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| HCC > SEC Filings for HCC > Form 10-Q on 7-Nov-2008 | All Recent SEC Filings |
7-Nov-2008
Quarterly Report
• non-risk-bearing fee and commission income received by our underwriting agency and broker operations,
• ceding commissions in excess of policy acquisition costs earned by our insurance company operations,
• investment income earned by all of our operations, and
• other operating income.
During the past several years, we substantially increased our shareholders' equity by retaining most of our earnings. With this additional equity, we increased the underwriting capacity of our insurance companies and made strategic acquisitions, adding new lines of business or expanding those with favorable underwriting characteristics. Our 2007 and 2008 acquisitions are listed below. Net earnings and cash flows from each acquired business are included in our operations beginning on the effective date of each transaction.
Effective date
Company Segment acquired
Promoregistration.com Agency March 2, 2007
Pioneer General Insurance Company Insurance Company November 1, 2007
MultiNational Underwriters, LLC Agency January 2, 2008
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The following section discusses our key operating results. Comparisons refer to
the first nine months of 2008 compared to the first nine months of 2007, unless
otherwise noted. The reasons for any significant variations between the quarters
ended September 30, 2008 and 2007 are the same as those discussed for the
respective nine month periods, unless otherwise noted. Amounts in the following
tables are in thousands, except for earnings per share, percentages, ratios and
number of employees.
Results of Operations
Net earnings were $232.5 million ($2.01 per diluted share) in the first nine
months of 2008 compared to $295.8 million ($2.54 per diluted share) in the same
period of 2007. The decrease in year-to-date earnings primarily related to
hurricane losses and the investment-related items described below. Net earnings
decreased to $59.1 million ($0.51 per diluted share) in the third quarter of
2008 from $97.9 million ($0.84 per diluted share) in the third quarter of 2007
for the same reasons. The following items affected our pretax earnings as
indicated:
• We incurred losses of $89.9 million gross and $24.5 million net related to
hurricanes Gustav and Ike (referred to herein as "the 2008 hurricanes") in
the third quarter of 2008. The net losses are included in loss and loss
adjustment expense.
• Our alternative investments generated $16.7 million of losses in 2008, compared to $14.5 million of income in 2007. These investments generated $14.3 million of losses in the third quarter of 2008, compared to $2.0 million of income in the third quarter of 2007. The related income or loss is included in net investment income.
• In the third quarter of 2008, to manage credit-related risk in our investment portfolio, we sold all of our investments in preferred stock and bonds of certain entities that were experiencing financial difficulty. We recorded a realized investment loss of $19.4 million related to these sales. The total net realized investment loss on the sale of all securities was $12.8 million and $0.6 million in 2008 and 2007, respectively, and $12.8 million and zero in the third quarter of 2008 and 2007, respectively.
• We recognized other-than-temporary impairments on securities in our available for sale securities portfolio of $6.0 million in 2008, including $4.4 million in the third quarter of 2008, which we recorded in net realized investment loss. There were no such impairments recorded in 2007.
• Our trading portfolio had losses of $11.7 million in 2008, compared to $1.0 million in 2007. There were no losses in the third quarter of 2008, compared to $9.3 million in the third quarter of 2007. These losses are reported in other operating income. We discontinued the active trading of securities in late 2006 and sold the remaining positions in 2008.
• We sold strategic investments in 2008 and 2007 and realized gains of $9.2 million and $21.6 million, respectively. There were no sales in the third quarter of either year. These gains are reported in other operating income.
The items described above are summarized as follows:
Nine months ended September 30, Three months ended September 30,
2008 2007 2008 2007
Income (loss) from:
2008 hurricanes $ (24,534 ) $ - $ (24,534 ) $ -
Alternative investments (16,735 ) 14,540 (14,321 ) 1,971
Net realized investment loss (12,761 ) (601 ) (12,808 ) 23
Other-than-temporary impairments (6,029 ) - (4,430 ) -
Trading securities (11,698 ) (987 ) 29 (9,261 )
Strategic investments 9,158 21,618 - -
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The following table sets forth the relationships of certain income statement items as a percent of total revenue. The percent of net earned premium is higher in both periods of 2008 primarily due to the impact of the net realized investment losses, as well as lower other operating income in the nine-month period. The higher percent of loss and loss adjustment expense principally is due to the 2008 hurricanes.
Nine months ended September 30, Three months ended September 30,
2008 2007 2008 2007
Net earned premium 87.1 % 83.7 % 89.2 % 84.6 %
Fee and commission income 5.8 6.0 6.7 7.3
Net investment income 7.6 8.3 6.3 8.6
Net realized investment loss (1.1 ) - (3.0 ) -
Other operating income (loss) 0.6 2.0 0.8 (0.5 )
Total revenue 100.0 100.0 100.0 100.0
Loss and loss adjustment expense, net 53.3 49.9 57.3 48.4
Policy acquisition costs, net 16.4 15.1 17.0 16.0
Other operating expense 10.1 9.6 10.2 9.9
Interest expense 0.7 0.4 0.7 0.5
Earnings before income tax expense 19.5 25.0 14.8 25.2
Income tax expense 6.0 8.3 4.4 8.4
Net earnings 13.5 % 16.7 % 10.4 % 16.8 %
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Total revenue of $1.7 billion in 2008 decreased 3%, or $46.4 million, compared to 2007, due to the investment-related items described above. Net earned premium increased 1% in the nine months and 2% in the third quarter of 2008, compared to 2007. Our gross written premium, net written premium and net earned premium are detailed below. Gross written premium increased primarily from growth in our diversified financial products and other specialty lines of business and our recent acquisitions. Net written premium increased for the same reasons, as well as higher retentions and lower reinsurance costs. See the Insurance Company Segment section below for further discussion of the relationship and changes in premium revenue.
Nine months ended September 30, Three months ended September 30,
2008 2007 2008 2007
Gross written premium $ 1,887,556 $ 1,857,764 $ 612,964 $ 593,062
Net written premium 1,556,382 1,500,465 495,585 469,680
Net earned premium 1,505,128 1,484,908 504,972 492,922
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The table below shows the source of our fee and commission income. The decrease in agency fee and commission income relates to a higher percentage of business being written directly on our insurance companies' paper, rather than being brokered through our agencies.
Nine months ended September 30, Three months ended September 30,
2008 2007 2008 2007
Agency $ 62,750 $ 69,033 $ 18,932 $ 23,900
Insurance companies 36,808 36,962 18,863 18,834
Fee and commission income $ 99,558 $ 105,995 $ 37,795 $ 42,734
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The sources of net investment income are detailed below.
Nine months ended September 30, Three months ended September 30,
2008 2007 2008 2007
Fixed income securities
Taxable $ 72,716 $ 64,661 $ 25,394 $ 23,173
Exempt from U.S. income taxes 56,795 44,747 18,821 15,839
Total fixed income securities 129,511 109,408 44,215 39,012
Short-term investments 20,408 28,230 6,837 10,208
Alternative investments (16,735 ) 14,540 (14,321 ) 1,971
Other investments 575 - 77 -
Total investment income 133,759 152,178 36,808 51,191
Investment expense (2,927 ) (4,125 ) (846 ) (1,302 )
Net investment income $ 130,832 $ 148,053 $ 35,962 $ 49,889
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Net investment income decreased in 2008 due to losses from our alternative
investments, primarily fund-of-fund hedge fund investments, which were impacted
by generally poor equity and debt market conditions, particularly in the third
quarter of 2008. During that quarter, we notified the fund managers that we plan
to liquidate all of our alternative investments, which had a value of $133.5
million at September 30, 2008. We expect the alternative investment portfolio to
be substantially liquidated and reinvested in fixed income securities during the
first quarter of 2009. Investment income on our fixed income securities
increased 18% year-over-year due to higher fixed income investments, which
increased to $3.9 billion at September 30, 2008 compared to $3.6 billion at
September 30, 2007. The growth in fixed income securities resulted primarily
from cash flow from operations, the increase in net loss reserves (particularly
from our diversified financial products line of business, which generally has a
longer time period between reporting and payment of claims), and our shift away
from short-term investments in the first half of 2008 as short-term interest
rates declined. We continue to invest most of our funds in fixed income
securities, although we are holding more short-term investments than we held at
June 30, 2008 due to the pending reinvestment of recently sold securities.
During the third quarter of 2008, we transferred $108.9 million of bonds
denominated in British pound sterling (GBP) from our available for sale
portfolio to a new held to maturity portfolio. We are holding these GBP bonds to
hedge the foreign exchange risk associated with insurance claims that we will
pay in GBP. The bonds mature in March 2009. By designating the bonds as held to
maturity, any foreign exchange gain/loss on these bonds will be recorded through
income and will substantially offset any foreign exchange gain/loss on the
related liabilities. Conversely, if GBP-denominated bonds are held to hedge
GBP-denominated liabilities, the foreign exchange gain/loss on the available for
sale bonds would be recorded as a component of accumulated other comprehensive
income within shareholders' equity, whereas the opposite foreign exchange
movement on the hedged liabilities would be recorded through income.
At September 30, 2008, the net unrealized loss on our fixed income securities
portfolio was $98.1 million, compared to a net unrealized gain of $25.0 million
at December 31, 2007. The change in the net unrealized gain or loss, net of the
related income tax effect, is recorded in other comprehensive income and
fluctuates principally due to changes in market interest rates. The net
unrealized loss on our fixed income securities portfolio at October 31, 2008 was
$140.0 million.
We evaluate the securities in our investment portfolio for possible
other-than-temporary impairment losses at each quarter end. We consider various
factors including:
• amount by which the security's fair value is less than its cost,
• length of time the security has been impaired,
• the security's credit rating and any recent downgrades,
• whether the impairment is due to an issuer-specific event, credit issues or change in market interest rates, and
• our ability and intent to hold the security for a period of time sufficient to allow full recovery or until maturity.
When we conclude that a decline in a security's fair value is other than
temporary, we recognize the impairment as a realized loss. We recognized
other-than-temporary impairment losses of $6.0 million in 2008 and $4.4 million
in the third quarter of 2008. There were no other-than-temporary impairment
losses in 2007.
Our general policy has been to hold our fixed income securities, substantially
all of which are classified as available for sale, through periods of
fluctuating interest rates and to not realize significant gains or losses from
their sale. In the third quarter of 2008, we sold $26.6 million of bonds and
preferred stock of certain issuers with credit-related exposure, as a result of
current extreme credit market issues, and realized losses of $19.4 million.
Information about our portfolio of fixed income securities and short-term investments is as follows:
Nine months ended September 30, Three months ended September 30,
2008 2007 2008 2007
Average fixed income yield* 4.5% 4.5% 4.4 % 4.4 %
Average fixed income tax equivalent
yield* 5.2% 5.4% 5.2 % 5.3 %
Short-term investment yield 3.5 % 5.3 % 4.3 % 5.6 %
Combined fixed income and short-term
yield* 5.0 % 5.4 % 5.1 % 5.4 %
Weighted average fixed income
maturity 6.9 years 7.0 years
Weighted average fixed income
duration 5.1 years 5.0 years
Average rating on fixed income
securities AA+ AAA
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* Excluding realized and unrealized gains and losses. At September 30, 2008, within our portfolio of fixed income securities, we held a portfolio of residential mortgage-backed securities (MBSs) and collateralized mortgage obligations (CMOs) with a fair value of $813.3 million. Within our residential MBS/CMO portfolio, $712.3 million of bonds were issued by the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), which are backed by the U.S. government, while $89.6 million, $8.9 million and $2.6 million of bonds are collateralized by prime, Alt A and subprime mortgages, respectively. All subprime and Alt A securities were current as to principal and interest and have an average rating of AAA and a weighted average life of approximately 3.9 years. At September 30, 2008, we held a commercial MBS securities portfolio with a fair value of $165.7 million, an average rating of AAA, and a weighted average life of approximately 5.1 years. We had a corporate bond portfolio with a fair value of $541.6 million, an overall rating of A+, and a weighted average life of 3.4 years. We also held $14.8 million of senior debt obligations of Fannie Mae and Freddie Mac, with an unrealized gain of $0.3 million. We owned no collateralized debt obligations (CDOs) or collateralized loan obligations (CLOs) and have never been counterparty to any credit default swap. Other operating income, detailed in the table below, was substantially lower year-over-year. The market value of our trading securities declined in 2008, consistent with recent market conditions. We sold our remaining trading securities positions in 2008. We also realized more gains from the sales of strategic investments in 2007 than in 2008. In the second quarter of 2008, we entered into an agreement to provide reinsurance coverage for certain residential mortgage guaranty contracts. We recorded this contract using the deposit method of accounting, whereby all consideration received is initially recorded as a deposit liability. We are reporting the change in the deposit liability as a component of other operating income. Period to period comparisons of our other operating income may vary substantially, depending on the earnings generated by new transactions or investments, income or loss related to changes in the market values of certain investments, and gains or losses related to any disposition.
Nine months ended September 30, Three months ended September 30,
2008 2007 2008 2007
Strategic investments $ 13,074 $ 24,295 $ 910 $ 1,058
Trading securities (11,698 ) (987 ) 29 (9,261 )
Financial instruments 2,275 4,303 (507 ) 1,610
Contract using deposit accounting 774 - 472 -
Other 6,404 8,000 3,924 3,519
Other operating income (loss) $ 10,829 $ 35,611 $ 4,828 $ (3,074 )
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Loss and loss adjustment expense increased in 2008 compared to 2007, primarily
due to the 2008 hurricanes. Our current accident year loss ratios were higher
for 2008 for most of our product lines, but the majority of this effect was
offset by the positive impact of re-underwriting business acquired in late 2006
and a change in the mix of our lines of business to those with a lower loss
ratio. Policy acquisition costs increased 6% in 2008, primarily due to growth in
net earned premium and the mix of business. See the Insurance Company Segment
section below for further discussion of the changes in loss and loss adjustment
expense and policy acquisition costs.
Other operating expense increased 3% in 2008. The increase primarily related to
compensation and other operating expenses of acquired subsidiaries and
substantially lower professional fees and legal costs related to our 2006 stock
option matter, which we incurred in early 2007. We had 1,783 employees at
September 30, 2008 compared to 1,646 a year earlier, with the increase primarily
due to acquisitions.
Our effective income tax rate was 30.9% for 2008, compared to 33.4% for 2007.
The lower rate in 2008 relates to the increased benefit from more tax-exempt
investment income and a lower pretax income base.
Segments
Insurance Company Segment
Net earnings of our insurance company segment were down year-over-year due to
losses from alternative investments, net realized investment losses and the 2008
hurricanes. Our combined ratio was 85.3% for 2008 compared to 82.9% in 2007. The
2008 hurricanes accounted for 1.7 percentage points of the 2008 loss and
combined ratios. Even though there is pricing competition in many of our
markets, our underwriting margin remains at an acceptable level of profitability
due to our underwriting discipline and risk selection.
Premium
Total gross written premium was up slightly in 2008 compared to 2007, although
there were offsetting changes in our lines of business. Premium increased due to
the business we acquired in 2008 and more demand for certain products, together
with related price increases for these products, and was partially offset by
decreases due to competitive market pressures. We elected to write less premium
in 2008 in certain lines affected by competition and the resulting softening of
market rates if, in matching competitors' lower rates, the business would be
unprofitable for us. In some lines of business, we have written the same
exposure as in 2007 but at lower, albeit profitable, rates. The overall
percentage of retained premium, as measured by the percent of net written
premium to gross written premium, increased to 82% in 2008 from 81% in 2007.
. . .
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