Certain amounts in the 2002-2005 selected consolidated financial data have been reclassified to conform to the 2006 presentation. Such reclassifications had no effect on our consolidated net earnings, shareholders’ equity or cash flows.
We sold our retail brokerage operation, HCC Employee Benefits, Inc., in 2003. The net earnings of HCC Employee Benefits, the 2003 gain on sale and the subsequent gains in 2004 and 2005 from a contractual earnout are classified as discontinued operations. Consistent with this presentation, all pre-sale revenue and expense of HCC Employee Benefits was reclassified to discontinued operations.
We underwrite a variety of specialty lines of business identified as diversified financial products; group life, accident and health; aviation; London market account; and other specialty lines of business. Products in each line are marketed by our insurance companies and agencies, either through a network of independent agents and brokers, or directly to customers. With the exception of our public company directors’ and officers’ liability business, certain international aviation and special financial product risks, and our London market business, the majority of our business is generally lower limit, smaller premium business that is less susceptible to price competition, severity of loss or catastrophe risk.
We generate our revenue from five primary sources: 1) risk-bearing earned premium produced by our insurance company operations, 2) non-risk-bearing fee and commission income received by our underwriting agency and intermediary operations, 3) ceding commissions in excess of policy acquisition costs earned by our insurance company operations, 4) investment income earned by all of our operations and 5) other operating income. We produced $2.1 billion of revenue in 2006, an increase of 26% over 2005, primarily from higher net earned premium as a result of increased retentions, recent acquisitions, organic growth, increased investment income and increases in other operating income.
The following section discusses our key operating results. The reasons for any significant variations between 2005 and 2004 are the same as those discussed for variations between 2006 and 2005, unless otherwise noted. Amounts in the following tables are in thousands, except for earnings per share, percentages, ratios and number of employees.
Net earnings increased 79% to $342.3 million ($2.93 per diluted share) in 2006 from $191.2 million ($1.75 per diluted share) in 2005. Net earnings in 2006 included after-tax losses of $13.1 million ($0.11 per diluted share) due to a large reinsurance commutation and $9.3 million ($0.08 per diluted share) for costs
During 2005 and 2004, catastrophic events occurred related to three major hurricanes, Katrina, Rita and Wilma, and two others (collectively, the 2005 hurricanes) and four major hurricanes, Charley, Frances, Ivan and Jeanne (collectively, the 2004 hurricanes). We recognized pre-tax losses after reinsurance recoveries and including the cost of premiums to reinstate our reinsurance protection of $89.7 million in 2005 and $33.1 million in 2004 in our insurance company segment as a result of these hurricanes.
The table below shows the source of our fee and commission income.
Loss and loss adjustment expense increased 10% in 2006, and 43% in 2005. Both years increased due to growth in net retained premium. Additionally, hurricane losses and a commutation loss affect the increase in losses in 2005 over 2004. Policy acquisition costs increased 22% in 2006 and 18% in 2005, primarily due to the growth in net earned premium. See the Insurance Company Segment section below for further discussion of the changes in loss and loss adjustment expense and policy acquisition costs.
At December 31, 2006, book value per share was $18.28, up from $15.26 at December 31, 2005 and $12.99 at December 31, 2004. Total assets were $7.6 billion and shareholders’ equity was $2.0 billion, up from $7.0 billion and $1.7 billion, respectively, at December 31, 2005.
We operate our businesses in three segments: 1) insurance company, 2) agency and 3) other operations. Our Chief Executive Officer, as chief decision maker, monitors and evaluates the individual financial results of each subsidiary in the insurance company and agency segments. Each subsidiary provides monthly reports of its actual and budgeted results, which are aggregated on a segment basis for management review and monitoring. The operating results of our insurance company and agency segments are discussed below.
The following table details premium amounts and their percentages of gross written premium.
The changes in premium volume and retention levels between years resulted principally from the following factors:
exposure. Profit margins remain at acceptable levels despite increased competition from the fully insured market.
Other specialty lines - We experienced organic growth in our other specialty lines of business from increased writings in several products. The changing mix of products will affect the retention percentages. Rates in this line have been relatively stable.
We decided for the 2006 and 2005 underwriting years to retain more underwriting risk in certain lines of business with the intention of retaining a greater proportion of any underwriting profits. In doing so, we will necessarily purchase less reinsurance applicable to a line or choose to restructure the applicable reinsurance programs, obtaining more excess of loss reinsurance and less proportional reinsurance, which significantly reduces the amount of ceded premium. Also, we have chosen not to purchase any reinsurance on other business where volatility or catastrophe risks are considered remote.
In our proportional reinsurance programs, we generally receive an overriding (ceding) commission on the premium ceded to reinsurers. This compensates our insurance companies for the direct costs associated with the production of the business, the servicing of the business during the term of the policies ceded and the costs associated with the placement of the related reinsurance. In addition, certain of our reinsurance treaties allow us to share in any net profits generated under such treaties with the reinsurers. Various reinsurance
brokers, including subsidiaries, arrange for the placement of this proportional and other reinsurance coverage on our behalf and are compensated, directly or indirectly, by the reinsurers.
We have a reserve of $14.9 million at December 31, 2006 for potential collectibility issues related to reinsurance recoverables, including disputed amounts and associated expenses. While we believe the reserve is adequate based on information currently available, conditions may change or additional information might be obtained that may require us to change the reserve in the future. We periodically review our financial exposure to the reinsurance market and the level of our reserve and continue to take actions in an attempt to mitigate our exposure to possible loss.
Our gross adverse development (redundancy) relating to prior year losses was $(3.3) million in 2006, $29.3 million in 2005 and $116.1 million in 2004.
We increased our gross losses related to prior accident years on certain run-off assumed accident and health reinsurance business reported in our discontinued lines of business by $15.1 million in 2006, $49.8 million in 2005 and $127.7 million in 2004 due to our processing of additional information received and our continuing evaluation of gross and net reserves related to this business. We considered a combination of factors including: 1) the nature of the business, which is primarily excess of loss reinsurance, 2) late reported losses by insureds, reinsureds and state guaranty associations and 3) changes in our actuarial assumptions to reflect additional information received during the year. The run-off assumed accident and health reinsurance business is primarily reinsurance that provides excess coverage for large losses related to workers’ compensation policies. This business is slow to develop and may take as many as twenty years to pay out. Primary losses must develop first before the excess coverage attaches. Thus, the losses are reported to excess of loss reinsurers later in the life cycle of the claim. Compounding this late reporting is the fact that a number of large insurance companies that were cedants of this business failed and were taken over by state regulatory authorities in 2002 and 2003. The state guaranty associations covering these failed companies have been slow to report losses to us. Based on the higher amount of actual losses reported, we revised the expected loss ratios used in our actuarial calculations. After consideration of all available information, we increased our gross and net reserves to amounts that management determined were appropriate to cover losses projected, given the risk inherent in this type of business.
Comments on significant changes in net loss ratios by line of business follow:
Group life, accident and health - Rate pressure from competition as well as medical cost inflation have resulted in increasing loss ratios in this line of business. Additionally, in 2006 the loss ratio for the business acquired in the Health Products Division acquisition were higher than the loss ratios for our existing business, increasing our overall loss ratio. Over time, we expect that the loss ratios for the acquired business will be brought into line with the rest of our book. Overall, our underwriting margins for this line of business remain satisfactory.
London market account - The adjustment of hurricane reserves reduced the 2006 net loss ratio by 9.1 percentage points. The 2005 hurricanes increased the net loss ratio by 63.2 percentage points and the 2004 hurricanes increased the net loss ratio by 14.1 percentage points. The 2006 loss ratio was also adversely affected by higher than expected attritional losses for energy business and poor underwriting results for marine business. The London market account line of business can have relatively high year-to-year volatility due to catastrophe exposure.
Revenue from our agency segment decreased to $180.0 million in 2006 from $188.9 million in 2005 and $226.8 million in 2004, primarily due to the consolidation of two underwriting agencies into our insurance companies effective January 1, 2005 and April 1, 2006, less business produced in certain lines and the overall effect of ceding less reinsurance. These effects were partially offset in 2006 due to acquisitions and growth in certain other lines of business. While these actions resulted in less fee and commission income to our agency segment, they resulted in increased insurance company revenue and net earnings. Segment earnings in 2005 are less than in 2004 primarily as a result of the same factors that caused the decrease in revenue. Segment net earnings would have decreased in 2006, except the agency segment benefited from lower corporate cost allocations.
Revenue and net earnings from our other operations segment increased to $75.1 million and $48.8 million, respectively, in 2006 from $35.3 million and $22.6 million, respectively, in 2005 and $13.0 million and $7.9 million, respectively, in 2004 primarily due to net gains from trading securities and the sale of strategic investments. In the fourth quarter of 2006, we began liquidating our trading portfolio, investing the proceeds primarily in fixed income securities. We expect the trading portfolio to be fully liquidated in 2007. Results of this segment may vary substantially period to period depending on our investment in or disposition of strategic investments and activity in our trading portfolio.
Cash provided by operating activities can fluctuate due to timing differences in the collection of premiums and reinsurance recoverables and the payment of losses and premium and reinsurance balances payable, the completion of commutations and activity in our trading portfolio. Our cash provided by operating activities has been strong in recent years due to: 1) our increasing net earnings, 2) growth in net written premium and net loss reserves due to organic growth and increased retentions, 3) commutations of selected reinsurance agreements and 4) expansion of our diversified financial products line of business as a result of which we retain premium for a longer duration than had been the case prior to entering this business.
At December 31, 2006, we had $3.9 billion of investment assets, an increase of $670.6 million from the end of 2005. The increase resulted from strong operating cash flows. The majority of our investment assets are held by our insurance companies. All of our fixed income securities are classified as available for sale and are recorded at market value.
This table indicates the expected maturity distribution of the estimated market value of our fixed income securities at December 31, 2006.
The weighted average life of our asset-backed and mortgage-backed securities is 6.7 years.
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 $300.0 million Revolving Loan Facility to pay claims. However, this credit facility can provide additional short-term liquidity if an unexpected event were to occur.
been satisfied under the applicable purchase agreement, we record a liability to the former owners with an offsetting increase to goodwill. Accrued amounts are generally paid in the next year. At December 31, 2006, we accrued earnouts totaling $47.7 million related to these two acquisitions. The purchase agreement for HCC Global requires us to pay an earnout based on pre-tax earnings on business underwritten by HCC Global from the acquisition date through September 30, 2007, with no maximum amount due to the former owners. The contractual pre-tax earnings include underwriting results on longer-duration business written by HCC Global and, per the agreement, the earnout cannot be finally determined until all future losses are paid. The purchase agreement for CUL provides for a maximum earnout of $15.0 million based on CUL’s 2004 through 2006 pre-tax earnings, but could be reduced based on the ultimate underwriting results for those years.
Pursuant to our by-laws, Delaware Corporate law and certain contractual agreements, we are required to advance attorneys’ fees and other expenses and indemnify our current and former Directors and officers for liabilities arising from any action, suit or proceeding brought because the individual was acting as an officer or director of our company. Under certain limited circumstances, the individual may be required to reimburse us for any advances or indemnification payments made by us. In addition, we maintain directors’ and officers’ liability insurance, which may cover certain of these costs. We expense payments as advanced and recognize offsets if cash reimbursement is received. During 2006, we expensed $1.3 million of attorneys’ fees incurred by current and former Directors and officers who claimed the right to indemnity in conjunction with our stock option investigation. It is not possible to determine the maximum potential impact on our consolidated net earnings, since our by-laws, Delaware law and our contractual agreements do not limit any such advances or indemnification payments.
Our $300.0 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 by 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. We had no borrowings under this facility at December 31, 2006.
In 2006, we entered into a $34.0 million Standby Letter of Credit Facility and utilized that facility to replace a portion of our funds at Lloyd’s of London with standby letters of credit. Letters of credit issued under the Standby Letter of Credit Facility are unsecured commitments of HCC. The Standby Letter of Credit Facility contains standard restrictive covenants, which in many cases are identical to or incorporate by reference the restrictive covenants from our Revolving Loan Facility.
At December 31, 2006, certain of our subsidiaries maintained revolving lines of credit with a bank in the combined maximum amount of $40.7 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 $50.8 million, the actual amount of collateral at any one time being 125% of the aggregate amount outstanding. Interest on the lines is payable at the bank’s prime rate of interest (8.25% at December 31, 2006) for draws on the letters of credit and either prime or prime less 1% on short-term cash advances. At December 31, 2006, letters of credit totaling $20.0 million had been issued to insurance companies by the bank on behalf of our subsidiaries, with total securities of $24.9 million collateralizing the lines.
As a result of the delayed filing of our Quarterly Reports on Form 10-Q for the second and third quarters of 2006, we are ineligible to register our securities on Form S-3 or use our previously filed universal shelf registration statement for one year after December 27, 2006, the date these reports were filed with the SEC. We may use Form S-1 to raise capital and borrow money utilizing public debt or to complete acquisitions of other companies, which could increase transaction costs and adversely impact our ability to raise capital and borrow money or complete acquisitions in a timely manner.
any other regulatory proceeding or governmental enforcement action, we could be required to pay damages and penalties or have other remedies imposed, which could harm our business, financial condition, results of operations and cash flows.
In connection with our stock option investigation, we incurred $14.2 million of expense for professional services, consulting fees and other related charges. The total includes accruals of $4.3 million for the estimated cost to reimburse certain employees for their lost spread on discounted options and $2.3 million for our estimated liability to pay our employees’ personal tax liabilities under Section 409A of the Internal Revenue Code for options exercised in 2006. Section 409A imposes certain restrictions and additional taxes on the recipients of discounted options. Prior to December 31, 2006, the final date allowable under Section 409A, Directors and certain officers agreed to reprice their unexercised discounted options to the closing price on the actual accounting measurement date as determined by the investigation; therefore, these options are no longer subject to Section 409A. Prior to December 31, 2007, the final date allowable under Section 409A, we intend to offer all other employees who received discounted options the same opportunity to reprice their options to also relieve them from Section 409A taxation. Employees accepting the offer will receive cash payments sufficient to reimburse them for the reduced value of their repriced options, calculated as the difference between the original strike price of the option and the closing price of our stock on the actual accounting measurement date. We expect to pay up to several million dollars for additional professional services fees in the next few months associated with matters emanating from the investigation.
The table below shows our recorded net reserves at December 31, 2006 by line of business, the actuarial reserve point estimates, and the high and low ends of the actuarial reserve range as determined by our reserving actuaries.
$27.3 million in 2004. These losses resulted from late reporting of claims by cedants and state guaranty associations and changes in our actuarial assumptions related to this business. To mitigate our exposure to unexpected losses reported by cedants, our claims personnel review reported losses to ensure they are reasonable and consistent with our expectations. In addition, our claims personnel periodically audit the cedants’ claims processing functions to assess whether cedants are submitting timely and accurate claims reports to us. Disputes with insureds related to claims or coverage issues are administered in the normal course of business or settled through arbitration. Based on the negative factors we experienced and the higher risk of this discontinued line of business relative to our continuing lines of business, management believes there may be a greater likelihood of future adverse development in the run-off assumed accident and health reinsurance business than in our other lines of business. We periodically reassess loss reserves for this assumed business and adjust them, if needed.
The majority of the assumed reinsurance in our London market account, aviation line of business and part of our diversified financial products lines of business is facultative reinsurance. This business involves reinsurance of a company’s entire captive insurance program or business that must be written through another insurance company licensed to write insurance in a particular country or locality. In all cases, we underwrite the business and administer the claims, which are reported without a lag by the brokers. Disputes, if any, generally relate to claims or coverage issues with insureds and are administered in the normal course of business. We establish loss reserves for this assumed reinsurance using the same methods and assumptions we use to set reserves for comparable primary business.
The majority of the assumed reinsurance in our group life, accident and health and the remainder of the diversified financial products lines of business is related to acquisitions. Subsequent renewals of the policies are written as direct business. The assumed reserves for the diversified financial products lines of business are expected to take several years to pay out, whereas the assumed reserves in the group life, accident and health line of business (substantially all of which are from the Health Products Division acquisition) are expected to pay out in 12-18 months.
We have no material exposure to asbestos claims or environmental pollution losses. Our largest insurance company subsidiary only began writing business in 1981, and its policies normally contain pollution exclusion
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 consolidated 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 $14.9 million at December 31, 2006, compared to $12.1 million at December 31, 2005. We increased the reserve in 2006 by $5.6 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. We wrote off a $3.0 million recoverable balance in 2006. We assessed the collectibility of our year-end recoverables and believe amounts are collectible and any potential losses are adequately reserved based on currently available information.
We assess the impairment of goodwill annually, or sooner if an event occurs or circumstances change that would more-likely-than-not reduce the fair value of a reporting unit below its carrying amount. In determining the fair value of a reporting unit, we utilize the expected cash flow approach in Statement of Financial Accounting Concepts CON 7, Using Cash Flow Information and Present Values in Accounting Measurements. This approach utilizes a risk-free rate of interest, estimates of future cash flows and probabilities as to the occurrence of the future cash flows. We utilize our budgets and projections of future operations based on historical and expected industry trends to estimate our future cash flows and the probability of their occurring as projected. Based on our latest impairment test, the fair value of each of our reporting units exceeded its carrying amount by a satisfactory margin.
Staff Accounting Bulletin (SAB) No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, became effective in the fourth quarter of 2006. SAB 108 establishes a standard approach for quantifying the materiality of errors to current and prior period financial statements. We had no prior year or current year misstatements that required adjustment to our 2006 consolidated financial statements under SAB 108.
The FASB has issued FIN No. 48, Accounting for Uncertainty in Income Taxes, which is effective January 1, 2007. FIN 48 clarifies the accounting for uncertain income tax positions. The guidance of FIN 48 will require us to recognize uncertain tax positions in the financial statements when it is more-likely-than-not the position will be sustained upon examination by the tax authorities. We expect to take an immaterial charge to retained earnings to increase our reserves and recognize interest for uncertain tax positions. This adjustment will be recorded as a cumulative effect adjustment as of January 1, 2007.