The selected consolidated financial data set forth below has been derived from the Consolidated Financial Statements. All information contained herein should be read in conjunction with the Consolidated Financial Statements and related Notes, the Schedules, and Management’s Discussion and Analysis of Financial Condition and Results of Operations included elsewhere in this Report.
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 $29.81 on February 17, 2012, resulting in market capitalization of $3.1 billion.
We produced total revenue of $2.4 billion, of which 90% related to net earned premium and 9% related to net investment income.
We recognized $13.0 million of profit commissions due from reinsurers, related to the U.S. D&O and International D&O lines of business.
We increased our dividend for the 15th consecutive year and paid $65.8 million of dividends.
Our 2011 and 2010 results include the impact of catastrophic events around the world. We experienced catastrophe losses primarily from the Japan earthquake and tsunami, New Zealand earthquakes, United States tornados and Hurricane Irene, Denmark storms and Thailand floods in 2011 and the Chile earthquake in 2010. We had no significant catastrophe losses in 2009. We reinsured a portion of our exposure to these catastrophic events. In 2011, we incurred $14.0 million of additional cost for net reinstatement premium to continue our reinsurance coverage for future loss events. The following table summarizes our catastrophe losses, as well as the impact on our net earnings and key metrics in 2011 and 2010.
In addition to the catastrophe losses, we increased our loss reserves by $47.4 million in 2011 to reflect the impact of net adverse prior year loss development and the additional accident year 2011 losses related to our diversified financial products (DFP) line of business. Adverse (favorable) loss development was $10.1 million, $(22.7) million and $(53.5) million for 2011, 2010 and 2009, respectively, and the DFP losses totaled $37.3 million. See the “Segment Operations” section below for further discussion of the catastrophes, loss development and DFP accident year 2011 losses.
Total revenue increased $71.8 million in 2011, compared to 2010, primarily due to higher net earned premium and net investment income, offset by lower other operating income and net realized investment gains. Total revenue decreased $16.3 million in 2010, compared to 2009, due to lower other operating income, partially offset by increased investment income from growth in our investment portfolio. Other operating income in 2009 included $25.0 million related to termination of a reinsurance contract, which is discussed below.
Other operating expense included $12.4 million, $13.6 million and $16.0 million in 2011, 2010 and 2009, respectively, of stock-based compensation expense, after the effect of the deferral and amortization of policy acquisition costs related to stock-based compensation for our underwriters. Stock-based compensation expense was lower in 2011 and 2010 due to the forfeiture of restricted stock grants and full vesting of certain stock options. In 2011, we granted $13.9 million of restricted stock awards and units, with a weighted-average life of 4.1 years. At December 31, 2011, there was approximately $25.7 million of total unrecognized compensation expense related to unvested options and restricted stock awards and units that is expected to be recognized over a weighted-average period of 3.0 years. In 2012, we expect to recognize $9.8 million of expense, including the amortization of deferred policy acquisition costs, for all stock-based awards outstanding at year-end 2011.
In 2010 and again in 2011, we wrote less premium in many of these product lines due to continued competition in the segment’s markets. In particular, our E&O volume declined as we continued to re-underwrite that product, employing more stringent underwriting criteria in reaction to higher losses. Premium grouped in Other includes numerous types of specialty insurance products. The 2011 increase in Other included $16.7 million of premium generated by our three new underwriting teams focused on technical property, primary casualty and excess casualty coverages. Net written premium increased in aviation, public risk and certain Other product lines in 2011, due to changes in timing and amount of our reinsurance programs.
The segment’s expense ratio was higher in 2011, primarily due to higher compensation costs and lower segment revenue. The higher expense ratio in 2010, compared to 2009, primarily related to lower segment revenue in 2010. We terminated our interest in a derivative contract in 2010 and in a reinsurance contract in 2009, which generated $5.0 million and $15.6 million, respectively, of pretax earnings in these years. Related to these transactions, we received cash of $8.3 million in 2010 and $25.0 million in 2009, which was included in other revenue, and incurred reinsurance and other direct costs of $3.0 million in 2010 and $9.9 million in 2009, which were included in other expense. The segment’s remaining other revenue relates to fee and commission income earned by our agencies from third party insurance companies.
The following tables summarize the operations of the Professional Liability segment.
The Professional Liability segment pretax earnings declined 72% in 2011, compared to 2010, due to lower net earned premium and adverse loss development, partially offset by increased income related to profit commissions due from reinsurers (including $13.0 million directly related to favorable development in the U.S. D&O and International D&O lines of business in 2011). Segment earnings decreased year-over-year in 2010 due to lower net earned premium, reduced profit commissions from reinsurers, and adverse loss development. Gross written premium decreased 6% in 2011 and 7% in 2010 because we wrote less D&O business in the United States due to pricing competition. Net written premium increased in 2011 due to a change in our reinsurance programs.
The segment had adverse loss development of $47.1 million in 2011, compared to $9.6 million in 2010 and minimal development in 2009. The 2011 and 2010 development primarily related to our DFP line of business (included in U.S. D&O), which provides coverage for private equity partnerships, hedge funds and investment managers. In 2011, DFP recorded $104.2 million of adverse development, as well as $37.3 million of additional losses related to our increase in the ultimate loss ratio for accident year 2011. These reserve changes resulted primarily from revised assumptions with regards to the frequency and severity of claims in the 2008 - 2011 accident years. Our U.S. D&O and International D&O lines of business had favorable development of $32.2 million and $24.9 million, respectively, in 2011, which partially offset the adverse development from DFP. The favorable D&O development related to lower than expected reported loss development in accident years 2002 - 2005. The higher 2011 loss ratio for U.S. D&O, shown above, included the impact of DFP’s adverse development, partially offset by the favorable development for the U.S. D&O line of business. The low loss ratio in 2011 for International D&O directly related to the favorable development, discussed above. In 2009, for our D&O products, we re-estimated our exposure on the 2004 - 2007 underwriting years. As a result, the International D&O reserves had favorable development, which was substantially offset by adverse development in the U.S. D&O reserves.
The fluctuations in the expense ratio primarily related to profit commissions in 2011 and 2009. The profit commissions, which offset the segment’s other expense, reduced the 2011 expense ratio by 3.3 percentage points and the 2009 expense ratio by 2.3 percentage points. There were minimal profit commissions in 2010. The lower expense ratio in 2009, after consideration of the effect of profit commissions, related to the higher level of net earned premium relative to 2011 and 2010.
The segment had favorable loss development of $6.1 million in 2011, compared to adverse development of $9.8 million and $3.1 million in 2010 and 2009, respectively. The 2011 favorable development primarily related to the 2009 - 2010 underwriting years for our medical stop-loss, medical excess and HMO reinsurance products. This favorable development was substantially offset by higher losses in 2011. The 2010 adverse development primarily related to the 2008 and 2009 underwriting years for our medical excess, short-term medical and HMO reinsurance products.
Our U.S. Surety & Credit pretax segment earnings increased 21% in 2011, compared to 2010, due to increased net earned premium and a higher amount of favorable development in 2011. Segment earnings increased 27% in 2010, compared to 2009, due to higher net earned premium, partially offset by higher expenses and a reduced amount of favorable loss experience compared to 2009.
Gross written premium was flat in 2011, due to slight offsetting changes in our surety and credit product lines. In 2010, increased pricing for commercial surety bonds written by a company we acquired in early 2009 contributed to the growth in gross written premium. In addition, our large commercial surety team, hired in 2009, wrote more premium in 2010. Our credit premium grew in 2011 and 2010 due to improved market pricing following the 2008 world-wide credit market crisis.
The segment had favorable loss development of $11.3 million in 2011, compared to $7.2 million in 2010 and $10.5 million in 2009. In all three years, the favorable development related to lower than expected reported loss development in both our surety and credit product lines.
The following table summarizes the investment results of our Investing segment.
The following table summarizes the investment results related to our investment portfolio.
The decline in the weighted-average rating of our fixed income portfolio at year-end 2011 was a direct result of Standard & Poor’s Corporation’s downgrade of the U.S. government debt rating in August 2011. The ratings of our individual securities within our portfolio at December 31, 2011 were as follows:
The average long-term tax equivalent yield of our fixed income securities portfolio was 4.8%, 5.0% and 5.1% in 2011, 2010 and 2009, respectively. These yields reflect general declines in market interest rates over this period, partially offset by longer average duration of our new investments. Realized gains and losses from sales of securities are usually minimal, unless we sell securities for investee credit-related reasons, or because we can reinvest the proceeds at a higher effective yield. We recognized net realized investment gains of $3.7 million in 2011 and $12.1 million in both 2010 and 2009.
The table below indicates the contractual or expected maturity distribution of our fixed income securities at December 31, 2011. In the table, we allocated the maturities of 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 4.3 years based on expected future cash flows.
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, on an ongoing basis, thereafter. The underlying average credit rating of our special purpose revenue bond issuers, excluding any bond insurance, was AA at December 31, 2011. Although recent economic conditions in the United States may reduce the sources 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, 2011, we held corporate fixed income securities issued by foreign corporations with an aggregate fair value of $364.5 million. In addition, we held securities issued by foreign governments, agencies or supranational entities with an aggregate fair value of $281.1 million. The following table details our holdings of foreign debt at December 31, 2011.
* Supranational represents investments in European Bank for Reconstruction and Development, European Investment Bank, Inter-American Development Bank, and International Bank for Reconstruction and Development.
At December 31, 2011, we held a commercial mortgage-backed securities portfolio with a fair value of $256.1 million, an average rating of AA+ and an average loan-to-value ratio of 70%. We owned no collateralized debt obligations (CDOs) or collateralized loan obligations (CLOs), and we are not counterparty to any credit default swap transactions.
Some of our fixed income 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.
Our Corporate & Other category includes operations not related to our segments, including unallocable corporate operating expenses, consolidated interest expense and underwriting results of our Exited Lines of business.
The following table summarizes activity in the Corporate & Other category.
In March 2011, we replaced our $575.0 million Revolving Loan Facility with a four-year $600.0 million Revolving Loan Facility that expires on March 8, 2015. We had $407.4 million of borrowing capacity available at December 31, 2011.
Our long-term debt consists of $300.0 million principal amount of unsecured 6.30% Senior Notes due November 15, 2019. Our debt to total capital ratio was 12.7% at December 31, 2011 and 8.3% at December 31, 2010, with the increase related to our borrowings under the Revolving Loan Facility.
Our domestic insurance companies have the ability to pay $255.1 million in dividends in 2012 to the parent company without obtaining special permission from state regulatory authorities. Our underwriting agencies have no restrictions on the amount of dividends that can be paid. HCC can utilize these dividends for any purpose, including to pay down debt, pay dividends to shareholders, fund acquisitions, purchase our common stock and pay operating expenses.
The parent company has a short-duration fixed income securities portfolio of $233.6 million, which is available to cover the holding company’s required cash disbursements in 2012.
We generated cash from operations of $421.3 million in 2011, $415.2 million in 2010 and $582.8 million in 2009. The components of our net operating cash flows are summarized in the following table.
On March 10, 2011, the Board approved the purchase of up to $300.0 million of our common stock. This plan was exhausted in September and, on September 23, 2011, the Board approved purchases of an additional $300.0 million (the Plan). Purchases 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 opportunistically from time-to-time, 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 principal assets of HCC are the shares of capital stock of its insurance company subsidiaries. HCC’s obligations include servicing outstanding debt and interest, paying dividends to shareholders, repurchasing HCC’s common stock, and paying corporate expenses. Historically, we have not relied on dividends from our insurance companies to meet HCC’s obligations as we have had sufficient cash flow from our underwriting agencies to meet our corporate cash flow requirements. However, a greater percentage of profit is now being earned in our insurance companies, which has generated available capital in these companies. As a result, we have increased the amount of dividends paid by our insurance companies to fund HCC’s repurchase of common stock and other cash obligations.
In 2011, 2010 and 2009, our domestic and foreign insurance companies paid HCC dividends of $248.2 million, $285.7 million and $134.0 million, respectively. The 2011 and 2010 dividends included $138.3 million and $135.4 million, respectively, of fixed income securities plus the related accrued interest. 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 $255.1 million in dividends in 2012 without obtaining special permission from U.S. state regulatory authorities.
We acquired HCC Global Financial Products (HCC Global), which underwrites our U.S. and International D&O liability business, in 2002. The purchase agreement, as amended, includes a contingency for future earnout payments. The earnout is based on HCC Global’s pretax earnings from the acquisition date through September 30, 2007, with no maximum amount due to the former owners. When conditions specified under the purchase agreement are met, we record a net amount owed to or due from the former owners based on our estimate, at that point in time, of how claims will ultimately be settled. This net amount will fluctuate in the future, and the ultimate total net earnout payments cannot be finally determined until all claims are settled or paid. In March 2011, certain amendments were made to the purchase agreement, which resulted in an adjustment to our estimate of the ultimate amounts to be settled under the agreement. As of December 31, 2011, we estimated the future ultimate claims settlements for the applicable periods of our U.S. D&O and International D&O lines of business, including the impact of favorable loss development recorded in 2011. Based on this, we recorded a projected net amount due to the former owners of $31.3 million at year-end 2011, which is payable in 2012.
The following table summarizes our total contractual cash payment obligations by estimated payment date at December 31, 2011.
Inflation can also affect interest rates. A significant increase in interest rates could increase our net investment income related to newly invested cash flow and could also have a material adverse effect on the fair value of our investments. The fair value of our fixed income securities was $5.9 billion at December 31, 2011. If market interest rates were to change 100 basis points, the fair value of our fixed income securities would change approximately $294.0 million before tax, based on our year-end portfolio value. The change in fair value was determined using duration modeling assuming no prepayments. In addition, the interest rate payable under our Revolving Loan Facility fluctuates with market interest rates. At December 31, 2011, we had outstanding borrowings of $180.0 million under the Facility. If average interest rates increased by 100 basis points during 2012 as compared to 2011, our projected 2012 interest expense would increase by approximately $2.0 million. The interest rate on our 6.30% Senior Notes is fixed and not subject to interest rate changes.
The process of estimating our loss and loss adjustment expense is inherently uncertain and involves a considerable degree of judgment. Our recorded reserves represent management’s best estimate of unpaid losses and loss adjustment expenses as of each quarter end. See the “Reserves for Insurance Claims” section of Item 1, Business for a description of the factors considered by management in making loss reserve estimates, as well as the change in such estimates over the past ten years.
We utilize the actuarial point and range estimates prepared by our internal actuaries to monitor the adequacy and reasonableness of our recorded reserves. Each quarter end, management compares recorded reserves to the most recent actuarial point estimate. If the recorded reserves vary significantly from the actuarial point estimate, management determines the reasons for the variances and may adjust the reserves up or down to an amount that, in management’s judgment, is adequate based on all of the facts and circumstances considered, including the actuarial point estimates. Historically, our consolidated net reserves have been above the total actuarial point estimate but within the actuarial range.
The following table shows our recorded net reserves by segment, as well as the actuarial reserve point estimates, and the high and low ends of the actuarial reserve range as determined by our reserving actuaries, as of December 31, 2011.
While standard actuarial techniques are utilized in making actuarial point estimates, these techniques require a high degree of judgment, and changing conditions can cause fluctuations in the reserve estimates. The actuarial point estimates represent our actuaries’ estimate of the most likely amount that will ultimately be paid to settle the net reserves we have recorded at a particular point in time. While, from an actuarial standpoint, a point estimate is considered the most likely amount to be paid, there is inherent uncertainty in the point estimate, and it can be thought of as the expected value in a distribution of possible reserve estimates. The actuarial ranges represent our actuaries’ estimate of a likely lowest amount and highest amount that will ultimately be paid to settle the net reserves. There is still a possibility of ultimately paying an amount below the range or above the range. The range determinations are based on estimates and actuarial judgments and are intended to encompass reasonably likely changes in one or more of the variables that were used to determine the point estimates.
We determine our IBNR reserves by subtracting case reserves from our total estimated loss reserves, which are based on the ultimate expected losses for each product. The level of IBNR reserves in relation to total reserves depends upon the characteristics of the specific products within each segment, particularly related to the speed with which losses are reported and outstanding claims reserves are adjusted. Segments that contain products for which losses are reported moderately or slowly will have a higher percentage of IBNR reserves than segments with products that report and settle claims more quickly.
Based on our reserving techniques, estimation processes and past results, we believe that our net reserves are adequate.
We purchase reinsurance on a proportional basis to cover loss frequency, individual risk severity and catastrophe exposure. Some of the proportional reinsurance agreements may have maximum loss limits, most of which are at or greater than a 200% loss ratio. We also purchase reinsurance on an excess of loss basis to cover individual risk severity and catastrophe exposure. Additionally, we may obtain facultative reinsurance protection on a single risk. The type and amount of reinsurance we purchase varies year to year based on our risk assessment, our desired retention levels based on profitability and other considerations, and on the market availability of quality reinsurance at prices we consider acceptable. Our reinsurance programs renew throughout the year, and the price changes in recent years have not been material to our net underwriting results. Our reinsurance generally does not cover war or terrorism risks.
We continuously monitor our financial exposure to the reinsurance market and take necessary actions in an attempt to mitigate our exposure to possible loss. We monitor reinsurance recoverables to ensure no one reinsurer’s balances exceed 10% of our consolidated reinsurance recoverables. 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 collectability of our reinsurance recoverables 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 collectability of the recoverables and the financial condition of reinsurers can change, and these changes can affect the level of reserve required.
Based on our 2011 impairment test, the fair value of each of our reporting units as of June 30, 2011 exceeded its carrying amount. In addition, we had no indication of impairment at December 31, 2011. We will conduct our next annual goodwill impairment test as of June 30, 2012, unless other events occur that indicate there is an impairment in our goodwill prior to that date. See Note 1, “General Information and Significant Accounting and Reporting Policies - Recent Accounting Policies” to the Consolidated Financial Statements for a new accounting standard related to goodwill valuation that we will adopt in 2012.
A security has an impairment loss when its fair value is less than its cost or amortized cost at the balance sheet date. Our available for sale fixed income securities had gross unrealized losses of $12.9 million (0.2% of the aggregate fair value of total available for sale fixed income securities) at December 31, 2011, compared to $35.6 million (0.7% of aggregate fair value) at December 31, 2010. We evaluate our securities for possible other-than-temporary impairment (OTTI) losses at each quarter end. See Note 1, “General Information and Significant Accounting and Reporting Policies - Other-than-temporary Impairments” to the Consolidated Financial Statements for the factors we use to evaluate our securities.
We have reviewed our impaired securities at each quarter end and assessed whether we have any OTTI losses, based on all relevant facts and circumstances for each impaired security. To assist us in our evaluation, our outside investment advisor also performs detailed credit evaluations of all of our fixed income securities on an ongoing basis. Our quarterly reviews have covered all impaired securities where the loss exceeded $0.5 million and the loss either exceeded 10% of cost or the security had been in a loss position for longer than twelve consecutive months.
At December 31, 2011, we had $0.9 million of after-tax OTTI losses, related to mortgage-backed securities, included in shareholders’ equity. This amount includes the after-tax unrealized gains and losses on these impaired securities resulting from changes in their fair value subsequent to their initial OTTI measurement dates.
The financial statements and supplementary financial information listed in the accompanying Index to Consolidated Financial Statements and Schedules are incorporated herein as part of this Report.