Summary of HCC INSURANCE HOLDINGS INC/DE/

Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following Management's Discussion and Analysis should be read in conjunction with the Condensed Consolidated Financial Statements and the related Notes thereto.
Overview
We are a specialty insurance group with operations in the United States, the United Kingdom, Spain and Ireland, transacting business in approximately 150 countries. Our group consists of insurance companies, underwriting agencies and participation in two Lloyd's of London syndicates that we manage. Our shares trade on the New York Stock Exchange and closed at $27.35 on September 30, 2009 and $26.39 on October 31, 2009. We had a market capitalization of $3.0 billion at October 31, 2009.
We had shareholders' equity of $3.0 billion at September 30, 2009. Our book value per share increased 14% in the first nine months of 2009 to $26.54 at September 30, 2009, up from $23.27 at December 31, 2008. We had net earnings of $269.1 million, or $2.37 per diluted share, and generated $417.5 million of cash flow from operations in the first nine months of 2009. We declared dividends of $0.385 per share in the first nine months of 2009, compared to $0.345 per share in the first nine months of 2008, and paid $42.2 million of dividends in 2009. We repurchased 1.7 million shares of our common stock for $35.5 million, at an average cost of $21.36 per share in 2009. We currently have $4.9 billion of fixed income securities with an average rating of AA+ that are available to fund claims and other liabilities. We maintain a $575.0 million Revolving Loan Facility that allows us to borrow up to the maximum on a revolving basis, under which we have $240.0 million of additional capacity at October 31, 2009. The facility expires in December 2011. We are rated "AA (Very Strong)" by Standard & Poor's Corporation and "AA (Very Strong)" by Fitch Ratings. Our major domestic insurance companies are rated "A+ (Superior)" by A.M. Best Company, Inc. We earned $269.1 million, or $2.37 per diluted share in the first nine months of 2009, compared to $230.5 million, or $1.99 per diluted share, in the first nine months of 2008. Our third quarter net earnings were $94.3 million, or $0.83 per diluted share in 2009, compared to $58.4 million, or $0.50 per diluted share, in 2008. Our 2009 year-to-date earnings include $15.6 million of pretax benefit due to a $25.0 million termination payment we received in the first quarter to commute a reinsurance contract that had been accounted for using the deposit method of accounting. Our year-to-date loss ratio for 2009 was 59.8%, compared to 61.2% for 2008. The 2008 loss ratio included $24.5 million of losses related to the 2008 hurricanes. Profitability from our underwriting operations remains at acceptable levels. Our year-to-date combined ratio was 84.6% for 2009, compared to 85.3% for 2008. Investment income increased $10.9 million year-over-year due to the effect of $16.7 million of losses on alternative investments in 2008 and lower short-term investment income in 2009. Realized investment gains offset the other-than-temporary credit losses in 2009, compared to $18.8 million of losses realized in 2008, primarily in the third quarter, related to the credit crisis. Our 2008 year-to-date results also included an $11.7 million loss related to trading securities, which we sold in the third quarter of that year. See the "Results of Operations" section below for additional discussion.
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, through a network of independent agents and brokers, directly to customers or through third party administrators. The majority of our business is low limit or small premium business that has less intense price competition, as well as lower catastrophe and volatility risk. We reinsure a significant portion of our catastrophic exposure to hurricanes and earthquakes to minimize the potential impact on our net earnings and shareholders' equity.
We generate our revenue from six primary sources:
• risk-bearing earned premium produced by our insurance companies' operations,

• non-risk-bearing fee and commission income received by our underwriting agencies,

• ceding commissions in excess of policy acquisition costs earned by our insurance companies,

• investment income earned by all of our operations,

• realized investment gains and losses, and other-than-temporary impairment losses, related to our fixed income securities portfolio, and

• other operating income and losses, mainly from strategic investments and events that do not occur each year.

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We produced $1.8 billion of revenue in the first nine months of 2009, which was $56.1 million or 3% higher than in the first nine months of 2008. This increase principally resulted from: 1) higher net earned premium, 2) $25.0 million related to the commutation of a reinsurance contract in 2009 that had been accounted for using the deposit method of accounting, and 3) losses in 2008 on fixed income investments, alternative investments and trading securities, mainly due to the credit crisis.
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. Since January 2008, we have acquired an insurance business and five underwriting agencies for total consideration of $84.0 million. Net earnings and cash flows from each acquired entity are included in our operations beginning on the effective date of each transaction. The following section discusses our key operating results. Amounts in the following tables are in thousands, except for earnings per share, percentages, ratios and number of employees. Comparisons refer to the first nine months of 2009 compared to the same period of 2008, unless otherwise noted. Certain 2008 amounts have been adjusted to reflect our adoption of the new convertible debt and earnings per share accounting standards as of January 1, 2009. See the "Accounting Guidance Adopted in 2009" section below for additional information. Results of Operations
Net earnings were $269.1 million ($2.37 per diluted share) in the first nine months of 2009, compared to $230.5 million ($1.99 per diluted share) in the same period of 2008 and $94.3 million ($0.83 per diluted share) in the third quarter of 2009, compared to $58.4 million ($0.50 per diluted share) in the same period of 2008. The increase in year-to-date net earnings primarily resulted from: 1) the 2009 commutation of a reinsurance contract that had been accounted for using the deposit method of accounting, 2) catastrophic losses in 2008 from the 2008 hurricanes, and 3) higher investment-related losses in 2008, as described more fully below. Net earnings were higher quarter-over-quarter principally due to the lower investment-related losses in 2009 and hurricane losses in 2008. Diluted earnings per share in both periods of 2009 benefited from the repurchase of 4.7 million shares of our common stock in 2008 and the first quarter of 2009. The share repurchases reduced our diluted weighted-average shares outstanding, which were 112.9 million and 115.9 million in the first nine months of 2009 and 2008, respectively, and 112.9 million and 115.4 million in the third quarter of 2009 and 2008, respectively.
The following items affected pretax earnings in 2009 compared to 2008:

                                                        Nine months ended September 30,                      Three months ended September 30,
                                                          2009                  2008                            2009                  2008
Pretax earnings (loss) from:
Commutation of reinsurance contract, net of
related costs                                        $      15,600        $             -                  $           -        $             -
Prior years' positive reserve development                   36,647                 58,377                         25,375                 43,979
2008 hurricanes                                                  -                (24,534 )                            -                (24,534 )
Other-than-temporary impairments                            (5,279 )               (6,029 )                         (325 )               (4,430 )
Alternative investments                                       (958 )              (16,735 )                            -                (14,321 )
Trading securities                                               -                (11,698 )                            -                     29
Sale of strategic investments and subsidiary,
net                                                         (1,767 )                9,158                         (1,767 )                    -

• In 2009, we commuted, loss-free, all liability under a contract to provide reinsurance coverage for certain residential mortgage guaranty contracts. We had been recording revenue under this contract using the deposit method of accounting because we determined the contract did not transfer significant underwriting risk. We received a cash termination payment of $25.0 million in the first quarter. The termination increased other operating income by $20.5 million and fee and commission income by $5.0 million. This revenue was offset by $9.9 million of expenses for reinsurance and other direct costs, which were recorded in other operating expense.

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• In 2009, we had favorable development of our prior years' net loss reserves of $36.6 million, primarily from our U.K. professional indemnity business and the 2005 hurricanes. We had favorable development of $58.4 million in 2008 principally related to our directors' and officers' liability, property and U.K. professional indemnity businesses.

• In 2008, we incurred losses of $89.9 million before reinsurance and $24.5 million after reinsurance related to hurricanes Gustav and Ike (referred to herein as "the 2008 hurricanes"). The losses are included in loss and loss adjustment expense.

• We recognized, through earnings, other-than-temporary impairment losses of $5.3 million in 2009 and $6.0 million in 2008 on securities in our available for sale fixed income securities portfolio.

• Our alternative investments generated $1.0 million of losses in 2009, compared to $16.7 million in 2008. These investments were fully liquidated by the second quarter of 2009. The income or loss on these investments is included in net investment income.

• Our trading portfolio, which we liquidated during 2008, had losses of $11.7 million in 2008. These losses are reported in other operating income.

• We sold strategic investments in insurance-related companies and realized a gain of $2.4 million in 2009 and $9.2 million in 2008. We also sold 100% of the stock of a subsidiary and realized a loss of $4.2 million in 2009. These net gains and losses are reported in other operating income.

The following table sets forth the relationships of certain income statement items as a percent of total revenue.

                                                         Nine months ended September 30,                    Three months ended September 30,
                                                           2009                    2008                       2009                    2008
                                                                               (as adjusted)                                      (as adjusted)
Net earned premium                                             85.5 %                   87.1 %                    86.4 %                   89.2 %
Fee and commission income                                       5.0                      5.8                       5.3                      6.7
Net investment income                                           8.0                      7.6                       8.0                      6.3
Other operating income                                          1.7                      0.6                       0.2                      0.8
Net realized investment and OTTI gain (loss)                   (0.2 )                   (1.1 )                     0.1                     (3.0 )

Total revenue                                                 100.0                    100.0                     100.0                    100.0
Loss and loss adjustment expense, net                          51.1                     53.3                      50.5                     57.3
Policy acquisition costs, net                                  15.2                     16.4                      15.4                     17.0
Other operating expense                                        11.0                     10.1                      10.8                     10.2
Interest expense                                                0.7                      0.9                       0.6                      0.9

Earnings before income tax expense                             22.0                     19.3                      22.7                     14.6
Income tax expense                                              7.0                      6.0                       7.0                      4.3

Net earnings                                                   15.0 %                   13.3 %                    15.7 %                   10.3 %

Gross written premium, net written premium and net earned premium are detailed below. Written premium reflects growth in our diversified financial products and London market account lines of business and from our 2008 acquisitions. Written premium also reflects reductions due to the discontinuance of an assumed quota share agreement and our U.K. motor business in 2008. 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,
                                                     2009                   2008                     2009                   2008
Gross written premium                          $     1,904,086          $ 1,887,556            $      620,382          $      612,964
Net written premium                                  1,527,889            1,556,382                   493,287                 495,585
Net earned premium                                   1,524,425            1,505,128                   520,059                 504,972

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The table below shows the source of our fee and commission income. Fee and commission income decreased 11% year-over-year and 16% quarter-over-quarter. The decrease in 2009 primarily related to lower third party agency and broker commissions, the sale of the operations of our commercial marine agency business in the second quarter of 2009, and lower income from reinsurance overrides and profit commissions on quota share treaties, partially offset by the $5.0 million termination payment for commutation of a reinsurance contract that had been accounted for using the deposit method of accounting in the first quarter of 2009.

                                                     Nine months ended September 30,                  Three months ended September 30,
                                                      2009                    2008                      2009                    2008
Agencies                                         $        61,721         $        62,750           $        17,688         $        18,932
Insurance companies                                       26,392                  36,808                    13,999                  18,863

Fee and commission income                        $        88,113         $        99,558           $        31,687         $        37,795

The sources of net investment income are detailed below.

                                                         Nine months ended September 30,                    Three months ended September 30,
                                                          2009                     2008                      2009                     2008
Fixed income securities
Taxable                                             $         78,894         $         72,716           $        26,795         $          25,394
Exempt from U.S. income taxes                                 61,589                   56,795                    20,776                    18,821

Total fixed income securities                                140,483                  129,511                    47,571                    44,215
Short-term investments                                         4,943                   20,408                     1,464                     6,837
Alternative investments                                         (958 )                (16,735 )                       -                   (14,321 )
Other investments                                                  -                      575                         -                        77

Total investment income                                      144,468                  133,759                    49,035                    36,808
Investment expense                                            (2,728 )                 (2,927 )                    (924 )                    (846 )

Net investment income                               $        141,740         $        130,832           $        48,111         $          35,962

Net investment income increased 8% year-over-year and 34% quarter-over-quarter, primarily due to the effect of losses on alternative investments in 2008 and higher income from fixed income securities in 2009. This increase was partially offset by our earning significantly less income on short-term investments due to lower market interest rates in 2009. Our fixed income securities portfolio increased from $3.9 billion at September 30, 2008 to $4.9 billion at September 30, 2009. The growth in fixed income securities resulted primarily from cash flow from operations and liquidation of our alternative investments in late 2008 and early 2009. We reduced our exposure to alternative investments, which were primarily fund-of-fund hedge fund investments, by redeeming $52.6 million in the fourth quarter of 2008 and the remaining $44.3 million in 2009. We have collected substantially all of these redeemed funds through September 30, 2009.
Other operating income was $29.8 million in the first nine months of 2009, compared to $10.8 million in the first nine months of 2008 and $1.4 million in the third quarter of 2009, compared to $4.8 million in the third quarter of 2008. The 2009 income includes the $20.0 million termination payment to commute a reinsurance contract that had been accounted for using the deposit method of accounting. The 2009 year-to-date and third quarter income include a $2.4 million gain from the sale of a strategic investment and a $4.2 million loss from sale of a subsidiary during the third quarter of 2009. The 2008 nine-month period included a $9.2 million gain from the sale of a strategic investment and losses related to our trading security portfolio that was sold in 2008. Period to period comparisons in this category may vary substantially, depending on acquisition of new investments, income or loss related to changes in the market values of certain investments, and gains or losses related to dispositions. The following table details the components of our other operating income.

                                                        Nine months ended September 30,                    Three months ended September 30,
                                                         2009                    2008                       2009                      2008
Contract using deposit accounting                   $       20,532         $            774           $               -          $           472
Strategic investments                                        4,714                   13,074                       2,859                      910
Trading securities                                               -                  (11,698 )                         -                       29
Financial instruments                                        3,469                    2,275                        (188 )                   (507 )
Other                                                        1,109                    6,404                      (1,266 )                  3,924

Other operating income                              $       29,824         $         10,829           $           1,405          $         4,828

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We recognized, as a reduction of earnings, $5.3 million and $6.0 million of other-than-temporary impairment losses in the first nine months of 2009 and 2008, respectively, and $0.3 million and $4.4 million in the third quarter of 2009 and 2008, respectively. Gains on the sale of fixed income securities substantially offset the impairment losses in the first nine months of 2009. 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 extreme credit market issues, and realized losses of $19.4 million. Loss and loss adjustment expense decreased year-over-year and quarter-over-quarter due to the 2008 hurricane losses in 2008, partially offset by losses recorded on increased net earned premium in 2009. Policy acquisition costs decreased year-over-year and quarter-over-quarter, principally due to lower commission rates on certain lines of business and a change in 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, which includes compensation expense, increased 12% in the first nine months of 2009 and 13% in the third quarter of 2009, compared to the same 2008 periods. The 2009 increase included compensation and other operating expenses of businesses acquired in the fourth quarter of 2008 and the first quarter of 2009. We had 1,916 employees at September 30, 2009 compared to 1,783 a year earlier, with the increase primarily due to acquisitions. In addition, other operating expense for 2009 includes $9.9 million of expenses for costs directly related to the first quarter commutation of a reinsurance contract that had been accounted for using the deposit method of accounting. Other operating expense includes $10.7 million and $9.2 million in the first nine months of 2009 and 2008, 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. At September 30, 2009, there was approximately $24.1 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 2.6 years. Our effective income tax rate was 31.5% for the nine-month period of 2009, compared to 30.9% for the nine-month period of 2008. The lower effective rate in 2008 related to the increased benefit from tax-exempt investment income relative to a lower pretax income base.
At September 30, 2009, book value per share was $26.54, up from $23.27 at December 31, 2008. Total assets were $9.0 billion and shareholders' equity was $3.0 billion, compared to $8.3 billion and $2.6 billion, respectively, at December 31, 2008. We repurchased 1.7 million shares of our common stock in the first quarter of 2009, which increased book value per share by $0.07. Segments
Insurance Company Segment
Net earnings of our insurance company segment increased $43.4 million, or 19%, and $40.5 million, or 71%, in the first nine months and third quarter of 2009 compared to the same periods in 2008. The increases resulted from: 1) additional earned premium, 2) the net impact of the commutation in 2009 of a reinsurance contract that had been accounted for using the deposit method of accounting and
3) higher investment income. Both the 2008 year-to-date and quarter-to-date periods were negatively impacted by losses on alternative investments and losses from the 2008 hurricanes. Our margins remain at an acceptable level of profitability in 2009 even though there is pricing competition in certain of our markets. Premium
Gross written premium was 1% higher in 2009, due to the effects of growth in our diversified financial products and London market account lines of business and our recent acquisitions, offset by lower aviation writings in the first half of 2009 and the discontinuance of an assumed quota share contract and our U.K. motor business in 2008. The overall percentage of retained premium, as measured by the percent of net written premium to gross written premium, decreased slightly to 80% in 2009 from 82% in 2008.

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The following tables provide premium information by line of business.

                                                 Gross               Net               NWP             Net
                                                written            written           as % of         earned
                                                premium            premium             GWP           premium
Nine months ended September 30, 2009

Diversified financial products                $   815,085        $   661,129             81 %      $   668,640
Group life, accident and health                   636,018            592,438             93            597,598
Aviation                                          133,913             95,655             71             98,514
London market account                             161,475             93,241             58             75,587
Other specialty lines                             157,593             85,449             54             84,109
Discontinued lines                                      2                (23 )           nm                (23 )


Totals                                        $ 1,904,086        $ 1,527,889             80 %      $ 1,524,425


Nine months ended September 30, 2008

Diversified financial products                $   744,920        $   622,702             84 %      $   593,378
Group life, accident and health                   629,214            595,112             95            582,193
Aviation                                          147,268            106,996             73            105,125
London market account                             154,028             97,142             63             80,824
Other specialty lines                             207,361            129,667             63            138,846
Discontinued lines                                  4,765              4,763             nm              4,762


Totals                                        $ 1,887,556        $ 1,556,382             82 %      $ 1,505,128


Three months ended September 30, 2009

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