UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

		for the Quarterly Period Ended September 30, 2009.

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

Yes o No o

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

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

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

Yes o No þ

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

On October 31, 2009, there were approximately 112.5 million shares of common stock outstanding.

 

 

HCC INSURANCE HOLDINGS, INC.

TABLE OF CONTENTS

		Page
Part I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets — September 30, 2009 and December 31, 2008 (as adjusted) (unaudited)			5
Condensed Consolidated Statements of Earnings — Nine months and three months ended September 30, 2009 and 2008 (as adjusted) (unaudited)			6
Condensed Consolidated Statement of Changes in Shareholders’ Equity — Nine months ended September 30, 2009 (unaudited)			7
Condensed Consolidated Statements of Cash Flows — Nine months ended September 30, 2009 and 2008 (as adjusted) (unaudited)			8
Notes to Condensed Consolidated Financial Statements (unaudited)			9
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			27
Item 3. Quantitative and Qualitative Disclosures About Market Risk			46
Item 4. Controls and Procedures			46
Part II. OTHER INFORMATION
Item 1. Legal Proceedings			47
Item 1A. Risk Factors			47
Item 6. Exhibits			47
Signatures			48
EX-12
EX-31.1
EX-31.2
EX-32.1

FORWARD-LOOKING STATEMENTS

This report on Form 10-Q contains certain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are intended to be covered by the safe harbors created by those laws. 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 growth of our business and operations, business strategy, competitive strengths, goals, plans, future capital expenditures and references to future successes may be considered forward-looking statements. 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 have an impact on the matters addressed in these forward-looking statements, which could affect our future financial results and performance, including, among other things:

•

the effects of catastrophic losses,

•

the cyclical nature of the insurance business,

•

inherent uncertainties in the loss estimation process, which can adversely impact the adequacy of loss reserves,

•

the effects of emerging claim and coverage issues,

•

the effects of extensive governmental regulation of the insurance industry,

•

potential credit risk with brokers,

•

our assessment of underwriting risk,

•

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

•

the adequacy of reinsurance protection,

•

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

•

the occurrence of terrorist activities,

•

our ability to maintain our competitive position,

•

changes in our assigned financial strength ratings,

•

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

•

attraction and retention of qualified employees,

•

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

•

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

•

impairment of goodwill,

•

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

•

fluctuations in foreign exchange rates,

	•		failures of our information technology systems,
	•		potential changes in the country’s health care delivery system, and

•

change of control.

We describe these risks and uncertainties in greater detail in Item 1A, Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2008.

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 that are included in this report, our inclusion of this information is not a representation by us or any other person that our objectives or plans will be achieved.

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

HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

(unaudited, in thousands except per share data)

		September 30,				December 31,
		2009				2008
						(as adjusted)
ASSETS
Investments:
Fixed income securities – available for sale, at fair value (amortized cost: 2009 – $4,575,847; 2008 – $4,118,539)		$	4,784,343			$	4,133,165
Fixed income securities – held to maturity, at amortized cost (fair value: 2009 – $104,077; 2008 – $125,561)			103,286				123,553
Short-term investments, at cost, which approximates fair value			559,907				497,477
Other investments			4,691				50,088
Total investments			5,452,227				4,804,283
Cash			56,874				27,347
Restricted cash and cash investments			183,769				174,905
Premium, claims and other receivables			602,957				770,823
Reinsurance recoverables			1,046,548				1,054,950
Ceded unearned premium			261,346				234,375
Ceded life and annuity benefits			62,645				64,235
Deferred policy acquisition costs			203,031				188,652
Goodwill			824,658				858,849
Other assets			141,287				153,581
Assets held for sale			205,684				—
Total assets		$	9,041,026			$	8,332,000
LIABILITIES
Loss and loss adjustment expense payable		$	3,529,217			$	3,415,230
Life and annuity policy benefits			62,645				64,235
Reinsurance balances payable			147,313				122,189
Unearned premium			1,035,476				977,426
Deferred ceding commissions			69,553				63,123
Premium and claims payable			190,347				405,287
Notes payable			444,682				343,649
Accounts payable and accrued liabilities			409,474				300,838
Liabilities related to assets held for sale			164,898				—
Total liabilities			6,053,605				5,691,977
SHAREHOLDERS’ EQUITY
Common stock, $1.00 par value; 250.0 million shares authorized (shares issued: 2009 – 117,216 and 2008 – 116,457; outstanding: 2009 – 112,543 and 2008 – 113,444)			117,216				116,457
Additional paid-in capital			902,917				881,534
Retained earnings			1,907,923				1,677,831
Accumulated other comprehensive income			158,164				27,536
Treasury stock, at cost (shares: 2009 – 4,673 and 2008 – 3,013)			(98,799	)			(63,335	)
Total shareholders’ equity			2,987,421				2,640,023
Total liabilities and shareholders’ equity		$	9,041,026			$	8,332,000

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)

		Nine months ended September 30,								Three months ended September 30,
		2009				2008				2009				2008
						(as adjusted)								(as adjusted)
REVENUE
Net earned premium		$	1,524,425			$	1,505,128			$	520,059			$	504,972
Fee and commission income			88,113				99,558				31,687				37,795
Net investment income			141,740				130,832				48,111				35,962
Other operating income			29,824				10,829				1,405				4,828
Net realized investment gain (loss)			4,852				(12,761	)			864				(12,808	)
Other-than-temporary impairment loss:
Total loss			(6,089	)			(6,029	)			(380	)			(4,430	)
Portion recognized in other comprehensive income			810				—				55				—
Net loss recognized in earnings			(5,279	)			(6,029	)			(325	)			(4,430	)
Total revenue			1,783,675				1,727,557				601,801				566,319
EXPENSE
Loss and loss adjustment expense, net			911,944				920,433				303,808				324,506
Policy acquisition costs, net			271,358				284,695				92,418				96,582
Other operating expense			195,509				174,420				64,985				57,702
Interest expense			11,816				14,547				3,549				4,768
Total expense			1,390,627				1,394,095				464,760				483,558
Earnings before income tax expense			393,048				333,462				137,041				82,761
Income tax expense			123,972				102,941				42,720				24,370
Net earnings		$	269,076			$	230,521			$	94,321			$	58,391
Net earnings per common share:
Basic		$	2.39			$	2.00			$	0.84			$	0.51
Diluted		$	2.37			$	1.99			$	0.83			$	0.50

See Notes to Condensed Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Statement of Changes in Shareholders’ Equity

(unaudited, in thousands except per share data)

														Accumulated
						Additional								other								Total
		Common				paid-in				Retained				comprehensive				Treasury				shareholders’
		stock				capital				earnings				income				stock				equity
Balance at December 31, 2008 (as previously reported)		$	116,457			$	861,867			$	1,696,816			$	27,536			$	(63,335	)		$	2,639,341
Cumulative effect of accounting change (convertible debt)			—				19,667				(18,985	)			—				—				682
Balance at December 31, 2008 (as adjusted)			116,457				881,534				1,677,831				27,536				(63,335	)			2,640,023
Cumulative effect of accounting change (other-than-temporary impairments in investments)			—				—				4,301				(4,301	)			—				—
Comprehensive income:
Net earnings			—				—				269,076				—				—				269,076
Other comprehensive income:
Change in unrealized gain (loss) on investments, net of tax			—				—				—				125,604				—				125,604
Other-than-temporary impairment loss, net of tax			—				—				—				(527	)			—				(527	)
Other, net of tax			—				—				—				9,852				—				9,852
Total other comprehensive income																							134,929
Comprehensive income																							404,005
Issuance of 528 shares for exercise of options, including tax effect			528				8,895				—				—				—				9,423
Purchase of 1,660 common shares			—				—				—				—				(35,464	)			(35,464	)
Stock-based compensation			231				12,488				—				—				—				12,719
Cash dividends declared, $0.385 per share			—				—				(43,285	)			—				—				(43,285	)
Balance at September 30, 2009		$	117,216			$	902,917			$	1,907,923			$	158,164			$	(98,799	)		$	2,987,421

See Notes to Condensed Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(unaudited, in thousands)

		Nine months ended September 30,
		2009				2008
						(as adjusted)
Operating activities:
Net earnings		$	269,076			$	230,521
Adjustments to reconcile net earnings to net cash provided by operating activities:
Change in premium, claims and other receivables			36,443				22,705
Change in reinsurance recoverables			14,853				(119,825	)
Change in ceded unearned premium			(25,093	)			6,121
Change in loss and loss adjustment expense payable			51,519				278,156
Change in reinsurance balances payable			24,548				(4,344	)
Change in unearned premium			39,441				41,162
Change in premium and claims payable, net of restricted cash			(63,727	)			(105,135	)
Change in accounts payable and accrued liabilities			22,132				(49,446	)
Change in trading securities			—				49,091
Stock-based compensation expense			12,472				9,990
Depreciation and amortization expense			11,796				10,436
(Gain) loss on investments			(3,152	)			26,367
Other, net			27,238				5,376
Cash provided by operating activities			417,546				401,175
Investing activities:
Sales of available for sale fixed income securities			337,615				421,677
Maturity or call of available for sale fixed income securities			260,839				255,439
Maturity or call of held to maturity fixed income securities			86,190				—
Cost of available for sale fixed income securities acquired			(1,020,506	)			(1,088,234	)
Cost of held to maturity fixed income securities acquired			(59,677	)			—
Cost of other investments acquired			—				(36,735	)
Change in short-term investments			(91,617	)			33,665
Proceeds from sales of strategic and other investments			114,940				54,355
Payments for purchase of businesses, net of cash received			(37,995	)			(73,996	)
Proceeds from sale of assets of business			6,188				—
Other, net			(13,109	)			(3,203	)
Cash used by investing activities			(417,132	)			(437,032	)
Financing activities:
Advances on line of credit			115,000				106,000
Payments on line of credit and notes payable			(15,032	)			(56,000	)
Sale of common stock			9,423				13,884
Purchase of common stock			(35,464	)			(21,870	)
Dividends paid			(42,244	)			(38,061	)
Other, net			(2,570	)			13,013
Cash provided by financing activities			29,113				16,966
Net increase (decrease) in cash			29,527				(18,891	)
Cash at beginning of period			27,347				39,135
Cash at end of period		$	56,874			$	20,244

See Notes to Condensed Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

(1)

General Information

HCC Insurance Holdings, Inc. and its subsidiaries (collectively, we, us or our) include domestic and foreign property and casualty and life insurance companies and underwriting agencies. We provide specialized property and casualty, surety, and group life, accident and health insurance coverages and related agency services to commercial customers and individuals. We market our products both directly to customers and through a network of independent brokers, producers, agents and third party administrators. Our lines of business include diversified financial products (which includes directors’ and officers’ liability, errors and omissions liability (known as professional indemnity outside the U.S.), employment practices liability, surety, credit, and fidelity coverages); group life, accident and health (which includes medical stop-loss, short-term medical, occupational accident, and other coverages); aviation; our London market account (which includes energy, property, marine, and accident and health coverages); and other specialty lines of insurance (which includes public entity, U.K. liability, event cancellation, contingency, and other coverages). We operate primarily in the United States, the United Kingdom, Spain and Ireland, although some of our operations have a broader international scope.

Basis of Presentation

Our unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (U.S. GAAP) and include the accounts of HCC Insurance Holdings, Inc. and its subsidiaries. We have made all adjustments that, in our opinion, are necessary for a fair statement of results of the interim periods, and all such adjustments are of a normal recurring nature. All significant intercompany balances and transactions have been eliminated in consolidation. The condensed consolidated financial statements should be read in conjunction with our annual audited consolidated financial statements and related notes. The condensed consolidated balance sheet at December 31, 2008 (as adjusted) was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles.

Management must make estimates and assumptions that affect amounts reported in our condensed consolidated financial statements and in disclosures of contingent assets and liabilities. Ultimate results could differ from those estimates. We have reclassified certain amounts in our 2008 condensed consolidated financial statements to conform to the 2009 presentation. None of our reclassifications had an effect on our consolidated net earnings, shareholders’ equity or cash flows. Certain 2008 amounts have been adjusted to reflect our adoption of the new convertible debt and earnings per share accounting standards as of January 1, 2009. See the “Accounting Guidance Adopted in 2009” section below for additional information.

We have evaluated subsequent events through November 5, 2009, which is the date these financial statements were issued.

Accounting Guidance Adopted in 2009

Codification

Effective July 1, 2009, the Accounting Standards Codification (ASC or the Codification) issued by the Financial Accounting Standards Board (FASB) became the single authoritative source of U.S. GAAP. Rules and interpretive releases issued by the Securities and Exchange Commission (SEC) are the only other source of U.S. GAAP for SEC registrants. Although the Codification renames and renumbers all previous accounting literature, it does not change current U.S. GAAP. Our accounting policies were not affected by our adoption and usage of the Codification.

Convertible Debt

A new accounting standard, originally issued as FSP APB 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement), became effective January 1, 2009, required retrospective application to prior financial statements and did not permit early adoption. This change to ASC Topic 470, Debt, clarifies that convertible debt instruments that may be settled in cash upon conversion are not totally debt, and requires issuers to bifurcate and separately account for the liability and equity components. In our condensed consolidated financial statements, we bifurcated the debt and equity components of our 1.30% Convertible Notes and 2.00% Convertible Notes and retrospectively adjusted our consolidated financial statements for all periods prior to 2009. The effective interest rate on our 1.30% and 2.00% Convertible Notes increased to 4.80% and 3.86%, respectively, which resulted in the recognition of a $22.6 million and $8.3 million discount, respectively, with the offsetting after-tax impact recorded in additional paid-in capital.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

The following line items in our 2008 condensed consolidated financial statements were affected by this change in accounting principle:

		Nine months ended September 30, 2008												Three months ended September 30, 2008
		As originally												As originally
		reported				As adjusted				Change				reported				As adjusted				Change
Interest expense		$	11,517			$	14,547			$	3,030			$	3,750			$	4,768			$	1,018
Earnings before income tax expense			336,492				333,462				(3,030	)			83,779				82,761				(1,018	)
Income tax expense			104,001				102,941				(1,060	)			24,726				24,370				(356	)
Net earnings			232,491				230,521				(1,970	)			59,053				58,391				(662	)
Diluted earnings per share		$	2.01			$	1.99			$	(0.02	)		$	0.51			$	0.50			$	(0.01	)
														December 31, 2008
														As originally
														reported				As adjusted				Change
Other assets (debt issuance costs and deferred tax asset)														$	153,964			$	153,581			$	(383	)
Notes payable															344,714				343,649				(1,065	)
Additional paid-in capital															861,867				881,534				19,667
Retained earnings															1,696,816				1,677,831				(18,985	)
Total shareholders’ equity															2,639,341				2,640,023				682

The reduction in retained earnings and the increase in additional paid-in capital resulted from amortization of the implied discount as interest expense through the first contractual put date of the 2.00% Convertible Notes at September 1, 2007 and the 1.30% Convertible Notes at April 1, 2009. The 2.00% Convertible Notes were submitted for conversion during September and October 2007. The implied discount on the 1.30% Convertible Notes was fully amortized in the first quarter of 2009. At September 30, 2009, there was no remaining equity component and the liability component was $124.7 million. At December 31, 2008, the 1.30% Convertible Notes had an equity component of $1.1 million and a liability component of $123.6 million, consisting of a principal amount of $124.7 million less a discount of $1.1 million. The effective interest rate on our 1.30% Convertible Notes was 2.47% for the nine months ended September 30, 2009 and 4.80% for the nine months ended September 30, 2008. The contractual interest expense was $1.2 million in the first nine months of 2009 and 2008. Interest expense resulting from amortization of the implied discount was $1.1 million and $3.0 million in the nine months ended September 30, 2009 and 2008, respectively. Our adoption of this guidance did not impact our past or current consolidated cash flows.

Fair Value Measurements

A new accounting standard, originally issued as FSP FAS 157-2, Effective Date of FASB Statement No. 157, became effective January 1, 2009. This guidance requires prospective application of ASC Topic 820, Fair Value Measurement and Disclosure, to nonfinancial assets and nonfinancial liabilities measured at fair value on a nonrecurring basis, such as goodwill. Our adoption of this revised guidance had no impact on our condensed consolidated financial statements.

New accounting standards, originally issued as FSP FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions that Are Not Orderly; FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments; and FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments, became effective prospectively on April 1, 2009. These changes to ASC Topic 820, Fair Value Measurements and Disclosures, and ASC Topic 320, Investments – Debt and Equity Securities, modify the accounting guidance for determining fair value of financial instruments under distressed market conditions, revise the recognition and measurement requirements for other-than-temporary impairment losses on debt securities and expand the related disclosures. Our adoption of this guidance did not have a material effect on our 2009 condensed consolidated financial statements. See Note 3 for additional discussion of these changes.

Earnings per Share

A new accounting standard, originally issued as FSP EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions are Participating Securities, became effective January 1, 2009 and required retrospective application to prior periods. This change to ASC Topic 260, Earnings Per Share, clarifies whether instruments granted in share-based payments, such as restricted stock, are participating securities prior to vesting and, therefore, must be included in the earnings allocation in

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

calculating earnings per share under the two-class method described in ASC Topic 260-10-45-59A, Participating Securities and the Two-Class Method. As revised, ASC Topic 260 requires that unvested share-based payments that contain non-forfeitable rights to dividends or dividend-equivalents are treated as participating securities. Our adoption of this guidance had no material impact on our consolidated earnings per share in any prior period due to immateriality of our restricted stock awards that have such terms.

Subsequent Events

A new accounting standard, originally issued as SFAS No. 165, Subsequent Events, provides guidance to account for and disclose events that occur after the balance sheet date but before financial statements are issued or available to be issued. We adopted this change to ASC Topic 855, Subsequent Events, as of June 30, 2009 and included the required disclosures in our condensed consolidated financial statements.

Business Combinations

A new accounting standard, originally issued as SFAS No. 141 (revised 2007), Business Combinations, became effective January 1, 2009. This change to ASC Topic 805, Business Combinations, modifies certain accounting treatment for business combinations and impacts presentation of financial statements on the acquisition date and accounting for acquisitions in subsequent periods. Since January 1, 2009, we have recorded all new acquisitions in accordance with this guidance.

Consolidation

A new accounting standard, originally issued as SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment of Accounting Research Bulletin No. 51, became effective January 1, 2009. This change to ASC Topic 810, Consolidation, modifies the accounting and reporting for minority interests, which are now recharacterized as noncontrolling interests and classified as a component of shareholders’ equity. Our adoption of this guidance had no impact on our condensed consolidated financial statements.

Derivatives

A new accounting standard, originally issued as SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133, became effective January 1, 2009. This change to ASC Topic 815, Derivatives and Hedging, expands the required disclosures about a company’s derivative and hedging activities. Our adoption had no impact on our condensed consolidated financial statements.

Recent Accounting Guidance

A new accounting standard, originally issued as SFAS No. 167, Amendments to FASB Interpretation No. 46(R), was issued in June 2009. The guidance, which will be incorporated into ASC Topic 810, Consolidation, changes various aspects of accounting for and disclosures of interests in variable interest entities. We will adopt the guidance effective January 1, 2010. We do not expect our adoption to have a material impact on our consolidated financial statements.

Net Earned Premium, Policy Acquisition Costs and Ceding Commissions

Substantially all of the property and casualty, surety, and accident and health policies written by our insurance companies qualify as short-duration contracts. We recognize in current earned income the portion of the premium that provides insurance protection in the period. For the majority of our insurance policies, we recognize premium, net of reinsurance, on a pro rata basis over the term of the related contract. For certain directors’ and officers’ liability tail policies, surety bonds and energy construction contracts, we recognize premium, net of reinsurance, over the period of risk in proportion to the amount of insurance protection provided. Unearned premium represents the portion of premium written that relates to the unexpired term of coverage. Premium for commercial title insurance and group life policies is recognized in earnings when the premium is due. When the limit under a specific excess of loss reinsurance layer has been exhausted, we effectively expense the remaining premium for that limit and defer and amortize the reinstatement premium over the remaining period of risk.

Income Tax

For the nine months ended September 30, 2009 and 2008, the income tax provision was calculated based on an estimated effective tax rate for each fiscal year. Our effective tax rate differs from the United States Federal statutory rate primarily due to tax-exempt municipal bond interest.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

Notes Payable

Notes payable at September 30, 2009 and December 31, 2008 are shown in the table below. The estimated fair value of our Convertible Notes ($156.8 million at September 30, 2009 and $149.8 million at December 31, 2008) is based on quoted market prices. The estimated fair value of our Revolving Loan Facility is based on current borrowing rates offered to us and approximates the carrying value at both balance sheet dates.

		September 30,				December 31,
		2009				2008
1.30% Convertible Notes		$	124,682			$	123,649
$575.0 million Revolving Loan Facility			320,000				220,000
Total notes payable		$	444,682			$	343,649

Our 1.30% Convertible Notes are due in 2023. We pay interest semi-annually on April 1 and October 1. Each one thousand dollar principal amount of notes is convertible into 44.1501 shares of our common stock, which represents an initial conversion price of $22.65 per share. The initial conversion price is subject to standard anti-dilution provisions designed to maintain the value of the conversion option in the event we take certain actions with respect to our common stock, such as stock splits, reverse stock splits, stock dividends and extraordinary dividends, that affect all of the holders of our common stock equally and that could have a dilutive effect on the value of the conversion rights of the holders of the notes or that confer a benefit upon our current shareholders not otherwise available to the 1.30% Convertible Notes. Holders may surrender notes for conversion if, as of the last day of the preceding calendar quarter, the closing sale price of our common stock for at least 20 consecutive trading days during the period of 30 consecutive trading days ending on the last trading day of that quarter is more than 130% ($29.45 per share) of the conversion price per share of our common stock. This condition was not met at September 30, 2009. While the notes are not convertible during the fourth quarter of 2009, the convertible value of the notes, if converted, at September 30, 2009 was $150.6 million, which exceeds the principal amount by $25.9 million. We must settle any conversions by paying cash for the principal amount of the notes and issuing our common stock for the value of the conversion premium. We can redeem the notes at any time. If we announce our intent to redeem the notes, the notes will become immediately convertible, and the holders may surrender them for conversion, payable on the same terms as described above, at any time until two business days prior to the redemption date. Holders may require us to repurchase the notes on April 1, 2014 or 2019. The repurchase price to settle any such put by the holders will equal the principal amount of the notes plus accrued and unpaid interest and will be paid in cash.

Stock-Based Compensation

In the first nine months of 2009, we granted the following shares of common stock, restricted stock, restricted stock units and stock options for the purchase of shares of our common stock. The fair value of the common stock was expensed on the grant date. The fair value of the restricted stock, restricted stock units and stock options will be expensed over the vesting period.

						Weighted-average
		Number of				grant date				Aggregate				Vesting
		shares				fair value				fair value				period
Common stock			75			$	23.84			$	1,778				—
Restricted stock			160				23.98				3,846			3-4 years
Restricted stock units			21				23.90				509			4 years
Stock options			335				5.41				1,814			3-5 years

Acquisition, Dispositions and Assets Held for Sale

On February 27, 2009, we acquired Surety Company of the Pacific, which writes license and permit bonds for California contractors. We included the results of operations of the acquired company in our condensed consolidated financial statements beginning on March 1, 2009. We valued all identifiable assets and liabilities at fair value and allocated $5.6 million to goodwill. The goodwill is not deductible for United States Federal income tax purposes.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

On June 30, 2009, we sold the assets and licensed the intangibles related to our commercial marine agency business. We entered into a five-year managing general underwriter’s agreement that allows the purchaser to write that same business utilizing policies issued by one of our insurance companies. We reduced goodwill by $18.0 million, the amount assigned to this reporting unit, and recognized an immaterial gain on the transaction.

On October 3, 2009, we executed a contract to sell 100% of the stock of our reinsurance broker, Rattner Mackenzie Limited (RML), to an affiliate of Marsh & McLennan Companies, Inc. (MMC) for $42.5 million of MMC common stock. We also executed an agreement with MMC and its affiliates whereby our insurance companies and agencies will continue to utilize MMC and its affiliates to place certain of our reinsurance. The sale closed on October 8, 2009. At September 30, 2009, we recorded RML’s assets and liabilities at fair value less the costs to sell and recognized a loss on the transaction of $4.2 million, which was included in other operating income in our condensed consolidated statement of earnings for the third quarter of 2009. We also removed RML’s assets and liabilities from the separate lines in our condensed consolidated balance sheet at September 30, 2009 and reported the applicable items as assets held for sale or liabilities related to assets held for sale, as follows:

Assets:
Short-term investments		$	33,083
Premium, claims and other receivables			130,296
Goodwill			41,926
Other assets			379
Assets held for sale		$	205,684
Liabilities:
Premium and claims payable		$	160,447
Accounts payable and accrued liabilities			4,451
Liabilities related to assets held for sale		$	164,898

Goodwill

The above acquisition and dispositions impacted our goodwill in 2009. In addition, we transferred $21.9 million of goodwill from two reporting units in our agency segment to a reporting unit in our insurance company segment, based on a reorganization that created a permanent change in cash flows. The changes in goodwill were as follows:

		Insurance								Other
		Company				Agency				Operations				Total
Balance at December 31, 2008		$	646,527			$	211,999			$	323			$	858,849
Additions:
Acquisitions			7,356				804				—				8,160
Earnouts on prior acquisitions			15,265				2,478				—				17,743
Disposition			—				(18,048	)			—				(18,048	)
Classification as assets held for sale			—				(41,926	)			—				(41,926	)
Transfer and other			21,821				(21,941	)			—				(120	)
Balance at September 30, 2009		$	690,969			$	133,366			$	323			$	824,658

(2)

Fair Value

We value financial assets and financial liabilities at fair value. In determining fair value, we generally apply the market approach, which uses prices and other relevant data based on market transactions involving identical or comparable assets and liabilities. We classify our financial instruments into the following three-level hierarchy:

	•		Level 1 – Inputs are based on quoted prices in active markets for identical instruments.
	•		Level 2 – Inputs are based on observable market data (other than quoted prices), or are derived from or corroborated by observable market data.
	•		Level 3 – Inputs are unobservable and not corroborated by market data.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

Our Level 1 investments are primarily U.S. Treasuries, for which we use quoted prices for identical instruments to measure fair value.

Our Level 2 investments include most of our fixed income securities, which consist of U.S. government agency securities, municipal bonds, certain corporate debt securities, and certain mortgage-backed and asset-backed securities. Our Level 2 instruments also include our interest rate swap agreements, which were reflected as liabilities in our condensed consolidated balance sheet at September 30, 2009. We measure fair value for the majority of our Level 2 investments using quoted prices of securities with similar characteristics. The remaining investments are valued using pricing models or matrix pricing. The fair value measurements consider observable assumptions, including benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, default rates, loss severity and other economic measures.

We use independent pricing services to assist us in determining fair value for over 99% of our Level 1 and Level 2 investments. The pricing services provide a single price or quote per security. We use data provided by our third party investment manager to value the remaining Level 2 investments. To validate that these quoted and modeled prices are reasonable estimates of fair value, we perform various quantitative and qualitative procedures, including: 1) evaluation of the underlying methodologies, 2) analysis of recent sales activity, 3) analytical review of our fair values against current market prices, and 4) comparison of the pricing services’ fair value to other pricing services’ fair value for the same investment. Based on these procedures, we did not adjust the prices or quotes provided by our independent pricing services or third party investment manager as of September 30, 2009 or December 31, 2008. In 2008 and 2009, the FASB issued new accounting guidance related to determining the fair value of securities in inactive markets. We did not apply the criteria of this guidance as of September 30, 2009 and December 31, 2008, since no markets for our investments were judged to be inactive as of those balance sheet dates.

Our Level 3 financial instruments include certain fixed income securities and two insurance contracts that we account for as derivatives. We determine fair value based on internally developed models that use assumptions or other data that are not readily observable from objective sources. Because we use the lowest level significant input to determine our hierarchy classifications, a financial instrument may be classified in Level 3 even though there may be significant readily-observable inputs.

We excluded from our fair value disclosures our $103.3 million held to maturity investment portfolio and two investments valued at $4.1 million at September 30, 2009, which are measured at amortized cost and at cost, respectively. Our held to maturity portfolio had a fair value of $104.1 million at September 30, 2009.

The following table presents our assets and interest rate swap liabilities that were measured at fair value.

		Level 1				Level 2				Level 3				Total
September 30, 2009
Fixed income securities		$	253,874			$	4,521,894			$	8,575			$	4,784,343
Other investments			14				—				—				14
Other assets			—				—				19,569				19,569
Total assets measured at fair value		$	253,888			$	4,521,894			$	28,144			$	4,803,926
Accounts payable and accrued liabilities		$	—			$	(3,778	)		$	—			$	(3,778	)
Total liabilities measured at fair value		$	—			$	(3,778	)		$	—			$	(3,778	)
December 31, 2008
Fixed income securities		$	87,678			$	4,038,972			$	6,515			$	4,133,165
Other investments			16				—				—				16
Other assets			—				1,125				16,100				17,225
Total assets measured at fair value		$	87,694			$	4,040,097			$	22,615			$	4,150,406
Accounts payable and accrued liabilities		$	—			$	(8,031	)		$	—			$	(8,031	)
Total liabilities measured at fair value		$	—			$	(8,031	)		$	—			$	(8,031	)

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

The following table presents the changes in fair value of our Level 3 category during the first nine months and the third quarter of 2009.

		Fixed
		income				Other
		securities				assets				Total
Balance at December 31, 2008		$	6,515			$	16,100			$	22,615
Net redemptions			(1,590	)			—				(1,590	)
Gains and (losses) – unrealized			1,018				3,469				4,487
Gains and (losses) – realized			30				—				30
Transfers into Level 3			6,263				—				6,263
Transfers out of Level 3			(3,661	)			—				(3,661	)
Balance at September 30, 2009		$	8,575			$	19,569			$	28,144
Balance at June 30, 2009		$	5,982			$	19,757			$	25,739
Net redemptions			(327	)			—				(327	)
Gains and (losses) – unrealized			487				(188	)			299
Transfers into Level 3			4,348				—				4,348
Transfers out of Level 3			(1,915	)			—				(1,915	)
Balance at September 30, 2009		$	8,575			$	19,569			$	28,144

Unrealized gains and losses on our Level 3 fixed income securities are reported in other comprehensive income within shareholders’ equity, and unrealized gains and losses on our Level 3 other assets are reported in other operating income. Transfers of investments into Level 3 occurred due to our inability to obtain a fair value using inputs based on observable market data. Transfers of investments out of Level 3 occurred because we were able to determine their fair value using inputs based on observable market data.

(3)

Investments

Substantially all of our fixed income securities are investment grade and 97% are rated “A” or better. The cost or amortized cost, gross unrealized gain or loss, and fair value of investments in fixed income securities that are classified as available for sale were as follows:

		Cost or				Gross				Gross
		amortized				unrealized				unrealized				Fair
		cost				gain				loss				value
September 30, 2009
U.S. government and government agency securities		$	455,025			$	7,967			$	(9	)		$	462,983
Fixed income securities of states, municipalities and political subdivisions			1,012,861				67,462				(209	)			1,080,114
Special purpose revenue bonds of states, municipalities and political subdivisions			1,069,921				64,330				(601	)			1,133,650
Corporate fixed income securities			542,098				24,875				(349	)			566,624
Residential mortgage-backed securities			930,891				45,121				(5,772	)			970,240
Commercial mortgage-backed securities			160,863				729				(8,411	)			153,181
Asset-backed securities			27,783				721				(1,623	)			26,881
Foreign government securities			254,627				8,758				(773	)			262,612
Foreign non-government securities			121,778				6,280				—				128,058
Total available for sale fixed income securities		$	4,575,847			$	226,243			$	(17,747	)		$	4,784,343

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

		Cost or				Gross				Gross
		amortized				unrealized				unrealized				Fair
		cost				gain				loss				value
December 31, 2008
U.S. government and government agency securities		$	196,856			$	9,447			$	(15	)		$	206,288
Fixed income securities of states, municipalities and political subdivisions			1,082,855				23,948				(14,900	)			1,091,903
Special purpose revenue bonds of states, municipalities and political subdivisions			899,466				16,249				(16,083	)			899,632
Corporate fixed income securities			517,794				5,308				(11,464	)			511,638
Residential mortgage-backed securities			796,522				40,229				(13,673	)			823,078
Commercial mortgage-backed securities			179,479				42				(27,685	)			151,836
Asset-backed securities			72,646				78				(6,772	)			65,952
Foreign government securities			230,829				7,699				(431	)			238,097
Foreign non-government securities			142,092				2,877				(228	)			144,741
Total available for sale fixed income securities		$	4,118,539			$	105,877			$	(91,251	)		$	4,133,165

The amortized cost and fair value of investments in fixed income securities that are classified as held to maturity were as follows:

		Amortized				Fair
		cost				value
September 30, 2009
U.S. government securities		$	14,995			$	15,018
Foreign government securities			80,683				81,396
Foreign non-government securities			7,608				7,663
Total held to maturity fixed income securities		$	103,286			$	104,077
December 31, 2008
U.S. government securities		$	21,319			$	21,823
Foreign government securities			95,268				96,661
Foreign non-government securities			6,966				7,077
Total held to maturity fixed income securities		$	123,553			$	125,561

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

All fixed income securities were income producing in 2009. The following table displays the gross unrealized losses and fair value of all available for sale fixed income securities that were in a continuous unrealized loss position for the periods indicated:

		Less than 12 Months								12 Months or more								Total
						Unrealized								Unrealized								Unrealized
		Fair value				losses				Fair value				losses				Fair value				losses
September 30, 2009
U.S. government and government agency securities		$	28,650			$	(9	)		$	—			$	—			$	28,650			$	(9	)
Fixed income securities of states, municipalities and political subdivisions			—				—				20,961				(209	)			20,961				(209	)
Special purpose revenue bonds of states, municipalities and political subdivisions			8,291				(64	)			30,862				(537	)			39,153				(601	)
Corporate fixed income securities			4,237				(188	)			5,404				(161	)			9,641				(349	)
Residential mortgage-backed securities			9,969				(579	)			45,575				(5,194	)			55,544				(5,773	)
Commercial mortgage-backed securities			1,278				(9	)			100,751				(8,402	)			102,029				(8,411	)
Asset-backed securities			2,641				(636	)			10,264				(986	)			12,905				(1,622	)
Foreign government securities			17,372				(634	)			8,657				(139	)			26,029				(773	)
Total		$	72,438			$	(2,119	)		$	222,474			$	(15,628	)		$	294,912			$	(17,747	)
December 31, 2008
U.S. government and government agency securities		$	13,240			$	(10	)		$	590			$	(5	)		$	13,830			$	(15	)
Fixed income securities of states, municipalities and political subdivisions			294,887				(7,819	)			98,682				(7,081	)			393,569				(14,900	)
Special purpose revenue bonds of states, municipalities and political subdivisions			289,204				(9,055	)			98,743				(7,028	)			387,947				(16,083	)
Corporate fixed income securities			298,464				(7,217	)			18,753				(4,247	)			317,217				(11,464	)
Residential mortgage-backed securities			63,640				(8,805	)			16,409				(4,868	)			80,049				(13,673	)
Commercial mortgage-backed securities			77,252				(10,028	)			72,642				(17,657	)			149,894				(27,685	)
Asset-backed securities			54,798				(4,062	)			7,401				(2,710	)			62,199				(6,772	)
Foreign government securities			—				—				25,613				(431	)			25,613				(431	)
Foreign non-government securities			20,620				(211	)			6,381				(17	)			27,001				(228	)
Total		$	1,112,105			$	(47,207	)		$	345,214			$	(44,044	)		$	1,457,319			$	(91,251	)

A security has an impairment loss when its fair value is less than its cost or amortized cost at the balance sheet date. We evaluate the securities in our fixed income securities portfolio for possible other-than-temporary impairment losses at each quarter end. We adopted a new accounting standard, which specifies new criteria for identification and recognition of other-than-temporary impairment losses, as of April 1, 2009. This standard requires us to determine, for each impaired fixed income security, that (a) we do not intend to sell the security and (b) it is more likely than not that we will not be required to sell the security before recovery of its amortized cost basis. If we cannot assert either of these, the impairment is recorded as an other-than-temporary loss through earnings in the current period. For all other impaired securities, the impairment is considered an other-than-temporary loss if the net present value of the cash flows expected to be collected from the security is less than its amortized cost basis. Such a shortfall in cash flows is referred to as a “credit loss.” For any such security, the impairment loss is separated into (a) the credit loss and (b) the amount related to all other factors, such as interest rate changes, market conditions, etc. (the “non-credit” loss). The credit loss is charged to current period earnings and the non-credit loss is charged to other comprehensive income, within shareholders’ equity, on an after-tax basis. A security’s cost basis is permanently reduced by the amount of an other-than-temporary loss recorded through earnings.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

To adopt the new accounting standard, we reviewed all securities with a previous other-than-temporary impairment loss that we still held at April 1, 2009. For each, we determined the credit and non-credit component as of the adoption date. We calculated the net present value of each security by discounting our best estimate of projected future cash flows at the effective interest rate implicit in the security prior to impairment. For our mortgage-backed securities, the estimated cash flows included prepayment assumptions and other assumptions regarding the underlying collateral including default rates, recoveries and changes in value. We recorded a cumulative adjustment of $4.3 million after-tax to reclassify the non-credit portion of the loss from retained earnings to accumulated other comprehensive income as of the adoption date.

We review our impaired securities and assess whether any impairments are other-than-temporary at each quarter end, based on all relevant facts and circumstances for each impaired security. During 2009 and 2008, our reviews covered all impaired securities where the loss exceeded $0.5 million and the loss either exceeded 10% of cost or the security had been in a loss position for longer than twelve consecutive months. Our review in the third quarter of 2009 covered 79% of the total unrealized losses in the portfolio.

The determination that a security has incurred an other-than-temporary decline in value and the amount of any current loss recognition requires management judgment and a continual review of market conditions and our investment portfolio. In the second quarter of 2009, we changed our criteria for determining if an impaired security has an other-than-temporary impairment to comply with the new accounting standard. Our evaluation now considers various factors including:

	•		amount by which the security’s fair value is less than its cost,
	•		length of time the security has been impaired,
	•		the security’s credit rating and any recent downgrades,
	•		whether the impairment is due to an issuer-specific event,
	•		whether we intend to sell the security,
	•		if it is more likely than not that we will have to sell the security before recovery of its amortized cost basis, and
	•		stress testing of expected cash flows for mortgage-backed and asset-backed securities under various scenarios.

To assist us in our evaluation, our outside investment advisors also perform detailed credit evaluations of all of our fixed income securities on an ongoing basis.

The new accounting standard also changed the earnings recognition criteria for other-than-temporary impairment losses. Prior to our adoption of this standard, when we concluded that a decline in a security’s fair value was other-than-temporary, we recognized the impairment as a realized investment loss in our consolidated statements of earnings. Beginning in the second quarter of 2009, we recognize an other-than-temporary impairment loss in earnings in the period that we determine: 1) we intend to sell the security, 2) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, or 3) the security has a credit loss.

We identified and recognized pretax other-than-temporary impairment losses as follows:

		Nine months ended September 30,								Three months ended September 30,
		2009				2008				2009				2008
Total other-than-temporary impairment loss		$	(6,089	)		$	(6,029	)		$	(380	)		$	(4,430	)
Portion recognized in other comprehensive income			810				—				55				—
Net other-than-temporary impairment loss recognized in earnings		$	(5,279	)		$	(6,029	)		$	(325	)		$	(4,430	)

At September 30, 2009, we had $4.8 million after-tax of other-than-temporary impairments, primarily related to mortgage-backed and asset-backed securities, included in accumulated other comprehensive income.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

The roll forward of the credit-related portion of our pretax other-than-temporary impairment loss recognized in earnings, for which a portion of the other-than-temporary loss was recognized in other comprehensive income, beginning at the date of adoption of the new accounting standard, was as follows:

		Six months ended				Three months ended
		September 30, 2009				September 30, 2009
Balance at beginning of period		$	—			$	3,373
Credit losses included in retained earnings related to adoption of new accounting standard			2,723				—
Credit losses recognized in earnings:
Securities previously impaired			550				200
Securities not previously impaired			425				125
Balance at September 30, 2009		$	3,698			$	3,698

Significant price deterioration in our fixed income securities occurred in the second half of 2008, principally due to the effects of the recent credit crisis, changes in market interest rates and widening of credit spreads. We did not consider the $91.3 million of gross unrealized losses in our available for sale fixed income securities at December 31, 2008 to be other-than-temporary impairments as of that date because: 1) we received all contractual interest and principal payments on these securities as of year-end 2008, 2) based on our fourth quarter 2008 review, we believed it was probable that we would continue to collect all such cash payments due in the future, and 3) as of December 31, 2008, we had the intent and ability to hold these securities until maturity or for a period of time sufficient to allow recovery of the impaired security’s fair value. Based on the guidance in the new accounting standard adopted on April 1, 2009, we do not consider the $17.7 million of gross unrealized losses in our portfolio at September 30, 2009 to be other-than-temporary impairments as of that date because: 1) we received all contractual interest and principal payments on these securities as of September 30, 2009, 2) we do not intend to sell the securities, 3) it is more likely than not that we will not be required to sell the securities before recovery of their amortized cost bases, and 4) for those securities with a credit loss at September 30, 2009, the unrealized loss relates to non-credit factors, such as interest rate changes and market conditions.

The change in our unrealized pretax net gains (losses) on investments during each period was as follows:

		Nine months ended September 30,								Three months ended September 30,
		2009				2008				2009				2008
Available for sale fixed income securities		$	193,870			$	(123,100	)		$	135,831			$	(63,985	)
Strategic and other investments			(2	)			48				—				1,285
Net unrealized investment gains (losses)		$	193,868			$	(123,052	)		$	135,831			$	(62,700	)