Our principal and executive offices are located in Houston, Texas, in buildings owned by Houston Casualty Company. We also maintain offices in over 25 locations elsewhere in the United States, the United Kingdom, Spain and Bermuda. The majority of these additional locations are in leased facilities.
(2) During 2000, we changed certain of our revenue recognition methods for our underwriting agencies and intermediaries to agree to guidance contained in Securities and Exchange Commission's Staff Accounting Bulletin Number 101 entitled "Revenue Recognition in Financial Statements".
(3) During 2002, we adopted Statement of Financial Accounting Standards ("SFAS") No. 142 entitled "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, 1999.
(5) We sold our retail brokerage operation, HCC Employee Benefits, Inc., in December 2003. The net earnings of HCC Employee Benefits, Inc. and the gain on its sale have been classified as discontinued operations in our consolidated statements of earnings. Consistent with this presentation, all revenue and expense of HCC Employee Benefits, Inc. have been reclassified from continuing operations in our consolidated statement of earnings.
We primarily receive our revenue from earned premium derived from our insurance company operations, fee income generated by our underwriting agency operations, commission income produced by our intermediary operations, proceeds from ceded reinsurance (ceding commissions in excess of acquisition costs) earned by our insurance company subsidiaries, investment income from all of our operations and other operating income. Our core underwriting activities involve providing 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 directly to customers or through a network of independent or affiliated agents, third party administrators and brokers.
During the past several years, we have substantially increased our shareholders' equity through the issuance of equity securities and through retaining our earnings, 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 and added new lines of business, 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 each of our lines of business. We purchase different types of reinsurance in amounts we consider appropriate for each of our lines of business based upon market conditions and the level of risk we wish to retain.
Net earned premium grew 46% to $738.3 million in 2003, primarily due to increased rates, a reduction in ceded reinsurance, organic growth and higher renewal retentions.
Fee and commission income increased 23% to $142.6 million in 2003 due to increased rates, organic growth and acquisitions made in late 2002.
Compensation expense increased to $82.9 million during 2003 from $58.6 million in 2002. Subsidiaries acquired during the past year accounted for the majority of the increase, with the remaining amount primarily due to larger incentive based compensation accruals as a result of increased earnings.
Net earnings increased 36% to $143.6 million, or $2.23 per diluted share, in 2003. Net earnings in 2003 includes a $30.1 million (net of income tax), or $0.47 per share, gain on sale of a subsidiary and an $18.7 million (net of income tax), or $0.29 per share, loss due to the discount related to a commutation. The increase in net earnings resulted from increasing operating revenue and profits and an increase in investment income.
Gross written premium increased 50% to $1.7 billion in 2003 due to increased rates, organic growth and higher percentage of renewals. Gross written premium is expected to continue to increase in 2004.
Revenue and net income of other operations increased to $64.4 million and $36.2 million, respectively. Most of this increase came from the $52.7 million gain ($30.1 million net of income tax) on the sale of HCC Employee Benefits, Inc. The segment also saw an increase in revenue and net income due to income from our March 2003 strategic investment in Argonaut Group, Inc. and income from our strategic investment and trading accounts. Also, segment revenue increased as a result of the initial consolidation of a real estate partnership to comply with Financial Accounting Standards Board Interpretation No. 46. Period to period comparisons may vary substantially depending on strategic investments, trading activities or dispositions in any given period.
Compensation expense increased to $58.6 million during 2002 from $50.8 million in 2001. Much of this increase was due to the underwriting agency subsidiaries acquired in 2002 and late 2001, somewhat offset by a decrease from operations sold or otherwise disposed of during late 2001 and efficiencies gained from the consolidation of certain of our underwriting agencies into our insurance company operations.
The income tax provision related to continuing operations was $52.9 million for 2002 compared to $27.8 million in 2001. Our effective tax rate was 34.7% in 2002. The unusually high tax rate for 2001 results from the write off related to the impairment of goodwill, which was not deductible for income tax purposes.
Gross written premium increased 15% to $1.2 billion for 2002 from $1.0 billion in 2001. This increase was 33% before the discontinued lines of business. The increase resulted from organic growth and premium rate increases in our London market account line of business, plus our diversified financial products line of business not previously written, offset by the decrease in discontinued lines of business.
Net written premium for 2002 increased 46% to $545.9 million from $373.0 million in 2001, as our insurance companies have increased their overall retentions, in addition to the effect of the changes in gross premium described above. Net earned premium also increased 47% to $505.5 million for the same
Revenue from our underwriting agencies (primarily fee income) increased 25% to $112.0 million for 2002, compared to $89.8 million in 2001. The underwriting agencies acquired in 2002 and late 2001 accounted for much of the increase together with organic growth, partially offset by a decrease in fee income from our other underwriting agencies as we continued the consolidation of certain other underwriting agency operations into our insurance companies. Net earnings of our underwriting agencies increased to $25.3 million for 2002 from $17.2 million in 2001 as a result of increased revenue and the adoption of SFAS No. 142, somewhat offset by the integration of certain underwriting agencies into our insurance companies. There was $5.9 million (net of income tax) of goodwill amortization recorded in 2001.
We receive substantial cash from premiums, reinsurance recoverables and management fee and commission income and, to a lesser extent, investment income and proceeds from sales and redemptions of investments and other assets. Our principal cash outflows are for the payment of claims and loss adjustment expenses, payment of premiums to reinsurers, purchase of investments, debt service and payment of policy acquisition costs, operating expenses, income and other taxes and dividends. Variations in operating cash flows can occur due to timing differences in either the payment of claims and the collection of related recoverables or the collection of receivables and the payment of related payable amounts. We limit our liquidity exposure by holding funds, letters of credit and other security such that net balances due to us are less than the gross balances shown in our condensed consolidated balance sheets.
We maintain a substantial level of cash and liquid short-term investments which are used to meet anticipated payment obligations. Our consolidated cash and investment portfolio increased $591.8 million, or 49% during 2003 and totaled $1.8 billion as of December 31, 2003, of which $614.9 million was cash and short-term investments. The increase in investments resulted primarily from operating cash flows. Total assets increased to $4.9 billion as of December 31, 2003.
share) of the conversion price per share of our common stock. Holders of the notes may require us to repurchase the notes on April 1, 2009, 2014 and 2019. If the holders exercise this option, we may choose to pay the purchase price in cash, in shares of our common stock, or in a combination thereof, although our intent is to pay in cash.
Our 2% Convertible Notes are due in 2021. Each one thousand dollar principal amount is convertible into 31.25 shares of our common stock, which represents an initial conversion price of $32.00 per share. The initial conversion price is subject to change under certain conditions. We pay interest on March 1 and September 1 of each year. Holders may surrender notes for conversion into shares of our common stock in any calendar quarter if, as of the last day of the preceding calendar quarter, the closing sale price of our common stock for at least 20 trading days in the period of 30 consecutive trading days ending on the last trading day of the quarter is more than 120% ($38.40 per share) of the conversion price per share of our common stock on the last trading day of the quarter. We can redeem the notes for cash at any time on or after September 1, 2006. Holders of the notes may require us to repurchase the notes on September 1, 2004, 2006, 2008, 2011 and 2016. If the holders exercise this option, we may choose to pay the purchase price in cash, in shares of our common stock, or a combination thereof, although our intent is to pay in cash.
Our $200.0 million Revolving Loan Facility allows us to borrow up to the maximum amount allowed by the facility on a revolving basis until the facility expires on December 17, 2004. The facility is collateralized in part by the pledge of our insurance companies' stock and guarantees entered into by our underwriting agencies and intermediaries. The facility agreement contains certain restrictive covenants, which we believe are typical for similar financing arrangements. As of December 31, 2003, there were no borrowings on this facility. We intend to replace the facility at expiration with another facility.
The following is a summary of our contractual cash payment obligations as of December 31, 2003 (in thousands):
The 2% Convertible notes due 2021 are shown in the 2004 column in the above table because of the put option on September 1, 2004. Both convertible notes have various put and redemption dates as discussed in the paragraphs above. See Notes (5) and (9) in Notes to the Consolidated Financial Statements for additional information concerning these obligations.
We have sold businesses in the past. In connection with these sales, we have provided indemnifications to the buyers, which we believe are typical for transactions of this nature, based upon the type of business sold. Certain of these indemnifications have no limit. It is not possible to estimate the maximum potential amount under these indemnifications as our performance under the indemnifications and our ultimate liability are based upon the occurrence of future events which may or may not occur. We currently have a liability in the amount of $5.9 million recorded for performance under one such indemnification. This indemnification was given by a company we acquired, prior to its acquisition, in connection with a sale of one of its subsidiaries.
All of the property and casualty policies written by our insurance companies qualify as short-duration contracts as defined by current accounting literature. Written premium, net of reinsurance, is primarily included in earnings on a pro rata basis over the lives of the related policies. However, for certain types of business, it is recognized over the period of risk in proportion to the amount of insurance risk provided. Policy acquisition costs, including commissions, taxes, fees and other direct costs of underwriting policies less amounts reimbursed by reinsurers, are deferred and charged or credited to earnings proportionate to the premium earned. Historical and current loss and loss adjustment expense experience and anticipated investment income are considered in determining premium deficiencies and the recoverability of deferred policy acquisition costs.
Our net loss and loss adjustment expense reserves are composed of reserves for reported losses and reserves for incurred but not reported losses less a reduction for reinsurance recoverable related to those reserves. Reserves are recorded on an undiscounted basis, except for reserves acquired in transactions recorded using the purchase method of accounting. The reserves for reported losses related to our direct
The sum of the individual lines of business for the low end of the actuarial range and the high end of the actuarial range will not equal the total net reserves. Moreover, 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.
When there is no significant future servicing obligation, fee and commission income from our underwriting agencies and intermediaries are recognized on the later of the effective date of policy, the date when the premium can be reasonably established, or the date when substantially all the services relating to the insurance placement have been rendered to the client. Profit commissions based upon the profitability of business written are recorded as revenue at the end of each accounting period based upon the respective formula calculation. Such amounts are adjusted should experience change. When additional services are require, the service revenue is deferred and recognized over the service period. We also record an allowance for estimated return commissions that may be required to be paid upon the early termination of policies. Proceeds from ceded reinsurance (ceding commissions in excess of acquisition costs) are also earned pro rata over the term of the underlying policies.
The following table displays the gross unrealized losses and fair value of investments as of December 31, 2003 that were in a continuous unrealized loss position for the periods indicated (dollars in thousands):