During 2000, we changed certain of our revenue recognition methods for our underwriting agencies and reinsurance brokers to agree to guidance contained in the Securities and Exchange Commission’s Staff Accounting Bulletin Number 101, Revenue Recognition in Financial Statements.
Book value per share is calculated by dividing the sum of outstanding shares plus contractually issuable shares into total shareholders’ equity.
We sold our retail brokerage operation, HCC Employee Benefits, in December 2003. The net earnings of HCC Employee Benefits, the 2003 gain on its sale and the subsequent gain in 2004 from a contractual earnout have been classified as discontinued operations in our consolidated statements of earnings. Consistent with this presentation, all revenue and expense of HCC Employee Benefits have been reclassified to discontinued operations in our consolidated statement of earnings.
In accordance with Emerging Issues Task Force Issue No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings per Share, we retroactively changed our calculation of diluted earnings per share in the fourth quarter of 2004. This standard had no impact on diluted earnings per share and an immaterial impact on weighted average shares outstanding.
Market conditions improved across all of our lines of business during the period 2000 through 2003, primarily due to the extended period of severe competition during the 1990’s, resulting in extremely poor underwriting results for most of the insurance industry. This improvement accelerated after the September 11, 2001 terrorist attack and continued throughout 2003, with significant rate increases particularly evident in our diversified financial products line of business. Premium rates in some of our lines began to soften in 2004, although the rate decreases were more gradual than the prior increases so that our underwriting activities remain very profitable. We have expanded our underwriting activities and increased our retentions in response to these market conditions and plan to continue these actions as long as market conditions warrant.
companies are included in our operations beginning on the effective date of each transaction. The following table provides a list of our most important acquisitions.
Net earnings increased 14% to $163.0 million, or $2.47 per diluted share, in 2004 from $143.6 million, or $2.23 per diluted share, in 2003. Net earnings in 2004 included an after-tax loss of $21.5 million, or $0.33 per diluted share, due to the combined effects of four hurricanes, discussed in more detail below. Growth in all components of revenue contributed to the increase in 2004 net earnings. Net earnings for 2004 included a $5.4 million increase from the operations of subsidiaries acquired in 2004. Net earnings increased 36% to $143.6 million, or $2.23 per diluted share, in 2003 from $105.8 million, or $1.68 per diluted share, in 2002. Net earnings in 2003 included $36.7 million (net of tax), or $0.58 per share, from discontinued operations (including a $30.1 million net of tax gain on sale of a subsidiary) and loss of $18.7 million (net of tax), or $0.29 per diluted share, due to a commutation. Net earnings in 2003 also included $20.5 million due to acquisitions made in the fourth quarter of 2002. Earnings from continuing operations grew 49% to $159.0 million, or $2.41 per diluted share in 2004, from $106.9 million, or $1.66 per diluted share in 2003. The 2003 amount represented an increase of 7% from $99.5 million, or $1.58 per diluted share in 2002.
During the third quarter of 2004, catastrophic events occurred related to four major hurricanes: Charley, Frances, Ivan and Jeanne (collectively, the “hurricanes”). We recognized a pre-tax loss after reinsurance of $33.1 million in our insurance company segment. This loss included $23.3 million recorded in loss and loss adjustment expense and $9.8 million for premiums to reinstate our excess of loss reinsurance protection, which reduced net earned premium. The effect of the hurricanes increased our net loss ratio 2.9% and our combined ratio 3.2%.
During 2003, we reached an agreement with various reinsurers to commute certain reinsurance recoverables relating to our assumed accident and health business in our discontinued line of business. We received a cash payment, which was less than the related recoverable, from the reinsurers in consideration for discounting the recoverables and reassuming the losses. The pre-tax loss of $28.8 million was included in loss and loss adjustment expense in our insurance company segment. The effect of the commutation increased our net loss ratio and combined ratio 3.9%.
Total revenue increased 36% to $1.3 billion in 2004 and 41% to $942.0 million in 2003, driven by significant growth in net earned premium, fee and commission income, and investment income. Approximately 15% of the increase in 2004 revenue and 40% of the increase in 2003 revenue was due to the acquisition of subsidiaries. We expect the growth in total revenue to continue in 2005.
Net investment income increased 37% to $64.9 million in 2004 and 25% in 2003, compared to the prior year. These increases were due to higher investment assets, which increased to $2.5 billion at December 31, 2004 compared to $1.7 billion at December 31, 2003 and $1.2 billion at December 31, 2002. The growth in investment assets resulted from significant cash flow from operations and increased net loss reserves in both years, our public offering of stock in 2004, commutations completed in 2004 and 2003, and, to a lesser extent, from acquisitions. Net investment income increased despite low yields on our fixed income and short-term investments. If market interest rates rise, the growth in investment income would be expected to accelerate, since our operating cash flow, short-term investments, investment income and current maturities from our long-term portfolio could be invested at higher rates. We expect investment assets and investment income to increase during 2005.
Other operating income increased $6.2 million in both 2004 and 2003, compared to the prior year. The 2004 increase includes $4.3 million of income related to two mortgage impairment insurance policies, which are written as insurance policies but treated for accounting purposes as derivative financial instruments, and a $1.5 million gain from the sale of a building. The 2003 increase was due to increased gains on our portfolio of insurance-related trading securities and our investment in Argonaut Group, Inc. Period to period comparisons in this category may vary substantially depending on other operating investments or dispositions of such investments.
Other operating expense increased $17.9 million in 2004 and $16.6 million in 2003. The increases in 2004 and 2003 were principally due to additional expenses of acquired subsidiaries. During 2004, we also expensed $10.1 million to cover estimated settlement costs related to pending litigation. In 2003, there was a one-time currency gain of $1.3 million from settlement of an advance of funds to an unaffiliated entity.
In December 2003, we sold the business of our retail brokerage subsidiary, HCC Employee Benefits, Inc., for $62.5 million in cash. We recognized a gain of $52.7 million ($30.1 million after-tax) in 2003 and an estimated additional gain of $6.3 million ($4.0 million after-tax) from a contractual earnout in 2004. The after-tax earnings from discontinued operations and the after-tax gain on sale are reported as earnings from discontinued operations in the consolidated statements of earnings.
Net earnings of our insurance company segment increased 44% to $107.4 million in 2004 compared to $74.4 million in 2003, which in turn increased 9% from $68.2 million in 2002. The 2004 net earnings included an after-tax loss of $21.5 million due to the hurricanes and the 2003 net earnings included an after-tax loss of $18.7 million due to a commutation. Offsetting the effects of the hurricanes and the commutation were higher gross premium volume, increased retentions, improved underwriting results and increased investment income, all of which contributed to the growth in segment net earnings. In addition, the acquisition of American Contractors Indemnity Company contributed $6.1 million to the increase in net earnings during 2004. We expect net earnings from our insurance companies to continue to grow in 2005.
Gross written premium increased 14% to $2.0 billion in 2004 and 50% in 2003. Net written premium increased 28% to $1.1 billion in 2004 and 59% in 2003, and net earned premium increased 37% to $1.0 billion in 2004 and 46% in 2003. These increases were due to organic growth; a higher retention level in our group life, accident and health, diversified financial products and aviation lines of business; and the acquisitions of American Contractors Indemnity Company in January 2004, RA&MCO in October 2004, and HCC Global, HCC Diversified and HCC Europe in late 2002. Gross written premium is expected to remain relatively flat in 2005 as we maintain our underwriting discipline as rates soften and competition increases. Net written premium is expected to continue to increase in 2005, primarily due to increased retentions. The changes in premium volume and retention levels between years resulted principally from the following factors:
increases in our professional indemnity and surety business due to organic growth and acquisitions. In 2004, there was increasing competition in the insurance industry and to a lesser degree in our specialty lines, but we believe that our business will remain very profitable, at least through 2005. We expect much slower growth in gross written premium in 2005 as we become more selective, although net written premium will continue to grow from higher retentions. Our increased retentions resulted from a reduction of proportional reinsurance, some of which has been replaced by excess of loss reinsurance.
We increased the overall percentage of retained risk from 47% in 2002 to 50% in 2003 to 56% in 2004, although substantially more on certain lines of business. Annually, we analyze our overall threshold for risk, then structure a specific reinsurance program for each line of business we underwrite. We purchase reinsurance to reduce our net liability on individual risks, to protect against catastrophe losses and volatility and to achieve a desired ratio of net written premium to policyholders’ surplus. We purchase reinsurance on a proportional basis (where we pay a pro rata portion of the premium we receive) to cover loss frequency, individual risk severity and catastrophe exposure. We also purchase reinsurance on an excess of loss basis (where we pay a specific reinsurance premium) to cover individual risk severity and catastrophe exposure. Additionally, we may obtain facultative reinsurance protection on a single risk. The type, cost and limits of reinsurance we purchase vary year to year based on our perception of the particular risks inherent in the policies underwritten, our desired retention levels based on profitability, and the market availability of quality reinsurance at an acceptable price.
The net loss ratio was 63.8% in 2004, 66.2% in 2003 and 60.6% in 2002. The 2004 net loss ratio included 2.3% due to the hurricanes. Our net loss and loss adjustment expense deficiency was $30.5 million in 2004 and $23.8 million in 2003, compared to a redundancy of $6.8 million in 2002. During 2004, as a result of adverse development in certain assumed accident and health business in our discontinued line of business, we strengthened our reserves on this line to bring them above our actuarial point estimate. The 2004 deficiency resulted primarily from losses and reserve strengthening of $27.3 million related to the accident and health business. The 2003 deficiency resulted from a commutation charge of $28.8 million, partially offset by a net redundancy of $5.0 million from all other sources. Deficiencies and redundancies in the reserves occur as we continually review our loss reserves with our actuaries, increasing or reducing loss reserves as a result of such reviews and as losses are finally settled and claims exposures are reduced. We believe we have provided for all material net incurred losses.
Group life, accident and health - The 2004 net loss ratio was higher than 2003 due to the increase in premium rates on recent business written being slightly lower than the trend in medical costs, as a result of increased pricing competition. However, underwriting margins in this line of business remain very acceptable.
London market account - In 2004, the hurricanes increased the loss ratio 14.1%. Otherwise, loss ratios improved in 2004 because we have been more selective in our underwriting and have moved to higher layer excess of loss business where there is less loss frequency.
Aviation - The hurricanes increased the loss ratio 6.5% for 2004. Otherwise, underwriting results have generally been better in 2004 than in 2003. The low loss ratio in 2002 was due to unusually good loss experience in that year.
Discontinued lines - All periods have been affected by reserve additions resulting from our ongoing review of outstanding claims and additional information received. The 2004 loss ratio was impacted by losses of $27.3 million on certain accident and health business. As a result of adverse development in our discontinued line of business, we strengthened our reserves on this line to bring them above our actuarial point estimate. The 2003 loss ratio was impacted by the $28.8 million commutation loss, and the 2002 loss ratio was increased due to a $7.7 million reserve charge.
Revenue from our agency segment increased 13% to $226.3 million in 2004 compared to 2003, primarily from increased new business. Acquisitions accounted for approximately one third of the $26.0 million increase in 2004 revenue. Segment net earnings increased 9% to $54.0 million in 2004. The lower percentage increase in net earnings was due to higher corporate expense allocations in 2004, plus additional incentive compensation expense based on the underwriting profitability of the business written. Revenue and net earnings from our agency operations increased 50% and 80%, respectively, in 2003 compared to 2002. These increases were primarily due to the incremental business activity of three agencies that we acquired in the fourth quarter of 2002. We expect the revenue and net earnings of this segment to decrease in 2005 as, effective January 1, 2005, we consolidated one of our largest underwriting agencies into our life insurance company. In addition, the reduced amount of ceded reinsurance due to increased retentions will result in less agency fees and commissions, but increased insurance company revenue.
recent years, principally due to our increasing net earnings, growth in net written premium and net loss reserves due to organic growth and increased retentions, commutations of selected reinsurance agreements and expansion of our diversified financial products line of business.
As demonstrated in the above table, we maintain sufficient liquidity to pay anticipated policyholder claims. In addition, we can use operating cash flow to pay claims as they become due. At December 31, 2004, the weighted average duration of our claims payable is approximately two years. We manage the liquidity of our insurance company subsidiaries such that each subsidiary’s anticipated claims payments will be met by its own current operating cash flows, cash, short-term investments or investment maturities. We do not foresee the need to sell securities prior to their maturity to fund claims payments, nor do we anticipate needing to use our $200.0 million Revolving Loan Facility to pay claims. However, this credit facility can provide additional liquidity if such an unexpected event was to occur.
The market value of our fixed income securities is sensitive to changing interest rates. As interest rates increase, the market value will generally decrease and as rates decrease, the market value will generally increase. The fluctuations in market value are somewhat muted by the relatively short duration of our portfolio. During 2004, the net after tax unrealized gain on our investments recorded in other comprehensive income increased $6.4 million due to market value changes. We estimate that a 1% increase in interest rates would decrease the market value of our fixed income securities by approximately $78.9 million and a 1% decrease would increase the market value by a like amount.
The following table presents a summary of our total contractual cash payment obligations by estimated payment date at December 31, 2004. To prepare this table, we made certain estimates and assumptions, which are explained in the table’s footnotes.
In conjunction with the sale of business assets and subsidiaries, we have provided indemnifications to the buyers. Certain indemnifications cover typical representations and warranties related to our responsibilities to perform under the sales contract. Other indemnifications agree to reimburse the purchaser for taxes or ERISA-related amounts, if any, assessed after the sale date but related to pre-sale activities. Certain of these indemnifications have no time limit. For those with a time limit, the longest such indemnification expires on December 31, 2009.
If a claim has not been made, we have not recorded a liability related to these indemnifications since, at this time, we do not know of any circumstances that would create a claim. We cannot estimate the maximum potential amount covered by these indemnifications as the indemnifications cover many matters, operations and possibilities, the total exposure to which is not presently quantifiable. One indemnification was given by a company we acquired, before its acquisition, in connection with the sale of a subsidiary. This indemnification, which has no time limit or cap, covers certain net losses incurred on insurance contracts entered into before the sale date. The indemnification requires that we reimburse the purchaser
Our $200.0 million Revolving Loan Facility allows us to borrow up to the maximum allowed by the facility on a revolving basis until the facility expires on November 30, 2009. The facility is collateralized in part by the pledge of our insurance companies’ stock and guarantees entered into by our underwriting agencies and reinsurance brokers. The facility agreement contains certain restrictive covenants, which we believe are typical for similar financing arrangements.
At December 31, 2004, certain of our subsidiaries maintained revolving lines of credit with a bank in the combined maximum amount of $37.5 million available through November 30, 2009. 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 $46.9 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 (5.25% at December 31, 2004) for draws on the letters of credit and either prime or prime less 1% on short-term cash advances. At December 31, 2004, letters of credit totaling $14.6 million had been issued to insurance companies by the bank on behalf of our subsidiaries, with total securities of $18.3 million collateralizing the lines.
We have filed registration statements with the United States Securities and Exchange Commission that provide a shelf registration for an aggregate of $750.0 million of our securities, of which we have $525.0 million available to be issued. These securities may be debt securities, equity securities or a combination thereof. We sold 3.0 million shares of our common stock in the fourth quarter of 2004 under this shelf registration at a price of $33.25 per share. We used the net proceeds of $96.7 million to make a $75.0 million capital contribution to one of our insurance company subsidiaries and $17.0 million to pay down bank debt.
We believe that our operating cash flows, investments, bank facility and shelf registration will provide sufficient sources of liquidity to meet our operating needs for the foreseeable future.
Our operations, like those of other property and casualty insurers, are susceptible to the effects of inflation, as premiums are established before the ultimate amounts of loss and loss adjustment expense are known. Although we consider the potential effects of inflation when setting premium rates, for competitive reasons, such premiums may not fully offset the effects of inflation. However, because the majority of our 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.
The preparation of our consolidated financial statements in conformity with generally accepted accounting principles requires us to make estimates and assumptions when applying our accounting policies. The following sections provide information about our estimation processes related to certain of our critical accounting policies.
Our net loss and loss adjustment expense reserves are composed of reserves for reported losses and reserves for incurred but not reported losses, less a reduction for reinsurance recoverables related to those reserves. Reserves are recorded by product line and are undiscounted, except for reserves related to acquisitions recorded using the purchase method of accounting.
reported to us, as well as an estimate of potential development in outstanding claim reserves. When there is the possibility that information related to reserves may be reported late or where there is the possibility that claims may take a long time to develop, our actuaries’ estimates are based on our historical trends in paid and incurred losses or, if we do not have enough history, on industry trends and factors. These estimates take into consideration that claims or information related to outstanding claims can be reported late or be slow in developing, especially with respect to assumed reinsurance because it takes an extended time for cedants to gather and report information and for certain insolvent cedants, especially when their claims are being administered by state authorities or guarantee associations.
With the exception of 2004 when we had negative development principally in the reserves related to our discontinued line of business, our net reserves have historically shown positive development except for the effects of losses on commutations which we have completed in the past and may negotiate in the future. Commutations can produce negative prior year development since, for generally accepted accounting principles purposes, any excess of undiscounted reserves assumed over assets received must be recorded as a loss at the time the commutation is effected. However, economically, the loss generally represents the time value of money discount that will be earned over the payout of the undiscounted reserves; thus, the loss may be recouped as investment income is earned on the assets received. Based on our reserving techniques and our past results, we believe that any future negative development will not have a material impact on our consolidated net reserves or net earnings.
The following table details the characteristics and major actuarial assumptions utilized in the estimation of our loss reserves by major products within our lines of business. We considered all major lines of business written by the insurance industry when determining the relative characteristics of claims duration, speed of loss reporting and reserve volatility. Other companies may classify their own insurance products in different lines of business or utilize different actuarial assumptions.
We utilize the work of our actuaries together with input from our underwriting and claims personnel and other factors in setting loss and loss adjustment expense reserves. We utilize the point and range estimates to monitor the adequacy of our reserves. Generally, we maintain our total net reserves above the actuarial point estimate.
We determine our incurred but not reported reserves by first projecting the ultimate expected losses by product within each line of business. We then subtract paid losses and outstanding loss reserves from the ultimate loss reserves. The remainder is our incurred but not reported reserves. The level of incurred but not reported reserves in relation to total reserves depends upon the characteristics of the particular line of business, particularly with respect to the speed by which losses are reported and outstanding claims reserves are adjusted. Lines for which losses are reported fast will have a lower percentage incurred but not reported reserve than slower reporting lines, and lines for which reserve volatility is low will have a lower percentage incurred but not reported loss reserve than high volatility lines.
The percentage of net incurred but not reported reserves to net total reserves decreased from 58% at December 31, 2003 to 49% at December 31, 2004 as the business matured and losses were reported. The reasons for the significant decreases by line of business were:
Total reserves in our diversified financial products line of business increased $197.2 million from 2003 to 2004 as this relatively new line of business continues to grow. The incurred but not reported portion of the total reserves for this line of business are higher than in most of our other lines, since these losses report slower and have a longer duration.
Total reserves in our London market account increased $24.0 million and the percentage of incurred but not reported reserves declined from 2003 to 2004, due to reported claims for the hurricanes.
Certain reinsurers have delayed or suspended payment of amounts recoverable under reinsurance contracts to which we are a party. We limit our liquidity exposure for uncollected recoverables by holding funds, letters of credit or other security, such that net balances due are significantly less than the gross balances shown in our balance sheets. We constantly monitor the collectibility of the reinsurance recoverables of our insurance companies 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 collectibility of the recoverables and the financial condition of reinsurers can change, and these changes can affect the level of reserve required. The reserve was $20.4 million at December 31, 2004, compared to $14.9 million at December 31, 2003. We increased the reserve in 2004 by $5.5 million to cover additional recoverables for which changed conditions caused us to believe that part or all of the outstanding balances may not be collectible. Amounts charged against the reserve in 2004 and 2003 were immaterial.
We are currently in negotiations with most reinsurers who have delayed or suspended payments, but if such negotiations do not result in a satisfactory resolution, we may seek or be involved in litigation or arbitration. In some cases, the final resolution of such disputes through arbitration or litigation may extend over several years. At December 31, 2004, our insurance companies have $6.8 million, mostly in excess of one year old, that has not been paid to us under contracts subject to arbitration proceedings that we initiated. We estimate there could be up to an additional $22.6 million of incurred losses and loss expenses and other balances due under the subject contracts.
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 below cost attributable to issuer-specific events are based on 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. At December 31, 2004, we had gross unrealized losses on fixed income securities of $5.1 million (0.3% of aggregate market value) compared to $3.7 million (0.3% of aggregate market value) at December 31, 2003.
The following table displays the gross unrealized losses and fair value of our fixed income securities at December 31, 2004 that were in a continuous unrealized loss position for the periods indicated (in thousands):
are impaired because of interest rate and/or sector spread increases. The delay in the effective date for the measurement and recognition guidance of EITF 03-1 did not suspend existing requirements for assessing whether investment impairments are other-than-temporary. It is expected that the proposed guidance under FSP EITF Issue 03-1a will be finalized in 2005. We are monitoring the outcome of the EITF’s consideration of these issues.