(1) Certain amounts in the 2002, 2001, 2000 and 1999 selected consolidated financial data have been reclassified to conform to the 2003 presentation. Among these reclassifications, proceeds from ceded reinsurance (ceding commissions in excess of acquisition costs) have been classified as fee and commission income rather than a reduction of operating expenses. Also, compensation and other operating expenses of our underwriting agency subsidiaries representing acquisition costs have been classified as policy acquisition costs to be offset by the portion of ceding commission which represents the reimbursement of those acquisition costs. Such reclassifications had no effect on our net earnings, shareholders' equity or cash flows.
Market conditions improved across all of our lines of business during the period 2000 through 2003. This improvement accelerated after the September 11, 2001 terrorist attack and highly publicized corporate governance failures and continued throughout 2003 with significant rate increases particularly evident in our diversified financial products line of business. We have expanded our underwriting activities and increased our retentions in response to these hardening market conditions and plan to continue these actions as long as market conditions warrant.
During the period 2001 through 2003, we acquired the following companies in transactions that were recorded using the purchase method of accounting. Accordingly, the results of operations and cash flows of these companies are included in our operations beginning on the effective date of each transaction.
The following table sets forth certain premium revenue information for the three years ended December 31, 2003 (in thousands):
The following table sets forth the relationships of certain income statement items as a percent of total revenue for the three years ended December 31, 2003:
YEAR ENDED DECEMBER 31, 2003 VERSUS YEAR ENDED DECEMBER 31, 2002
Total revenue increased 41% to $942.0 million for 2003 from $666.6 million in 2002, driven by significant increases in net earned premium and, to a lesser extent, fee and commission income and investment income. We anticipate continued revenue growth in 2004.
Net investment income increased 25% to $47.3 million in 2003 due to higher investment assets, which increased 46% to $1.7 billion in 2003 as a result of increased loss reserves due to higher retentions and growth in lines of business where losses take longer to settle, as well as significant cash flow from operations. Net investment income increased despite lower yields on our short duration, high quality investment portfolio of fixed income securities and on our short-term investments. We expect investment assets to continue to increase and produce additional growth in investment income in 2004, even if interest rates do not increase significantly. If market interest rates were to rise, the growth in investment income would be accelerated as our current portfolio has a relatively short duration and would be available to be invested on a longer-term basis to take advantage of higher rates. Our weighted average tax equivalent yield was 3.8% in 2003 compared to 4.6% in 2002. The weighted average duration of our fixed income portfolio was 3.7 years and the weighted average maturity was 4.5 years.
Other operating income increased 89% to $13.2 million in 2003, principally due to increased gains on our portfolio of insurance related trading securities and income from a real estate partnership that was first included in our consolidated financial statements in 2003.
The income tax provision related to continuing operations was $59.9 million for 2003 compared to $52.9 million in 2002. The effective tax rate was 35.9% in 2003 compared to 34.7% in 2002. The increased rate results from higher expenses, which are not deductible for tax purposes and higher state income taxes. The tax rate on the gain on the sale of our discontinued operations is higher than the statutory rate due to non-deductible goodwill of $8.3 million, which was included in the cost of the discontinued operations sold.
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. The net cash received from the sale was utilized to acquire American Contractors Indemnity Company, a surety company, in January, 2004. We believe that the results of operations of American Contractors Indemnity Company will at least replace the earnings from discontinued operations.
Our book value per share was $16.37 as of December 31, 2003, up from $14.15 as of December 31, 2002.
Net written premium in 2003 increased 59% to $865.5 million due to our insurance companies increasing retentions together with the factors discussed above. Net earned premium also increased 46% to $738.3 million for the same reasons. Growth in net written and net earned premium is expected to continue in 2004.
Net loss and loss adjustment expense was $488.7 million for 2003 compared to $306.5 million in 2002. The net loss ratio was 66.2% for 2003 compared to 60.6% in 2002. Our net loss and loss adjustment expense deficiency relating to prior year losses was $23.8 million in 2003 compared to a redundancy of $6.8 million in 2002. The deficiency for 2003 included a commutation loss of $28.8 million, which represents the discount on the reinsurance recoverables commuted. The commutation increased the net loss ratio for 2003 by 3.9%. The overall loss ratio for the continuing lines was virtually unchanged. The net loss ratio in the aviation line of business increased due to unusually good loss experience in 2002 compared to a loss ratio in 2003 that was more in line with expectations, producing an excellent underwriting profit. Loss experience in the other specialty lines improved in 2003 as it approached its expected level. The loss ratio in the discontinued lines of business increased in 2003 following reserve additions resulting from our ongoing review of outstanding claims and the $28.8 million commutation loss recorded in the fourth quarter of 2003, somewhat offset by a $7.7 million charge recorded in the third quarter of 2002.
The gross loss ratio was 70.3% in 2003 compared to 58.6% in 2002. Our gross loss and loss adjustment expense deficiency relating to prior year losses was $151.1 million in 2003 compared to a redundancy of $23.2 million in 2002. During 2003, we increased our gross losses related to prior accident years by $132.9 million on certain assumed accident and health reinsurance contracts reported in our discontinued line of business due to our processing of additional information received and our continuing evaluation of reserves related to this business. Also 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. As all these losses were substantially reinsured, they had no material effect on our net losses or earnings.
The expense ratio for 2003 is slightly lower than 2002 due to the effects of greater premium volume. After removing the effect of the commutation loss, the combined ratios for 2003 and 2002 are virtually the same.
Policy acquisition costs, which are net of reimbursement with respect to reinsurance ceded, increased to $138.2 million due to higher earned premium. The ratio of policy acquisition costs to earned premium was 18.7% in 2003 compared to 19.7% in 2002. The decrease in percentages is due to changes in the mix of business and spreading certain costs over a larger premium volume.
Revenue from our intermediaries (primarily commission income) increased 12% to $48.6 million in 2003 due to general market conditions and organic growth. Net earnings of our intermediaries increased 31% to $9.9 million in 2003 for the same reasons. There was also a reduction in intergroup interest and a lower effective tax rate in 2003 compared to 2002 due to the negative effects of a tax allocation true-up during 2002. The operations of HCC Employee Benefits, Inc., which are included in the intermediary segment, were sold in December 2003 and are classified as discontinued operations in our consolidated statement of earnings. It accounted for $22.9 million and $21.9 million in revenue and $5.5 million and $5.3 million in net earnings in 2003 and 2002, respectively. These segment earnings of HCC Employee Benefits, Inc. include allocated general corporate overhead expenses (net of income tax) of $1.0 million and $1.1 million, respectively, in 2003 and 2002. The remaining subsidiaries in the intermediary segment are expected to continue to grow in 2004.
The net loss of the corporate segment was $5.4 million for 2003 compared to net income of $2.9 million in 2002. The decrease in segment earnings between years resulted primarily from the increase in incentive compensation. The segment results in 2002 were positively affected by inter-segment income tax adjustments, additional intergroup interest charged to subsidiaries and the adjustment of certain accruals to their ultimate liabilities. The 2003 results were positively affected by a one-time currency conversion gain in the amount of $1.3 million.
Total revenue increased 30% to $666.6 million for 2002 from $511.2 million in 2001. The revenue increase in the insurance company segment resulted from organic growth in our existing lines of business, the addition of our new diversified financial products line of business and increased premium retention. The revenue in the underwriting agency segment increased due to organic growth and acquisitions made in 2002 and late 2001, but the increase was partially offset by reduced revenue in the intermediary and other operations segments as a result of market conditions and the sale or other disposition of various operations in 2001.
Net investment income decreased to $37.8 million for 2002 from $39.6 million in 2001. This decrease was due to the reduction in interest rates, substantially offset by the higher level of invested assets which resulted from cash flow provided by operating activities and capital contributions made to our insurance company subsidiaries.
The year 2001 was adversely affected as we experienced the largest loss to our insurance company operations in our history due to the terrorist attack on September 11, with incurred net losses of $35.0 million. In 2001, we also recorded a charge totaling $37.3 million related to our primary workers' compensation line of business and other lines of business that we decided to cease writing. Included in this charge was $15.0 million related to the impairment of goodwill associated with our primary workers' compensation line of business.
Other operating expense decreased to $41.4 million during 2002 compared to $63.0 million in 2001, primarily as a result of the reduction in the amortization of goodwill, operations sold or disposed of and the goodwill impairment charge in 2001. These decreases were offset by the effect of acquisitions in 2002 and late 2001. Currency conversion gains amount to $1.2 million in 2002 compared to $0.3 million in 2001.
reasons. Increases in net written and net earned premiums were 69% and 62%, respectively, before the discontinued lines of business.
Net loss and loss adjustment expense was $306.5 million for 2002 compared to $267.4 million in 2001. The 2001 net loss expense included $35.0 million from the September 11 terrorist attack and $18.8 million from the charge for lines of business we decided to cease writing. Because of these items and generally better underwriting results in 2002 as a result of higher pricing and improved policy terms and conditions, the net loss ratio was greatly improved at 60.6% for 2002 compared to 78.0% in 2001, on substantially increased earned premiums. The loss ratios for the continuing lines, with the exception of the specialty lines, also improved for these reasons. The loss ratio in the other specialty lines increased as a result of some adverse development on policies, which were subsequently not renewed. During the third quarter of 2002, we also recorded a charge in the amount of $7.7 million related to certain business included in discontinued lines. This business was acquired as part of our purchase of The Centris Group, Inc. in 1999 and was of a type that we have not historically written. The gross loss ratio was 58.6% in 2002 compared to 105.5% in 2001. The 2001 gross loss ratio was high because we recorded gross losses of $55.0 million due to the Petrobras production platform, $141.0 million due to the September 11 terrorist attack and $49.0 million due to the Total Oil Company loss. Additionally, in 2002, as a result of further evaluation, we reduced our gross losses from the September 11 terrorist attack by $21.5 million and reduced the gross losses from the Total loss by $14.0 million. Offsetting this positive gross development was $36.2 million of negative development due to late reporting of an aggregate program that we no longer write. As the adjustments related to gross losses that were substantially reinsured, there was no material net effect.
During 2002, we had net loss and loss adjustment expense redundancy of $6.8 million relating to prior year losses compared to a redundancy of $10.7 million in 2001 and we had gross loss and loss adjustment expense redundancy of $23.2 million compared to a deficiency of $44.5 million in 2001. The gross deficiency for 2001 resulted from late reported loss information received during 2001, primarily from assumed reinsurance business written by one of our insurance companies. There was no material net effect on our earnings as that business was substantially reinsured. The deficiencies and redundancies result from our continued review of our loss reserves with our actuaries and the increase or reduction of reserves as losses are finally settled and claims exposures are reduced. We continue to believe we have provided for all material net incurred losses.
Policy acquisition costs, which are net of reimbursement with respect to reinsurance ceded, increased to $99.5 million or 19.7% of earned premium during 2002, from $66.3 million or 19.3% of earned premium in 2001. This increase is due to the higher earned premium and the reduction in ceding commissions as a result of our retaining more business. Included in the 2001 amount is $2.2 million from the charge for lines of business we decided to cease writing. The expense ratio was substantially unchanged at 25.4% for 2002 compared to 2001 which, when added to our greatly improved loss ratio, produced a substantially lower combined ratio of 86.0% for 2002 compared to 103.7% in 2001.
Net earnings of our insurance companies increased to $68.2 million in 2002 from a net loss of $2.9 million in 2001, due to increased revenue and improved underwriting results in 2002. The 2001 results include the effects from the terrorist attack on September 11 and the charge for lines of business we decided to cease writing. There was $2.1 million (net of income tax) of goodwill amortization recorded in 2001.
Revenue from our intermediaries (primarily commission income) decreased to $43.6 million for 2002, compared to $46.7 million in 2001 due to general market conditions and less ceded reinsurance being placed on behalf of our insurance companies as they increased their retentions. Net earnings of our intermediaries decreased to $7.6 million for 2002 compared to $8.7 million in 2001. There was $3.4 million (net of income tax) of goodwill amortization recorded in 2001 compared to none in 2002 due to the adoption of SFAS No. 142. HCC Employee Benefits, Inc. accounted for $21.9 million and $18.4 million in revenue and $5.3 million and $2.6 million in net earnings in 2002 and 2001, respectively. These segment earnings of HCC Employee Benefits, Inc. include allocated general corporate overhead expenses (net of income tax) of $1.1 million and $0.5 million, respectively, in 2002 and 2001.
Our investment portfolio includes a high percentage of liquid investments and generates a significant amount of investment income, which serves as a source of cash flow. The average tax equivalent yield on investments was 3.8% in 2003, compared to 4.6% in 2002. The weighted average maturity of our fixed income securities is 4.5 years and weighted average duration of the portfolio was 3.7 years, both as of December 31, 2003. During 2003, over 97% of our fixed income securities were rated "A" or better by Standard & Poor's Corporation. The value of our portfolio of fixed income securities is inversely correlated to changes in market interest rates. In addition, 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.
On March 25, 2003, we sold an aggregate $125.0 million principal amount of 1.3% Convertible Notes due in 2023 in a public offering. We pay interest on April 1 and October 1 of each year. Each one thousand dollar principal amount of notes is convertible into 29.4377 shares of our common stock, which represents an initial conversion price of $33.97 per share. Holders may surrender notes for conversion into shares of our common stock if, as of the last day of the preceding calendar quarter, the closing sale price of our common stock for at least 20 consecutive trading days during the period of 30 consecutive trading days ending on the last trading day of that quarter is more than 130% ($44.16 per
Our debt securities are rated "A" by Standard & Poor's Corporation (3rd of 10 ratings).
At December 31, 2003, certain of our subsidiaries maintained revolving lines of credit with a bank in the combined maximum amount of $31.8 million available through December 17, 2004. 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 $39.8 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 (4.0% at December 31, 2003) for draws on the letters of credit and prime less 1% on short-term cash advances. As of December 31, 2003, letters of credit totaling $16.7 million had been issued to insurance companies by the bank on behalf of our subsidiaries, with total securities of $20.9 million collateralizing the lines.
The principal assets of HCC Insurance Holdings, Inc. are the shares of capital stock of our insurance companies. Historically, we have not relied on dividends from our insurance companies to meet the obligations of the parent holding company, which are primarily outstanding debt and debt service obligations, dividends to shareholders and corporate expenses, but, rather, we have had sufficient cash flow from our underwriting agencies and intermediaries to meet our cash flow requirements. 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 Insurance Holdings, Inc.'s two direct insurance company subsidiaries can pay an aggregate of $40.9 million in dividends in 2004 without obtaining special permission from state regulatory authorities.
We have a reserve of $14.9 million as of December 31, 2003 for potential collectibility issues and associated expenses related to reinsurance recoverables. This includes the exposure we have with respect to disputed amounts. While we believe that the reserve is adequate based on currently available information, conditions may change or additional information might be obtained which may result in a future change in the reserve. We periodically review our financial exposure to the reinsurance market and the level of our reserve and continue to take actions in an attempt to mitigate our exposure to possible loss.
A number of reinsurers have delayed or suspended the payment of amounts recoverable under certain reinsurance contracts to which we are a party. Such delays have affected, although not materially to date, the investment income of our insurance companies, but not to any extent their liquidity. We limit our liquidity exposure by holding funds, letters of credit or other security such that net balances due are significantly less than the gross balances shown in our consolidated balance sheets. We expect to collect the full amounts recoverable and, if necessary, we may seek collection through judicial or arbitral proceedings.
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 generally lower than such guidelines. For the year ended December 31, 2003, our statutory gross written premium to policyholders' surplus was 295.1%. For the year ended December 31, 2003, our statutory net written premium to policyholders' surplus was 146.6%. As of December 31, 2003, 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.
business is comprised of lines which have relatively short lead times between the occurrence of an insured event, reporting of the claims to us and the final settlement of the claims, the effects of inflation are minimized.
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 with respect 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. For the year ended December 31, 2003, our gain from currency conversion was $4.1 million compared to a gain of $1.2 million in 2002 and a gain of $0.3 million in 2001. 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.
business and certain reinsurance assumed are initially set by our claims personnel or independent claims adjusters hired by us and subject to our review with a goal of setting the reserves at the ultimate expected loss amount as soon as possible as information becomes available. Reserves for reported losses with respect to other reinsurance assumed are recorded based upon information supplied to us by the ceding company. Our claims personnel monitor these reinsurance assumed reserves on a current basis and audit ceding companies' claims to ascertain that claims are being recorded currently and that net reserves are being set at levels that properly reflect the liability related to the claims. Our actuaries, in conjunction with our claims personnel, determine the amount of our incurred but not reported reserves as well as review the reported claim reserves for positive or adverse development. Reserves are estimates and changed conditions can cause changes in the estimates. However, we believe that our review process is effective such that any required changes are recognized in the period of change as soon as the need for the change is evident. Reinsurance recoverables offset our gross reserves based upon the contractual terms of our reinsurance agreements.
The table below shows our recorded reserves as of December 31, 2003 (in thousands) by line of business compared to the high and low ends of the reserve range as determined by our reserving actuaries. Based upon our historical reserving techniques and the fact that our net reserves have historically shown positive development, except for the effects of losses on commutations, which losses represent the discount
on the reinsurance recoverables commuted, we believe that there will not be any negative development in our consolidated reserves:
We constantly review the collectibility of the reinsurance recoverables of our insurance companies and record a reserve for potentially uncollectible reinsurance. Our estimates utilized to calculate the reserve are evaluated on a current basis but are subject to change and this could affect the level of the reserve required. We believe, based upon periodic detail reviews of our disputed and aged recoverables, that we have sufficiently provided for potential losses that are currently evident.
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 as set forth in FASB Concepts Statement No. 7. 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 upon historical and expected industry trends to estimate our future cash flows and the probability of their occurring as projected. Based upon our last 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 maturity investments and equity securities below cost attributable to issuer-specific events are based upon all relevant facts and circumstances for each investment and are recognized when appropriate. For fixed maturity investments with unrealized losses due to market conditions or industry-related events where we have the positive intent and ability to hold the investment for a period of time sufficient to allow a market recovery or to maturity, declines in value below cost are not assumed to be other than temporary. Our policy for equity securities is to recognize impairment losses on specific securities that have had continuous material unrealized losses for more than three consecutive quarters or less, due to market conditions or industry-related events. As of December 31, 2003, we had gross unrealized losses on fixed income and marketable equity securities of $3.8 million (0.3% of aggregate market value) compared to $1.5 million (0.2% of aggregate market value) as of December 31, 2002.