a substitute for results of operations in accordance with generally accepted accounting principles. We believe including this information is useful to allow a comparison of our operating results with those of other companies in the insurance industry. The source of the industry average is A.M. Best Company, Inc. A.M. Best Company, Inc. reports on insurer performance on the basis of statutory accounting principles to provide for more standardized comparisons among individual companies, as well as overall industry performance and is not an evaluation directed at investors.

Reserves

      Our net loss and loss adjustment expense reserves are composed of reserves for reported losses and reserves for incurred but not reported losses, less a reduction for reinsurance recoverables related to those reserves. Reserves are recorded by product line and are undiscounted, except for reserves related to acquisitions recorded using the purchase method of accounting.

      The reserves for reported losses related to our direct business and certain reinsurance assumed are initially set by our claims personnel or independent claims adjusters hired by us. The reserves are subject to our review, with a goal of setting them at the ultimate expected loss amount as soon as possible as information becomes available. Reserves for reported losses related to other reinsurance assumed are recorded based upon information supplied to us by the ceding company. Our claims personnel monitor these reinsurance assumed reserves on a current basis and audit ceding companies’ claims to ascertain that claims are being recorded currently and that net reserves are being set at levels that properly reflect the liability related to the claims.

      Our actuaries, in conjunction with our claims personnel, estimate the amount of our incurred but not reported reserves, which include an estimate for losses that have occurred but have not been actually reported to us, as well as an estimate of potential development in outstanding claim reserves. When there is the possibility that information related to reserves may be reported late or where there is the possibility that claims may take a long time to develop, our actuaries’ estimates are based on our historical trends in paid and incurred losses or, if we do not have enough history, on industry trends and factors. These estimates take into consideration that claims or information related to outstanding claims can be reported late or be slow in developing. This may be especially true with respect to: 1) assumed reinsurance because it takes an extended time for cedants to gather and report information, 2) excess of loss reinsurance because it may be an extended period of time before claims increase and affect the excess layers, and 3) certain insolvent cedants because their claims are being administered by state authorities or guarantee associations and they may be slow reporting the claim.

      Our actuaries utilize standard actuarial techniques in making their reserve determinations. These techniques may require a high degree of judgment. Reserves are estimates, and changed conditions can cause changes in the estimates. However, we believe that our review process is effective, such that any required changes are recognized in the period of change as soon as the need for the change is evident. Reinsurance recoverables offset our gross reserves based upon the contractual terms of our reinsurance agreements.

      With the exception of 2004 when we had negative development principally in the reserves related to our discontinued line of business, our net reserves have historically shown positive development except for the effects of losses on commutations that we have completed in the past and may negotiate in the future. Commutations can produce negative prior year development since, for generally accepted accounting principles purposes, any excess of undiscounted reserves assumed over assets received must be recorded as a loss upon commutation. However, economically, the loss generally represents the time value of money discount that will be earned over the payout of the undiscounted reserves; thus, the loss may be recouped as investment income is earned on the assets. Based on our reserving techniques, we believe that there will not be any material negative development in our December 31, 2004 consolidated net reserves.

      The reserving process is intended to reflect the impact of inflation and other factors affecting loss payments by taking into account changes in historical payment patterns and perceived trends. However, there is no precise method for the subsequent evaluation of the adequacy of the consideration given to inflation, or to any other specific factor, or to the way one factor may impact another.

      We underwrite, directly and through reinsurance, risks which are denominated in a number of foreign currencies and, therefore, maintain loss reserves with respect to these policies in the respective currencies. These reserves are subject to exchange rate fluctuations, which may have an effect on our net earnings.

      The loss development triangles below show changes in our reserves in subsequent years from the prior loss estimates, based on experience at the end of each succeeding year, on the basis of generally accepted accounting principles. The estimate is increased or decreased as more information becomes known about the frequency and severity of losses for individual years. A redundancy means the original estimate was higher than the current estimate; a deficiency means that the current estimate is higher than the original estimate.

      The first line of each loss development triangle presents, for the years indicated, our gross or net reserve liability including the reserve for incurred but not reported losses. The first section of each table shows, by year, the cumulative amounts of loss and loss adjustment expense paid at the end of each succeeding year. The second section sets forth the re-estimates in later years of incurred losses, including payments, for the years indicated. The “cumulative redundancy (deficiency)” represents, at the date indicated, the difference between the latest re-estimated liability and the reserves as originally estimated.

      This loss development triangle shows development in loss reserves on a gross basis (in thousands):

      The gross deficiencies reflected in the above table for years after 1998 resulted from the following:

      We incurred net losses of $27.3 million related to gross loss development during 2004. As the losses related to the other years were substantially reinsured, they caused no material effect on our net earnings.

      The gross reserves in the discontinued line of business, particularly with respect to accident and health reinsurance, have shown substantial negative development in the last few years. This business is primarily excess of loss reinsurance or reinsurance which is characterized by late reporting losses and losses that tend to develop and affect excess covers in later years. Additionally, certain primary writers of the other reinsurance that is developing negatively have experienced financial difficulty and certain of them are in liquidation, with guaranty funds now responsible for administering the business. Losses related to this business are historically late reporting. While we attempt to anticipate these conditions in setting our gross reserves, we have only been partially successful to date, and there could be additional negative development in these reserves in the future. The gross losses that have developed negatively have been substantially reinsured and have been reported to our reinsurance companies as they are reported to us. Our reinsurers are thus aware of the losses and are honoring their reinsurance obligations at this time.

      The gross deficiencies reflected in the table for the years prior to 1999 result from three principal conditions:

      The following table provides a reconciliation of the gross liability for loss and loss adjustment expense payable on the basis of generally accepted accounting principles (in thousands):

      This loss development triangle shows development in loss reserves on a net basis (in thousands):

      During 2004 and 2003, we had net loss and loss adjustment expense deficiencies of $30.5 million and $23.8 million, respectively, relating to prior year losses, compared to a redundancy of $6.8 million in 2002. In 2004, as a result of adverse development in certain assumed accident and health business in our discontinued line of business, we strengthened our reserves on this line to bring them above our actuarial point estimate. The 2004 deficiency resulted primarily from losses and reserve strengthening of $27.3 million related to the assumed accident and health business, which primarily affected the 2001 accident year. The 2003 deficiency resulted from a commutation charge of $28.8 million which primarily affected the 2000 and 1999 accident years, partially offset by a net redundancy of $5.0 million from all other sources. The 2002 redundancy resulted from a deficiency of $7.7 million due to a third quarter charge related to certain business included in discontinued lines, offset by a net redundancy of $14.5 million from all other sources. Deficiencies and redundancies in the reserves occur as we continually review our loss reserves with our actuaries, increasing or reducing loss reserves as a result of such reviews and as losses are finally settled and claims exposures are reduced. We believe we have provided for all material net incurred losses.

      This table below provides a reconciliation of the liability for loss and loss adjustment expense payable, net of reinsurance ceded, on the basis of generally accepted accounting principles (in thousands):

      We have no material exposure to environmental pollution losses because Houston Casualty Company only began writing business in 1981 and its policies normally contain pollution exclusion clauses which limit pollution coverage to “sudden and accidental” losses only, thus excluding intentional (dumping) and seepage claims. Policies issued by our other insurance company subsidiaries do not have significant environmental exposures. Therefore, because of the types of risks covered, we do not expect to experience any material loss development for environmental pollution claims. Likewise, we have no material exposure to asbestos claims.

Investments

      Insurance company investments must comply with applicable regulations which prescribe the type, quality and concentration of investments. These regulations permit investments, within specified limits and

subject to certain qualifications, in federal, state and municipal obligations, corporate bonds and preferred and common equity securities. At December 31, 2004, we had $2.5 billion of investment assets. The majority of our investment assets are held by our insurance companies. All of our fixed income securities are classified as available for sale and are recorded at market value.

      Our investment policy is determined by our Board of Directors and our Investment Committee and is reviewed on a regular basis. We engage a nationally prominent investment advisor, General Re-New England Asset Management, a subsidiary of Berkshire Hathaway, Inc., to oversee our investments and to make recommendations. Although we generally intend to hold fixed income securities to maturity, we regularly re-evaluate our position based on market conditions. At December 31, 2004, our fixed income securities had a weighted average maturity of 6.6 years and a weighted average duration of 4.6 years. Our financial statements reflect an unrealized gain of $20.8 million on fixed income securities available for sale at December 31, 2004.

      We have maintained a substantial level of cash and liquid short-term instruments in our insurance companies in order to maintain the ability to fund losses of our insureds. Our underwriting agencies and reinsurance brokers typically have short-term investments, which are fiduciary funds held on behalf of others. At December 31, 2004, we had cash and short-term investments of $799.9 million, of which $332.3 million was in our underwriting agencies and reinsurance brokers.

      This table shows a profile of our investments, excluding trading securities. The table shows the average amount of investments, income earned and the yield thereon (dollars in thousands):

      This table summarizes the estimated market value of our investments by type at December 31, 2004 (dollars in thousands):

      This table summarizes, by rating, the market value of our investments in fixed income securities at December 31, 2004 (dollars in thousands):

      The table below indicates the expected maturity distribution of the estimated market value of our fixed income securities at December 31, 2004 (dollars in thousands):

      The weighted average life of our asset-backed and mortgage-backed securities is 3.2 years. The value of our portfolio of fixed income securities is inversely correlated to changes in market interest rates. In addition, some of our fixed income securities have call or prepayment options. This could subject us to a reinvestment risk should interest rates fall or issuers call their securities and we are forced to invest the proceeds at lower interest rates. We mitigate this risk by investing in securities with varied maturity dates, so that only a portion of the portfolio will mature at any point in time. Some of our asset-backed securities are subject to re-evaluation and additional specialized impairment tests. Under this guidance, these securities have to be written down in value if certain tests are met. Any write down is recouped prospectively through net investment income, if contractual cash flows are ultimately received. The total amount of securities held by us at December 31, 2004 that would be subject to these tests and potential write downs is $0.7 million.

Regulation

      The business of insurance is extensively regulated by the government. At this time, the insurance business in the United States is regulated primarily by the individual states. A form of federal financial services modernization legislation enacted in 1999 has long been expected to result in additional federal regulation of the insurance industry. However, a framework of federal regulatory oversight has not been implemented to date. In addition, some insurance industry trade groups are actively lobbying for legislation that would allow an option for a separate federal charter for insurance companies. The full extent to which the federal government will decide to directly regulate the business of insurance has not been determined by lawmakers. Also, various foreign governments regulate our international operations.

      Our business depends on our compliance with applicable laws and regulations and our ability to maintain valid licenses and approvals for our operations. We devote a significant effort toward obtaining and maintaining our licenses and compliance with a diverse and complex regulatory structure. In all jurisdictions, the applicable laws and regulations are subject to amendment or interpretation by regulatory authorities. Generally, regulatory authorities are vested with broad discretion to grant, renew and revoke

licenses and approvals and to implement regulations governing the business and operations of insurers and insurance agents.

      Our insurance companies, in common with other insurers, are subject to regulation and supervision by the states and by other jurisdictions in which they do business. Regulation by the states varies, but generally involves regulatory and supervisory powers of a state insurance official. The regulation and supervision of our insurance operations relates primarily to:

      In the United States, state insurance regulations are intended primarily for the protection of policyholders rather than shareholders. The state insurance departments monitor compliance with regulations through periodic reporting procedures and examinations. The quarterly and annual financial reports to the state insurance regulators utilize accounting principles that are different from the generally accepted accounting principles we use in our reports to shareholders. Statutory accounting principles, in keeping with the intent to assure the protection of policyholders, are generally based on a liquidation concept, while generally accepted accounting principles are based on a going-concern concept.

      Houston Casualty Company is domiciled in Texas. It operates on an admitted basis in Texas and may write reinsurance on all lines of business that it may write on a direct basis. Houston Casualty Company is an accredited reinsurer in 40 states and an approved surplus lines insurer or is otherwise permitted to write surplus lines insurance in 48 states, three U.S. territories and the District of Columbia. When a reinsurer obtains accreditation from a particular state, insurers within that state are permitted to obtain statutory credit for risks ceded to the reinsurer. Surplus lines insurance is offered by non-admitted companies on risks that are not insured by admitted companies. All surplus lines insurance is required to be written through licensed surplus lines insurance brokers, who are required to be knowledgeable of and follow specific state laws prior to placing a risk with a surplus lines insurer.

      Houston Casualty Company’s branch office in London, England is subject to regulation by regulatory authorities in the United Kingdom. Avemco Insurance Company is domiciled in Maryland and operates as a licensed admitted insurer in all states and the District of Columbia. U.S. Specialty Insurance Company is domiciled in Texas and operates as a licensed admitted insurer in all states and the District of Columbia. HCC Life Insurance Company is domiciled in Indiana and operates as a licensed admitted insurer in 42 states and the District of Columbia. HCC Specialty Insurance Company is domiciled in Oklahoma and operates on a surplus lines basis in Texas. American Contractors Indemnity Company is

domiciled in California and operates on an admitted basis in 45 states, the District of Columbia and two U.S. territories. HCC Europe is domiciled in Spain and operates on the equivalent of an “admitted” basis throughout the European Union. United States Surety Company is domiciled in Maryland and operates on an admitted basis in eleven states and the District of Columbia.

      State insurance regulations also affect the payment of dividends and other distributions by insurance companies to their shareholders. Generally, insurance companies are limited by these regulations to the payment of dividends above a specified level. Dividends in excess of those thresholds are “extraordinary dividends” and subject to prior regulatory approval.

      In addition to the regulation of insurance companies, the states impose licensing and other requirements on the insurance agency and service operations of our other subsidiaries. These regulations relate primarily to:

      The manner of operating our underwriting agency and reinsurance and insurance broker activities in particular states may vary according to the licensing requirements of the particular state, which may require, among other things, that we operate in the state through a local corporation. In a few states, licenses are issued only to individual residents or locally-owned business entities. In such cases, we may have arrangements with residents or business entities licensed to act in the state. The majority of states, however, have recently enacted legislation in response to the Federal Gramm-Leach-Bliley Act that streamlines and makes more uniform the licensing requirements.

      The principal differences between statutory accounting principles and generally accepted accounting principles, the method by which we report our financial results to our shareholders, are:

      Because we are an insurance holding company, we are subject to the insurance holding company system regulatory requirements of a number of states. Under these regulations, we are required to report information regarding our capital structure, financial condition and management. We are also required to provide prior notice to, or seek the prior approval of insurance regulatory authorities of certain agreements and transactions between our affiliated companies. These agreements and transactions must satisfy certain regulatory requirements.

      The National Association of Insurance Commissioners has developed a formula for analyzing insurance companies called risk-based capital. The risk-based capital formula is intended to establish minimum capital thresholds that vary with the size and mix of a company’s business and assets. It is designed to identify companies with capital levels that may require regulatory attention. At December 31, 2004, each of our domestic insurance companies’ total adjusted capital was significantly in excess of the authorized control level risk-based capital.

      The National Association of Insurance Commissioners has developed a rating system, the Insurance Regulatory Information System, primarily intended to assist state insurance departments in overseeing the financial condition of all insurance companies operating within their respective states. The Insurance Regulatory Information System consists of eleven key financial ratios that address various aspects of each insurer’s financial condition and stability. Our insurance companies’ Insurance Regulatory Information System ratios generally fall within the usual prescribed ranges.

      The Federal Terrorism Risk Insurance Act of 2002 was enacted for the purpose of ensuring the availability of insurance coverage for terrorist acts in the United States. The law establishes a financial “backstop” program through the end of 2005 to assist the commercial property and casualty insurance industry in providing coverage related to future acts of terrorism within the United States. It is unknown at this time whether or not the Act will be extended beyond December 31, 2005 or on what terms. If it is not renewed, our current policies allow us to cancel the terrorism coverage in force at that time and we will no longer be required to offer the coverage.

      Under the Act, we are required to offer terrorism coverage to our commercial policyholders in certain lines of business written in the United States, for which we may, when warranted, charge an additional premium. The policyholders may or may not accept such coverage. This law also established a deductible that each insurer would have to meet before U.S. Federal reimbursement would occur. For 2005, our deductible is approximately $93.7 million. Thereafter, the Federal government would provide reimbursement for 90% of our covered losses up to the maximum amount set out in the Act.

      In recent years, state legislatures have considered or enacted laws that modify and, in many cases, increase state authority to regulate insurance companies and insurance holding company systems. State insurance regulators are members of the National Association of Insurance Commissioners, which seeks to promote uniformity of and to enhance the state regulation of insurance. In addition, the National Association of Insurance Commissioners and state insurance regulators, as part of the National Association of Insurance Commissioners’ state insurance department accreditation program and in response to new federal laws, have re-examined existing state laws and regulations, specifically focusing on insurance company investments, issues relating to the solvency of insurance companies, licensing and market conduct issues, streamlining agent licensing and policy form approvals, adoption of privacy rules for handling

policyholder information, interpretations of existing laws, the development of new laws and the definition of extraordinary dividends.

      In recent years, a variety of measures have been proposed at the federal level to reform the current process of federal and state regulation of the financial services industries in the United States, which include the banking, insurance and securities industries. These measures, which are often referred to as financial services modernization, have as a principal objective the elimination or modification of regulatory barriers to cross-industry combinations involving banks, securities firms and insurance companies. A form of financial services modernization legislation was enacted at the federal level in 1999 through the Gramm-Leach-Bliley Act. That federal legislation was expected to have significant implications on the banking, insurance and securities industries and to result in more cross-industry consolidations among banks, insurance companies and securities firms and increased competition in many of the areas of operations. Such wide-spread cross-industry consolidation has not occurred to date. It also mandated the adoption of laws allowing reciprocity among the states in the licensing of agents and, along with other federal laws, mandated the adoption of laws and regulations dealing with the protection of the privacy of policyholder information. Also, the federal government has conducted investigations of the current condition of the insurance industry in the United States to determine whether to impose overall federal regulation of insurers. If so, we believe state regulation of the insurance business would likely continue. This could result in an additional layer of federal regulation.

      Recently, state regulators in many states have initiated or are participating in industry-wide investigations of sales and marketing practices in the insurance industry. Such investigations have resulted in restitution and settlement payments by some companies and criminal charges against some individuals. The investigations are expected to lead to changes in the structure of compensation arrangements, the offering of certain products and increased transparency in the marketing of many insurance products. We intend to cooperate fully with such investigations and, based on presently available information, do not expect any adverse results from such investigations.