Our principal and executive offices are located in Houston, Texas, in a building owned by Houston Casualty Company. We also maintain offices in over 25 locations elsewhere in the United States, England and Spain. 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". See Note (1) in the Notes to Consolidated Financial Statements.
(4) Book value per share is calculated by dividing the sum of outstanding shares plus contractually issuable shares into total shareholders' equity.
The following table sets forth certain premium revenue information for the three years ended December 31, 2002 (in thousands):
Other operating expense decreased to $47.6 million during 2002 compared to $71.1 million in 2001, primarily as a result of the reduction in the amortization of goodwill, operations sold or disposed of, somewhat offset by the effect of acquisitions in 2002 and late 2001, and the goodwill impairment charge in 2001. Currency conversion gains amount to $1.2 million in 2002 compared to $0.3 million in 2001.
Our book value per share was $14.15 as of December 31, 2002, up from $12.40 as of December 31, 2001. Net earnings and the unrealized gain on available for sale securities contributed to the increase in book value per share.
The following tables provide information by line of business (in thousands):
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 global financial products line of business not previously written, offset by the decrease in discontinued lines of business. Gross written premium is expected to continue to increase in 2003.
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 reasons. Increases in net written and net earned premiums were 69% and 62%, respectively, before the discontinued lines of business. Increases in net written and net earned premium are expected to continue in 2003.
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
The tables below show the composition of net and gross incurred loss and loss adjustment expense (amounts in thousands):
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. Barring future catastrophic events, we expect this trend to continue into 2003.
The decrease in other operating income to $7.0 million during 2002 from $17.4 million in 2001 was principally due to the disposition or closure of certain operations during 2001 and the resultant gains totaling $8.2 million from certain of those dispositions. Net earnings of other operations decreased to $3.1 million in 2002 from $7.1 million in 2001 for the same reasons. Period to period comparisons may vary substantially depending on other operating investments or dispositions thereof in any given period. We anticipate new strategic investments and possibly a service company acquisition in 2003, which would provide growth in this revenue.
The net income of the corporate segment was $2.9 million for 2002 compared to a net loss of $1.0 million in 2001. This improvement resulted from lower interest expense due primarily to lower interest rates.
Year Ended December 31, 2001 Versus Year Ended December 31, 2000
During 2001, we experienced three significant gross losses. The largest loss was as a result of the terrorist attack on September 11, which produced the biggest loss to our insurance company operations in our history. Although we had no involvement in the insurance coverages of the airlines involved, we had significant exposure in our accident and health reinsurance account. Our estimates of ultimate exposure were developed through a review of policy coverages, consideration of the effect on the estimate if the attack was considered multiple events rather than a single event, and communications from our clients and producers. We also had participations in property coverage on the World Trade Center and some of the surrounding buildings. In addition, we anticipate some claims from other business written in the New York City area. We also received some reported claims and estimates of losses for others. We utilized this information together with known coverage and reinstatement premium information to establish our gross and net losses reserve of $141.0 million and $35.0 million, respectively. A charge for the net amount has been included in our 2001 consolidated financial statements. The other two losses were the Petrobras (Brazilian offshore energy production platform) and Total (chemical factory near Toulouse, France) incidents, which produced gross losses of $55.0 million and $49.0 million, respectively. Because these policies were substantially reinsured, the net losses were not material to our results of operations.
Compensation expense decreased to $69.8 million for 2001 from $83.1 million in 2000. The decrease is due principally to the disposition of non-core subsidiaries, the subsequent closing or reduction of some operations of an acquired company and efficiencies gained from the consolidation of some of our underwriting agency operations with those of our insurance companies.
Other operating expense for 2001 included $16.3 million from charges related to lines of business that we decided to cease writing. Excluding these charges, other operating expense in 2001 was somewhat reduced for the same reasons as compensation expense, but to a much lesser extent, and the decrease was offset by a general increase in expenses in our operating subsidiaries as business grew. In addition, guarantee fund and other assessments increased $3.5 million in 2001 compared to 2000. Other operating expenses for 2000 also included a credit of $0.8 million reflecting the reversal of some restructuring charges recorded during the previous year, whereas during 2001 we recorded $0.2 million in merger expense resulting from an acquisition. Currency conversion gains amounted to $0.3 million in 2001 compared to losses of $0.3 million in 2000.
Income tax expense on earnings before the change in accounting was $30.2 million for 2001 down from $37.2 million for 2000 primarily due to the reduction in pre-tax income. The unusual effective tax rate for 2001 of 50% , compared to 39% for 2000, primarily results from the charge for the impairment of goodwill, which was not deductible for income tax purposes.
Gross written premium increased to $1.0 billion for 2001 from $967.5 million in 2000 with strong growth in the group life, accident and health and London market account lines of business, as rates continued to rise. Gross written premium growth was not our focus in 2001, as we were able to grow our revenue simply by retaining more of the business. Net written premium for 2001 increased 31% to $373.0 million compared to the previous year, as our insurance companies increased retentions on many of their lines of business as underwriting profitability improved. Net earned premium increased 28% to $342.8 million for the same reason. Increases in net written premium and net earned premium were 39% and 38%, respectively, before the discontinued lines of business.
Loss and loss adjustment expense increased to $267.4 million for 2001 compared to $198.5 million in 2000 substantially due to losses and expenses arising from the September 11 loss and the charge related to lines of business we decided to cease writing. The net loss ratio was 78.0% for 2001 compared to 74.2% in 2000. The group life, accident and health, aviation and London market account loss ratios improved, in spite of losses sustained from the September 11, 2001 terrorist attack, due generally to rate increases and better terms and conditions. The other specialty lines loss ratio increased between years as a result of adverse development on policies, which were subsequently not renewed. The discontinued lines loss ratio increased as a result of the charge related to lines of business we decided to cease writing and the September 11, 2001 loss. The gross loss ratio was 105.5% in 2001 compared to 79.4% for 2000. The Petrobras and Total claims were substantially reinsured and did not have a material effect on our net loss ratio or net earnings. The combined ratio was 103.7% in 2001 compared to 95.2% for 2000. The expense ratio increased in 2001 to 25.7% from 21.0% in 2000 principally as a result of reduced ceding commissions as we retained more profitable business.
Policy acquisition costs, which are net of ceding commissions on reinsurance ceded, increased somewhat to $27.9 million during 2001 compared to 2000. During 2001, our insurance companies charged higher policy issuance fees on certain lines of business which are recorded as a reduction in acquisition costs. This reduction in costs is offset by the increase in policy acquisition costs resulting from higher earned premium and part of the charge from lines of business we decided to cease writing.
Management fees decreased to $61.8 million for 2001 compared to $96.1 million in 2000. Much of the decrease is the result of our consolidation of the operations of three of our underwriting agencies into the operations of our insurance companies effective January 1, 2001. Additional decreases are due to lines of business either sold or exited and increased retentions of our insurance companies. Net earnings of our underwriting agencies decreased to $17.2 million for 2001 from $21.4 million in 2000 for the same reasons.
The net loss of the corporate segment was $1.0 million for 2001 compared to a net loss of $4.7 million in 2000. This improvement resulted from the reduction of interest expense as we paid off our debt under the bank facility by using the proceeds from the March, 2001 public offering of common stock and the August, 2001 offering of 2% convertible notes, lower bank interest rates and the low interest rate on our newly issued 2% convertible notes. Also included in the amounts for 2000 were the costs of the closing of some operations of an acquired company.
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 4.6% in 2002, compared to 5.6% in 2001. The weighted average maturity of our fixed income securities is 4.2 years and weighted average duration of the portfolio was 3.5 years, both as of December 31, 2002. Over 96% 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. Each $1 thousand 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 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. We plan to use the
proceeds from this offering to pay down existing indebtedness under our bank facility, assist in financing future acquisitions and strategic investments and for general corporate purposes.
The following is a summary of our various commitments (in thousands) as of December 31, 2002, all of which expire during 2004 or 2005:
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 $6.2 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.
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.
Avemco Insurance Company is limited by the State of Maryland in the amount of dividends which it may pay in any twelve-month period, without prior regulatory approval, to the lesser of its statutory net investment income excluding realized capital gains for the prior calendar year or 10% of its statutory policyholders' surplus as of the prior year end. During 2003, Avemco Insurance Company's ordinary dividend capacity will be zero as a result of a special approved dividend paid in 2002.
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, 2002, our statutory gross written premium to policyholders' surplus was 222.1%. For the year ended December 31, 2002, our statutory net written premium to policyholders' surplus was 104.1%. As of December 31, 2002, 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.
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 bank loan fluctuates with that of the market. Any significant increase in interest rates could have a material adverse effect on our 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 with respect to fluctuations in the exchange rates between the major European currencies (particularly the British pound sterling and 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, 2002, our gain from currency conversion was $1.2 million compared to a gain of $0.3 million in 2001 and a loss of $0.3 million in 2000.
On a limited basis, we enter into foreign currency forward contracts as a hedge against foreign currency fluctuations. Rattner Mackenzie Limited has revenue streams in U.S. dollars and Canadian dollars but incurs expenses in British pound sterling. To mitigate the foreign exchange risk, from time to time we have entered into foreign currency forward contracts expiring at staggered times. As of December 31, 2002, we had no foreign currency forward contracts outstanding. The foreign currency forward contracts are used to convert currency at a known rate in an amount which either approximates or is less than monthly expenses. Thus, the effect of these transactions is to limit the foreign currency exchange risk of the recurring monthly expenses. We utilize these foreign currency forward contracts strictly as a cash flow hedge against existing exposure to foreign currency fluctuations rather than as a form of speculative or trading investment.
Losses in our group life and accident and health, aviation, London market accounts and other specialty lines of business are recorded and paid relatively quickly. There is not a significant amount of long-tailed liability exposure in these lines of business. Therefore, reserves can be determined and recorded with a higher degree of accuracy and significant development should not be expected with respect to losses in these lines of business. There is some reinsurance assumed in these lines of business, but, as discussed above, we monitor the assumed reported losses closely. Losses related to our global financial products line of business are reported relatively quickly but can develop over time as, especially with respect to directors and officers liability business where we write excess of loss risks, reported losses which are adjusted by the primary underwriter on the risk may not initially appear to be serious but can develop and affect our excess layer over time. We believe that we have adequately reserved for this eventuality. Our discontinued line of business contains both direct business and assumed business. Some of the losses in this line are administered by others, subject to our review. It is possible that there can be development in the loss reserves in this line of business as the business is in run off and some of it is subject to late reporting by those administering the claims. We monitor these reserves carefully on a current basis and believe that they are properly set based upon the information we have at this time.
our historical reserving techniques and the fact that our net reserves have historically shown positive development, 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. See also Item 3, Legal Proceedings and the Reinsurance Ceded section contained in Item 1, Business.
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, 2002, we had gross unrealized losses on fixed income and marketable equity securities of $1.5 million (.2% of aggregate market value) compared to $1.7 million (.3% of aggregate market value) as of December 31, 2001.
Statement of Financial Accounting Standards ("SFAS") No. 146 entitled "Accounting for Costs Associated with Exit or Disposal Activities" was issued in July, 2002 and will become effective for us on January 1, 2003. SFAS No. 146 will spread out the reporting of expenses related to restructurings and is a change to existing guidance. The commitment to a plan to exit an activity or dispose of long-lived assets will no longer be enough to record a one-time charge for most anticipated costs. Instead, companies will record exit or disposal costs when they are incurred and can be measured at fair value and the liability will be subsequently adjusted for changes in estimated cash flow. We do not expect the adoption of SFAS No. 146 to have a material effect on our financial position, results of operations or cash flows.
FIN No. 46 entitled "Consolidation of Variable Interest Entities", which is an interpretation of Accounting Research Bulletin No. 51 entitled "Consolidated Financial Statements" addresses consolidation by business enterprises of variable interest entities which have certain characteristics. FIN No. 46 requires consolidation of a qualifying variable interest entity when a party has a controlling financial interest regardless of whether or not the party has a majority voting interest. FIN No. 46 is immediately effective for qualifying variable interest entities created after January 31, 2003 and applicable to such entities created prior to February 1, 2003 by the end of our third fiscal quarter in 2003. We are currently studying FIN No. 46 for applicability to us. At the present time we believe FIN No. 46 will only be applicable to one entity in which we have an investment. We invested in a partnership, which owns a building which is rented to unaffiliated parties, as a long term investment. The partnership is not material to our financial position, results of
operations or cash flows. We have a maximum exposure to loss of $14.1 million with respect to this entity as a result of our investment and our guarantee of the partnership's debt.
Emerging Issues Task Force ("EITF") Issue No. 00-21 entitled "Revenue Arrangements with Multiple Deliverables" is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003 or alternatively can be applied retroactively. EITF Issue No. 00-21 addressed how to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. EITF Issue No. 00-21 also addresses how arrangement consideration should be measured and allocated to the separate units of accounting in the arrangement. We do not believe that this EITF Issue No. 00-21 will have a material effect on our financial position, results of operations or cash flows as the issues in EITF Issue No. 00-21 have been previously addressed when we adopted Securities and Exchange Commissions' Staff Accounting Bulletin 101.