Our principal and executive offices are located in Houston, Texas, in buildings owned by Houston Casualty Company. We also maintain offices in 45 locations elsewhere in the United States, the United Kingdom, Spain, Bermuda, Belgium and Ireland. The majority of these additional locations are in leased facilities. We are not dependent on our facilities to conduct business and such office space is suitable for the conduct of our business.
Our major domestic insurance companies are rated “AA (Very Strong)” by Standard & Poor’s Corporation, “AA (Very Strong)” by Fitch Ratings and “A+ (Superior)” by A.M. Best Company, Inc., and our international insurance companies are rated “AA” by Standard & Poor’s Corporation.
During the past several years, we substantially increased our shareholders’ equity by retaining most of our earnings and issuing additional shares of common stock. With this additional equity, we increased the underwriting capacity of our insurance companies and made strategic acquisitions, adding new lines of business or expanding those with favorable underwriting characteristics.
Our major acquisitions during the past three years are listed below. Net earnings and cash flows from each acquired entity are included in our operations beginning on the effective date of each transaction.
The following section discusses our key operating results. The reasons for any significant variations between 2006 and 2005 are the same as those discussed for variations between 2007 and 2006, unless otherwise noted. Amounts in the following tables are in thousands, except for earnings per share, percentages, ratios and number of employees.
In 2005, the property and casualty insurance industry suffered record losses from five major hurricanes that affected the Gulf Coast of the United States. We recorded gross losses of $394.6 million from these hurricanes in 2005. Recoveries expected from our reinsurance programs reduced this gross loss to a pre-tax loss of $89.7 million. This pre-tax loss was after reinsurance recoveries and included the cost of premiums to reinstate our reinsurance protection. There were no major hurricane losses in 2007 or 2006.
Total revenue increased 15% to $2.4 billion in 2007 and 26% to $2.1 billion in 2006, driven by significant growth in net earned premium and higher investment income and, in 2006, higher other operating income. Approximately 55% of the increase in revenue in 2007 and 28% in 2006 was due to the acquisition of businesses.
Loss and loss adjustment expense increased 17% in 2007 and 10% in 2006. Both years increased due to growth in net retained premium. Policy acquisition costs increased 15% in 2007 and 22% in 2006, primarily due to the growth in net earned premium. See the Insurance Company Segment section below for further discussion of the changes in loss and loss adjustment expense and policy acquisition costs.
Our effective income tax rate on earnings from continuing operations was 32.5% for 2007, compared to 32.9% for 2006 and 30.9% for 2005. The effective tax rate was lower in 2005 because our tax exempt interest income was a greater percentage of our pre-tax income and we recorded a special $2.8 million repatriation tax benefit.
At December 31, 2007, book value per share was $21.21 up from $18.28 at December 31, 2006 and $15.26 at December 31, 2005. Total assets were $8.1 billion and shareholders’ equity was $2.4 billion, up from $7.6 billion and $2.0 billion, respectively, at December 31, 2006.
Group life, accident and health - Gross written, net written and net earned premium of our medical stop-loss and medical excess products increased due to the 2006 acquisition of the Health Products Division. We retain all of our medical stop-loss and medical excess business because the business is non-volatile and has very little catastrophe exposure. Profit margins remain at acceptable levels despite competition from the fully-insured market.
We decided for the 2006 and 2005 underwriting years to retain more underwriting risk in certain lines of business in order to retain a greater proportion of expected underwriting profits. In doing so, we purchased less reinsurance and converted some reinsurance from proportional to excess of loss, which significantly reduced the amount of ceded premium in 2006. Ceded premium as a percentage of gross written premium remained constant at 19% in 2007 compared to 2006. We have chosen not to purchase any reinsurance on business where volatility or catastrophe risks are considered remote.
losses were paid and we collected amounts due from our reinsurers for their part of these paid losses. Our Reinsurance Security Committee carefully monitors the credit quality of the reinsurers we do business with on a current basis. Our recoverables are due principally from highly-rated reinsurers.
The other gross reserve redundancies resulted primarily from our review and reduction of reserves where the anticipated development was considered to be less than the recorded reserves. Deficiencies and redundancies also occur as a result of claims being settled for amounts different from recorded reserves, or as claims exposures change. Loss reserves on international medical malpractice business, in run-off since we acquired the subsidiary that wrote this business in 2002, were strengthened in 2007 in response to a deteriorating legal and settlement environment. The other gross reserve redundancies in 2007 related primarily to reserve reductions in our diversified financial products line of business from the 2003 and 2004 underwriting years. The other gross reserve redundancies in 2006 related primarily to a reduction in aviation reserves from the 2004 and 2005 accident years.
Diversified financial products - The decrease in the 2007 loss ratio was due to better underwriting results for certain business written in 2006 and earned in 2007, compared to business written in 2005 and earned in 2006, and favorable loss development on our directors’ and officers’ and international professional indemnity businesses, primarily on our 2003 and 2004 underwriting years. Additionally, our surety and credit businesses, which have lower loss ratios than other businesses in this line, are growing and reducing the overall loss ratio. Our domestic surety business also had favorable loss development during 2007.
The table below provides a reconciliation of our reserves for loss and loss adjustment expense payable, net of reinsurance ceded, the amount of our paid claims and our net paid loss ratios.
commission income to our agency segment, they resulted in increased insurance company revenue and net earnings. Segment earnings decreased to $33.9 million in 2007 from $42.3 million in 2006 due to the lower revenue, change in the mix of business that resulted in lower pre-tax margin, a higher income tax rate, and increased corporate cost allocations. Segment net earnings were $38.5 million in 2005 and would have decreased in 2006, except the agency segment benefited from lower corporate cost allocations.
Cash provided by operating activities can fluctuate due to timing differences in the collection of premiums and reinsurance recoverables and the payment of losses and premium and reinsurance balances payable, the completion of commutations, and activity in our trading portfolio. Our cash provided by operating activities has been strong in recent years due to:
We engage independent investment advisors to oversee our fixed income investments and to make investment recommendations. We invest our funds principally in highly-rated fixed income securities. Our historical investment strategy is to maximize interest income and yield, rather than to maximize total return. In accordance with our 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. Although we generally intend to hold fixed income securities to maturity, we regularly re-evaluate our position based on market conditions. Our portfolio turnover will fluctuate, depending upon opportunities to increase yields by replacing one security with another higher yielding security.
This table summarizes, by rating, the fair value of our investments in fixed income securities at December 31, 2007.
The weighted average life of our asset-backed and mortgage-backed securities is 5.6 years.
The fair value of our fixed income securities is sensitive to changing interest rates. As interest rates increase, the fair value will generally decrease and as rates decrease, the fair value will generally increase. The fluctuations in fair value are somewhat muted by the relatively short duration of our portfolio and our
The average duration of claims in many of our lines of business is relatively short and, accordingly, our investment portfolio has a relatively short duration. In recent years, we have expanded the directors’ and officers’ liability and professional indemnity components of our diversified financial products line of business, which have a longer claims duration than our other lines of business. We are taking these changes into consideration in determining the duration of our investment portfolio.
The following table compares our insurance company subsidiaries’ cash and investment maturities with their estimated future claims payments at December 31, 2007.
We maintain sufficient liquidity from our current cash and investment maturities, in combination with future operating cash flow, to pay anticipated policyholder claims on their expected payment dates. We manage the liquidity of our insurance company subsidiaries 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. We do not foresee the need to sell securities prior to their maturity to fund claims payments, nor do we anticipate needing to use our $575.0 million Revolving Loan Facility to pay claims. However, this credit facility can provide additional short-term liquidity if an unexpected event were to occur.
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 will be relatively consistent over time. 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 2009 - 2010 column since the holders may require us to repurchase the Notes on April 1, 2009. The Notes have various put and redemption dates as disclosed in Note 6 to the Consolidated Financial Statements. Amounts include interest payable in respective periods.
The $575.0 million Revolving Loan Facility expires on December 19, 2011. Interest on $200.0 million of the facility is included at an effective fixed rate of 4.6% through November 2009 due to interest rate swaps. Interest on the remaining facility is included at LIBOR plus 25 basis points (4.85% at December 31, 2007).
Our acquisition of HCC Global Financial Products, LLC (HCC Global) included a contingency for earnout payments based on earnings after the acquisition date, as defined in the purchase agreement. When the conditions for accrual have been satisfied under the applicable purchase agreement, we record a liability to the former owners with an offsetting increase to goodwill. Accrued amounts are generally paid in the next year. At December 31, 2007, we accrued earnout payments totaling $31.7 million related to this acquisition. The purchase agreement for HCC Global requires us to pay an earnout based on pre-tax earnings on business underwritten by HCC Global from the acquisition date through September 30, 2007, with no maximum amount due to the former owners. The contractual pre-tax earnings include underwriting results on longer-duration business written by HCC Global and, per the agreement, the earnout cannot be finally determined until all future losses are paid.
to perform under the sales contracts. Other indemnifications 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. Certain of these indemnifications have no time limit. For those with a time limit, the longest such indemnification expires on December 31, 2009.
We accrue a loss related to our indemnifications when a valid claim is made by a buyer and we believe we have potential exposure. We currently have several claims under indemnifications that cover certain net losses alleged to have been incurred in periods prior to our sale of certain subsidiaries or otherwise alleged to be covered under indemnification agreements related to such sales. As of December 31, 2007, we have recorded a liability of $14.8 million and have provided $5.2 million of letters of credit to cover our obligations or anticipated payments under these indemnifications.
Our $575.0 million Revolving Loan Facility allows us to borrow up to the maximum allowed by the facility on a revolving basis until the facility expires on December 19, 2011. At our option, subject to the lenders’ ability to obtain the necessary commitments, the amount available under the facility may be increased to $700.0 million. The interest rate is LIBOR plus a margin of 15 to 50 basis points, depending on our debt rating. The facility is collateralized by guarantees entered into by our domestic underwriting agencies and reinsurance brokers. The facility agreement contains certain restrictive covenants, which we believe are typical for similar financing arrangements. We had $200.0 million outstanding at December 31, 2007, which we borrowed in 2007 to fund conversion of our 2.00% Convertible Exchange Notes. At December 31, 2007, the contractual interest rate on the outstanding balance was LIBOR plus 25 basis points (4.85%), but the effective interest rate was 4.6% due to the fixed interest rate swaps discussed below.
In 2007, we increased our Standby Letter of Credit Facility from $34.0 million to $52.0 million with an increase to $82.0 million in 2008. This facility was entered into in 2006 to replace a portion of our funds at Lloyd’s of London with standby letters of credit to guarantee our performance in two Lloyd’s of London syndicates. Letters of credit issued under the Standby Letter of Credit Facility are unsecured commitments of HCC. The Standby Letter of Credit Facility contains standard restrictive covenants similar to our Revolving Loan Facility.
At December 31, 2007, certain of our subsidiaries maintained revolving lines of credit with a bank in the combined maximum amount of $43.3 million available through November 30, 2009. Advances under the lines of credit are limited to amounts required to fund draws, if any, on letters of credit issued by the bank on behalf of the subsidiaries and short-term direct cash advances. The lines of credit are collateralized by securities having an aggregate market value of up to $54.1 million, the actual amount of collateral at any one time being 125% of the aggregate amount outstanding. Interest on the lines is payable at the bank’s prime rate of interest (7.25% at December 31, 2007) for draws on the letters of credit and either prime or prime less 1% on short-term cash advances. At December 31, 2007, letters of credit totaling $20.5 million had been issued to insurance companies by the bank on behalf of our subsidiaries, with total securities of $25.6 million collateralizing the lines.
Our debt to total capital ratio was 11.7% at December 31, 2007 and 13.1% at December 31, 2006.
In 2006, we filed a “Universal Shelf” registration statement with the SEC, which replaced our previously filed shelf registration and provides for the issuance of an aggregate of $1.0 billion of our securities. These securities may be debt securities, equity securities, trust preferred securities, or a combination thereof. We sold 4.7 million shares of our common stock at $32.05 per share in 2005 under our previous shelf registration. Net proceeds of $150.0 million in 2005 were used to make $108.0 million of capital contributions to our insurance company subsidiaries and to fund acquisitions.
The process of estimating our loss and loss adjustment expense reserves involves a considerable degree of judgment by management and is inherently uncertain. The recorded reserves represent management’s best estimate of unpaid loss and loss adjustment expense by line of business. Because we provide insurance coverage in specialized lines of business that often lack statistical stability, management considers many factors, and not just the actuarial point estimates discussed below, in determining ultimate expected losses and the level of net reserves required and recorded.
The low end of the actuarial range and the high end of the actuarial range for the total net reserves will not equal the sum of the low and high ends for the individual lines of business. Moreover, in actuarial terms, it would not be appropriate to add the ranges for each line of business to obtain a range around the total net reserves because this would not reflect the diversification effects across our various lines of business. The diversification effects result from the fact that losses across the different lines of business are not completely correlated.
Direct insurance is coverage that is originated by our insurance companies and brokers in return for premium. Assumed reinsurance is coverage written by another insurance company, for which we assume all or a portion of the risk in exchange for all or a portion of the premium. Subscription business is direct insurance or assumed reinsurance where we only take a percentage of the total risk and premium and other insurers take their proportionate percentage of the remaining risk and premium. Assumed reinsurance represented 18% of our gross written premium in 2007 and 28% of our gross reserves at December 31, 2007. Approximately 39% of the assumed reinsurance reserves related to business in our discontinued lines, 30% related to assumed reinsurance in our London market account, aviation and diversified financial products lines of business, 13% related to assumed quota share surplus lines business in our other specialty lines, 9% related to assumed business in our group life, accident and health line of business, and 9% related Lloyd’s of London business in our other specialty lines. The remaining assumed reinsurance reserves covered various other reinsurance programs. The table above recaps the underwriting, claims characteristics and major actuarial assumptions for our assumed reinsurance business.
The run-off assumed accident and health reinsurance business is primarily reinsurance that provides excess coverage for large losses related to workers’ compensation policies. As discussed previously, we recorded significant increases in assumed reserves in 2003, 2004 and 2005. These losses resulted from late reporting of claims by cedants and state guaranty associations and changes in our actuarial assumptions related to this business. To mitigate our exposure to unexpected losses reported by cedants, our claims personnel review reported losses to ensure they are reasonable and consistent with our expectations. In addition, our claims personnel periodically audit the cedants’ claims processing functions to assess whether cedants are submitting timely and accurate claims reports to us. Disputes with insureds related to claims or coverage issues are administered in the normal course of business or settled through arbitration. Based on the negative factors we experienced and the higher risk of this discontinued line of business relative to our continuing lines of business, management believes there may be a greater likelihood of future adverse development in the run-off assumed accident and health reinsurance business than in our other lines of business. We periodically reassess loss reserves for this assumed business and adjust them, if needed.
Our assumed quota share surplus lines business in our other specialty lines is recorded monthly with a two-month time lag. Case reserves are reported directly to us by the cedant, and we establish incurred but not reported reserves based on our estimates. We periodically contact and visit the cedant to discuss loss trends and review claim files. We also receive copies of the cedant’s loss triangles on individual products. Because of the frequent communication, we receive sufficient information to use many of the same methods and assumptions we would use to set reserves for comparable direct business. We have not had any disputes with the cedant.
The majority of the assumed reinsurance in our London market account, aviation and diversified financial products lines of business is facultative reinsurance. This business involves reinsurance of a company’s entire captive insurance program or business that must be written through another insurance company licensed to write insurance in a particular country or locality. In all cases, we underwrite the business and administer the claims, which are reported without a lag by the brokers. Disputes, if any, generally relate to claims or coverage issues with insureds and are administered in the normal course of business. We establish loss reserves for this assumed reinsurance using the same methods and assumptions we use to set reserves for comparable direct business.
We determine our incurred but not reported reserves by first projecting the ultimate expected losses by product within each line of business. We then subtract paid losses and reported loss reserves from the ultimate loss reserves. The remainder is our incurred but not reported reserves. The level of incurred but not reported reserves in relation to total reserves depends upon the characteristics of the specific line of business, particularly with respect to the speed with which losses are reported and outstanding claims reserves are adjusted. Lines for which losses are reported fast will have a lower percentage of incurred but not reported loss reserves than slower reporting lines, and lines for which reserve volatility is low will have a lower percentage of incurred but not reported loss reserves than high volatility lines.
Our net reserves historically have shown favorable development except for the effects of commutations, which we have completed in the past and may negotiate in the future. Commutations can produce adverse prior year development since, under generally accepted accounting principles, any excess of undiscounted reserves assumed over assets received must be recorded as a loss at the time the commutation is completed. Economically, the loss generally represents the discount for the time value of money that will be earned over the payout of the reserves; thus, the loss may be recouped as investment income is earned on the assets received. Based on our reserving techniques and our past results, we believe that our net reserves are adequate.
We limit our liquidity exposure for uncollected recoverables by holding funds, letters of credit or other security, such that net balances due from reinsurers are significantly less than the gross balances shown in our consolidated balance sheets. We constantly monitor the collectibility of the reinsurance recoverables of our insurance companies and record a reserve for uncollectible reinsurance when we determine an amount is potentially uncollectible. Our evaluation is based on our periodic reviews of our disputed and aged recoverables, as well as our assessment of recoverables due from reinsurers known to be in financial difficulty. In some cases, we make estimates as to what portion of a recoverable may be uncollectible. Our estimates and judgment about the collectibility of the recoverables and the financial condition of reinsurers can change, and these changes can affect the level of reserve required.
The reserve was $8.5 million at December 31, 2007, compared to $14.9 million at December 31, 2006. We increased the reserve in 2007 by $2.2 million to cover additional recoverables for which changed conditions caused us to believe that part or all of the outstanding balances may not be collectible. We wrote off $8.6 million of uncollectible balances in 2007. We assessed the collectibility of our year-end recoverables and believe amounts are collectible and any potential losses are adequately reserved based on currently available information.
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 No. 7, Using Cash Flow Information and Present Values in Accounting Measurements. This approach utilizes estimated future cash flows, probabilities as to occurrence of these cash flows, a risk-free rate of interest and a risk premium for uncertainty in the cash flows. We utilize our budgets and projections 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.
Declines in the market value of invested assets below cost are evaluated for other-than-temporary impairment losses on a quarterly basis. Impairment losses for declines in value of fixed income securities below cost attributable to issuer-specific events, including recent subprime market issues, are based on all
FIN No. 48, Accounting for Uncertainty in Income Taxes, became effective January 1, 2007. Under FIN 48, a company may only recognize the tax benefit from an uncertain tax position if it is more likely than not the tax position will be sustained upon examination by the tax authority. See Note 7 to our Consolidated Financial Statements for discussion about our adoption of FIN 48.