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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 June 30, 2014.

¨

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 ¨

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 þ    No ¨

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 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 ¨		Non-accelerated filer ¨		Smaller reporting company ¨
				(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 ¨    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 July 25, 2014, there were approximately 100.0 million shares of common stock outstanding.

 

 

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Table of Contents

 

		Page
Part I. FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Consolidated Balance Sheets — June 30, 2014 and December 31, 2013		5
Consolidated Statements of Earnings — Six and three months ended June 30, 2014 and 2013		6
Consolidated Statements of Comprehensive Income — Six and three months ended June 30, 2014 and 2013		7
Consolidated Statement of Changes in Shareholders’ Equity — Six months ended June 30, 2014		8
Consolidated Statements of Cash Flows — Six months ended June 30, 2014 and 2013		9
Notes to Consolidated Financial Statements		10
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		24
Item 3. Quantitative and Qualitative Disclosures About Market Risk		40
Item 4. Controls and Procedures		40
Part II. OTHER INFORMATION
Item 1. Legal Proceedings		41
Item 1A. Risk Factors		41
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		41
Item 3. Defaults Upon Senior Securities		41
Item 4. Mine Safety Disclosures		41
Item 5. Other Information		41
Item 6. Exhibits		42
Signatures		43

 

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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. These forward-looking statements reflect our current expectations and projections about future events and 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. Generally, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “plan,” “probably” or similar expressions indicate 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 catastrophe 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 impact of past and future potential economic or credit market downturns, including any potential ratings downgrade or  impairment of the debt securities of sovereign issuers,

 

•

the effects of emerging claim and coverage issues,

 

•

the effects of extensive governmental regulation of the insurance industry,

 

•

changes to the country’s health care delivery system,

 

•

the effects of climate change on the risks we insure,

 

•

potential risk with agents and brokers,

 

•

the effects of industry consolidations,

 

•

our assessment of underwriting risk,

 

•

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

 

•

the adequacy of reinsurance protection,

 

•

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

 

•

the occurrence of terrorist activities,

 

•

our ability to maintain our competitive position,

 

•

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

 

•

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,

 

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•

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,

 

•

failure of, or loss of security related to, our information technology systems,

 

•

difficulties with outsourcing relationships, and

 

•

change of control.

We described 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, 2013.

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, 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.

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Consolidated Balance Sheets

(unaudited, in thousands except per share data)

 

		June 30,             2014				December 31,       2013
ASSETS
Investments
Fixed maturity securities – available for sale, at fair value (amortized cost: 2014 – $6,078,453 and 2013 – $5,921,487)		$	6,333,191			$	6,022,473
Equity securities – available for sale, at fair value (cost: 2014 – $394,685 and 2013 – $464,388)			448,685				517,466
Short-term investments, at cost (approximates fair value)			342,335				178,753
Total investments			7,124,211				6,718,692
Cash			70,907				58,301
Restricted cash and securities			130,920				125,777
Premium, claims and other receivables			676,340				580,107
Reinsurance recoverables			1,178,200				1,277,257
Ceded unearned premium			340,853				305,438
Ceded life and annuity benefits			53,406				56,491
Deferred policy acquisition costs			226,333				201,698
Goodwill			895,799				895,200
Other assets			165,022				125,559
Total assets		$	10,861,991			$	10,344,520
LIABILITIES
Loss and loss adjustment expense payable		$	3,841,497			$	3,902,132
Life and annuity policy benefits			53,406				56,491
Reinsurance, premium and claims payable			388,855				332,985
Unearned premium			1,272,969				1,134,849
Deferred ceding commissions			100,571				89,528
Notes payable			734,174				654,098
Accounts payable and accrued liabilities			556,464				500,007
Total liabilities			6,947,936				6,670,090
SHAREHOLDERS’ EQUITY
Common stock, $1.00 par value; 250,000 shares authorized (shares issued: 2014 – 126,252 and 2013 – 125,577; outstanding: 2014 – 100,050 and 2013 – 100,336)			126,252				125,577
Additional paid-in capital			1,091,773				1,073,105
Retained earnings			3,245,554				3,085,501
Accumulated other comprehensive income			220,422				118,651
Treasury stock, at cost (shares: 2014 – 26,202 and 2013 – 25,241)			(769,946)				(728,404)
Total shareholders’ equity			3,914,055				3,674,430
Total liabilities and shareholders’ equity		$	10,861,991			$	10,344,520

 

See Notes to Consolidated Financial Statements.

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Consolidated Statements of Earnings

(unaudited, in thousands except per share data)

 

		Six months ended June 30,								Three months ended June 30,
		2014				2013				2014				2013
REVENUE
Net earned premium		$	1,134,860			$	1,122,542			$	572,248			$	561,356
Net investment income			113,244				111,433				56,438				55,668
Other operating income			19,249				16,629				9,983				7,784
Net realized investment gain			25,151				13,193				4,905				4,623
Total revenue			1,292,504				1,263,797				643,574				629,431
EXPENSE
Loss and loss adjustment expense, net			648,938				672,171				327,094				339,474
Policy acquisition costs, net			142,011				137,745				72,970				70,796
Other operating expense			194,955				164,572				99,001				87,719
Interest expense			13,984				13,082				6,865				6,611
Total expense			999,888				987,570				505,930				504,600
Earnings before income tax expense			292,616				276,227				137,644				124,831
Income tax expense			87,569				82,215				40,508				36,669
Net earnings		$	205,047			$	194,012			$	97,136			$	88,162
Earnings per common share
Basic		$	2.05			$	1.93			$	0.97			$	0.88
Diluted		$	2.04			$	1.92			$	0.97			$	0.87

 

See Notes to Consolidated Financial Statements.

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Consolidated Statements of Comprehensive Income

(unaudited, in thousands)

 

		Six months ended June 30,								Three months ended June 30,
		2014				2013				2014				2013
Net earnings		$	205,047			$	194,012			$	97,136			$	88,162
Other comprehensive income (loss)
Investment gains (losses):
Investment gains (losses) during the period			179,825				(247,429)				93,745				(217,034)
Income tax charge (benefit)			63,818				(87,443)				33,248				(77,116)
Investment gains (losses), net of tax			116,007				(159,986)				60,497				(139,918)
Less reclassification adjustments to:
Net realized investment gain			25,151				13,193				4,905				4,623
Income tax expense			8,803				4,618				1,717				1,619
Total reclassifications included in net earnings, net of tax			16,348				8,575				3,188				3,004
Net unrealized investment gains (losses)			99,659				(168,561)				57,309				(142,922)
Foreign currency translation adjustment			1,691				(1,145)				903				911
Income tax charge (benefit)			(421)				(554)				11				(30)
Foreign currency translation adjustment, net of tax			2,112				(591)				892				941
Other comprehensive income (loss)			101,771				(169,152)				58,201				(141,981)
Comprehensive income (loss)		$	306,818			$	24,860			$	155,337			$	(53,819)

 

See Notes to Consolidated Financial Statements.

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Consolidated Statement of Changes in Shareholders’ Equity

Six months ended June 30, 2014

(unaudited, in thousands except per share data)

 

		Common   stock				Additional paid-in   capital				Retained   earnings				Accumulated other comprehensive   income				Treasury   stock				Total shareholders’   equity
Balance at December 31, 2013		$	125,577			$	1,073,105			$	3,085,501			$	118,651			$	(728,404)			$	3,674,430
Net earnings			-				-				205,047				-				-				205,047
Other comprehensive income			-				-				-				101,771				-				101,771
Issuance of 301 shares for exercise of options, including tax effect			301				9,786				-				-				-				10,087
Issuance of 44 shares for employee stock purchase plan			44				1,578				-				-				-				1,622
Purchase of 961 common shares			-				-				-				-				(41,542)				(41,542)
Stock-based compensation			330				7,304				-				-				-				7,634
Cash dividends declared, $0.45 per share			-				-				(44,994)				-				-				(44,994)
Balance at June 30, 2014		$	126,252			$	1,091,773			$	3,245,554			$	220,422			$	(769,946)			$	3,914,055

 

See Notes to Consolidated Financial Statements.

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(unaudited, in thousands)

 

		Six months ended June 30,
		2014				2013
Operating activities
Net earnings		$	205,047			$	194,012
Adjustments to reconcile net earnings to net cash provided by operating activities:
Change in premium, claims and other receivables			(109,043)				(99,897)
Change in reinsurance recoverables			96,770				(17,018)
Change in ceded unearned premium			(35,485)				(35,032)
Change in loss and loss adjustment expense payable			(57,118)				52,026
Change in unearned premium			138,248				119,759
Change in reinsurance, premium and claims payable			55,764				43,237
Change in accounts payable and accrued liabilities			(69,414)				(119,103)
Stock-based compensation expense			10,303				6,955
Depreciation and amortization expense			8,289				9,093
Gain on investments			(25,151)				(13,193)
Other, net			(22,924)				(38,849)
Cash provided by operating activities			195,286				101,990
Investing activities
Sales of available for sale fixed maturity securities			286,843				171,801
Sales of equity securities			170,182				44,308
Sales of other investments			-				23,719
Maturity or call of available for sale fixed maturity securities			269,468				375,924
Cost of available for sale fixed maturity securities acquired			(675,945)				(756,782)
Cost of equity securities acquired			(78,817)				(114,685)
Change in short-term investments			(168,241)				145,977
Payments for purchase of businesses			(2,579)				(8,214)
Proceeds from sales of subsidiaries			12,942				507
Other, net			(3,902)				(2,698)
Cash used by investing activities			(190,049)				(120,143)
Financing activities
Advances on line of credit			140,000				70,000
Payments on line of credit			(60,000)				(15,000)
Sale of common stock			11,709				7,408
Purchase of common stock			(41,542)				(46,586)
Dividends paid			(45,076)				(33,250)
Other, net			2,278				3,544
Cash provided (used) by financing activities			7,369				(13,884)
Net increase (decrease) in cash			12,606				(32,037)
Cash at beginning of year			58,301				71,390
Cash at end of period		$	70,907			$	39,353

 

See Notes to Consolidated Financial Statements.

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

(1) General Information

HCC Insurance Holdings, Inc. (HCC) and its subsidiaries (collectively we, us or our) include domestic and foreign property and casualty and life insurance companies and underwriting agencies with offices in the United States, the United Kingdom, Spain and Ireland. We underwrite a variety of largely non-correlated specialty insurance products, including property and casualty, accident and health, surety and credit product lines, in approximately 180 countries. We market our products through a network of independent agents and brokers, through managing general agents owned by the company, and directly to consumers. In addition, we assume insurance written by other insurance companies.

Basis of Presentation

Our unaudited consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (GAAP) and include the accounts of HCC 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 consolidated financial statements should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2013. The consolidated balance sheet at December 31, 2013 was derived from the audited financial statements but does not include all disclosures required by GAAP.

Management must make estimates and assumptions that affect amounts reported in our consolidated financial statements and in disclosures of contingent assets and liabilities. Ultimate results could differ from those estimates.

Goodwill

An indicator of impairment of goodwill exists when the fair value of a reporting unit is less than its carrying value. We conducted our annual goodwill impairment test as of June 30, 2014, which is consistent with the timeframe for our annual assessment in prior years. This test consisted of a qualitative assessment in which we determined that it is more likely than not that the fair value of each of our five reporting units exceeded its carrying amount as of June 30, 2014.

Recent Accounting Guidance

A new accounting standard issued in the second quarter of 2014 will change the manner in which most companies recognize revenue. The standard requires that revenue reflect the transfer of goods or services to customers based on the consideration/payment the company expects to be entitled to in exchange for those goods or services; however, the standard does not change the accounting for insurance contracts or investment income. The new standard also requires enhanced disclosures about revenue. This accounting guidance is effective in the first quarter of 2017 and may be applied on a full retrospective or modified retrospective approach. We are currently assessing the impact the implementation of this standard will have on our consolidated financial statements.

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

(2)  Investments

The cost or amortized cost, gross unrealized gain or loss, and fair value of our fixed maturity and equity securities, all of which are classified as available for sale, were as follows:

 

		Cost or   amortized               cost				Gross   unrealized               gain				Gross   unrealized               loss				Fair value
June 30, 2014
U.S. government and government agency securities		$	84,479			$	1,354			$	(206)			$	85,627
Fixed maturity securities of states, municipalities and political subdivisions			905,732				60,882				(909)				965,705
Special purpose revenue bonds of states, municipalities and political subdivisions			2,263,181				121,364				(7,582)				2,376,963
Corporate securities			1,151,993				51,846				(4,128)				1,199,711
Residential mortgage-backed securities			753,516				19,881				(8,863)				764,534
Commercial mortgage-backed securities			530,075				20,941				(3,899)				547,117
Asset-backed securities			304,866				622				(1,092)				304,396
Foreign government securities			84,611				4,630				(103)				89,138
Total fixed maturity securities		$	6,078,453			$	281,520			$	(26,782)			$	6,333,191
Equity securities		$	394,685			$	59,130			$	(5,130)			$	448,685
December 31, 2013
U.S. government and government agency securities		$	91,047			$	2,157			$	(495)			$	92,709
Fixed maturity securities of states, municipalities and political subdivisions			941,580				50,885				(5,979)				986,486
Special purpose revenue bonds of states, municipalities and political subdivisions			2,240,412				71,541				(46,758)				2,265,195
Corporate securities			1,195,387				40,860				(11,009)				1,225,238
Residential mortgage-backed securities			622,766				15,289				(19,936)				618,119
Commercial mortgage-backed securities			502,069				16,155				(13,336)				504,888
Asset-backed securities			183,660				319				(1,587)				182,392
Foreign government securities			144,566				3,237				(357)				147,446
Total fixed maturity securities		$	5,921,487			$	200,443			$	(99,457)			$	6,022,473
Equity securities		$	464,388			$	58,842			$	(5,764)			$	517,466

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

Substantially all of our fixed maturity securities are investment grade. The following tables display the gross unrealized losses and fair value of all available for sale securities that were in a continuous unrealized loss position for the periods indicated.

 

		Less than 12 months								12 months or more								Total
		Fair value				Unrealized     losses				Fair value				Unrealized     losses				Fair value				Unrealized     losses
June 30, 2014
Fixed maturity securities
U.S. government and government agency securities		$	5,838			$	(6)			$	11,410			$	(200)			$	17,248			$	(206)
Fixed maturity securities of states, municipalities and political subdivisions			6,015				(34)				38,173				(875)				44,188				(909)
Special purpose revenue bonds of states, municipalities and political subdivisions			51,330				(200)				327,557				(7,382)				378,887				(7,582)
Corporate securities			73,935				(366)				105,399				(3,762)				179,334				(4,128)
Residential mortgage-backed securities			58,198				(272)				259,170				(8,591)				317,368				(8,863)
Commercial mortgage-backed securities			-				-				150,806				(3,899)				150,806				(3,899)
Asset-backed securities			115,769				(927)				7,080				(165)				122,849				(1,092)
Foreign government securities			19,363				(55)				7,193				(48)				26,556				(103)
Equity securities			63,229				(4,599)				6,952				(531)				70,181				(5,130)
Total		$	393,677			$	(6,459)			$	913,740			$	(25,453)			$	1,307,417			$	(31,912)
December 31, 2013
Fixed maturity securities
U.S. government and government agency securities		$	23,717			$	(495)			$	-			$	-			$	23,717			$	(495)
Fixed maturity securities of states, municipalities and political subdivisions			136,160				(5,277)				8,997				(702)				145,157				(5,979)
Special purpose revenue bonds of states, municipalities and political subdivisions			684,560				(35,832)				83,228				(10,926)				767,788				(46,758)
Corporate securities			277,853				(8,202)				35,437				(2,807)				313,290				(11,009)
Residential mortgage-backed securities			306,874				(15,861)				31,687				(4,075)				338,561				(19,936)
Commercial mortgage-backed securities			203,347				(12,611)				4,915				(725)				208,262				(13,336)
Asset-backed securities			126,922				(1,587)				-				-				126,922				(1,587)
Foreign government securities			78,182				(357)				-				-				78,182				(357)
Equity securities			75,620				(5,437)				7,016				(327)				82,636				(5,764)
Total		$	1,913,235			$	(85,659)			$	171,280			$	(19,562)			$	2,084,515			$	(105,221)

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

At June 30, 2014, we held approximately 2,760 fixed maturity and equity securities, of which 20% included at least one lot in an unrealized loss position. 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 our securities for possible other-than-temporary impairment losses at each quarter end. Our reviews cover all impaired securities where the loss exceeds $1.0 million and the loss either exceeds 10% of cost or the security had been in a loss position for longer than twelve consecutive months. We do not consider the $31.9 million of gross unrealized losses in our portfolio at June 30, 2014 to be other-than-temporary impairments as these losses relate to non-credit factors, such as interest rate changes and market conditions. We recognized no other-than-temporary impairment losses in the first six months of 2014 and 2013.

The amortized cost and fair value of our fixed maturity securities at June 30, 2014, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. The weighted-average life of our mortgage-backed and asset-backed securities was 5.5 years at June 30, 2014.

 

										Cost or   amortized cost				Fair value
Due in 1 year or less										$	192,394			$	195,936
Due after 1 year through 5 years											1,012,738				1,064,207
Due after 5 years through 10 years											1,366,848				1,450,529
Due after 10 years through 15 years											942,481				992,274
Due after 15 years											975,535				1,014,198
Securities with contractual maturities											4,489,996				4,717,144
Mortgage-backed and asset-backed securities											1,588,457				1,616,047
Total fixed maturity securities										$	6,078,453			$	6,333,191
Realized pretax gains (losses) on the sale of investments included the following:
		Six months ended June 30,								Three months ended June 30,
		2014				2013				2014				2013
Gains
Fixed maturity securities		$	6,150			$	4,139			$	4,135			$	635
Equity securities			25,863				5,989				1,425				4,649
Other investments			-				5,345				-				817
Total gains			32,013				15,473				5,560				6,101
Losses
Fixed maturity securities			(3,688)				(994)				(650)				(306)
Equity securities			(3,174)				(1,286)				(5)				(1,172)
Total losses			(6,862)				(2,280)				(655)				(1,478)
Net
Fixed maturity securities			2,462				3,145				3,485				329
Equity securities			22,689				4,703				1,420				3,477
Other investments			-				5,345				-				817
Net realized investment gain		$	25,151			$	13,193			$	4,905			$	4,623

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

(3) Fair Value Measurements

Our financial instruments include assets and liabilities carried at fair value, as well as assets and liabilities carried at cost or amortized cost but disclosed at fair value in our financial statements. 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.

Our Level 1 investments consist of U.S. Treasuries, money market funds and equity securities traded in an active exchange market. We use unadjusted quoted prices for identical instruments to measure fair value.

Our Level 2 investments include most of our fixed maturity securities, which consist of U.S. government agency securities, municipal bonds (including those held as restricted securities), corporate debt securities, bank loans, mortgage-backed and asset-backed securities (including collateralized loan obligations), and deposits supporting our Lloyd’s syndicate business. Level 2 also includes certificates of deposit and other interest-bearing deposits at banks, which we report as short-term investments. We measure fair value for the majority of our Level 2 investments using matrix pricing and observable market data, including benchmark securities or yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, bids, offers, default rates, loss severity and other economic measures. We measure fair value for our structured securities using observable market data in cash flow models.

We are responsible for the prices used in our fair value measurements. We use independent pricing services to assist us in determining fair value for 99% of our Level 2 investments. The pricing services provide a single price or quote per security. We use data provided by our third party investment managers and Lloyd’s of London to value the remaining Level 2 investments. To validate that these quoted 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. No markets for our investments were judged to be inactive at period end. Based on these procedures, we did not adjust the prices or quotes provided by our independent pricing services, third party investment managers or Lloyd’s of London as of June 30, 2014 or December 31, 2013.

Our Level 2 financial instruments also include our notes payable. We determine the fair value of our 6.30% Senior Notes based on quoted prices in an inactive market. The fair value of borrowings under our Revolving Loan Facility approximates the carrying amount because interest is based on 30-day LIBOR plus a margin.

Our Level 3 securities include certain fixed maturity securities and an insurance contract that we account for as a derivative and classify in other assets. Our Level 3 category also includes a liability for future earnout payments due to former owners of a business we acquired, which is classified within accounts payable and accrued liabilities. We determine fair value of the derivative and the earnout payments based on internally developed models that use assumptions or other data that are not readily observable from objective sources. Fixed maturity securities classified as Level 3 at December 31, 2013 included special purpose revenue bond auction rate securities, which had interest rates that reset at periodic intervals. These securities were thinly traded and observable market data was not readily available. We determined the fair value of these securities using prices quoted by a broker.

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

The following tables present the fair value of our financial instruments that were carried or disclosed at fair value. Unless indicated, these items were carried at fair value on our consolidated balance sheets.

 

		Level 1				Level 2				Level 3				Total
June 30, 2014
Fixed maturity securities
U.S. government and government agency securities		$	77,934			$	7,693			$	-			$	85,627
Fixed maturity securities of states, municipalities and political subdivisions			-				965,705				-				965,705
Special purpose revenue bonds of states, municipalities and political subdivisions			-				2,376,963				-				2,376,963
Corporate securities			-				1,199,562				149				1,199,711
Residential mortgage-backed securities			-				764,534				-				764,534
Commercial mortgage-backed securities			-				547,117				-				547,117
Asset-backed securities			-				304,396				-				304,396
Foreign government securities			-				89,138				-				89,138
Total fixed maturity securities			77,934				6,255,108				149				6,333,191
Equity securities			448,685				-				-				448,685
Short-term investments*			186,602				155,733				-				342,335
Restricted cash and securities			-				2,269				-				2,269
Premium, claims and other receivables			-				63,802				-				63,802
Other assets			20				-				1,099				1,119
Total assets measured at fair value		$	713,241			$	6,476,912			$	1,248			$	7,191,401
Notes payable*		$	-			$	783,738			$	-			$	783,738
Accounts payable and accrued liabilities - earnout liability			-				2,269				7,386				9,655
Total liabilities measured at fair value		$	-			$	786,007			$	7,386			$	793,393

 

 

* Carried at cost or amortized cost on consolidated balance sheet.

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

		Level 1				Level 2				Level 3				Total
December 31, 2013
Fixed maturity securities
U.S. government and government agency securities		$	84,032			$	8,677			$	-			$	92,709
Fixed maturity securities of states, municipalities and political subdivisions			-				986,486				-				986,486
Special purpose revenue bonds of states, municipalities and political subdivisions			-				2,255,928				9,267				2,265,195
Corporate securities			-				1,225,088				150				1,225,238
Residential mortgage-backed securities			-				618,119				-				618,119
Commercial mortgage-backed securities			-				504,888				-				504,888
Asset-backed securities			-				182,392				-				182,392
Foreign government securities			-				147,446				-				147,446
Total fixed maturity securities			84,032				5,929,024				9,417				6,022,473
Equity securities			517,466				-				-				517,466
Short-term investments*			68,958				109,795				-				178,753
Restricted cash and securities			-				1,853				-				1,853
Premium, claims and other receivables			-				66,515				-				66,515
Other assets			20				-				941				961
Total assets measured at fair value		$	670,476			$	6,107,187			$	10,358			$	6,788,021
Notes payable*		$	-			$	707,656			$	-			$	707,656
Accounts payable and accrued liabilities - earnout liability			-				1,853				7,259				9,112
Total liabilities measured at fair value		$	-			$	709,509			$	7,259			$	716,768

 

 

*Carried at cost or amortized cost on consolidated balance sheet.

In the first quarter of 2013, we purchased $9.4 million of special purpose revenue bond auction rate securities, which we continued to hold and classify in Level 3 at December 31, 2013. We sold these securities in the first quarter of 2014. There were no transfers between Level 1, Level 2 or Level 3 in the first six months of 2014 and 2013.

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

(4) Reinsurance

In the normal course of business, our insurance companies cede a portion of their premium to reinsurers through treaty and facultative reinsurance agreements. Although reinsurance does not discharge the direct insurer from liability to its policyholder, our insurance companies participate in such agreements in order to limit their loss exposure, protect them against catastrophic losses and diversify their business. The following tables present the effect of such reinsurance transactions on our premium, loss and loss adjustment expense and policy acquisition costs.

 

		Six months ended June 30,								Three months ended June 30,
		2014				2013				2014				2013
Direct written premium		$	1,369,751			$	1,294,681			$	749,239			$	713,110
Reinsurance assumed			209,700				234,967				83,490				96,333
Reinsurance ceded			(342,255)				(321,430)				(185,715)				(180,409)
Net written premium		$	1,237,196			$	1,208,218			$	647,014			$	629,034
Direct earned premium		$	1,288,995			$	1,237,629			$	651,682			$	621,224
Reinsurance assumed			152,341				171,308				76,318				86,036
Reinsurance ceded			(306,476)				(286,395)				(155,752)				(145,904)
Net earned premium		$	1,134,860			$	1,122,542			$	572,248			$	561,356
Direct loss and loss adjustment expense		$	725,911			$	693,480			$	375,184			$	335,968
Reinsurance assumed			63,274				110,708				21,472				71,017
Reinsurance ceded			(140,247)				(132,017)				(69,562)				(67,511)
Net loss and loss adjustment expense		$	648,938			$	672,171			$	327,094			$	339,474
Policy acquisition costs		$	215,210			$	204,031			$	110,565			$	103,745
Ceding commissions			(73,199)				(66,286)				(37,595)				(32,949)
Net policy acquisition costs		$	142,011			$	137,745			$	72,970			$	70,796
The table below shows the components of our reinsurance recoverables in our consolidated balance sheets.
										June 30,				December 31,
										2014				2013
Reinsurance recoverable on paid losses										$	98,451			$	156,026
Reinsurance recoverable on outstanding losses											453,653				459,134
Reinsurance recoverable on incurred but not reported losses											627,596				663,597
Reserve for uncollectible reinsurance											(1,500)				(1,500)
Total reinsurance recoverables										$	1,178,200			$	1,277,257

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

Reinsurers not authorized by the respective states of domicile of our U.S. domiciled insurance companies are required to collateralize reinsurance obligations due to us. The table below shows letters of credit and cash that are available to us as collateral, as well as amounts we owe reinsurers that can be offset against amounts due to us.

 

		June 30,				December 31,
		2014				2013
Payables to reinsurers		$	220,281			$	208,850
Letters of credit			85,752				100,529
Funds held in trust			148,508				88,310
Total credits		$	454,541			$	397,689

(5) Liability for Unpaid Loss and Loss Adjustment Expense

The table below provides a reconciliation of our liability for loss and loss adjustment expense payable (referred to as reserves).

 

		Six months ended June 30,								Three months ended June 30,
		2014				2013				2014				2013
Reserves at beginning of period		$	3,902,132			$	3,767,850			$	3,847,417			$	3,774,162
Less reinsurance recoverables on reserves			1,122,731				1,018,047				1,098,576				1,012,920
Net reserves at beginning of period			2,779,401				2,749,803				2,748,841				2,761,242
Net loss and loss adjustment expense			648,938				672,171				327,094				339,474
Net loss and loss adjustment expense payments			(674,070)				(586,326)				(319,114)				(286,797)
Foreign currency adjustment			5,979				(24,627)				3,427				(2,898)
Net reserves at end of period			2,760,248				2,811,021				2,760,248				2,811,021
Plus reinsurance recoverables on reserves			1,081,249				1,003,663				1,081,249				1,003,663
Reserves at end of period		$	3,841,497			$	3,814,684			$	3,841,497			$	3,814,684

We recognized no loss development in the first six months or second quarter of 2014. In the first six months and second quarter of 2013, we recognized favorable development of $9.5 million in our U.S. Surety & Credit segment and $2.3 million in our International segment. Our review of reserves in our U.S. Surety & Credit segment at that time indicated better experience than our actuarial expectations compared to the prior year review. As a result, we recognized favorable development of $3.7 million and $5.8 million for our surety and credit lines of business, respectively, related to the 2010 and prior underwriting years. In the International segment, we released catastrophe reserves related to the 2010 New Zealand earthquake, due to settlement of these claims in 2013.

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

(6) Notes Payable

Our notes payable consisted of the following:

 

						June 30,				December 31,
						2014				2013
6.30% Senior Notes						$	299,174			$	299,098
Revolving Loan Facility							435,000				355,000
Total notes payable						$	734,174			$	654,098
On April 30, 2014, we entered into an agreement to modify our $600.0 million Revolving Loan Facility (Facility). The amended agreement increased the borrowing capacity under the Facility to $825.0 million and extended the term by two years to April 30, 2019, among other changes. The weighted-average interest rate on borrowings under the Facility at June 30, 2014 was 1.4%. The borrowings and letters of credit issued under the Facility reduced our available borrowing capacity on the Facility to $384.1 million at June 30, 2014.   There were no other material changes to the Facility or to the terms and conditions of our Senior Notes or Standby Letter of Credit Facility (Standby Facility) from those described in Note 7, “Notes Payable” to the Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2013.   We were in compliance with debt covenants related to our 6.30% Senior Notes, the Facility and the Standby Facility at June 30, 2014.   (7) Accumulated Other Comprehensive Income   The components of accumulated other comprehensive income in our consolidated balance sheets were as follows:
		Net unrealized    investment gains				Foreign currency translation       adjustment				Accumulated other   comprehensive     income
Six months ended June 30, 2014
Balance at December 31, 2013		$	99,960			$	18,691			$	118,651
Other comprehensive income			99,659				2,112				101,771
Balance at June 30, 2014		$	199,619			$	20,803			$	220,422
Three months ended June 30, 2014
Balance at March 31, 2014		$	142,310			$	19,911			$	162,221
Other comprehensive income			57,309				892				58,201
Balance at June 30, 2014		$	199,619			$	20,803			$	220,422

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

(8) Earnings Per Share

The following table details the numerator and denominator used in our earnings per share calculations.

 

		Six months ended June 30,								Three months ended June 30,
		2014				2013				2014				2013
Net earnings		$	205,047			$	194,012			$	97,136			$	88,162
Less: net earnings attributable to unvested restricted stock			(3,282)				(3,227)				(1,590)				(1,445)
Net earnings available to common stock		$	201,765			$	190,785			$	95,546			$	86,717
Weighted-average common shares outstanding			98,551				98,965				98,442				98,870
Dilutive effect of outstanding securities (determined using treasury stock method)			240				245				218				251
Weighted-average common shares and potential common shares outstanding			98,791				99,210				98,660				99,121
Earnings per common share
Basic		$	2.05			$	1.93			$	0.97			$	0.88
Diluted		$	2.04			$	1.92			$	0.97			$	0.87

(9) Stock-Based Compensation

In 2014, we granted the following shares of common stock, restricted stock and restricted stock units.

 

		Number      of shares				Weighted-average     grant date fair value				Aggregate       fair value				Vesting        period
Common stock			38			$	46.41			$	1,771				None
Restricted stock			333				43.60				14,525				0 - 4 years
Restricted stock units			13				45.14				593				4 years

For common stock grants, we measure fair value based on the closing stock price of our common stock on the grant date and expense it on the grant date.

Certain awards of restricted stock and restricted stock units contain a performance condition based on the ultimate results for the applicable underwriting year. The number of such shares that vest could be higher or lower than initially granted. We measure fair value for these awards based on the closing price of our common stock on the grant date, and we recognize expense on a straight-line basis over the vesting period for those restricted stock awards or units expected to vest.

Certain of our executive officers were granted performance-based restricted stock in 2014. This restricted stock vests after three years and can vest from 0% to 200% of the initial shares granted. Vesting is based equally on an operating return on equity performance factor and a total shareholder return performance factor.

 

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HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

(10) Segments

We report HCC’s results in six operating segments, including the following five insurance underwriting segments:

 

 

The Investing segment includes our consolidated investment portfolio, as well as all investment income, investment related expenses, realized investment gains and losses, and other-than-temporary impairment credit losses on investments. All investment activity is reported as revenue, consistent with our consolidated presentation.

In addition to our segments, we include a Corporate & Other category to reconcile segment results to consolidated totals. The Corporate & Other category includes corporate operating expenses not allocated to the segments, interest expense on long-term debt, foreign currency expense (benefit), and underwriting results of our Exited Lines. Our Exited Lines include product lines that we no longer write and do not expect to write in the future.

The following tables present information by business segment.

 

		U.S. Property & Casualty				Professional  Liability				Accident  & Health				U.S. Surety  & Credit				International				Investing				Corporate  & Other				Consolidated
Six months ended June 30, 2014
Net earned premium		$	185,588			$	173,577			$	472,481			$	97,134			$	205,460			$	-			$	620			$	1,134,860
Other revenue			9,946				470				5,502				868				1,899				138,395				564				157,644
Segment revenue			195,534				174,047				477,983				98,002				207,359				138,395				1,184				1,292,504
Loss and LAE			93,388				103,321				341,295				28,558				82,380				-				(4)				648,938
Other expense			58,148				34,545				74,254				53,407				79,979				-				50,617				350,950
Segment expense			151,536				137,866				415,549				81,965				162,359				-				50,613				999,888
Segment pretax earnings (loss)		$	43,998			$	36,181			$	62,434			$	16,037			$	45,000			$	138,395			$	(49,429)			$	292,616
Six months ended June 30, 2013
Net earned premium		$	184,963			$	185,223			$	434,947			$	97,231			$	210,412			$	-			$	9,766			$	1,122,542
Other revenue			11,429				325				2,330				621				1,902				124,626				22				141,255
Segment revenue			196,392				185,548				437,277				97,852				212,314				124,626				9,788				1,263,797
Loss and LAE			107,394				111,821				320,566				18,851				104,916				-				8,623				672,171
Other expense			52,757				35,872				63,709				53,681				71,921				-				37,459				315,399
Segment expense			160,151				147,693				384,275				72,532				176,837				-				46,082				987,570
Segment pretax earnings (loss)		$	36,241			$	37,855			$	53,002			$	25,320			$	35,477			$	124,626			$	(36,294)			$	276,227

 

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Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

		U.S. Property & Casualty				Professional  Liability				Accident   & Health				U.S. Surety   & Credit				International				Investing				Corporate   & Other				Consolidated
Three months ended June 30, 2014
Net earned premium		$	88,536			$	88,127			$	240,338			$	50,191			$	104,727			$	-			$	329			$	572,248
Other revenue			4,070				195				3,862				580				931				61,343				345				71,326
Segment revenue			92,606				88,322				244,200				50,771				105,658				61,343				674				643,574
Loss and LAE			46,733				52,189				172,296				14,862				40,765				-				249				327,094
Other expense			29,055				17,420				37,875				27,463				41,302				-				25,721				178,836
Segment expense			75,788				69,609				210,171				42,325				82,067				-				25,970				505,930
Segment pretax earnings (loss)		$	16,818			$	18,713			$	34,029			$	8,446			$	23,591			$	61,343			$	(25,296)			$	137,644
Three months ended June 30, 2013
Net earned premium		$	91,432			$	92,444			$	217,822			$	50,054			$	105,270			$	-			$	4,334			$	561,356
Other revenue			4,245				739				1,140				384				1,124				60,291				152				68,075
Segment revenue			95,677				93,183				218,962				50,438				106,394				60,291				4,486				629,431
Loss and LAE			55,238				55,435				160,139				5,637				58,997				-				4,028				339,474
Other expense			25,452				18,124				32,583				27,402				36,212				-				25,353				165,126
Segment expense			80,690				73,559				192,722				33,039				95,209				-				29,381				504,600
Segment pretax earnings (loss)		$	14,987			$	19,624			$	26,240			$	17,399			$	11,185			$	60,291			$	(24,895)			$	124,831

(11) Commitments and Contingencies

Catastrophe and Large Loss Exposure

We have exposure to catastrophic and other large losses caused by natural perils (such as hurricanes, earthquakes, floods, tsunamis, hail storms and tornados) and man-made events (such as terrorist attacks). The incidence, timing and severity of these losses are unpredictable. We assess our exposures in areas most vulnerable to natural catastrophes and apply procedures to ascertain our probable maximum loss from a single event. We maintain reinsurance protection to reduce our potential losses from a future event. In the first six months of 2014, we recognized accident year net catastrophe losses, after reinsurance and reinstatement premium, of $9.5 million related to various small catastrophes. We recognized $26.6 million in the first six months of 2013, primarily due to European floods during the second quarter and various small catastrophes.

Litigation

We are a party to lawsuits, arbitrations and other proceedings that arise in the normal course of our business. Many of such lawsuits, arbitrations and other proceedings involve claims under policies that we underwrite as an insurer or reinsurer, the liabilities for which, we believe, have been adequately included in our loss reserves. Also, from time to time, we are a party to lawsuits, arbitrations and other proceedings that relate to disputes with third parties, or that involve alleged errors and omissions on the part of our subsidiaries. We have provided accruals for these items to the extent we deem the losses probable and reasonably estimable. Although the ultimate outcome of these matters cannot be determined at this time, based on present information, the availability of insurance coverage and advice received from our outside legal counsel, we believe the resolution of any such matters will not, individually or in the aggregate, have a material adverse effect on our consolidated financial position, results of operations or cash flows.

 

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Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

 

Indemnifications

In conjunction with the sales of business assets and subsidiaries, we have provided indemnifications to the buyers. Certain indemnifications cover typical representations and warranties related to our responsibilities to perform under the sales contracts. Under other indemnifications, we agree to reimburse the purchasers for taxes or ERISA-related amounts, if any, assessed after the sale date but related to pre-sale activities. We cannot quantify the maximum potential exposure covered by all of our indemnifications because the indemnifications cover a variety of matters, operations and scenarios and some have no time limit. For those with a time limit, the longest indemnification expires in 2025. We accrue a loss when a valid claim is made by a purchaser and we believe we have potential exposure.

(12) Supplemental Information

Supplemental cash flow information was as follows:

 

		Six months ended June 30,								Three months ended June 30,
		2014				2013				2014				2013
Income taxes paid		$	70,413			$	99,941			$	70,891			$	67,799
Interest paid			14,984				13,322				13,445				11,932
Proceeds from sales of available for sale fixed maturity securities			286,843				171,801				167,832				13,666
Proceeds from sales of equity securities			170,182				44,308				26,107				26,500
Dividends declared but not paid at end of period			22,493				16,523

 

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

The following Management’s Discussion and Analysis should be read in conjunction with our Consolidated Financial Statements and the related Notes as of June 30, 2014 and December 31, 2013.

Overview

We are a specialty insurance group with offices in the United States, the United Kingdom, Spain and Ireland, transacting business in approximately 180 countries. Our shares trade on the New York Stock Exchange and closed at $47.94 on July 25, 2014, resulting in market capitalization of $4.8 billion.

We underwrite and manage a variety of largely non-correlated specialty insurance products through these five insurance underwriting segments: U.S. Property & Casualty, Professional Liability, Accident & Health, U.S. Surety & Credit and International. We market our insurance products through a network of independent agents and brokers, through managing general agents owned by the company, and directly to consumers. In addition, we assume insurance written by other insurance companies.

Our organization is focused on generating consistent, industry-leading combined ratios. We concentrate our insurance writings in selected specialty lines of business in which we believe we can achieve meaningful underwriting profit. We rely on experienced underwriting personnel working within defined and monitored limits and our access to and expertise in the reinsurance marketplace to limit or reduce risk. By focusing on underwriting profitability, we are able to accomplish our primary objectives of maximizing net earnings and growing book value per share.

Our major insurance companies have financial strength ratings of AA (Very Strong) from Standard & Poor’s Corporation, A+ (Superior) from A.M. Best Company, Inc., AA (Very Strong) from Fitch Ratings, and A1 (Good Security) from Moody’s Investors Service, Inc.

Our results and key metrics for the six months and quarter ended June 30, 2014 were as follows:

 

		Six months ended June 30,								Three months ended June 30,
		2014				2013				2014				2013
Net earnings		$	205,047			$	194,012			$	97,136			$	88,162
Earnings per diluted share		$	2.04			$	1.92			$	0.97			$	0.87
Net loss ratio			57.2	%			59.9	%			57.2	%			60.5	%
Expense ratio			26.0				24.6				26.3				24.8
Combined ratio			83.2	%			84.5	%			83.5	%			85.3	%

Key facts about our consolidated group as of and for the six months and quarter ended June 30, 2014 are as follows:

 

•

We had consolidated shareholders’ equity of $3.9 billion, with book value per share of $39.12.

 

•

We produced total revenue of $1.3 billion and $643.6 million in the first six months and second quarter, respectively.

 

•

We purchased $41.5 million of our common stock at an average cost of $43.21 per share in the first six months.

 

•

We declared dividends of $0.45 per share and paid $45.1 million of dividends in the first six months.

 

•

Our debt to total capital ratio was 15.8%.

 

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Comparisons in the following sections refer to the first six months of 2014 compared to the same period of 2013, unless otherwise noted. Amounts in tables are in thousands, except for earnings per share, percentages, ratios and number of employees.

Revenue

Gross written premium, net written premium and net earned premium are detailed below by segment.

 

		Six months ended June 30,								Three months ended June 30,
		2014				2013				2014				2013
U.S. Property & Casualty		$	357,287			$	358,388			$	184,280			$	183,251
Professional Liability			245,930				246,393				140,502				142,374
Accident & Health			486,476				430,470				250,559				214,909
U.S. Surety & Credit			112,697				111,438				61,645				59,189
International			376,441				373,193				195,414				205,386
Exited Lines			620				9,766				329				4,334
Total gross written premium		$	1,579,451			$	1,529,648			$	832,729			$	809,443
U.S. Property & Casualty		$	185,385			$	208,869			$	95,377			$	104,987
Professional Liability			163,805				163,761				94,204				96,135
Accident & Health			483,761				429,868				249,010				214,600
U.S. Surety & Credit			98,058				98,128				53,977				52,624
International			305,567				297,826				154,117				156,354
Exited Lines			620				9,766				329				4,334
Total net written premium		$	1,237,196			$	1,208,218			$	647,014			$	629,034
U.S. Property & Casualty		$	185,588			$	184,963			$	88,536			$	91,432
Professional Liability			173,577				185,223				88,127				92,444
Accident & Health			472,481				434,947				240,338				217,822
U.S. Surety & Credit			97,134				97,231				50,191				50,054
International			205,460				210,412				104,727				105,270
Exited Lines			620				9,766				329				4,334
Total net earned premium		$	1,134,860			$	1,122,542			$	572,248			$	561,356

Growth in written premium occurred primarily in the Accident & Health segment, from growth of our medical stop-loss and short-term medical products. See the “Segment Operations” section below for further discussion of the relationship and changes in premium revenue within each insurance underwriting segment.

Net investment income, which is included in our Investing segment, increased 2% year-over-year primarily due to higher dividend income from equity securities, partially offset by lower income from reduced reinvestment yields. We recognized $25.2 million of net realized investment gains in the first six months of 2014, principally due to the sale of equity securities in the first quarter, compared to $13.2 million in the first six months of 2013. See the “Investing Segment” section below for further discussion of our investing activities.

 

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Loss and Loss Adjustment Expense

The tables below detail our net loss and loss adjustment expense and our net loss ratios on a consolidated basis and for our segments.

 

		Six months ended June 30,								Three months ended June 30,
		2014				2013				2014				2013
U.S. Property & Casualty		$	93,388			$	107,394			$	46,733			$	55,238
Professional Liability			103,321				111,821				52,189				55,435
Accident & Health			341,295				320,566				172,296				160,139
U.S. Surety & Credit			28,558				18,851				14,862				5,637
International			82,380				104,916				40,765				58,997
Exited Lines			(4)				8,623				249				4,028
Net loss and loss adjustment expense		$	648,938			$	672,171			$	327,094			$	339,474
U.S. Property & Casualty			50.3	%			58.1	%			52.8	%			60.4	%
Professional Liability			59.5				60.4				59.2				60.0
Accident & Health			72.2				73.7				71.7				73.5
U.S. Surety & Credit			29.4				19.4				29.6				11.3
International			40.1				49.9				38.9				56.0
Consolidated net loss ratio			57.2	%			59.9	%			57.2	%			60.5	%
Consolidated accident year net loss ratio			57.2	%			60.9	%			57.2	%			62.6	%

Net loss and loss adjustment expense (referred to as loss expense) decreased $23.2 million in the first six months of 2014 compared to the same period in 2013. The lower loss expense stemmed from our: 1) U.S. Property & Casualty segment, primarily due to lower losses in our public risk business, 2) Professional Liability segment, primarily due to lower earned premium and 3) International segment, due to lower earned premium, lower catastrophe losses in our property treaty line of business and a lower loss ratio in our surety & credit line of business. These decreases were partially offset by higher loss expense from: 1) our Accident & Health segment, due to growth of our medical stop-loss and short-term medical products and 2) favorable development in 2013, primarily in our U.S. Surety & Credit segment. We recognized no prior year reserve development in the first six months of 2014. See the “Segment Operations” section below for additional discussion of the changes in our loss expense, as well as discussion of the net loss ratios for each segment for 2014 and 2013.

 

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The table below provides a reconciliation of our consolidated reserves for loss and loss adjustment expense payable, net of reinsurance ceded, the amount of our paid claims, and our net paid loss ratio.

 

		Six months ended June 30,								Three months ended June 30,
		2014				2013				2014				2013
Net reserves at beginning of period		$	2,779,401			$	2,749,803			$	2,748,841			$	2,761,242
Net loss and loss adjustment expense			648,938				672,171				327,094				339,474
Net loss and loss adjustment expense payments			(674,070)				(586,326)				(319,114)				(286,797)
Foreign currency adjustment			5,979				(24,627)				3,427				(2,898)
Net reserves at end of period		$	2,760,248			$	2,811,021			$	2,760,248			$	2,811,021
Net paid loss ratio			59.4	%			52.2	%			55.8	%			51.1	%

The amount of claims paid fluctuates year-over-year due to the timing of claims settlement, the occurrence of catastrophic events and commutations, and the mix of our business. In the first six months of 2014, we paid $124.5 million to settle claims related to Spanish surety bonds, of which approximately 60% was reinsured, increasing the net paid loss ratio by 4.6 percentage points.

Policy Acquisition Costs

The percentage of policy acquisition costs to net earned premium was 12.5% and 12.3% for the first six months of 2014 and 2013, respectively, and 12.8% and 12.6% for the second quarter of 2014 and 2013, respectively. The difference between periods primarily related to increased commission rates on certain of our businesses.

Other Operating Expense

Other operating expense increased 18% year-over-year and 13% quarter-over-quarter in 2014 compared to 2013, primarily due to the fluctuation in foreign currency benefit/expense. Our foreign currency expense was $6.7 million and $2.8 million in the first six months and second quarter of 2014, respectively. We recognized a foreign currency benefit of $9.0 million and expense of $1.9 million in the first six months and second quarter of 2013, respectively. The foreign currency benefit/expense related to changes in the value of the British pound sterling and the Euro relative to the U.S. dollar.

Excluding the effect of foreign currency benefit/expense, other operating expense increased 8% year-over-year and 12% quarter-over-quarter, mainly due to increased compensation and benefit costs in 2014. Our employee count has grown to 1,933 from 1,900 at December 31, 2013, and our bonus expense increased in 2014 due to higher pretax earnings. Other operating expense included stock-based compensation expense of $9.3 million in 2014 and $7.2 million in 2013. At June 30, 2014, there was approximately $33.7 million of total unrecognized compensation expense related to unvested restricted stock awards and units, options and our employee stock purchase plan that is expected to be recognized over a weighted-average period of 2.5 years.

Interest Expense

Interest expense was $14.0 million and $13.1 million in the first six months of 2014 and 2013, respectively, and included $9.7 million for our Senior Notes in both years.

Income Tax Expense

Our effective income tax rate was 29.9% for the first six months of 2014, compared to 29.8% for the same period of 2013.

 

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Segment Operations

Each of our insurance segments bears risk for insurance coverage written within its portfolio of insurance products. Each segment generates income from premium written by our underwriting agencies, through third party agents and brokers, or on a direct basis. Certain segments also write facultative or individual account reinsurance, as well as treaty reinsurance business. In some cases, we purchase reinsurance to limit our losses from both individual policy losses and multiple policy losses from catastrophic occurrences and from aggregate losses in a year. Our segments maintain disciplined expense management and a streamlined management structure, which results in favorable expense ratios. The following provides operational information about our insurance underwriting segments, Investing segment and Corporate & Other category.

In 2014, we changed the presentation of certain categories of business that we disclose within our insurance underwriting segments and recast prior period financial data to be comparative with the revised presentation. However, we did not change our reportable segments. We believe this realignment of certain categories within segments provides better operational information for management and our shareholders.

U.S. Property & Casualty Segment

The following tables summarize the operations of the U.S. Property & Casualty segment.

 

		Six months ended June 30,								Three months ended June 30,
		2014				2013				2014				2013
Net earned premium		$	185,588			$	184,963			$	88,536			$	91,432
Other revenue			9,946				11,429				4,070				4,245
Segment revenue			195,534				196,392				92,606				95,677
Loss and loss adjustment expense, net			93,388				107,394				46,733				55,238
Other expense			58,148				52,757				29,055				25,452
Segment expense			151,536				160,151				75,788				80,690
Segment pretax earnings		$	43,998			$	36,241			$	16,818			$	14,987
Net loss ratio			50.3	%			58.1	%			52.8	%			60.4	%
Expense ratio			29.7				26.9				31.4				26.6
Combined ratio			80.0	%			85.0	%			84.2	%			87.0	%
Aviation		$	54,130			$	56,286			$	27,371			$	28,429
Liability			53,667				48,927				27,029				24,977
Sports & Entertainment			15,555				12,480				7,418				6,168
Public Risk			25,007				32,755				11,973				16,395
Other			37,229				34,515				14,745				15,463
Total net earned premium		$	185,588			$	184,963			$	88,536			$	91,432
Aviation			60.9	%			63.0	%			61.9	%			64.3	%
Liability			59.9				63.7				59.8				64.3
Sports & Entertainment			49.3				61.6				51.0				74.3
Public Risk			58.4				76.7				58.0				75.1
Other			16.1				23.0				19.7				25.9
Total net loss ratio			50.3	%			58.1	%			52.8	%			60.4	%

 

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		Six months ended June 30,								Three months ended June 30,
		2014				2013				2014				2013
Aviation		$	70,344			$	75,182			$	37,897			$	38,184
Liability			92,145				76,432				48,673				39,339
Sports & Entertainment			77,090				81,528				34,948				47,093
Public Risk			35,570				37,105				14,847				15,664
Other			82,138				88,141				47,915				42,971
Total gross written premium		$	357,287			$	358,388			$	184,280			$	183,251
Aviation		$	58,650			$	60,134			$	33,327			$	31,520
Liability			64,110				55,255				33,015				28,011
Sports & Entertainment			13,714				14,163				6,649				8,390
Public Risk			18,779				29,880				7,891				14,109
Other			30,132				49,437				14,495				22,957
Total net written premium		$	185,385			$	208,869			$	95,377			$	104,987

Our U.S. Property & Casualty segment pretax earnings increased 21% year-over-year, and 12% quarter-over-quarter, primarily due to lower loss expense, partially offset by higher other expenses. Gross written premium decreased in 2014 due to: 1) reduced pricing from increased competition in Aviation and 2) cyclical reductions in Sports & Entertainment and title and residual value insurance (both included in Other). These decreases were largely offset by increased writings of our expanding casualty business, included in Liability, and timing of renewals for our brown water marine business (included in Other). Net written premium for Public Risk decreased in 2014 due to additional quota share reinsurance. Higher net earned premium, due to growth in our casualty business, was partially offset by reduced premium earned by Public Risk due to the change in our reinsurance program. Loss expense decreased in 2014, compared to 2013, primarily due to lower losses in Public Risk based on our re-underwriting of that book of business in 2013. The segment’s expense ratio increased in 2014 primarily due to higher compensation costs.

Regarding changes in presentation, the segment now includes Liability and Sports & Entertainment categories. The Liability category includes the prior E&O category, as well as employment practices liability, primary casualty and excess casualty, which were previously included in the Other category. The Sports & Entertainment category includes disability and contingency, which were previously included in the Other category.

 

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Professional Liability Segment

The following tables summarize the operations of the Professional Liability segment.

 

		Six months ended June 30,								Three months ended June 30,
		2014				2013				2014				2013
Net earned premium		$	173,577			$	185,223			$	88,127			$	92,444
Other revenue			470				325				195				739
Segment revenue			174,047				185,548				88,322				93,183
Loss and loss adjustment expense, net			103,321				111,821				52,189				55,435
Other expense			34,545				35,872				17,420				18,124
Segment expense			137,866				147,693				69,609				73,559
Segment pretax earnings		$	36,181			$	37,855			$	18,713			$	19,624
Net loss ratio			59.5	%			60.4	%			59.2	%			60.0	%
Expense ratio			19.8				19.3				19.7				19.4
Combined ratio			79.3	%			79.7	%			78.9	%			79.4	%
Gross written premium		$	245,930			$	246,393			$	140,502			$	142,374
Net written premium		$	163,805			$	163,761			$	94,204			$	96,135

Our Professional Liability segment pretax earnings decreased 4% year-to-date in 2014, compared to the same period of 2013, due to lower net earned premium that was partially offset by an improved net loss ratio. The decrease in net earned premium related to lower net written premium in the second half of 2013, compared to the second half of 2012.

 

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Accident & Health Segment

The following tables summarize the operations of the Accident & Health segment.

 

		Six months ended June 30,								Three months ended June 30,
		2014				2013				2014				2013
Net earned premium		$	472,481			$	434,947			$	240,338			$	217,822
Other revenue			5,502				2,330				3,862				1,140
Segment revenue			477,983				437,277				244,200				218,962
Loss and loss adjustment expense, net			341,295				320,566				172,296				160,139
Other expense			74,254				63,709				37,875				32,583
Segment expense			415,549				384,275				210,171				192,722
Segment pretax earnings		$	62,434			$	53,002			$	34,029			$	26,240
Net loss ratio			72.2	%			73.7	%			71.7	%			73.5	%
Expense ratio			15.5				14.6				15.5				14.9
Combined ratio			87.7	%			88.3	%			87.2	%			88.4	%
Medical Stop-loss		$	429,124			$	404,604			$	214,894			$	202,010
Other			43,357				30,343				25,444				15,812
Total net earned premium		$	472,481			$	434,947			$	240,338			$	217,822
Medical Stop-loss			74.8	%			75.2	%			74.8	%			75.2	%
Other			46.4				53.9				45.2				51.8
Total net loss ratio			72.2	%			73.7	%			71.7	%			73.5	%
Medical Stop-loss		$	431,811			$	405,039			$	216,413			$	202,231
Other			54,665				25,431				34,146				12,678
Total gross written premium		$	486,476			$	430,470			$	250,559			$	214,909
Medical Stop-loss		$	429,096			$	404,604			$	214,864			$	202,010
Other			54,665				25,264				34,146				12,590
Total net written premium		$	483,761			$	429,868			$	249,010			$	214,600

The Accident & Health segment pretax earnings increased 18% in the first six months of 2014, and 30% in the second quarter of 2014, compared to the respective periods in 2013. This increase was directly attributable to writing new medical stop-loss and short-term medical business, as well as rate increases on renewal business in 2014. The segment’s expense ratio increased in 2014 due to higher commissions related to the short-term medical product, as well as higher compensation costs.

 

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U.S. Surety & Credit Segment

The following tables summarize the operations of the U.S. Surety & Credit segment.

 

		Six months ended June 30,								Three months ended June 30,
		2014				2013				2014				2013
Net earned premium		$	97,134			$	97,231			$	50,191			$	50,054
Other revenue			868				621				580				384
Segment revenue			98,002				97,852				50,771				50,438
Loss and loss adjustment expense, net			28,558				18,851				14,862				5,637
Other expense			53,407				53,681				27,463				27,402
Segment expense			81,965				72,532				42,325				33,039
Segment pretax earnings		$	16,037			$	25,320			$	8,446			$	17,399
Net loss ratio			29.4	%			19.4	%			29.6	%			11.3	%
Expense ratio			54.5				54.9				54.1				54.3
Combined ratio			83.9	%			74.3	%			83.7	%			65.6	%
Surety		$	71,723			$	72,725			$	36,878			$	37,118
Credit			25,411				24,506				13,313				12,936
Total net earned premium		$	97,134			$	97,231			$	50,191			$	50,054
Surety			24.9	%			19.8	%			24.7	%			14.9	%
Credit			42.2				18.1				43.2				0.8
Total net loss ratio			29.4	%			19.4	%			29.6	%			11.3	%
Surety		$	80,333			$	80,327			$	43,131			$	42,631
Credit			32,364				31,111				18,514				16,558
Total gross written premium		$	112,697			$	111,438			$	61,645			$	59,189
Surety		$	71,712			$	72,146			$	38,896			$	38,456
Credit			26,346				25,982				15,081				14,168
Total net written premium		$	98,058			$	98,128			$	53,977			$	52,624

Our U.S. Surety & Credit segment pretax earnings decreased $9.3 million year-over-year and $9.0 million quarter-over-quarter, due to $9.5 million of favorable loss development recognized in the first six months and second quarter of 2013. We recognized no loss development for the same periods of 2014.

In the second quarter of 2013, we conducted a limited review of the segment’s reserves due to the settlement of a large 2010 claim on favorable terms. This review indicated that actual loss experience for the 2010 and prior underwriting years was significantly better in 2013 compared to the prior year review. As a result, we recognized favorable development of $3.7 million for Surety and $5.8 million for Credit in the second quarter of 2013.

 

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International Segment

The following tables summarize the operations of the International segment.

 

		Six months ended June 30,								Three months ended June 30,
		2014				2013				2014				2013
Net earned premium		$	205,460			$	210,412			$	104,727			$	105,270
Other revenue			1,899				1,902				931				1,124
Segment revenue			207,359				212,314				105,658				106,394
Loss and loss adjustment expense, net			82,380				104,916				40,765				58,997
Other expense			79,979				71,921				41,302				36,212
Segment expense			162,359				176,837				82,067				95,209
Segment pretax earnings		$	45,000			$	35,477			$	23,591			$	11,185
Net loss ratio			40.1	%			49.9	%			38.9	%			56.0	%
Expense ratio			38.6				33.9				39.1				34.0
Combined ratio			78.7	%			83.8	%			78.0	%			90.0	%
Marine & Energy		$	43,550			$	52,292			$	21,703			$	26,584
Property Treaty			51,413				58,498				26,648				29,743
Surety & Credit			40,139				36,066				20,203				17,853
Liability			40,365				35,583				21,229				18,408
Other			29,993				27,973				14,944				12,682
Total net earned premium		$	205,460			$	210,412			$	104,727			$	105,270
Marine & Energy			49.8	%			48.0	%			51.8	%			46.5	%
Property Treaty			20.1				51.1				19.4				77.1
Surety & Credit			45.6				63.0				42.7				62.5
Liability			49.3				49.4				47.5				48.9
Other			40.4				34.3				37.8				27.9
Total net loss ratios			40.1	%			49.9	%			38.9	%			56.0	%
Marine & Energy		$	118,602			$	125,658			$	80,854			$	91,036
Property Treaty			99,929				113,995				31,937				41,650
Surety & Credit			55,251				46,196				28,894				25,030
Liability			50,078				40,210				27,387				22,077
Other			52,581				47,134				26,342				25,593
Total gross written premium		$	376,441			$	373,193			$	195,414			$	205,386

 

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		Six months ended June 30,								Three months ended June 30,
		2014				2013				2014				2013
Marine & Energy		$	82,082			$	82,972			$	57,197			$	61,499
Property Treaty			87,829				101,266				27,291				35,099
Surety & Credit			49,085				40,290				26,038				21,641
Liability			46,326				37,577				25,182				21,007
Other			40,245				35,721				18,409				17,108
Total net written premium		$	305,567			$	297,826			$	154,117			$	156,354

Our International segment pretax earnings increased $9.5 million in the first six months and $12.4 million in the second quarter of 2014, compared to the same period of 2013, due to the favorable impact of lower net catastrophe losses in Property Treaty, partially offset by lower net earned premium and higher other expenses in 2014. Gross written premium and net written premium increased year-to-date in 2014, compared to 2013, due to increased writings in Surety & Credit, Liability and our direct and facultative property line of business (included in Other). These increases were largely offset by decreased writings of Marine & Energy and Property Treaty, due to reduced pricing and expanded competition in these lines. The segment’s expense ratio increased in 2014 primarily due to higher compensation expense and the stronger British pound sterling compared to the U.S. dollar in 2014.

In the second quarter of 2013, we recognized large catastrophe losses of $15.0 million related to European floods, including $2.0 million of inward reinstatement premium. There were no large catastrophe losses in the first six months of 2014. The remaining net catastrophe losses in 2014 and 2013 related to small catastrophes. The following table summarizes the segment’s net catastrophes losses, as well as the impact on key metrics:

 

		Six months ended June 30,								Three months ended June 30,
		2014				2013				2014				2013
Loss and loss adjustment expense, after reinsurance		$	10,355			$	29,921			$	5,172			$	22,935
Reinstatement premium, net			(816)				(3,291)				(269)				(1,515)
Total net catastrophe losses		$	9,539			$	26,630			$	4,903			$	21,420
Impact of net catastrophe losses (percentage points):
Net loss ratio			4.9	%			13.7	%			4.8	%			21.2	%
Expense ratio			(0.1)				(0.5)				(0.1)				(0.5)
Combined ratio			4.8	%			13.2	%			4.7	%			20.7	%

In the second quarter of 2013, we recognized favorable loss development of $2.3 million in the direct and facultative property line of business related to our 2010 New Zealand earthquake catastrophe losses, due to settlement of these claims in 2013.

Regarding changes in presentation, the Marine & Energy category now includes the marine business, which was previously included in the Other category.

 

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Investing Segment

We invest the majority of our funds in highly-rated fixed maturity securities, which are designated as available for sale securities. We held $6.3 billion of fixed maturity securities at June 30, 2014. Substantially all of our fixed maturity securities were investment grade and 73% were rated AAA or AA. In addition, we held $448.7 million of equity securities at June 30, 2014.

The following tables summarize the results and certain key metrics of our Investing segment.

 

		Six months ended June 30,								Three months ended June 30,
		2014				2013				2014				2013
Net investment income from:
Fixed maturity securities
Taxable		$	47,279			$	51,022			$	24,019			$	25,062
Exempt from U.S. income taxes			57,175				56,075				28,592				28,186
Total fixed maturity securities			104,454				107,097				52,611				53,248
Equity securities			12,143				7,808				5,506				4,228
Other			728				399				297				434
Total investment income			117,325				115,304				58,414				57,910
Investment expense			(4,081)				(3,871)				(1,976)				(2,242)
Total net investment income			113,244				111,433				56,438				55,668
Net realized investment gain			25,151				13,193				4,905				4,623
Segment pretax earnings		$	138,395			$	124,626			$	61,343			$	60,291
Fixed maturity securities:
Average yield *			3.5 %				3.7	%			3.5	%			3.6	%
Average tax equivalent yield *			4.4 %				4.5	%			4.4	%			4.5	%
Weighted-average life			8.2 years				8.4 years
Weighted-average duration			4.7 years				5.5 years
Weighted-average rating			AA				AA

 

 

* Excluding realized and unrealized gains and losses.

 

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This table summarizes our investments by type, all of which were reported at fair value, at June 30, 2014 and December 31, 2013.

 

		June 30, 2014								December 31, 2013
		Amount				%				Amount				%
Fixed maturity securities
U.S. government and government agency securities		$	85,627				1	%		$	92,709				1	%
Fixed maturity securities of states, municipalities and political subdivisions			965,705				14				986,486				15
Special purpose revenue bonds of states, municipalities and political subdivisions			2,376,963				33				2,265,195				34
Corporate securities			1,199,711				17				1,225,238				18
Residential mortgage-backed securities			764,534				11				618,119				9
Commercial mortgage-backed securities			547,117				8				504,888				7
Asset-backed securities			304,396				4				182,392				3
Foreign government securities			89,138				1				147,446				2
Equity securities			448,685				6				517,466				8
Short-term investments			342,335				5				178,753				3
Total investments		$	7,124,211				100	%		$	6,718,692				100	%

At June 30, 2014, we held corporate fixed maturity securities issued by foreign corporations with an aggregate fair value of $484.3 million. In addition, we held securities issued by foreign governments, agencies or supranational entities with an aggregate fair value of $89.1 million. At December 31, 2013, we held $497.0 million and $147.4 million, respectively.

Our total investments increased $405.5 million in 2014, principally from a $154.7 million increase in the pretax net unrealized gain and newly generated cash flow. At June 30, 2014, the net unrealized gain on our investment portfolio was $308.7 million. The increase in the net unrealized gain was due to the decline in interest rates in 2014. Rates on 10-year U.S. Treasury notes declined 50 basis points in the first six months of 2014. The weighted-average duration of our fixed maturity securities portfolio decreased to 4.7 years at June 30, 2014 (compared to 5.1 years at December 31, 2013 and 5.5 years at June 30, 2013), primarily due to the impact of the lower market interest rates on our municipal securities with call options and structured securities with prepayment options.

In the first quarter of 2014, we sold equity securities with a book value of $142.0 million, and realized a net gain of $21.3 million, in order to reposition our overall investment portfolio. In July 2014, we sold equity securities with a book value of $197.0 million and realized a net gain of $35.2 million, which will be reported in the third quarter. Due to an increase in equity valuations in early July, we made a decision at that time to further reduce our overall equity exposure.

The ratings of our individual securities within our fixed maturity securities portfolio at June 30, 2014 were as follows:

 

		Amount				%
AAA		$	906,225				14	%
AA			3,753,885				59
A			1,268,221				20
BBB			253,753				4
BB and below			151,107				3
Total fixed maturity securities		$	6,333,191				100	%

 

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Corporate & Other

The following table summarizes activity in the Corporate & Other category.

 

		Six months ended June 30,								Three months ended June 30,
		2014				2013				2014				2013
Net earned premium		$	620			$	9,766			$	329			$	4,334
Other revenue			564				22				345				152
Total revenue			1,184				9,788				674				4,486
Loss and loss adjustment expense, net			(4)				8,623				249				4,028
Other expense - Exited Lines			1,872				2,523				919				1,184
Other expense - Corporate			28,207				31,138				15,236				15,773
Interest expense			13,861				12,843				6,800				6,457
Foreign currency expense (benefit)			6,677				(9,045)				2,766				1,939
Total expense			50,613				46,082				25,970				29,381
Pretax loss		$	(49,429)			$	(36,294)			$	(25,296)			$	(24,895)

Net earned premium decreased year-over-year as we wrote less business due to our exiting HMO and medical excess reinsurance in late 2012. Premium related to the other products included in Exited Lines was insignificant in both periods. The loss and loss adjustment expense in 2013 related to the HMO and medical excess reinsurance products.

Our Corporate expenses not allocated to the segments decreased year-over-year, primarily due to lower compensation and benefit costs and allocation of certain stock-based compensation expense to our insurance underwriting segments beginning in 2014. The impact of foreign currency benefit/expense fluctuated period-over-period principally due to changes in the value of the British pound sterling and the Euro relative to the U.S. dollar. We hold available for sale securities denominated in non-functional currencies to economically hedge the currency exchange risk on our loss reserves denominated in non-functional currencies. The foreign currency benefit/expense related to loss reserves is recorded through the income statement, while the foreign currency benefit/expense related to available for sale securities is recorded through other comprehensive income within shareholders’ equity. This mismatch may cause fluctuations in our reported foreign currency benefit/expense in future periods.

 

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Liquidity and Capital Management

We believe we have sufficient sources of liquidity at both a consolidated and insurance company legal entity level at a reasonable cost to pay claims and meet our other contractual obligations and liabilities as they become due in the short-term and long-term. Our current sources of liquidity include: 1) significant operating cash flow generated by our insurance companies, 2) our investment portfolio, most of which is held by our insurance companies, 3) our revolving loan and standby letter of credit facilities and 4) a $1.0 billion shelf registration. Our sources of liquidity are discussed below.

Cash Flow

We manage the liquidity of our insurance companies such that each subsidiary’s anticipated claims payments will be met by its own current operating cash flows, cash, short-term investments or investment maturities. Our insurance companies receive substantial cash from premiums, reinsurance recoverables, surety collateral, outward commutations, proceeds from sales and redemptions of investments, and investment income. Their principal cash outflows are for the payment of claims and loss adjustment expenses, premium payments to reinsurers, return of surety collateral, inward commutations, purchases of investments, policy acquisition costs, operating expenses, taxes and dividends paid to the parent company. We report all of the insurance companies’ investing activity in our Investing segment for segment reporting purposes. Our parent company’s principal cash inflows relate to its investment portfolio and dividends paid by the insurance companies, and its principal cash outflows relate to debt service, operating expenses, dividends paid to shareholders and common stock purchases. Cash provided by operating activities can fluctuate due to timing differences in the collection of premium receivables, reinsurance recoverables and surety collateral; the payment of losses, premium payables and return of surety collateral; and the completion of commutations.

The components of our net operating cash flows are summarized in the following table.

 

		Six months ended June 30,
		2014				2013
Net earnings		$	205,047			$	194,012
Change in premium, claims and other receivables, net of reinsurance, premium and claims payables			(53,279)				(56,660)
Change in unearned premium, net			102,763				84,727
Change in loss and loss adjustment expense payable, net of reinsurance recoverables			39,652				35,008
Change in accounts payable and accrued liabilities			(69,414)				(119,103)
Gain on investments			(25,151)				(13,193)
Other, net			(4,332)				(22,801)
Cash provided by operating activities		$	195,286			$	101,990

Our cash provided by operating activities was $195.3 million in the first six months of 2014, compared to $102.0 million in the same period of 2013. Cash provided by operating activities includes collateral funds we receive or refund for our U.S. surety business, for which we record a liability within accounts payable and accrued liabilities. We refunded U.S. surety collateral of $16.1 million in 2014 and $74.3 million in 2013. In addition, we paid $70.4 million of income tax payments in 2014, compared to $99.9 million in 2013. Other fluctuations in our cash provided by operating activities relate to the timing of the collection and the payment of insurance-related receivables and payables.

The net impact of our payment of claims and collection of recoverables related to Spanish surety bonds is expected to impact our cash provided by operating activities in future periods, although the amount and timing of such payments and receipts are not determinable at this time.

 

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Investments

At June 30, 2014, we held a $7.1 billion investment portfolio, which included $342.3 million of liquid short-term investments. Our fixed maturity and equity securities portfolios are classified as available for sale. We expect to hold our fixed maturity securities until maturity, but we would be able to sell these securities, as well as our equity securities, to generate cash if needed. The parent company held $629.5 million of cash and investments at June 30, 2014, which are available to cover the holding company’s required cash disbursements.

Revolving Loan and Standby Letter of Credit Facilities

At June 30, 2014, we maintained an $825.0 million Revolving Loan Facility (Facility) with $384.1 million of available capacity. During the past several years, we used the Facility to fund purchases of our common stock. We expect to continue to use the Facility to opportunistically repurchase stock in 2014. We also have a $90.0 million Standby Letter of Credit Facility (Standby Facility) that is used to guarantee our performance in our Lloyd’s of London syndicate. The Facility expires in April 2019 and the Standby Facility expires in December 2017. See Note 7, “Notes Payable” to the Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2013 for additional information related to the Facility, the Standby Facility and our long-term debt.

Share Purchases

In 2012, the Board approved a $300.0 million stock purchase plan (the Plan). Purchases under the Plan may be made in the open market or in privately negotiated transactions from time-to-time in compliance with applicable laws, rules and regulations, including Rule 10b-18 under the Securities Exchange Act of 1934, as amended. Purchases under the Plan will be made subject to market and business conditions, the level of cash generated from our operations, cash required for acquisitions, our debt covenant compliance, and other relevant factors. The Plan does not obligate us to purchase any particular number of shares, has no expiration date, and may be suspended or discontinued at any time at the Board’s discretion. As of July 25, 2014, $164.7 million of repurchase authority remains under the Plan.

We purchased our common stock in 2014 and 2013 as follows:

 

		Six months ended June 30,								Three months ended June 30,
		2014				2013				2014				2013
Shares of common stock			961				1,024				225				290
Total cost		$	41,542			$	40,929			$	10,129			$	12,160
Weighted-average cost per share		$	43.21			$	39.96			$	44.98			$	41.94

Shelf Registration

We have a “Universal Shelf” registration statement that expires in March 2015. The Universal Shelf provides for the issuance of $1.0 billion of securities, which may be debt securities, equity securities, or a combination thereof. The Universal Shelf provides us the means to access the debt and equity markets relatively quickly, if we are satisfied with the current pricing in the financial markets.

Recent Accounting Guidance

See Note 1, “General Information — Recent Accounting Guidance” to the Consolidated Financial Statements for a description of recently issued accounting guidance that will impact our consolidated financial statements in future periods.

Critical Accounting Policies

We provided information about our critical accounting policies in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies”, in our Annual Report on Form 10-K for the year ended December 31, 2013. We have made no changes in the identification or methods of application of these policies.

 

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

There have been no material changes in market risk from the information provided in Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” in our Annual Report on Form 10-K for the year ended December 31, 2013.

Item 4. Controls and Procedures

(a) Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Act)) that are designed to ensure that required information is recorded, processed, summarized and reported within the required timeframe, as specified in rules set forth by the Securities and Exchange Commission. Our disclosure controls and procedures are also designed to ensure that information required to be disclosed is accumulated and communicated to management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO), to allow timely decisions regarding required disclosures.

Our management, with the participation of our CEO and CFO, evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2014 using criteria established in the Internal Control – Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this evaluation, our CEO and CFO concluded that our disclosure controls and procedures were effective in providing reasonable assurance of achieving the purposes described in Rule 13a-15(e) under the Act as of June 30, 2014.

(b) Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting that occurred during the quarter ended June 30, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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Part II — Other Information

Item 1. Legal Proceedings

We are a party to lawsuits, arbitrations and other proceedings that arise in the normal course of our business. Many of such lawsuits, arbitrations and other proceedings involve claims under policies that we underwrite as an insurer or reinsurer, the liabilities for which, we believe, have been adequately included in our loss reserves. Also, from time to time, we are a party to lawsuits, arbitrations and other proceedings that relate to disputes with third parties, or that involve alleged errors and omissions on the part of our subsidiaries. We have provided accruals for these items to the extent we deem the losses probable and reasonably estimable. Although the ultimate outcome of these matters cannot be determined at this time, based on present information, the availability of insurance coverage and advice received from our outside legal counsel, we believe the resolution of any such matters will not, individually or in the aggregate, have a material adverse effect on our consolidated financial position, results of operations or cash flows.

Item 1A. Risk Factors

There have been no material changes in the risk factors described in our Annual Report on Form 10-K for the year ended December 31, 2013.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

In 2012, the Board approved the purchase of up to $300.0 million of our common stock (the Plan). Purchases under the Plan may be made in the open market or in privately negotiated transactions from time-to-time in compliance with applicable laws, rules and regulations, including Rule 10b-18 under the Securities Exchange Act of 1934, as amended. Purchases under the Plan will be made, subject to market and business conditions, the level of cash generated from our operations, cash required for acquisitions, our debt covenant compliance, and other relevant factors. The Plan does not obligate us to purchase any particular number of shares, has no expiration date, and may be suspended or discontinued at any time at the Board’s discretion. Our purchases in the second quarter of 2014 were as follows:

 

Period		Total number of             shares purchased		Average price                  paid per share		Total number of shares       purchased as part of publicly announced plans or programs		Approximate dollar         value of shares that may         yet be purchased under the plans or programs
April		184,462		$44.77		184,462		$167,901,624
May		40,741		$45.94		40,741		$166,029,942
June		-		-		-		$166,029,942

Item 3. Defaults Upon Senior Securities

None.

Item 4. Mine Safety Disclosures

None.

Item 5. Other Information

None.

 

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Item 6. Exhibits

 

Exhibit Number
3.1				Restated Certificate of Incorporation and Amendment of Certificate of Incorporation of HCC Insurance Holdings, Inc., filed with Delaware Secretary of State on July 23, 1996 and May 21, 1998, respectively (incorporated by reference to Exhibit 4.1 to Registration Statement on Form S-8 (Registration No. 333-61687) filed on August 17, 1998).
3.2				Fourth Amended and Restated Bylaws of HCC Insurance Holdings, Inc. (incorporated by reference to Exhibit 3.1 to Current Report on Form 8-K filed on August 22, 2013).
4.1				Indenture, dated August 23, 2001, between HCC Insurance Holdings, Inc. and First Union National Bank related to Debt Securities (Senior Debt) (incorporated by reference to Exhibit 4.1 to Current Report on Form 8-K filed on August 24, 2001).
4.2				Form of Fourth Supplemental Indenture, dated November 16, 2009, between HCC Insurance Holdings, Inc. and U.S. Bank National Association related to 6.30% Senior Notes due 2019 (incorporated by reference to Exhibit 4.2 to Current Report on Form 8-K filed on November 13, 2009).
10.1				Third Amendment to Loan Agreement, dated April 30, 2014, among HCC Insurance Holdings, Inc., Wells Fargo Bank, National Association, as Administrative Agent, Barclays Bank PLC and KeyBank National Association, as Co-Syndication Agents, Bank of America, N.A., BMO Harris Bank, N.A., JPMorgan Chase Bank, N.A., The Royal Bank of Scotland PLC and U.S. Bank National Association, as Co-Documentation Agents, and the other lenders party thereto (incorporated by reference to Exhibit 10.1 to Current Report on Form 8-K filed on May 1, 2014).
12		†		Statement Regarding Computation of Ratios.
31.1		†		Certification by Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2		†		Certification by Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1		†		Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101		†		The following financial statements from the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2014 formatted in XBRL: 1) Consolidated Balance Sheets, 2) Consolidated Statements of Earnings, 3) Consolidated Statements of Comprehensive Income, 4) Consolidated Statement of Changes in Shareholders’ Equity, 5) Consolidated Statements of Cash Flows and 6) Notes to Consolidated Financial Statements.

 

 

†	Filed herewith.

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

				HCC Insurance Holdings, Inc.
				(Registrant)
August 1, 2014				/s/ Christopher J.B. Williams
(Date)				Christopher J.B. Williams,
				Chief Executive Officer
August 1, 2014				/s/ Pamela J. Penny
(Date)				Pamela J. Penny, Executive Vice President and Chief Accounting Officer

 

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