(1) Calculated by dividing net loss and loss adjustment expense by net earned premium.
We are a specialty insurance group with offices in the United States, the United Kingdom, Spain and Ireland, transacting business in approximately 180 countries. Our shares trade on the New York Stock Exchange and closed at $43.83 on February 14, 2014, resulting in market capitalization of $4.4 billion.
Our organization is focused on generating consistent, industry-leading combined ratios. We concentrate our insurance writings in selected specialty lines of business in which we believe we can achieve meaningful underwriting profit. We rely on experienced underwriting personnel working within defined and monitored limits and our access to and expertise in the reinsurance marketplace to limit or reduce risk. By focusing on underwriting profitability, we are able to accomplish our primary objectives of maximizing net earnings and growing book value per share.
Key facts about our consolidated group as of and for the year ended December 31, 2013 are as follows:
We had consolidated shareholders’ equity of $3.7 billion, with book value per share of $36.62.
We generated net earnings of $407.2 million, or $4.04 per diluted share.
Our net loss ratio was 57.6% and our combined ratio was 83.4%.
Total revenue increased $11.1 million in 2013, compared to 2012, primarily due to higher net realized investment gains. Total revenue increased $151.8 million in 2012, compared to 2011, primarily due to higher net earned premium, net investment income and net realized investment gains.
Our other operating income primarily consists of fee and commission income related to third party agency and broker commissions and income from a financial instrument.
Policy acquisition costs relate to direct costs we incur to issue insurance policies, including commissions, premium taxes and compensation of our underwriters. The percentage of policy acquisition costs to net earned premium was 12.5% in all three years. We record profit commissions due from reinsurers as an offset to policy acquisition costs.
Excluding the indemnification benefit and foreign currency benefit/expense, other operating expense increased 4% in 2013 and 6% in 2012 mainly due to increased employee compensation and benefits expense. Approximately 64%, 61% and 62% of our other operating expense in 2013, 2012 and 2011, respectively, related to employee compensation and benefits.
Other operating expense included $16.2 million, $13.2 million and $12.4 million of stock-based compensation expense in the respective three years. Stock-based compensation expense was higher in 2013 due to the timing of vesting and forfeitures of awards. In 2013, we granted $17.2 million of restricted stock awards and units, with a weighted-average life of 3.1 years. At December 31, 2013, there was approximately $28.3 million of total unrecognized compensation expense related to unvested options, restricted stock awards and units, and our employee stock purchase plan that is expected to be recognized over a weighted-average period of 2.6 years. In 2014, we expect to recognize $11.3 million of expense for all stock-based awards outstanding at year-end 2013.
Interest expense was $26.2 million, $25.6 million and $23.1 million in 2013, 2012 and 2011, respectively. Our interest expense has increased due to a higher amount of outstanding borrowings on our $600.0 million Revolving Loan Facility. Interest expense included $19.3 million per year for our Senior Notes.
Each of our insurance segments bears risk for insurance coverage written within its portfolio of insurance products. Each segment generates income from premium written by our underwriting agencies, through third party agents and brokers, or on a direct basis. Certain segments also write facultative or individual account reinsurance, as well as treaty reinsurance business. In some cases, we purchase reinsurance to limit our losses from both individual policy losses and multiple policy losses from catastrophic occurrences. Our segments maintain disciplined expense management and a streamlined management structure, which results in favorable expense ratios. The following provides operational information about our insurance underwriting segments and our Investing segment.
Our U.S. Property & Casualty segment pretax earnings increased $51.1 million in 2013, compared to 2012, primarily due to: 1) net favorable loss development of $39.4 million in 2013, compared to net adverse development of $2.3 million in 2012 and 2) net catastrophe losses of $2.0 million in 2013, compared to $11.3 million in 2012.
The segment’s net earned premium increased in 2013, compared to 2012, due to higher writings by our new underwriting teams for the excess casualty, primary casualty and technical property lines of business, as well as for sports and entertainment disability, residual value and title reinsurance (all grouped in Other). The increase in net earned premium in 2012 primarily related to the new underwriting teams, as well as increases in aviation, public risk, contingency, residual value and other premium. In 2012 and 2013, we wrote less premium in some lines of business, particularly aviation and E&O, due to continued competition. Changes in the segment’s net written premium relative to gross written premium were primarily due to writing more of the highly ceded disability and other business in 2013.
The net (favorable) adverse loss development recognized by line of business was as follows:
The segment’s premium decreased from 2011 to 2013 due to lower writings of our directors’ and officers’ liability and DFP products, mainly due to pricing competition and re-underwriting our DFP business. Net written premium and net earned premium also reflect the impact of reduced retention under our reinsurance program during the past two years.
The segment had net favorable loss development of $26.3 million in 2013 and $25.9 million in 2012, compared to net adverse development of $47.1 million in 2011. The development in each period resulted from our annual review of reserves for this segment, which we conducted in the third quarter of each year. The majority of the insurance coverage in this segment is provided through “claims made” policies, and the final settlement value of these claims is not expected to be determined for several years due to the underlying complex nature of the claims. Accordingly, changes to our ultimate losses for a given underwriting year typically result from management’s revised expectations, as compared to the prior year reserve review, with respect to the settlement value of known claims.
The 2012 net favorable development consisted of $9.0 million in U.S. D&O and $16.9 million in International D&O. Our 2012 review indicated that incurred loss development, primarily for underwriting years 2005 and 2006, was lower than expected as compared to our 2011 review, primarily due to actual outcomes on reported claims. This favorable development was partially offset by higher estimates of ultimate losses in the 2008 underwriting year, driven by our revised expectations with regard to the expected outcomes on outstanding claims, based upon actuarial loss development and other information available since the prior review.
The segment’s increase in gross written, net written and net earned premium in 2013 and 2012 was driven by higher writings in the energy and property treaty lines of business. Net written and net earned premium were relatively flat in 2013, compared to 2012, due to additional reinsurance on our energy line. The increase in premium in 2012 related to higher writings in the energy, property treaty and property insurance lines of business, related to the favorable pricing environment for these products, as well as lower reinstatement premium related to catastrophic events in 2012.
The lines of business in our International segment provide a variety of coverages, most of which are medium to long-tail lines with moderate timing for claims reporting and medium to high reserve volatility. This segment incurs most of our catastrophe losses. In energy, we insure complex, worldwide energy production facilities, oil rigs and offshore platforms that are subject to expensive business interruption claims and replacement costs. Catastrophe-related claims for energy projects may take several years to settle and can involve significant reserve volatility for coverage on both a primary and excess basis. The property and property treaty lines are short-tail with relatively fast claims reporting and lower reserve volatility.
We conducted our annual review of this segment’s reserves in the fourth quarter of 2012 and 2011. In 2013, we accelerated our review to the third quarter due to a growing actuarially-indicated redundancy in several lines of business and issues related to certain Spanish surety bonds.
The net adverse development in the surety & credit line of business in all three years was primarily related to our increase in reserves on a specific class of Spanish surety bonds, the majority of which were written prior to 2006. We recorded $12.8 million of net reserves in 2011 due to claims presented to us under these bonds. We recorded $48.9 million of additional net reserves in 2012 based on management’s evaluation of the claims and the likelihood that we would ultimately be required to pay the claims, based on information available at year-end 2012. In 2013, we revised the estimates of our liability under these bonds in light of an adverse Spanish Supreme Court ruling published in September 2013 against an unaffiliated insurance company with respect to a surety bond similar to ours. This resulted in $70.3 million of net adverse development in 2013.
The net favorable development of $12.9 million in 2012 in the Other category primarily related to reserve reductions related to the 2011 catastrophes in our property line of business.
These rising interest rates impacted the fair value of our fixed maturity securities portfolio at December 31, 2013, as described below. Conversely, the higher interest rates will result in higher anticipated yields as we invest our future cash flows.
The table below indicates the contractual or expected maturity distribution of our fixed maturity securities at December 31, 2013. In the table, we allocated the maturities of our mortgage-backed and asset-backed securities based on the expected future principal payments. The weighted-average life of our mortgage-backed and asset-backed securities is approximately 5.9 years based on expected future cash flows.
At December 31, 2013, we held $2.3 billion of special purpose revenue bonds, as well as $986.5 million of general obligation bonds, which are issued by states, municipalities and political subdivisions and collectively referred to as municipal bonds in the investment market. The overall rating of our municipal bonds was AA at December 31, 2013. Within our municipal bond portfolio, we held $404.4 million of pre-refunded bonds, which are supported by U.S. government debt obligations. Our special purpose revenue bonds are secured by revenue sources specific to each security. At December 31, 2013, the percentages of our special purpose revenue bond portfolio supported by these major revenue sources were as follows: 1) education - 23%, 2) transportation - 23%, 3) water and sewer - 18% and 4) electric - 14%.
Many of our special purpose revenue bonds are insured by mono-line insurance companies or supported by credit enhancement programs of various states and municipalities. We view bond insurance as credit enhancement and not credit substitution. We base our investment decision on the strength of the issuer. A credit review is performed on each issuer and on the sustainability of the revenue source before we acquire a special purpose revenue bond and periodically thereafter. The underlying average credit rating of our special purpose revenue bond issuers, excluding any bond insurance, was AA at December 31, 2013. Although recent economic conditions in the United States may reduce the source of revenue to support certain of these securities, the majority are supported by revenue from essential sources, as indicated above, which we believe generate a stable source of revenue.
At December 31, 2013, we held a commercial mortgage-backed securities portfolio with a fair value of $504.9 million, an average rating of AA+ and an average loan-to-value ratio of 61%. We owned no collateralized debt obligations (CDOs) and we are not counterparty to any credit default swap transactions.
Some of our fixed maturity securities have call or prepayment options. In addition, mortgage-backed and certain asset-backed securities have prepayment, extension or other market-related credit risk. Calls and prepayments subject us to reinvestment risk should interest rates fall and issuers call their securities and we reinvest the proceeds at lower interest rates. Prepayment risk exists if cash flows from the repayment of principal occurs earlier than anticipated because of declining interest rates. Extension risk exists if cash flows from the repayment of principal occurs later than anticipated because of rising interest rates. Credit risk exists if mortgagees default on the underlying mortgages. Net investment income and/or cash flows from investments that have call or prepayment options and prepayment, extension or credit risk may differ from what was anticipated at the time of investment. We mitigate these risks by investing in investment grade securities with varied maturity dates so that only a portion of our portfolio will mature at any point in time. In 2014, we expect approximately 7% of our fixed maturity securities portfolio to mature, call or prepay. Assuming prevailing interest rates remain constant throughout 2014, reinvestment of these funds will be at book yields and tax-equivalent yields that are approximately 70 basis points lower than the year-end 2013 yields for these securities.
(2) Includes all countries whose total foreign debt is individually less than $5.0 million.
Our Corporate & Other category includes operations not related to our segments, including unallocated corporate operating expenses, consolidated interest expense, foreign currency expense (benefit) and underwriting results of our Exited Lines of business.
Net earned premium declined in 2013 as we wrote less business related to our HMO and medical excess reinsurance products, which we exited in late 2012. Premium related to the other products included in Exited Lines was insignificant in all years. The majority of the loss and loss adjustment expense relates to the HMO and medical excess reinsurance products, which had higher losses in 2012 compared to 2011. The Exited Lines had net adverse loss development of $4.1 million in 2013 and net favorable development of $0.5 million and $7.3 million in 2012 and 2011, respectively. The Exited Lines incur operating costs primarily for claims personnel and facilities.
Our Corporate expenses not allocated to the segments decreased $6.3 million in 2013, compared to 2012, principally due to a $5.1 million indemnification benefit in 2013. We reduced our indemnification liability, which related to a 2001 subsidiary sale, due to favorable claims activity and successful subrogation recoveries. Our Corporate expenses not allocated to the segments increased $8.1 million in 2012, compared to 2011, principally due to higher employee compensation and benefit costs and incremental expense related to our new technology systems. Our interest expense increased year-over-year due to a higher amount of borrowings on our $600.0 million Revolving Loan Facility.
The components of our net operating cash flows are summarized in the following table.
Our cash provided by operating activities was $262.7 million in 2013, compared to $661.1 million in 2012 and $421.3 million in 2011. The payment of claims related to the Spanish surety bonds in the fourth quarter of 2013 reduced our 2013 cash provided by operating activities by $139.1 million. In addition, cash provided by operating activities includes collateral funds we receive or refund for our U.S. surety business, for which we record a liability within accounts payable and accrued liabilities. We refunded a net $121.7 million and $8.3 million of U.S. surety collateral in 2013 and 2011, respectively, compared to a net receipt of $96.6 million in 2012. The remaining reduction in our cash provided by operating activities in 2013 primarily related to higher income tax payments, compared to 2012, and the remaining increase in our cash provided by operating activities in 2012, compared to 2011, primarily related to additional premium collections.
In 2013, 2012 and 2011, our domestic and foreign insurance companies paid HCC dividends of $317.5 million, $262.4 million and $248.2 million, respectively. 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 direct U.S. insurance company subsidiaries can pay an aggregate of $350.8 million in dividends in 2014 without obtaining special permission from U.S. state regulatory authorities.
In August 2012, the Board approved a $300.0 million stock purchase plan (the Plan). Purchases under the Plan may be made in the open market or in privately negotiated transactions from time-to-time in compliance with applicable laws, rules and regulations, including Rule 10b-18 under the Securities Exchange Act of 1934, as amended. Purchases under the Plan will be made subject to market and business conditions, the level of cash generated from our operations, cash required for acquisitions, our debt covenant compliance, and other relevant factors. The Plan does not obligate us to purchase any particular number of shares, has no expiration date, and may be suspended or discontinued at any time at the Board’s discretion.
The average duration of claims in many of our lines of business is relatively short. However, we write D&O, E&O and casualty insurance, all of which have a longer claims duration than our other products. We consider these different claims payment patterns in determining the duration of our investment portfolio. The weighted-average duration of all claims was approximately 2.1 years, 2.2 years and 2.5 years in 2013, 2012 and 2011, respectively. The weighted-average duration of our fixed maturity securities was 5.1 years, 4.7 years and 5.0 years in 2013, 2012 and 2011, respectively. The longer duration of our fixed maturity securities reflects the effects of the investment of our capital.
(3) The $600.0 million Revolving Loan Facility expires in April 2017. In the above table, the outstanding borrowings of $355.0 million at December 31, 2013 are shown in 2017 with the annual interest of LIBOR plus 125 basis points on the outstanding balance and the annual commitment fee of 15 basis points on the unused balance shown in each applicable year.
(4) See Note 14, “Related Party Transactions” to the Consolidated Financial Statements for information related to our earnout liabilities.
(5) See Note 13, “Commitments and Contingencies - Indemnifications” to the Consolidated Financial Statements for information related to our indemnification.
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 claims payments. Inflation also may have a negative impact on insurance and reinsurance operations by causing higher claims settlements than originally 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 claims reserves, although we do consider market trends in our quarterly reserve reviews.