HCC INSURANCE HOLDINGS INC/DE/ – 10-Q – Management’s Discussion and Analysis of Financial Condition and Results of Operations
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The following Management's Discussion and Analysis should be read in conjunction with our Consolidated Financial Statements and the related Notes as ofMarch 31, 2013 andDecember 31, 2012 . Overview We are a specialty insurance group with offices inthe United States , theUnited Kingdom ,Spain andIreland , transacting business in approximately 180 countries. Our shares trade on theNew York Stock Exchange and closed at$41.91 onApril 26, 2013 , resulting in market capitalization of$4.2 billion . We underwrite and manage a variety of largely non-correlated specialty insurance products through five insurance underwriting segments and our Investing segment. Our insurance underwriting segments are U.S. Property & Casualty, Professional Liability, Accident & Health, U.S. Surety & Credit and International. We market our insurance products through a network of independent agents and brokers, through managing general agents owned by the company, and directly to consumers. In addition, we assume insurance written by other insurance companies. Our organization is focused on generating consistent, industry-leading combined ratios. We concentrate our insurance writings in selected specialty lines of business in which we believe we can achieve meaningful underwriting profit. We rely on experienced underwriting personnel and our access to and expertise in the reinsurance marketplace to limit or reduce risk. By focusing on underwriting profitability, we are able to accomplish our primary objectives of maximizing net earnings and growing book value per share. Our major domestic and international insurance companies have financial strength ratings of AA (Very Strong) from Standard & Poor's Corporation, A+ (Superior) fromA.M. Best Company, Inc. , AA (Very Strong) from Fitch Ratings and A1 (Good Security) fromMoody's Investors Service, Inc.
Key facts about our consolidated group as of and for the quarter ended
• We had consolidated shareholders' equity of$3.6 billion , with a book value per share of$35.68 . • We generated net earnings of$105.9 million , or$1.05 per diluted share.
• We produced total revenue of
earned premium and 9% related to net investment income. • Our net loss ratio was 59.3% and our combined ratio was 83.8%. • Our debt to capital ratio was 14.7%.
• We purchased
$39.18 per share. At quarter end, we had$221.0 million remaining under our current$300.0 million share buyback authorization. • We declared dividends of$0.165 per share and paid$16.7 million of dividends. Comparisons in the following sections refer to the first quarter of 2013 compared to the same period of 2012. Amounts in tables are in thousands, except for earnings per share, percentages, ratios and number of employees. We adjusted all prior segment data to reflect our exit from two lines of business previously included in our Accident & Health segment (see Note 10, "Segments" to the Consolidated Financial Statements). 23
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Results of Operations
Our results and key metrics for the first quarter of 2013 and 2012 were as follows: Three months ended March 31, 2013 2012 Net earnings $ 105,850$ 82,584 Earnings per diluted share $ 1.05 $ 0.79 Net loss ratio 59.3 % 60.1 % Expense ratio* 24.5 25.4 Combined ratio* 83.8 % 85.5 %
* 2012 adjusted to reflect change in Exited Lines.
Revenue
Total revenue increased
Gross written premium, net written premium and net earned premium are detailed below by segment. Three months ended March 31, 2013 2012 U.S. Property & Casualty $ 175,137$ 153,147 Professional Liability 104,019 101,245 Accident & Health 215,561 205,327 U.S. Surety & Credit 52,249 54,493 International 167,807 157,676 Exited Lines 5,432 10,801 Total gross written premium $ 720,205$ 682,689 U.S. Property & Casualty $ 103,882$ 92,328 Professional Liability 67,626 70,913 Accident & Health 215,268 205,098 U.S. Surety & Credit 45,504 44,704 International 141,472 134,570 Exited Lines 5,432 10,791 Total net written premium $ 579,184$ 558,404 U.S. Property & Casualty $ 93,531$ 89,018 Professional Liability 92,779 101,438 Accident & Health 217,125 206,881 U.S. Surety & Credit 47,177 47,729 International 105,142 91,284 Exited Lines 5,432 10,791 Total net earned premium $ 561,186$ 547,141 Growth in premium from our insurance underwriting segments occurred primarily in: 1) the U.S. Property & Casualty segment, from new business lines started in 2011 and increased disability, residual value, title and mortgage reinsurance, and other structured insurance products; 2) the Accident & Health segment, from the growth of our medical stop-loss product and 3) the International 24
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segment, from increases in our energy and property treaty lines of business. See the "Segment Operations" section below for further discussion of the relationship and changes in premium revenue within each insurance segment.
Net investment income, which is included in our Investing segment, decreased 2% year-over-year as the effect from growth in our investment portfolio was more than offset by the effect of reduced reinvestment yields. Our fixed maturity securities portfolio increased 3% from$6.0 billion atMarch 31, 2012 to$6.2 billion atMarch 31, 2013 . In addition, we added publicly traded equity securities to our portfolio and held$350.4 million atMarch 31, 2013 . The growth in investments resulted primarily from cash flow from operations during 2012 and an increase of$45.2 million in the net unrealized gain on our available for sale securities sinceMarch 31, 2012 .
Our other operating income primarily consists of third party agency and broker commissions and income from a financial instrument.
Loss and Loss Adjustment Expense
The tables below detail our net loss and loss adjustment expense and our net loss ratios on a consolidated basis and for our segments.
Three months ended March 31, 2013 2012 U.S. Property & Casualty$ 52,156 $ 49,261 Professional Liability 56,386 69,155 Accident & Health 160,427 152,522 U.S. Surety & Credit 13,214 11,033 International 45,919 37,767 Exited Lines 4,595 9,190 Net loss and loss adjustment expense$ 332,697 $ 328,928 U.S. Property & Casualty 55.8 % 55.3 % Professional Liability 60.8 68.2 Accident & Health 73.9 73.7 U.S. Surety & Credit 28.0 23.1 International 43.7 41.4
Consolidated net loss ratio 59.3 %
60.1 %
Consolidated accident year net loss ratio 59.3 %
60.1 %
Loss and loss adjustment expense increased 1% in 2013, compared to 2012, primarily due 1) to our Accident & Health segment, from growth of our medical stop-loss product writings and 2) our International segment, from growth of our energy and property treaty lines of business, partially offset by 3) decreased loss expense in our Professional Liability segment related to our expectation of lower losses in our diversified financial products (DFP) line of business in 2013 compared to 2012. See the "Segment Operations" section below for additional discussion of the changes in our net loss and loss adjustment expense and net loss ratios for each segment. We recognized no prior year loss development in the first quarter of 2013 and 2012. 25
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The table below provides a reconciliation of our consolidated reserves for loss and loss adjustment expense payable, net of reinsurance ceded, the amount of our paid claims, and our net paid loss ratio. Three months ended March 31, 2013 2012 Net reserves for loss and loss adjustment expense payable at beginning of period$ 2,749,803 $ 2,683,483 Net reserve additions from acquired businesses -
14,705
Foreign currency adjustment (21,729)
17,123
Net loss and loss adjustment expense 332,697
328,928
Net loss and loss adjustment expense payments (299,529)
(344,522)
Net reserves for loss and loss adjustment expense payable at end of period$ 2,761,242 $ 2,699,717 Net paid loss ratio 53.4 % 63.0 % The amount of claims paid fluctuates year-over-year due to the timing of claims settlement, occurrence of catastrophic events and mix of our business. In 2012, we commuted certain loss reserves on a large contract included in our Exited Lines for$27.5 million . The commutation had no material effect on net earnings but increased our net paid loss ratio by 5.1 percentage points in 2012. Excluding the commutation, our net paid loss ratio decreased 4.5 percentage points in 2013, primarily due to timing of claims payments and the mix of our businesses. Policy Acquisition Costs The percentage of policy acquisition costs to net earned premium was 11.9% and 12.7% in 2013 and 2012, respectively. The difference between years primarily relates to higher ceding commissions in 2013 and changes in the mix of business.
Other Operating Expense
Other operating expense decreased 12% in 2013 compared to 2012. The decrease in other operating expense was primarily due to the year-over-year fluctuation in foreign currency benefit/expense, partially offset by higher employee compensation and benefit costs in 2013. We recognized a foreign currency benefit of$11.0 million in the first quarter of 2013, compared to expense of$2.8 million in the first quarter of 2012, principally related to weakening of the British pound sterling relative to the U.S. dollar in 2013. Excluding the effect of foreign currency benefit/expense, 64% of other operating expense related to compensation and benefits for our 1,892 employees in 2013, compared to 61% in 2012. Other operating expense included stock-based compensation expense of$2.9 million in 2013 and$2.4 million in 2012. AtMarch 31, 2013 , there was approximately$28.0 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 2.9 years.
Interest Expense
Interest expense was$6.5 million and$6.9 million in the first quarter of 2013 and 2012, respectively, and included$4.8 million in each period for our Senior Notes. Income Tax Expense
Our effective income tax rate was 30.1% for 2013, compared to 29.4% for 2012. The higher effective rate in 2013 was due to pretax income increasing at a faster rate than tax-exempt investment income.
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Segment Operations
Each of our insurance segments bears risk for insurance coverage written within its portfolio of insurance products. Each segment generates income from premium written by our underwriting agencies, through third party agents and brokers, or on a direct basis. Certain segments also write facultative or individual account reinsurance, as well as treaty reinsurance business. In some cases, we purchase reinsurance to limit the segments' net losses from both individual policy losses and multiple policy losses from catastrophic risks. Our segments maintain disciplined expense management and a streamlined management structure, which results in favorable expense ratios. The following provides operational information about our five insurance underwriting segments and our Investing segment.
U.S. Property & Casualty Segment
The following tables summarize the operations of the U.S. Property & Casualty segment. Three months ended March 31, 2013 2012 Net earned premium$ 93,531 $ 89,018 Other revenue 7,184 2,363 Segment revenue 100,715 91,381 Loss and loss adjustment expense, net 52,156 49,261 Other expense 27,305 29,722 Segment expense 79,461 78,983 Segment pretax earnings$ 21,254 $ 12,398 Net loss ratio 55.8 % 55.3 % Expense ratio 27.1 32.5 Combined ratio 82.9 % 87.8 % Aviation$ 27,857 $ 28,823 E&O 13,198 16,377 Public Risk 16,360 15,218 Other 36,116 28,600 Total net earned premium$ 93,531 $ 89,018 Aviation 61.7 % 46.9 % E&O 60.2 61.0 Public Risk 78.2 93.0 Other 39.4 40.5 Total net loss ratio 55.8 % 55.3 % 27
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Table of Contents Three months ended March 31, 2013 2012 Aviation$ 36,998 $ 37,090 E&O 15,074 16,891 Public Risk 21,441 19,784 Other 101,624 79,382 Total gross written premium$ 175,137 $ 153,147 Aviation$ 28,614 $ 27,507 E&O 12,538 16,505 Public Risk 15,771 15,594 Other 46,959 32,722 Total net written premium$ 103,882 $ 92,328 Our U.S. Property & Casualty segment pretax earnings increased 71% year-over-year primarily due to a combination of the following: 1) no catastrophe losses in 2013, compared to$4.0 million in 2012, 2) higher ceding commissions in 2013 and 3) higher other revenue. Net earned premium increased in 2013, compared to 2012, due to higher writings by our new underwriting teams for the technical property, primary casualty and excess casualty lines of business, as well as for disability, residual value, title and mortgage reinsurance, and other structured insurance products. Higher losses in our aviation line of business during the first quarter of 2013 partially offset reduced losses in our public risk line of business, which included the segment's 2012 net catastrophe losses. Other expense and the expense ratio were lower in 2013 primarily due to higher ceding commissions, which offset policy acquisition costs. 28
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Professional Liability Segment
The following tables summarize the operations of the Professional Liability segment. Three months ended March 31, 2013 2012 Net earned premium$ 92,779 $ 101,438 Other revenue (414 ) 133 Segment revenue 92,365 101,571 Loss and loss adjustment expense, net 56,386 69,155 Other expense 17,748 17,531 Segment expense 74,134 86,686 Segment pretax earnings$ 18,231 $ 14,885 Net loss ratio 60.8 % 68.2 % Expense ratio 19.2 17.3 Combined ratio 80.0 % 85.5 % U.S. D&O$ 76,705 $ 86,254 International D&O 16,074 15,184 Total net earned premium$ 92,779 $ 101,438 U.S. D&O 62.8 % 71.0 % International D&O 51.2 51.9 Total net loss ratio 60.8 % 68.2 % U.S. D&O$ 75,239 $ 74,996 International D&O 28,780 26,249 Total gross written premium$ 104,019 $ 101,245 U.S. D&O$ 51,699 $ 55,705 International D&O 15,927 15,208 Total net written premium$ 67,626 $
70,913
Our Professional Liability segment pretax earnings increased 22% in 2013, compared to 2012, due to an improved net loss ratio, primarily related to our diversified financial products (DFP) line of business in U.S. D&O. We increased the 2011 ultimate loss ratio for DFP in the third quarter of 2011, based on our annual reserve review that indicated the frequency and severity of claims had increased in the 2011 accident year, and continued to use that same ultimate loss ratio as premium written in 2011 earned during 2012. We decreased DFP's ultimate loss ratio for premium written in 2012 and 2013, based on fewer expected losses due to our reunderwriting of the DFP business. Gross written premium increased 3% in 2013, primarily due to increased writings of U.S. and International D&O, partially offset by reduced writings of DFP. Net written premium decreased year-over-year due to changes in our reinsurance program. Net earned premium decreased in 2013 due to our reunderwriting of the DFP business in 2012. 29
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Accident & Health Segment
The following tables summarize the operations of the Accident & Health segment. Three months ended March 31, 2013 2012 Net earned premium$ 217,125 $ 206,881 Other revenue 1,190 1,337 Segment revenue 218,315 208,218 Loss and loss adjustment expense, net 160,427 152,522 Other expense 31,126 30,154 Segment expense 191,553 182,676 Segment pretax earnings$ 26,762 $ 25,542 Net loss ratio 73.9 % 73.7 % Expense ratio 14.3 14.5 Combined ratio 88.2 % 88.2 % Medical Stop-loss$ 202,594 $ 193,087 Other 14,531 13,794 Total net earned premium$ 217,125 $ 206,881 Medical Stop-loss 75.2 % 75.3 % Other 56.3 51.8 Total net loss ratio 73.9 % 73.7 % Medical Stop-loss$ 202,808 $ 193,233 Other 12,753 12,094 Total gross written premium$ 215,561 $ 205,327 Medical Stop-loss$ 202,594 $ 193,087 Other 12,674 12,011 Total net written premium$ 215,268 $
205,098
The Accident & Health segment pretax earnings increased 5% in the first quarter of 2013, compared to the same period of 2012. This increase was directly related to higher net earned premium in our medical stop-loss product line due to writing new business and rate increases on renewal business. The 2012 information shown above has been adjusted to reflect our exit from two lines of business in the third quarter of 2012. See Note 10, "Segments" to the Consolidated Financial Statements. 30
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U.S. Surety & Credit Segment
The following tables summarize the operations of the U.S. Surety & Credit segment. Three months ended March 31, 2013 2012 Net earned premium$ 47,177 $ 47,729 Other revenue 237 215 Segment revenue 47,414 47,944 Loss and loss adjustment expense, net 13,214 11,033 Other expense 26,279 28,120 Segment expense 39,493 39,153 Segment pretax earnings$ 7,921 $ 8,791 Net loss ratio 28.0 % 23.1 % Expense ratio 55.4 58.7 Combined ratio 83.4 % 81.8 % Surety$ 35,607 $ 39,920 Credit 11,570 7,809 Total net earned premium$ 47,177 $ 47,729 Surety 25.0 % 24.8 % Credit 37.4 14.6 Total net loss ratio 28.0 % 23.1 % Surety$ 37,696 $ 39,926 Credit 14,553 14,567 Total gross written premium$ 52,249 $ 54,493 Surety$ 33,690 $ 36,134 Credit 11,814 8,570 Total net written premium$ 45,504 $ 44,704 Our U.S. Surety & Credit segment pretax earnings decreased 10% year-over-year, primarily due to a higher net loss ratio in our credit line of business in 2013. Premium for our surety line of business decreased year-over-year, primarily due to competition and economic conditions impacting the construction industry. In the first quarter of 2012, we had a large loss in our credit line of business, which, because of its size, had significant reinsurance recoveries. Our losses net of these reinsurance recoveries were limited, resulting in a low loss ratio. The benefit related to this low loss ratio was offset by a reduction of net written premium and net earned premium due to$4.3 million of reinstatement premium related to this large loss. 31
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International Segment
The following tables summarize the operations of the International segment.
Three months ended March 31, 2013 2012 Net earned premium$ 105,142 $ 91,284 Other revenue 778 1,194 Segment revenue 105,920 92,478 Loss and loss adjustment expense, net 45,919 37,767 Other expense 35,709 32,153 Segment expense 81,628 69,920 Segment pretax income$ 24,292 $ 22,558 Net loss ratio 43.7 % 41.4 % Expense ratio 33.7 34.8 Combined ratio 77.4 % 76.2 % Energy$ 21,039 $ 15,094 Property Treaty 28,755 22,089 Liability 17,175 19,482 Surety & Credit 18,213 17,761 Other 19,960 16,858 Total net earned premium$ 105,142 $ 91,284 Energy 45.3 % 37.1 % Property Treaty 24.3 12.8 Liability 49.9 51.2 Surety & Credit 63.5 67.9 Other 46.4 43.3 Total net loss ratios 43.7 % 41.4 % Energy$ 26,545 $ 20,595 Property Treaty 72,345 69,338 Liability 18,133 19,260 Surety & Credit 21,166 20,958 Other 29,618 27,525 Total gross written premium$ 167,807 $ 157,676 32
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Table of Contents Three months ended March 31, 2013 2012 Energy$ 14,669 $ 12,824 Property Treaty 66,167 62,302 Liability 16,570 17,892 Surety & Credit 18,649 19,027 Other 25,417 22,525 Total net written premium$ 141,472 $ 134,570 Our International segment pretax earnings increased 8% in the first quarter of 2013, compared to the first quarter of 2012. The 2013 and 2012 pretax earnings included$5.2 million and$3.6 million , respectively, of net catastrophe losses related to small catastrophes in our property treaty line of business. The segment's increase in net earned premium in 2013 primarily related to increased writings of our energy and property treaty lines of business. 33
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Investing Segment
We invest the majority of our funds in highly-rated fixed maturity securities, which are designated as available for sale securities. We held$6.2 billion of fixed maturity securities atMarch 31, 2013 . Substantially all of our fixed maturity securities were investment grade and 72% were rated AAA or AA. The following tables summarize the results and key metrics of our Investing segment. Three months ended March 31, 2013 2012 Fixed maturity securities$ 53,849 $ 57,727 Equity securities 3,580 - Short-term investments 12 62 Other investments and deposits (47 ) 467 Net realized investment gain 8,570 171 Investment expenses (1,629 ) (1,246 ) Segment pretax earnings$ 64,335 $ 57,181 Fixed maturity securities: Average yield * 3.7 % 4.1 % Average tax equivalent yield * 4.6 % 5.0 % Weighted-average life 8.3 years 7.7 years Weighted-average duration 4.9 years 4.8 years Weighted-average rating AA AA
* Excluding realized and unrealized gains and losses.
In 2012, we began investing in bank loans (classified as corporate securities), which we expect will generate attractive yields and lower our overall duration without altering the weighted-average rating of the portfolio. We also began investing in global publicly traded equity securities. These investments in equity securities are focused on companies with a track record of above-market dividend yields. AtMarch 31, 2013 , our investments included$151.3 million of bank loans and$350.4 million of equity securities. The weighted-average duration of our fixed maturity securities portfolio increased between the first quarter of 2012 and the first quarter of 2013, due to additional investments in municipal bonds that have longer lives and the impact of higher interest rates. 34
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This table summarizes our investments by type, all of which were reported at fair value, at
March 31, 2013 December 31, 2012 Amount % Amount % Fixed maturity securities U.S. government and government agency securities$ 126,249 2 %$ 199,607 3 % Fixed maturity securities of states, municipalities and political subdivisions 1,043,001 15 1,065,811 15 Special purpose revenue bonds of states, municipalities and political subdivisions 2,251,190 33 2,200,331 32 Corporate securities 1,301,625 19 1,315,170 19 Residential mortgage-backed securities 655,623 10 664,887 10 Commercial mortgage-backed securities 522,063 8 524,289 8 Asset-backed securities 42,530 1 33,275 - Foreign government securities 243,175 3 278,411 4 Equity securities 350,352 5 284,639 4 Short-term investments 267,434 4 363,053 5 Other investments 2,810 - 20,925 - Total investments$ 6,806,052 100 %$ 6,950,398 100 % Our total investments decreased$144.3 million in 2013, principally from: 1) return of$67.1 million of collateral held for our surety business in the first quarter of 2013 and 2) a$39.0 million decrease in the pretax net unrealized gain associated with our available for sale securities. AtMarch 31, 2013 , the net unrealized gain on our available for sale portfolio was$397.7 million , compared to$436.7 million atDecember 31, 2012 .
The ratings of our individual securities within our fixed maturity securities portfolio at
Amount % AAA$ 827,900 13 % AA 3,652,766 59 A 1,263,454 20 BBB 286,206 5 BB and below 155,130 3 Total fixed maturity securities$ 6,185,456 100 % AtMarch 31, 2013 , we held$2.3 billion of special purpose revenue bonds, as well as$1.0 billion of general obligation bonds, which are issued by states, municipalities and political subdivisions and collectively referred to, in the investment market, as municipal bonds. The overall rating of our municipal bonds was AA atMarch 31, 2013 . Within our municipal bond portfolio, we held$431.5 million of pre-refunded bonds, which are supported by U.S. government debt obligations. Our special purpose revenue bonds are secured by revenue sources specific to each security. AtMarch 31, 2013 , the percentages of our special purpose revenue bond portfolio supported by these major revenue sources were as follows: 1) education - 23%, 2) transportation - 22%, 3) water and sewer - 18% and 4) electric - 14%. Many of our special purpose revenue bonds are insured by mono-line insurance companies or supported by credit enhancement programs of various states and municipalities. We view bond insurance as credit enhancement and not credit substitution. We base our investment decision on the strength of the issuer. A credit review is performed on each issuer and on the sustainability of the revenue source before we acquire a special purpose revenue bond and periodically thereafter. The underlying average credit rating of our special purpose revenue bond issuers, excluding any bond insurance, was AA atMarch 31, 2013 . Although recent economic conditions inthe United States may reduce the source of revenue to support certain of these securities, the majority are supported by revenue from essential sources, as indicated above, which we believe generate a stable source of revenue. 35
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AtMarch 31, 2013 , we held corporate fixed maturity securities issued by foreign corporations with an aggregate fair value of$534.8 million . In addition, we held securities issued by foreign governments, agencies or supranational entities with an aggregate fair value of$243.2 million .
The methodologies used to determine the fair value of our investments are described in Note 4, "Fair Value Measurements" to the Consolidated Financial Statements.
Some of our fixed maturity securities have call or prepayment options. In addition, mortgage-backed and certain asset-backed securities have prepayment, extension or other market-related credit risk. Calls and prepayments subject us to reinvestment risk should interest rates fall and issuers call their securities and we reinvest the proceeds at lower interest rates. Prepayment risk exists if cash flows from the repayment of principal occur earlier than anticipated because of declining interest rates. Extension risk exists if cash flows from the repayment of principal occur later than anticipated because of rising interest rates. Credit risk exists if mortgagees default on the underlying mortgages. Net investment income and/or cash flows from investments that have call or prepayment options and prepayment, extension or credit risk may differ from what was anticipated at the time of investment. We mitigate these risks by investing in investment grade securities with varied maturity dates so that only a portion of our portfolio will mature at any point in time. In 2013, we expect approximately 10% of our fixed maturity securities portfolio to mature, call or prepay. Assuming prevailing interest rates remain constant throughout 2013, reinvestment of these funds will be at book yields and tax-equivalent yields that are approximately 130 basis points and 110 basis points, respectively, lower than the year-end 2012 yields for these securities.
Corporate & Other
The following table summarizes activity in the Corporate & Other category.
Three months ended March 31, 2013 2012 Net earned premium$ 5,432 $ 10,791 Other revenue (130 ) (41 ) Total revenue 5,302 10,750
Loss and loss adjustment expense, net 4,595
9,190
Other expense - Exited Lines 1,339
1,809
Other expense - Corporate 15,365
14,579
Interest expense 6,386
6,802
Foreign currency expense (benefit) (10,984 )
2,765 Total expense 16,701 35,145 Pretax loss$ (11,399 ) $ (24,395 ) The 2012 amounts for net earned premium, loss and loss adjustment expense, and other expense - Exited Lines have been adjusted to reflect the addition of two product lines previously included in the Accident & Health segment. Net earned premium decreased year-over-year as we wrote less business related to our exited HMO and medical excess reinsurance products. Premium related to the other products included in Exited Lines was insignificant in both periods. The majority of the loss and loss adjustment expense relates to the HMO and medical excess reinsurance products. Our Corporate expenses not allocable to the segments increased$0.8 million in 2013, primarily due to higher employee compensation and benefit costs. The impact of foreign currency benefit/expense fluctuated period-over-period principally due to the weakening of the British pound sterling relative to the U.S. dollar in 2013. We hold available for sale securities denominated in non-functional currencies to economically hedge the currency exchange risk on our loss reserves denominated in non-functional currencies. The foreign currency benefit/expense related to loss reserves is recorded through the income statement, while the foreign currency benefit/expense related to available for sale securities is recorded through other comprehensive income within shareholders' equity. This accounting mismatch may cause fluctuations in our reported foreign currency benefit/expense in future periods. 36
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Liquidity and Capital Management
We believe we have sufficient sources of liquidity at both a consolidated and insurance company legal entity level at a reasonable cost to pay claims and meet our other contractual obligations and liabilities as they become due in the short-term and long-term. Our current sources of liquidity include: 1) significant operating cash flow generated by our insurance companies, 2) a$6.8 billion investment portfolio, substantially all of which is held by our insurance companies and is available for sale, 3) our revolving loan and standby letter of credit facilities and 4) a$1.0 billion shelf registration. Our insurance companies have sufficient resources to pay potential claims. Based on historical payment patterns and claims history, at year-end 2012, we projected that our insurance companies will pay approximately$1.4 billion of claims in 2013. We also projected that they will collect approximately$0.4 billion of reinsurance recoveries in 2013. In addition to expected cash flow from their 2013 operations, these companies had$6.4 billion of investments available to fund claims payments, if needed. Our sources of liquidity are discussed below.
We manage the liquidity of our insurance companies such that each subsidiary's anticipated claims payments will be met by its own current operating cash flows, cash, short-term investments or investment maturities. Our insurance companies receive substantial cash from premiums, reinsurance recoverables, surety collateral, outward commutations, proceeds from sales and redemptions of investments, and investment income. Their principal cash outflows are for the payment of claims and loss adjustment expenses, premium payments to reinsurers, return of surety collateral, inward commutations, purchases of investments, policy acquisition costs, operating expenses, taxes and dividends paid to HCC. We report all of the insurance companies' investing activity in our Investing segment for segment reporting purposes. Our parent company's principal cash inflows relate to its investment portfolio and dividends paid by the insurance companies, and its principal cash outflows relate to debt service, operating expenses, dividends paid to shareholders and common stock purchases. Cash provided by operating activities can fluctuate due to timing differences in the collection of premium receivables, reinsurance recoverables and surety collateral; the payment of losses, premium payables and return of surety collateral; and the completion of commutations. The components of our net operating cash flows are summarized in the following table. Three months ended March 31, 2013 2012 Net earnings$ 105,850
(2,934 ) 33,891 Change in unearned premium, net 15,708 1,658
Change in loss and loss adjustment expense payable, net of reinsurance recoverables
17,793
16,098
Change in accounts payable and accrued liabilities (101,424 ) (44,098 ) Gain on investments (8,570 ) (171 ) Other, net (24,326 ) (14,992 ) Cash provided by operating activities $ 2,097
Our cash provided by operating activities was$2.1 million in the first quarter of 2013, compared to$75.0 million in the same period of 2012. Cash provided by operating activities includes collateral funds we receive or refund for our U.S. surety business, as well as funds we pay to commute large contracts. We refunded surety collateral of$67.1 million in 2013 and$22.7 million in 2012 and also paid$27.5 million in 2012 to commute a large contract in our Exited Lines. The remaining$56.0 million reduction in our cash provided by operating activities primarily resulted from$26.4 million of higher income tax payments in 2013, compared to 2012, as well as the timing of the collection and the payment of insurance-related receivables and payables. 37
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Investments
AtMarch 31, 2013 , we held a$6.8 billion investment portfolio, which included$267.4 million of liquid short-term investments. Our fixed maturity and equity securities are classified as available for sale. We expect to hold our fixed maturity securities until maturity, but we would be able to sell these securities, as well as our equity securities and other investments, to generate cash if needed. See the "Investing Segment" section above for additional information about our investment portfolio. The parent company held$441.5 million of cash and investments, which are available to cover the holding company's required cash disbursements in 2013.
Revolving Loan and Standby Letter of Credit Facilities
We maintain a$600.0 million Revolving Loan Facility (Facility), of which$270.6 million of available capacity remained atMarch 31, 2013 . During the past several years, we used the Facility to fund purchases of our common stock, which we expect to continue to do as we opportunistically repurchase stock in 2013. OnApril 26, 2013 , we entered into an agreement to modify the Facility. Under the amended agreement, the Facility expires onApril 26, 2017 . We also have a$90.0 million Standby Letter of Credit Facility (Standby Facility) that is used to guarantee our performance in our Lloyd's ofLondon syndicate. The Standby Facility expires in 2016. See Note 6, "Notes Payable" to the Consolidated Financial Statements for additional information related to the Facility and Standby Facility and our long-term indebtedness.
Share Purchases
OnAugust 23, 2012 , the Board approved the purchase of up to$300.0 million of our common stock (the Plan). Purchases under the Plan may be made in the open market or in privately negotiated transactions from time-to-time in compliance with applicable laws, rules and regulations, including Rule 10b-18 under the Securities Exchange Act of 1934, as amended. Purchases under the Plan will be made subject to market and business conditions, the level of cash generated from our operations, cash required for acquisitions, our debt covenant compliance, and other relevant factors. The Plan does not obligate us to purchase any particular number of shares, has no expiration date, and may be suspended or discontinued at any time at the Board's discretion. In the first quarter of 2013, we purchased$28.8 million , or 0.7 million shares, at an average cost of$39.18 per share. As ofApril 26, 2013 ,$218.7 million of repurchase authority remains under the Plan.
Shelf Registration
We have a "Universal Shelf" registration statement that expires inMarch 2015 . The Universal Shelf provides for the issuance of$1.0 billion of securities, which may be debt securities, equity securities, or a combination thereof. The Universal Shelf provides us the means to access the debt and equity markets relatively quickly, if we are satisfied with the current pricing in the financial markets.
Critical Accounting Policies
We provided information about our critical accounting policies in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies", in our Annual Report on Form 10-K for the year endedDecember 31, 2012 . We have made no changes in the identification or methods of application of these policies; however, the following information supplements the "Reserves" disclosures on page 55 of our Annual Report on Form 10-K for the year endedDecember 31, 2012 . Our recorded reserves represent management's best estimate of unpaid losses and loss adjustment expenses as of each quarter end, based on information, facts and circumstances known at that time. The process of establishing reserves is complex, imprecise and inherently uncertain and, as such, involves a considerable degree of judgment involving our management review and actuarial processes. We must consider many variables that are subject to the outcome of future events. As a result, an integral component of our loss reserving process is the use of informed subjective estimates and judgments about our ultimate exposure to losses. Therefore, it is possible that management's estimate of the ultimate liability for losses as ofDecember 31, 2012 may change. 38
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Management considers many factors in determining the ultimate losses and reserves for the various products in our five insurance underwriting segments. These factors include: 1) actuarial point estimates and the estimated ranges around these estimates, 2) information used to price the applicable policies, 3) historical loss information, where available, 4) public industry data for the product or similar products, 5) an assessment of current market conditions, 6) information on individual claims, 7) an assessment of current or potential litigation involving claims and 8) information from underwriting and claims personnel. The estimate of our reserves is increased or decreased as more information becomes known about the frequency and severity of losses for prior and current years. We believe our review process is effective, such that any required changes in reserves are recognized in the period of change as soon as the need for the change is evident. Our actuaries monitor the adequacy and reasonableness of our recorded reserves for over 100 specialty insurance products by accident year or underwriting year, as applicable. The table on page 57 of our Annual Report on Form 10-K for the year endedDecember 31, 2012 details the characteristics for our major products in each segment. Although the duration (the time period between the occurrence of a loss and the settlement of a claim) is either short-term or medium-term for the majority of these products, approximately 50% of our total gross reserves atDecember 31, 2012 related to long-tail products in our Professional Liability and International segments and our Exited Lines. These long-tail products include directors' and officers' liability, large account E&O liability, International accident and health, and assumed accident and health reinsurance business that we no longer write. We write many of these contracts as excess insurance, where losses in lower layers must develop first before our excess coverage attaches. Significant periods of time, ranging up to several years or more, may elapse between occurrence of the loss, reporting of the loss to us, and settlement of the claim. In addition, many of these claims are susceptible to litigation and can be affected by escalating legal defense costs, contract interpretations and the changing economic and legal environment. As a result, our long-tail products are subject to greater levels of reserve volatility, creating favorable or adverse loss development over a longer period of time. Our actuaries perform a comprehensive review of loss reserves for each major product at least once each year. The reviews take into consideration the variety of trends that impact the ultimate settlement of claims for each product type. These reviews follow a pre-set schedule, which covers the product lines in each segment, as follows: 1) second quarter - Exited Lines, 2) third quarter - U.S. Property & Casualty and Professional Liability and 3) fourth quarter - Accident & Health, U.S. Surety & Credit, and International. In addition to these comprehensive reviews, each quarter the actuaries review the emergence of paid and reported losses relative to expectations (established during the annual reviews) for all product lines and, if considered necessary, perform a more detailed review of the particular reserves. Our actuaries' loss review process relies on the basic assumption that past experience, adjusted for the effects of current developments and likely trends, is a reasonable basis for predicting future outcomes. As part of their process, our actuaries use a variety of actuarial methods that analyze experience, trends and other relevant factors. The principal standard actuarial methods used by our actuaries for their comprehensive reviews include:
• Loss ratio method - This method uses loss ratios for prior accident years,
adjusted for current trends, to determine an appropriate expected loss ratio for a given accident year.
• Loss development methods - Loss development methods assume that the losses
yet to emerge for an accident year are proportional to the paid or
reported loss amounts observed to-date. The paid loss development method
uses losses paid to-date, while the reported loss development method uses
losses reported to-date. • Bornheutter-Ferguson method - This method is a combination of the loss
ratio and loss development methods, where the loss development factor is
given more weight as an accident year matures.
• Frequency/severity method - This method projects claim counts and average
cost per claim on a paid or reported basis for high frequency, low
severity products.
Our actuaries calculate an actuarial point estimate, as well as a high and low end of the actuarial range, for the products that they review. The actuarial point estimates represent our actuaries' estimate of the most likely amount that will ultimately be paid to settle the net reserves we have recorded at a particular point in time. While standard actuarial techniques are utilized in making these actuarial point estimates, these techniques require a high degree of judgment, and changing conditions can cause fluctuations in the reserve estimates. While, from an actuarial standpoint, a point estimate is considered the most likely amount to be paid, there is inherent uncertainty in the point estimate, and it can be thought of as the expected value in a distribution of possible reserve estimates. The actuarial ranges represent our actuaries' estimate of a likely lowest amount and highest amount that will ultimately be paid to settle the net reserves. There is still a possibility of ultimately paying an amount below the range or above the range. The range determinations are based on estimates and actuarial judgments and are intended to encompass reasonably likely changes in one or more of the variables that were used to determine the point estimates. 39
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Management evaluates the adequacy of our recorded consolidated reserves at each reporting period and approves increases or decreases in reserves, as considered necessary, based on a consideration of all material facts and circumstances known at that time. The Reserve Review Committee (which includes our CEO, President, CFO, executive management, chief actuary, segment management, and key actuarial, claims and accounting personnel) meets each quarter to review our actuaries' comprehensive review of loss reserves and assessment of the emergence of paid and reported losses relative to expectations. The Reserve Review Committee discusses factors impacting the reserves in that quarter, for each insurance segment, including the most recent actuarial point and range estimates to monitor the adequacy and reasonableness of the recorded reserves. If the recorded reserves vary significantly from the actuarial point estimate, management discusses the reasons for the variances. Based on the discussions during this meeting, and any additional subsequent meetings, the Reserve Review Committee determines whether any recorded reserves should be increased or decreased during the quarter to an amount that, in management's judgment, is adequate based on all of the facts and circumstances considered, including the actuarial point estimates. Historically, our consolidated net reserves at each quarter-end have been above the total actuarial point estimate and within the actuarial range. Any increase or decrease in prior years' reserves approved by the Reserve Review Committee generates favorable or adverse loss development related to our ultimate losses, which is reflected in our incurred but not reported (IBNR) reserves in the period of the reserve change. In addition, we may have loss development due to the normal claims settlement process. For our most recent accident years, recorded loss reserves are generally based on management's establishment of ultimate loss ratios for each product line, based on historical loss trends and current market considerations. We do not recognize favorable or adverse development for these recent accident years until loss trends emerge. The time required for credible loss trends to emerge differs based on the characteristics of the product, and with long-tail products this can take several years. Our recorded reserves align closer to the actuarial indications as we place additional weight on the credibility of assumptions relating to actual experience and claims outstanding, resulting in favorable or adverse development.
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