Certain amounts in the 2003, 2002, 2001 and 2000 selected consolidated financial data have been reclassified to conform to the 2004 presentation. Such reclassifications had no effect on our net earnings, shareholders’ equity or cash flows.
During 2002, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets, which required that goodwill and indefinite-lived intangible assets no longer be amortized. The adjusted amounts presented are amounts that we would have reported had we adopted SFAS No. 142 on January 1, 2000.
We primarily receive our revenue from earned premium derived from our insurance company operations, fee and commission income generated by our agency operations, ceding commissions in excess of policy acquisition costs earned by our insurance company operations, investment income from all of our operations, and other operating income. Our core underwriting activities involve providing insurance products in the group life, accident and health, diversified financial products, London market account, aviation and other specialty lines of business, each of which is marketed by our insurance companies and our underwriting agencies either through a network of independent agents and brokers or directly to customers.
During the past several years, we have substantially increased our shareholders’ equity through retaining our earnings, other than dividends to shareholders, and through the issuance of our common stock, thereby enabling us to increase the underwriting capacity of our insurance companies and make acquisitions. With this additional equity, we increased underwriting activity across many of our businesses adding new lines of business and emphasizing lines of business and individual opportunities with the most favorable underwriting characteristics at a particular point in the insurance cycle. As an insurer, we also purchase reinsurance for many of our lines of business. We purchase different types of reinsurance in amounts we consider appropriate for our individual lines of business based on market conditions and the level of risk we wish to retain.
During the past three years, we acquired numerous companies in transactions that were recorded using the purchase method of accounting. Accordingly, the results of operations and cash flows of these
The following section discusses our key operating results. The reasons for any significant variations between 2003 and 2002 are the same as those discussed for 2004 and 2003, unless otherwise noted. Amounts in the following tables are in thousands, except for earnings per share, percentages, ratios, and number of employees.
Gross written premium, net written premium and net earned premium are detailed below. We have experienced significant increases in premium due to organic growth of our diversified financial products line of business and acquisitions over the past three years. See the Insurance Company Segment section below for further discussion of the relationship and changes in premium revenue.
Fee and commission income increased 28% to $182.3 million in 2004 and 23% to $142.6 million in 2003. Agencies increased 20% and insurance companies increased 28% year over year in 2004 and 22% and 49%, respectively, year over year in 2003. The largest increase has been in our diversified financial products line of business due to acquisitions made during late 2002, which have continued to grow their business in 2003 and 2004. Our London reinsurance broker has also contributed to the growth for each year. We expect fee and commission income to decrease in 2005 as, effective January 1, 2005, we consolidated one of our largest underwriting agencies into our life insurance company. In addition, we have increased our retentions in certain lines of business, which results in less ceded reinsurance and therefore less commissions to our insurance companies and our reinsurance brokers. However, these actions will increase our underwriting profits in our insurance company subsidiaries.
Compensation expense increased 7% in 2004 and 42% in 2003, primarily due to the addition of employees from acquired subsidiaries and increases in incentive compensation due to increased profitability. Excluding discontinued operations, we had 1,268 employees at year-end 2004, 1,105 at year-end 2003, and 1,046 at year-end 2002. These amounts include approximately 200 employees added in December 2002, approximately 150 employees added in January 2004 and approximately 30 employees added in October 2004, due to acquisitions. The rate of increase in compensation expense for subsidiaries not acquired during the last two years was less than the rate of increase in revenue, thereby contributing to higher margins and increased net earnings.
Our effective income tax rate on earnings from continuing operations was 33.9% for 2004, compared to 35.9% for 2003 and 34.7% for 2002. The effective tax rate decreased primarily because our tax exempt interest income increased as a percentage of our pre-tax income, due to the increase in the tax exempt component of our investment portfolio, and because a higher proportion of our pre-tax income was earned by our insurance company subsidiaries and not subject to state income taxes.
At December 31, 2004, book value per share was $19.45, up from $16.37 at December 31, 2003. Total assets were $5.9 billion and shareholders’ equity was $1.3 billion, up from $4.9 billion and $1.0 billion, respectively, at December 31, 2003.
The largest premium growth, both gross and net, was in our diversified financial products line of business. We experienced organic growth in our directors’ and officers’ businesses, as well as
We reduced our London market account premium writings due to more selective underwriting in response to reduced premium rates from increased competition. Net written premium was also lower in 2004 than in 2003, due to the impact of reinstatement premiums under our catastrophe reinsurance programs as a result of the hurricane activity in the third quarter of 2004. Net written premium was reduced by $15.3 million for reinstatement premiums, compared to only $2.5 million in 2003. Risk retention in this line of business usually is lower than most of our other active lines of business, since the majority of the London market risks have catastrophe exposure; but retained premium is higher because reinsurance is predominantly on an excess of loss basis. Although the immediate effect of the hurricanes was to slow the softening of premium rates for property and energy business, at least temporarily, we cannot anticipate what impact the hurricanes will have on pricing in 2005.
Overall, our retentions increased on most non-catastrophe business as underwriting profitability stayed predictable. We consider our overall market to be relatively stable, although premium rates are still softening, but as long as our margins remain well above an acceptable level, we will continue to retain more of the risk. We are very disciplined underwriters and will not hesitate to reduce our business if market conditions deteriorate below our projected level.
The gross loss ratio was 69.3% in 2004, 70.3% in 2003 and 58.6% in 2002. Our gross loss and loss adjustment expense deficiency relating to prior year losses was $116.1 million in 2004 and $123.2 million in 2003, compared to a redundancy of $23.2 million in 2002. We increased our gross losses related to prior accident years on certain assumed accident and health reinsurance contracts reported in our discontinued line of business by $127.7 million in 2004 and $132.9 million in 2003 due to our processing of additional
information received and our continuing evaluation of reserves related to this business. This re-evaluation was due to a combination of factors including: 1) late reporting by insureds, reinsureds and guaranty associations, 2) changes in our actuarial assumptions to reflect additional information received, and 3) the nature of the business, which is primarily excess of loss reinsurance business where claims can develop slowly. During 2004, we reduced gross incurred but not reported losses for prior accident years on certain of our London market account business by $17.3 million, since these reserves were determined to be redundant. During 2003, we incurred a $30.0 million gross loss on a large warehouse fire and reduced gross losses related to prior accident years on a discontinued aggregate program by $14.3 million based on revised current information. On this same program in 2002, we recorded $36.2 million of adverse gross development. Also, during 2002 we reduced our gross losses from the September 11 terrorist attacks by $21.5 million and our gross loss from the Total Oil Company loss by $14.0 million to its ultimate settlement amount, thereby lowering the 2002 gross loss ratio. The majority of the discontinued and London market business discussed above was substantially reinsured; therefore, the net development was substantially less than the gross development.
Diversified financial products - The surety business of American Contractors Indemnity Company, acquired in January 2004, has a significantly lower loss ratio compared to our other products in this line. As surety business increases, it will have more impact on the diversified financial products net loss ratio. Loss ratios on the other business written in this line remained very stable.
Other specialty lines - The non-catastrophe loss ratio was as expected for new business activities commenced during the past year. The hurricanes increased the net loss ratio 6.5% for 2004.
Policy acquisition costs, which are net of the related portion of commissions on reinsurance ceded, increased to $224.3 million during 2004 from $138.2 million in 2003 and $99.5 million in 2002. These increases were proportionate to the increase in net earned premium after consideration of factors changing our expense ratio. The 2004 increase in the expense ratio was a result of reduced ceding commissions due to higher retentions, plus additional expenses of the surety business at American Contractors Indemnity Company, acquired in January 2004. As is common in the industry, our surety business has a significantly higher expense ratio than our other lines of business, although the surety business also has a much lower expected loss ratio. The 2003 decrease in the expense ratio was due to changes in the mix of business and spreading certain costs over a larger premium volume.
Regulatory guidelines suggest that a property and casualty insurer’s annual statutory gross written premium should not exceed 900% of its statutory policyholders’ surplus and net written premium should not exceed 300% of its statutory policyholders’ surplus. However, industry standards and rating agency criteria place these ratios at 300% and 200%, respectively. Our property and casualty insurance companies have maintained premium to surplus ratios lower than such guidelines. For the year ended December 31, 2004, our statutory gross written premium to policyholders’ surplus was 235.8%. For the year ended December 31, 2004, our statutory net written premium to policyholders’ surplus was 132.7%. At December 31, 2004, each of our domestic insurance companies’ total adjusted capital was significantly in excess of the authorized control level risk-based capital level prescribed by the National Association of Insurance Commissioners.
We receive substantial cash from premiums, reinsurance recoverables, fee and commission income and, to a lesser extent, investment income and proceeds from sales and redemptions of investments. Our principal cash outflows are for the payment of claims and loss adjustment expenses, premium payments to reinsurers, purchases of investments, debt service, policy acquisition costs, operating expenses, taxes and dividends.
Operating cash flows fluctuated due to timing differences in the payment of claims and the collection of related recoverables, and the collection of receivables and the payment of related liabilities. Over the past three years, we have increased the percentage of business we retain from 47% in 2002 to 56% in 2004. This increased our cash flow from premiums by reducing the amount of cash we paid to reinsurers. In addition, as we write more business in our diversified financial products line, our net unearned premium and reserves continue to grow due to expansion of this line and the fact that products in this line generally experience a longer time period between reporting and payment of claims. Since these claims are resolved over a longer period of time, we hold the premium dollars longer (until claims are paid) compared to our other lines of business. Other cash provided by operating activities was reduced approximately $21.0 million in 2004 for a federal income tax payment related to the gain on the subsidiary sold in December 2003.
We invest our funds in highly rated fixed income securities. Our strategy is to maximize interest income and yield, rather than to maximize total return. Our portfolio is managed by an outside investment advisor on an active basis in compliance with investment policies promulgated by us. In accordance with this strategy, realized gains and losses from sales of investment securities are usually minimal, unless we decide to capture gains to enhance statutory capital and surplus of our insurance company subsidiaries. Our portfolio turnover will fluctuate, depending upon opportunities to increase yields by replacing one security with another higher yielding security. Information about our portfolio of fixed income securities was as follows:
The following table compares our insurance company subsidiaries’ cash and investment maturities with their estimated future claims payments at December 31, 2004.
Some of our fixed income securities have call or prepayment options. This could subject us to reinvestment risk should interest rates fall or issuers call their securities and we reinvest the proceeds at lower interest rates. We mitigate this risk by investing in securities with varied maturity dates, so that only a portion of our portfolio will mature at any point in time. Fluctuations in interest rates have a minimal effect on the value of our short-term investments due to their very short maturities. In our current position, higher interest rates would have a positive effect on net earnings.
The estimated loss and loss adjustment expense payments for future periods assume that the percentage of ultimate losses paid from one period to the next period will be relatively consistent over time. The actual payments will be influenced by many factors and could vary from the estimated amounts above.
The 1.30% Convertible Notes mature in 2023, but are shown in the 2008-2009 column because of a put option on April 1, 2009. The 2.00% Convertible Exchange Notes mature in 2021, but are shown in the 2006-2007 column because of a put option on September 1, 2007. Both convertible notes have various put and redemption dates as disclosed in Note 5 to the Consolidated Financial Statements. In this table, we have included interest on these notes until the respective put dates.
after it pays covered claims to policyholders. We have a liability of $5.6 million recorded at December 31, 2004 to cover our anticipated payments under this indemnification.
The principal assets of HCC are the shares of capital stock of its insurance company subsidiaries. Historically, we have not relied on dividends from our insurance companies to meet the parent holding company’s obligations, which are primarily outstanding debt and debt service obligations, dividends to shareholders and corporate expenses, as we have had sufficient cash flow from our agencies to meet our corporate cash flow requirements. However, as more profit is now expected to be earned in our insurance companies, we may have to partially depend on cash flow from our insurance companies in the future. Principal payments on our convertible notes are not required until 2021 and 2023 and any puts of these notes under their terms, which have been minimal to date, could be substantially funded by our $200.0 million Revolving Loan Facility.
The payment of dividends by our insurance companies is subject to regulatory restrictions and will depend on the surplus and future earnings of these subsidiaries. HCC’s three direct insurance company subsidiaries can pay an aggregate of $64.4 million in dividends in 2005 without obtaining special permission from state regulatory authorities. In 2004, one insurance company subsidiary paid HCC a $20.0 million dividend, as approved by the Maryland Insurance Administration. The funds were then contributed to another insurance company subsidiary.
Our debt to capital ratio was 19.0% at December 31, 2004 and 22.9% at December 31, 2003.
A portion of our revenue is related to healthcare insurance and reinsurance products that are subject to the effects of the underlying inflation of healthcare costs. Such inflation in the costs of healthcare tends to generate increases in premiums for medical stop-loss coverage, resulting in greater revenue, but also higher claim payments. Inflation also may have a negative impact on insurance and reinsurance operations by causing higher claim settlements than may originally have been estimated, without an immediate increase in premiums to a level necessary to maintain profit margins. We do not specifically provide for inflation when setting underwriting terms and claim reserves, although we do consider trends. We continually review claim reserves to assess their adequacy and make necessary adjustments.
Inflation can also affect interest rates. Any significant increase in interest rates could have a material adverse effect on the market value of our investments. In addition, the interest rate payable under our $200.0 million Revolving Loan Facility fluctuates with market interest rates. Any significant increase in interest rates could have a material adverse effect on our net earnings, depending on the amount borrowed on our bank facility.
We underwrite risks which are denominated in a number of foreign currencies. As a result, we have receivables and payables in foreign currencies and we establish and maintain loss reserves with respect to our insurance policies in their respective currencies. Our net earnings could be impacted by exchange rate fluctuations affecting these balances. Our principal area of exposure is related to fluctuations in the exchange rates between the British pound sterling, the Euro and the U.S. dollar. We constantly monitor the balance between our receivables and payables and loss reserves to mitigate the potential exposure should an imbalance be expected to exist for other than a short period of time. Our gain from currency conversion was $1.2 million in 2004 compared to $4.1 million in 2003 and $1.2 million in 2002. Included in the 2003 amount was a one-time gain of $1.3 million from the settlement of an advance of funds to an unaffiliated entity.
Our actuaries, in conjunction with our claims personnel, estimate the amount of our incurred but not reported reserves, which include an estimate for losses that have occurred but have not been actually
We have insignificant exposure to asbestos and environmental losses, since we did not begin business until 1981 and the type of business we wrote contained pollution exclusions or did not subject us to asbestos or environmental risks.
inherent uncertainty in the point estimate, and it can be thought of as the expected value in a distribution of possible reserve estimates. The actuarial ranges represent our actuaries’ estimate of a likely lowest amount and highest amount that will ultimately be paid to settle the net reserves we have recorded at a particular point in time. While there is still a possibility of ultimately paying an amount below the range or above the range, the actuarial probability is very small. The range determinations are based on estimates and actuarial judgments and are intended to encompass reasonably likely changes in one or more of the variables that were used to determine the point estimates. In actuarial practice, some of our lines of business are more effectively modeled by a statistical distribution that is skewed or non-symmetric. These distributions are usually skewed towards large losses, which causes the midpoint of the range to be above the actuarial point estimate or mean value of the range. This should be kept in mind when using the midpoint as a proxy for the mean. The assumptions, estimates and judgments can change based on new information and changes in conditions and, if they change, it will affect the determination of the range amounts.
We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. We regularly review our deferred tax assets for recoverability and establish a valuation allowance based on our history of earnings, expectations for future earnings, taxable income in carry back years and the expected timing of the reversals of existing temporary differences. Although realization is not assured, we believe it is more likely than not that we will be able to realize the benefit of our deferred tax assets, with the exception of the benefit of certain pre-acquisition tax loss carryforwards for which valuation allowances have been provided. If there is a material change in the tax laws such that the actual effective tax rate changes or the time periods within which the underlying temporary differences become taxable or deductible change, we will need to reevaluate our assumptions, which could result in a change in the valuation allowance required.
We assess the impairment of goodwill annually, or sooner if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. In determining the fair value of a reporting unit, we utilize the expected cash flow approach in Statement of Financial Accounting Concepts CON 7, Using Cash Flow Information And Present Values In Accounting Measurements. This approach utilizes a risk-free rate of interest, estimates of future cash flows and probabilities as to the occurrence of the future cash flows. We utilize our budgets and projection of future operations based on historical and expected industry trends to estimate our future cash flows and the probability of their occurring as projected. Based on our latest impairment test, the fair value of each of our reporting units exceeded its carrying amount by a satisfactory margin.
The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards (SFAS) No. 123(R), Share-Based Payment, which requires stock-based employee compensation to be deducted from net income beginning in the third quarter of 2005. We are currently reviewing the requirements of SFAS No. 123(R).
In March 2004, the Emerging Issues Task Force (EITF) reached a consensus on Issue 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. EITF 03-1 provides guidance with respect to the meaning of other-than-temporary impairment and its application to investments classified as either available for sale or held to maturity under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and investments accounted for under the cost method or the equity method. In September 2004, the FASB issued a Staff Position, FSP EITF Issue 03-1-1, delaying the effective date for the measurement and recognition guidance included in EITF 03-1, and also issued an exposure draft, FSP EITF Issue 03-1a, which proposes guidance relating to debt securities that