UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

þ		Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

		for the Quarterly Period Ended September 30, 2010.

o		Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

		from                      to

Commission file number 001-13790

HCC Insurance Holdings, Inc.

 

(Exact name of registrant as specified in its charter)

Delaware		76-0336636
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)
13403 Northwest Freeway, Houston, Texas		77040-6094
(Address of principal executive offices)		(Zip Code)

(713) 690-7300

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer þ		Accelerated filer o		Non-accelerated filer o		Smaller reporting company o
				(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

Indicate the number of shares outstanding of each of the registrant’s classes of common stock as of the latest practicable date.

On October 31, 2010, there were approximately 115.3 million shares of common stock outstanding.

 

 

HCC INSURANCE HOLDINGS, INC.

TABLE OF CONTENTS

		Page
Part I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets — September 30, 2010 and December 31, 2009 (unaudited)			5
Condensed Consolidated Statements of Earnings — Nine months and three months ended September 30, 2010 and 2009 (unaudited)			6
Condensed Consolidated Statement of Changes in Shareholders’ Equity — Nine months ended September 30, 2010 (unaudited)			7
Condensed Consolidated Statements of Cash Flows — Nine months ended September 30, 2010 and 2009 (unaudited)			8
Notes to Condensed Consolidated Financial Statements (unaudited)			9
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			27
Item 3. Quantitative and Qualitative Disclosures About Market Risk			48
Item 4. Controls and Procedures			48
Part II. OTHER INFORMATION
Item 1. Legal Proceedings			49
Item 1A. Risk Factors			49
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			49
Item 6. Exhibits			50
Signatures			51
EX-12
EX-31.1
EX-31.2
EX-32.1
EX-101 INSTANCE DOCUMENT
EX-101 SCHEMA DOCUMENT
EX-101 CALCULATION LINKBASE DOCUMENT
EX-101 LABELS LINKBASE DOCUMENT
EX-101 PRESENTATION LINKBASE DOCUMENT
EX-101 DEFINITION LINKBASE DOCUMENT

FORWARD-LOOKING STATEMENTS

This Report on Form 10-Q contains certain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are intended to be covered by the safe harbors created by those laws. We have based these forward-looking statements on our current expectations and projections about future events. These forward-looking statements include information about possible or assumed future results of our operations. All statements, other than statements of historical facts, included or incorporated by reference in this Report that address activities, events or developments that we expect or anticipate may occur in the future, including such things as growth of our business and operations, business strategy, competitive strengths, goals, plans, future capital expenditures and references to future successes may be considered forward-looking statements. Also, when we use words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “plan,” “probably” or similar expressions, we are making forward-looking statements.

Many risks and uncertainties may have an impact on the matters addressed in these forward-looking statements, which could affect our future financial results and performance, including, among other things:

	•		the effects of catastrophic losses,
	•		the cyclical nature of the insurance business,
	•		inherent uncertainties in the loss estimation process, which can adversely impact the adequacy of loss reserves,
	•		the impact of the credit market downturn and subprime market exposures,
	•		the effects of emerging claim and coverage issues,
	•		the effects of extensive governmental regulation of the insurance industry,
	•		potential credit risk with brokers,
	•		the effects of industry consolidations,
	•		our assessment of underwriting risk,
	•		our retention of risk, which could expose us to potential losses,
	•		the adequacy of reinsurance protection,
	•		the ability and willingness of reinsurers to pay balances due us,
	•		the occurrence of terrorist activities,
	•		our ability to maintain our competitive position,
	•		changes in our assigned financial strength ratings,
	•		our ability to raise capital and funds for liquidity in the future,
	•		attraction and retention of qualified employees,
	•		fluctuations in securities markets, which may reduce the value of our investment assets, reduce investment income or generate realized investment losses,
	•		our ability to successfully expand our business through the acquisition of insurance-related companies,
	•		impairment of goodwill,

	•		the ability of our insurance company subsidiaries to pay dividends in needed amounts,
	•		fluctuations in foreign exchange rates,
	•		failures or constraints of our information technology systems,
	•		changes to the country’s health care delivery system,
	•		the effects , if any, of climate change, on the risks we insure,
	•		change of control, and
	•		difficulties with outsourcing relationships.

We describe these risks and uncertainties in greater detail in Item 1A, Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2009.

These events or factors could cause our results or performance to differ materially from those we express in our forward-looking statements. Although we believe that the assumptions underlying our forward-looking statements are reasonable, any of these assumptions, and, therefore, also the forward-looking statements based on these assumptions, could themselves prove to be inaccurate. In light of the significant uncertainties inherent in the forward-looking statements that are included in this Report, our inclusion of this information is not a representation by us or any other person that our objectives or plans will be achieved.

Our forward-looking statements speak only at the date made, and we will not update these forward-looking statements unless the securities laws require us to do so. In light of these risks, uncertainties and assumptions, any forward-looking events discussed in this Report may not occur.

HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets
(unaudited, in thousands except per share data)

		September 30,				December 31,
		2010				2009
ASSETS
Investments
Fixed income securities — available for sale, at fair value (amortized cost: 2010 — $4,865,445; 2009 — $4,381,762)		$	5,166,709			$	4,538,073
Fixed income securities — held to maturity, at amortized cost (fair value: 2010 — $198,317; 2009 — $104,008)			193,841				102,792
Short-term investments, at cost, which approximates fair value			474,066				810,673
Other investments			433				4,691
Total investments			5,835,049				5,456,229
Cash			98,213				129,460
Restricted cash and cash investments			157,677				146,133
Premium, claims and other receivables			658,670				600,332
Reinsurance recoverables			1,042,650				1,016,411
Ceded unearned premium			283,529				270,436
Ceded life and annuity benefits			58,985				61,313
Deferred policy acquisition costs			219,062				208,463
Goodwill			821,700				822,006
Other assets			118,360				123,608
Total assets		$	9,293,895			$	8,834,391
LIABILITIES
Loss and loss adjustment expense payable		$	3,555,505			$	3,492,309
Life and annuity policy benefits			58,985				61,313
Reinsurance balances payable			202,202				182,661
Unearned premium			1,069,594				1,044,747
Deferred ceding commissions			72,714				71,595
Premium and claims payable			142,445				154,596
Notes payable			298,598				298,483
Accounts payable and accrued liabilities			556,750				497,504
Total liabilities			5,956,793				5,803,208
SHAREHOLDERS’ EQUITY
Common stock, $1.00 par value; 250,000 shares authorized (shares issued: 2010 — 120,398 and 2009 — 118,724; outstanding: 2010 — 115,268 and 2009 — 114,051)			120,398				118,724
Additional paid-in capital			940,745				914,339
Retained earnings			2,177,266				1,977,254
Accumulated other comprehensive income			208,936				119,665
Treasury stock, at cost (shares: 2010 — 5,130 and 2009 — 4,673)			(110,243	)			(98,799	)
Total shareholders’ equity			3,337,102				3,031,183
Total liabilities and shareholders’ equity		$	9,293,895			$	8,834,391

See Notes to Condensed Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Statements of Earnings
(unaudited, in thousands except per share data)

		Nine months ended September 30,								Three months ended September 30,
		2010				2009				2010				2009
REVENUE
Net earned premium		$	1,532,138			$	1,524,425			$	516,166			$	520,059
Net investment income			150,603				141,740				51,137				48,111
Other operating income			35,035				69,765				7,888				12,166
Net realized investment gain			7,897				4,852				1,057				864
Other-than-temporary impairment loss
Total loss			(316	)			(6,089	)			(316	)			(380	)
Portion recognized in other comprehensive income			16				810				16				55
Net loss recognized in earnings			(300	)			(5,279	)			(300	)			(325	)
Total revenue			1,725,373				1,735,503				575,948				580,875
EXPENSE
Loss and loss adjustment expense, net			922,645				911,944				297,138				303,808
Policy acquisition costs, net			242,078				223,186				80,748				71,492
Other operating expense			189,953				195,509				60,770				64,985
Interest expense			15,907				11,816				5,280				3,549
Total expense			1,370,583				1,342,455				443,936				443,834
Earnings before income tax expense			354,790				393,048				132,012				137,041
Income tax expense			106,993				123,972				38,949				42,720
Net earnings		$	247,797			$	269,076			$	93,063			$	94,321
Earnings per common share
Basic		$	2.15			$	2.39			$	0.81			$	0.84
Diluted		$	2.15			$	2.37			$	0.81			$	0.83

See Notes to Condensed Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Statement of Changes in Shareholders’ Equity
(unaudited, in thousands except per share data)

														Accumulated
						Additional								other								Total
		Common				paid-in				Retained				comprehensive				Treasury				shareholders’
		stock				capital				earnings				income				stock				equity
Balance at December 31, 2009		$	118,724			$	914,339			$	1,977,254			$	119,665			$	(98,799	)		$	3,031,183
Comprehensive income
Net earnings			—				—				247,797				—				—				247,797
Other comprehensive income
Change in net unrealized gain on investments, net of tax			—				—				—				92,707				—				92,707
Other, net of tax			—				—				—				(3,436	)			—				(3,436	)
Total other comprehensive income																							89,271
Comprehensive income																							337,068
Issuance of 948 shares for exercise of options, including tax effect			948				17,691				—				—				—				18,639
Purchase of 457 common shares			—				—				—				—				(11,444	)			(11,444	)
Stock-based compensation			726				8,715				—				—				—				9,441
Cash dividends declared, $0.415 per share			—				—				(47,785	)			—				—				(47,785	)
Balance at September 30, 2010		$	120,398			$	940,745			$	2,177,266			$	208,936			$	(110,243	)		$	3,337,102

See Notes to Condensed Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows
(unaudited, in thousands)

		Nine months ended September 30,
		2010				2009
Operating activities
Net earnings		$	247,797			$	269,076
Adjustments to reconcile net earnings to net cash provided by operating activities:
Change in premium, claims and other receivables			(36,040	)			36,443
Change in reinsurance recoverables			(32,474	)			14,853
Change in ceded unearned premium			(15,368	)			(25,093	)
Change in loss and loss adjustment expense payable			76,829				51,519
Change in reinsurance balances payable			21,435				24,548
Change in unearned premium			30,471				39,441
Change in premium and claims payable, net of restricted cash			(9,934	)			(63,727	)
Change in accounts payable and accrued liabilities			12,593				22,132
Stock-based compensation expense			9,441				12,472
Depreciation and amortization expense			12,894				11,796
Gain on investments			(8,086	)			(3,152	)
Other, net			5,073				27,238
Cash provided by operating activities			314,631				417,546
Investing activities
Sales of available for sale fixed income securities			132,897				337,615
Maturity or call of available for sale fixed income securities			458,495				260,839
Maturity or call of held to maturity fixed income securities			25,187				86,190
Cost of available for sale fixed income securities acquired			(1,048,010	)			(1,020,506	)
Cost of held to maturity fixed income securities acquired			(115,215	)			(59,677	)
Change in short-term investments			328,951				(91,617	)
Proceeds from sales of strategic and other investments			4,577				114,940
Payments for purchase of businesses, net of cash received			(36,348	)			(37,995	)
Proceeds from sale of subsidiaries			15,278				6,188
Other, net			(6,755	)			(13,109	)
Cash used by investing activities			(240,943	)			(417,132	)
Financing activities
Advances on line of credit			—				115,000
Payments on line of credit			—				(15,032	)
Payments on convertible notes			(64,472	)			—
Sale of common stock			18,639				9,423
Purchase of common stock			(11,444	)			(35,464	)
Dividends paid			(46,532	)			(42,244	)
Other, net			(1,126	)			(2,570	)
Cash provided (used) by financing activities			(104,935	)			29,113
Net increase (decrease) in cash			(31,247	)			29,527
Cash at beginning of year			129,460				27,347
Cash at end of period		$	98,213			$	56,874

See Notes to Condensed Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements
(unaudited, tables in thousands except per share data)

(1) General Information

HCC Insurance Holdings, Inc. and its subsidiaries (collectively HCC, we, us or our) include domestic and foreign property and casualty and life insurance companies and underwriting agencies. We operate primarily in the United States, the United Kingdom, Spain and Ireland, although some of our operations have a broader international scope. We market our products both directly to customers and through a network of independent brokers, producers, agents and third party administrators. We provide specialized property and casualty, surety and credit, and accident and health insurance coverages and related agency services to commercial customers and individuals.

Basis of Presentation

Our unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (GAAP) and include the accounts of HCC Insurance Holdings, Inc. and its subsidiaries. We have made all adjustments that, in our opinion, are necessary for a fair statement of results of the interim periods, and all such adjustments are of a normal recurring nature. All significant intercompany balances and transactions have been eliminated in consolidation. The condensed consolidated financial statements should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2009. The condensed consolidated balance sheet at December 31, 2009 was derived from the audited financial statements, but does not include all disclosures required by GAAP.

Management must make estimates and assumptions that affect amounts reported in our condensed consolidated financial statements and in disclosures of contingent assets and liabilities. Ultimate results could differ from those estimates. We have reclassified certain amounts in our 2009 condensed consolidated financial statements to conform to the 2010 presentation, including the reclassification related to fee and commission income discussed below. None of our reclassifications had an effect on our consolidated net earnings, shareholders’ equity or cash flows.

HCC completed the reorganization of its management structure in the third quarter of 2010. Our segment reporting structure has been realigned to reflect these changes. See Note 2, “Segments” for a discussion of our new segment structure.

In connection with our resegmentation, we changed the presentation of our consolidated income statement to better represent our current operations. Previously, we presented reinsurance ceding commissions that exceeded policy acquisition costs as a component of fee and commission income, within total revenue. We now present all ceding commissions as an offset to policy acquisition costs, within total expense, and classify the remaining fee and commission income as a component of other operating income, within total revenue.

Accounting Guidance in 2010

A new accounting standard, originally issued as SFAS No. 167, Amendments to FASB Interpretation No. 46(R), became effective January 1, 2010. The guidance, which was incorporated into Accounting Standards Codification (ASC) Topic 810, Consolidation, changes various aspects of accounting for and disclosures of interests in variable interest entities. Our adoption of this guidance as of January 1, 2010 had no material impact on our condensed consolidated financial statements.

Effective January 1, 2010, we adopted Accounting Standards Update (ASU) No. 2010-06, which incorporated changes in disclosure requirements into ASC Topic 820, Fair Value Measurements and Disclosures. Where applicable, we have included the additional required disclosures in the notes to our condensed consolidated financial statements.

A new accounting standard, ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, was issued in July 2010. The new guidance expands disclosures related to financing receivables, including the nature of credit risk in financing receivables, how that risk is analyzed in determining the related allowance for credit losses, and changes to the allowance during the reporting period. We will provide the additional required disclosures in our Form 10-K for the year ended December 31, 2010.

A new accounting standard, originally issued as EITF 09-G, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts, was ratified in September 2010. The guidance, which will be incorporated into ASC Topic 944, Financial Services — Insurance, clarifies the definition of what constitutes an acquisition cost and limits the types of acquisition costs that

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, tables in thousands except per share data)

can be capitalized by insurance entities to those that are “directly related to” the acquisition of new and renewal insurance contracts. Under the new guidance, direct costs only include those that result in the successful acquisition of a policy. All costs incurred for unsuccessful efforts, along with indirect costs, are to be expensed as incurred. This guidance must be adopted by January 1, 2012, either prospectively or retrospectively, and may be adopted earlier at the beginning of an annual period. We are currently evaluating the timing and effect of our adoption of this guidance.

Derivative Financial Instruments

At December 31, 2009, we had interests in two long-term mortgage impairment insurance contracts that were denominated in British pound sterling. The exposure with respect to these two contracts was measured based on movement in a specified United Kingdom housing index. In the first quarter of 2010, we commuted our interest in one contract for $8.3 million cash. We recognized a gain of $8.0 million, which is included in other operating income in our condensed consolidated statements of earnings. The remaining contract qualifies as a derivative financial instrument, is unhedged and is reported at fair value in other assets in our condensed consolidated balance sheets. We record changes in fair value and any foreign exchange gain/loss on this contract as a component of other operating income.

Stock-based Compensation

In the first nine months of 2010, we granted the following shares of common stock, restricted stock, restricted stock units and stock options for the purchase of shares of our common stock. For all grants except stock options, we measure fair value based on our closing stock price on the grant date. For stock options, we use the Black-Scholes single option pricing model to determine the fair value of an option on its grant date. The fair value of the common stock was expensed on the grant date. The fair value of the restricted stock, restricted stock units and stock options will be expensed over the vesting period.

						Weighted-average
		Number				grant date				Aggregate				Vesting
		of shares				fair value				fair value				period
Common stock			33			$	25.33			$	840
Restricted stock			760				27.54				20,941			3-10 years
Restricted stock units			60				25.96				1,555			3-10 years
Stock options			395				6.07				2,398			5 years

Income Taxes

For the nine months ended September 30, 2010 and 2009, the income tax provision was calculated based on an estimated effective tax rate for each year. Our effective tax rate differs from the U.S. Federal statutory rate primarily due to the effect of tax-exempt municipal bond interest.

Disposition

In 2010, we sold an inactive subsidiary, HCC Insurance Company, for $14.7 million cash and realized a $0.5 million gain.

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, tables in thousands except per share data)

(2) Segments

In the third quarter of 2010, our chief executive officer, in the role of chief operating decision maker (CODM), completed the reorganization of HCC’s management structure in order to manage and evaluate the company’s operations from an insurance underwriting perspective, in line with our portfolio of insurance products. We have changed HCC’s segment reporting structure to reflect these changes. Previously, we reported our results in the Insurance Company, Agency, and Other Operations segments. We now report HCC’s results in the following six operating segments, each of which reports to an executive of HCC who is responsible for the segment results.

	•		U.S. Property & Casualty
	•		Professional Liability
	•		Accident & Health
	•		U.S. Surety & Credit
	•		International
	•		Investing

Insurance Underwriting Segments

Each of the five insurance-related 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. Fee and commission income earned by our agencies from third party insurance companies is included in segment revenue. Each segment also incurs insurance losses, acquisition costs and other administrative expenses related to our insurance companies and underwriting agencies. The CODM monitors and assesses each segment’s pretax results based on underwriting profit, gross and net written premium, and its combined ratio, consisting of the loss ratio and expense ratio.

Included in the portfolio of products for each insurance segment are the following key products:

	•		U.S. Property & Casualty — aviation, small account errors and omissions liability, public risk, employment practices liability, title, residual value, disability, contingency, kidnap and ransom and brown water marine written in the United States.
	•		Professional Liability — directors’ and officers’ liability, large account errors and omissions liability, diversified financial products and fidelity written in the United States and internationally.
	•		Accident & Health — medical stop-loss, short-term domestic and international medical, HMO reinsurance and medical excess written in the United States.
	•		U.S. Surety & Credit — contract, commercial, court and bail bonds written in the United States and credit insurance managed in the United States.
	•		International — energy, property treaty, liability, surety, credit, property, ocean marine, accident and health and other smaller product lines written outside the United States.

Investing Segment

The Investing segment includes our total investment portfolio, as well as all investment income, investment related expenses and realized investment gains and losses. All investment activity is reported as revenue, consistent with our consolidated presentation. While the insurance underwriting segments generate the cash flow underlying these investments, our CODM does not include investment income in his assessment of the underwriting results of the insurance underwriting segments. Rather, investments and investment results are managed and evaluated centrally.

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, tables in thousands except per share data)

Corporate & Other

The Corporate & Other category is used to reconcile segment results to consolidated totals and includes corporate operating expenses not allocable to the segments, interest expense on long-term debt, and underwriting results of our Exited Lines. Our Exited Lines include six product lines that we no longer write and do not expect to write in the future. The Exited Lines include: 1) accident and health business managed by our underwriting agency, LDG Reinsurance, 2) workers’ compensation, 3) provider excess, 4) Spanish medical malpractice, 5) U.K. motor and 6) film completion bonds. We have included premium, losses and expenses related to our Exited Lines in the Corporate & Other category for all periods presented.

All stock-based compensation is included in Corporate & Other because it is not included in the CODM’s evaluation of the five insurance underwriting segments. All contractual and discretionary bonuses are expensed in the respective employee’s segment in the year the bonuses are earned. Any such bonuses that will be paid by restricted stock awards, which will be granted by the Compensation Committee in the following year, are reversed within corporate operating expenses. The appropriate stock-based compensation expense will be recorded in Corporate & Other as the awards vest in future years. The majority of our depreciation and amortization expense is included in Corporate & Other.

All prior period information included in this Form 10-Q has been adjusted to present our segment disclosures and information on a consistent basis with our new segment reporting structure.

The following tables present information by business segment.

		U.S. Property				Professional				Accident				U.S. Surety												Corporate
		& Casualty				Liability				& Health				& Credit				International				Investing				& Other				Consolidated
Nine months ended September 30, 2010
Net earned premium		$	258,427			$	321,849			$	567,739			$	148,427			$	234,471			$	—			$	1,225			$	1,532,138
Other revenue			24,128				458				2,830				455				6,177				158,200				987				193,235
Segment revenue			282,555				322,307				570,569				148,882				240,648				158,200				2,212				1,725,373
Loss and LAE, net			164,684				196,154				412,438				38,157				107,601				—				3,611				922,645
Other expense			75,890				57,171				89,967				81,699				88,441				—				54,770				447,938
Segment expense			240,574				253,325				502,405				119,856				196,042				—				58,381				1,370,583
Segment pretax earnings		$	41,981			$	68,982			$	68,164			$	29,026			$	44,606			$	158,200			$	(56,169	)		$	354,790
Nine months ended September 30, 2009
Net earned premium		$	289,195			$	330,614			$	553,967			$	135,436			$	189,148			$	—			$	26,065			$	1,524,425
Other revenue			46,815				(134	)			3,964				182				18,803				141,313				135				211,078
Segment revenue			336,010				330,480				557,931				135,618				207,951				141,313				26,200				1,735,503
Loss and LAE, net			164,346				202,741				406,722				39,849				68,931				—				29,355				911,944
Other expense			85,813				38,988				88,802				72,527				83,941				—				60,440				430,511
Segment expense			250,159				241,729				495,524				112,376				152,872				—				89,795				1,342,455
Segment pretax earnings		$	85,851			$	88,751			$	62,407			$	23,242			$	55,079			$	141,313			$	(63,595	)		$	393,048

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, tables in thousands except per share data)

		U.S. Property				Professional				Accident				U.S. Surety												Corporate
		& Casualty				Liability				& Health				& Credit				International				Investing				& Other				Consolidated
Three months ended September 30, 2010
Net earned premium		$	84,802			$	103,696			$	193,252			$	49,807			$	84,539			$	—			$	70			$	516,166
Other revenue			5,033				20				1,113				127				1,466				51,894				129				59,782
Segment revenue			89,835				103,716				194,365				49,934				86,005				51,894				199				575,948
Loss and LAE, net			61,883				63,212				138,869				10,296				23,227				—				(349	)			297,138
Other expense			21,289				18,866				30,908				28,007				29,365				—				18,363				146,798
Segment expense			83,172				82,078				169,777				38,303				52,592				—				18,014				443,936
Segment pretax earnings		$	6,663			$	21,638			$	24,588			$	11,631			$	33,413			$	51,894			$	(17,815	)		$	132,012
Three months ended September 30, 2009
Net earned premium		$	94,453			$	121,387			$	185,937			$	45,709			$	65,421			$	—			$	7,152			$	520,059
Other revenue			6,979				(151	)			1,045				70				5,853				48,650				(1,630	)			60,816
Segment revenue			101,432				121,236				186,982				45,779				71,274				48,650				5,522				580,875
Loss and LAE, net			52,957				73,752				135,708				12,098				23,165				—				6,128				303,808
Other expense			27,601				9,250				29,899				25,332				28,478				—				19,466				140,026
Segment expense			80,558				83,002				165,607				37,430				51,643				—				25,594				443,834
Segment pretax earnings		$	20,874			$	38,234			$	21,375			$	8,349			$	19,631			$	48,650			$	(20,072	)		$	137,041

The following table presents total assets by segment. Assets in the insurance underwriting segments include goodwill that was allocated in conjunction with our resegmentation. See Note 3, “Goodwill” below for further discussion of the goodwill allocation. Goodwill was allocated to the December 31, 2009 balances based on the goodwill balances in each reportable segment as of September 30, 2010.

		September 30,				December 31,
		2010				2009
U.S. Property & Casualty		$	988,326			$	971,521
Professional Liability			979,606				954,613
Accident & Health			250,042				254,652
U.S. Surety & Credit			182,879				200,243
International			647,734				585,385
Investing			5,899,685				5,510,715
Corporate & Other			345,623				357,262
Total		$	9,293,895			$	8,834,391

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, tables in thousands except per share data)

For purposes of the disclosures in the tables below, we determine geographic location by the country of domicile of our subsidiaries that write the business and not by the location of insureds or reinsureds from whom the business was generated. The tables below present the split of our revenue, pretax earnings and total assets by geographic location.

		Nine months ended September 30,								Three months ended September 30,
		2010				2009				2010				2009
Domestic		$	1,361,153			$	1,402,396			$	448,535			$	464,422
Foreign			364,220				333,107				127,413				116,453
Total revenue		$	1,725,373			$	1,735,503			$	575,948			$	580,875
Domestic		$	262,311			$	295,816			$	78,767			$	98,672
Foreign			92,479				97,232				53,245				38,369
Total pretax earnings		$	354,790			$	393,048			$	132,012			$	137,041

		September 30,				December 31,
		2010				2009
Domestic		$	7,034,297			$	6,768,475
Foreign			2,259,598				2,065,916
Total assets		$	9,293,895			$	8,834,391

(3) Goodwill

We conducted our annual goodwill impairment test as of June 30, 2010, based on our prior reporting units, and noted no indicators of impairment. An indicator of impairment of goodwill exists when the fair value of a reporting unit is less than its carrying amount. We will conduct our next annual goodwill impairment test as of June 30, 2011, unless other events occur that indicate there is an impairment in our goodwill prior to that date.

In connection with the changes to our segment reporting structure, we allocated our consolidated goodwill to new reporting units and tested goodwill for impairment as of September 30, 2010. Based on this impairment test, the fair value of each new reporting unit exceeded its carrying amount.

We now have five reporting units, which are the same as our new insurance underwriting segments. To determine the fair value of each reporting unit, we utilized the income and market valuation approaches and based our assumptions and inputs on market participant data, as well as our own data. For the income approach, we estimated the present value of each reporting unit’s expected cash flows to determine its fair value. We utilized estimated future cash flows of the portfolio of products included in each reporting unit, as well as a risk-appropriate rate of return specific to each reporting unit. We utilized our budgets and projection of future operations based on historical and expected industry trends to estimate our future cash flows and their probability of occurring as projected. We also determined fair value of each reporting unit based on market participant data, and used those results to test the reasonableness and validity of the income approach results.

For goodwill impairment testing purposes only, we allocated the investments and investment income from the Investing segment to the five reporting units. We assigned investments to each reporting unit based on the amount of capital required by the reporting unit to maintain an A+ rating under A.M. Best’s capital allocation model. We assumed the same investment income rate of return for all investments.

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, tables in thousands except per share data)

We allocated goodwill to the reporting units based on the relative fair value of each reporting unit to the sum of the reporting units’ total fair value at September 30, 2010. In future periods, when we complete a business acquisition, we will assign goodwill to the applicable reporting units, based on the reporting unit’s share of the estimated future cash flows of all acquired insurance products.

There were no significant changes in goodwill related to our prior reportable segments during 2010. The balances by reportable segment after our resegmentation are presented below.

		September 30,
		2010
U.S. Property & Casualty		$	223,000
Professional Liability			250,000
Accident & Health			144,000
U.S. Surety & Credit			79,700
International			125,000
Total		$	821,700

(4) Fair Value Measurements

We value financial assets and financial liabilities at fair value. In determining fair value, we generally apply the market approach, which uses prices and other relevant data based on market transactions involving identical or comparable assets and liabilities. We classify our financial instruments into the following three-level hierarchy:

	•		Level 1 — Inputs are based on quoted prices in active markets for identical instruments.
	•		Level 2 — Inputs are based on observable market data (other than quoted prices), or are derived from or corroborated by observable market data.
	•		Level 3 — Inputs are unobservable and not corroborated by market data.

Our Level 1 investments are primarily U.S. Treasuries listed on exchanges. We use quoted prices for identical instruments to measure fair value.

Our Level 2 investments include most of our fixed income securities, which consist of U.S. government agency securities, municipal bonds, certain corporate debt securities, and certain mortgage-backed and asset-backed securities. Our Level 2 instruments also include our interest rate swap agreements, which are reflected as liabilities in our condensed consolidated balance sheets. We measure fair value for the majority of our Level 2 investments using quoted prices of securities with similar characteristics. The remaining investments are valued using pricing models or matrix pricing. The fair value measurements consider observable assumptions, including benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, default rates, loss severity and other economic measures.

We use independent pricing services to assist us in determining fair value for over 99% of our Level 1 and Level 2 investments. The pricing services provide a single price or quote per security. We use data provided by our third party investment manager to value the remaining Level 2 investments. To validate that these quoted and modeled prices are reasonable estimates of fair value, we perform various quantitative and qualitative procedures, including: 1) evaluation of the underlying methodologies, 2) analysis of recent sales activity, 3) analytical review of our fair values against current market prices, and 4) comparison of the pricing services’ fair value to other pricing services’ fair value for the same investment. Based on these procedures, we did not adjust the prices or quotes provided by our independent pricing services or third party investment managers as of September 30, 2010 or December 31, 2009. In addition, we did not apply GAAP criteria for determining the fair value of securities in inactive markets since no markets for our investments were judged to be inactive as of September 30, 2010 or December 31, 2009.

Our Level 3 securities include certain fixed income securities, and an insurance contract that we account for as a derivative classified in other assets. We determine fair value based on internally developed models that use assumptions or other data that are not readily observable from objective sources. Because we use the lowest level significant input to determine our hierarchy classifications, a financial instrument may be classified in Level 3 even though there may be significant readily-observable inputs.

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, tables in thousands except per share data)

In the first quarter of 2010, we commuted our interest in a second insurance contract that was accounted for as a derivative and also classified in other assets in Level 3 at December 31, 2009.

The following tables present our assets and interest rate swap liabilities that were measured at fair value.

		Level 1				Level 2				Level 3				Total
September 30, 2010
Fixed income securities — available for sale
U.S. government and government agency securities		$	152,578			$	183,041			$	—			$	335,619
Fixed income securities of states, municipalities and political subdivisions			—				1,132,448				—				1,132,448
Special purpose revenue bonds of states, municipalities and political subdivisions			—				1,575,914				—				1,575,914
Corporate fixed income securities			—				591,335				156				591,491
Residential mortgage-backed securities			—				1,099,360				—				1,099,360
Commercial mortgage-backed securities			—				157,730				—				157,730
Asset-backed securities			—				4,302				1,267				5,569
Foreign government securities			—				268,578				—				268,578
Total fixed income securities — available for sale			152,578				5,012,708				1,423				5,166,709
Other investments			12				—				—				12
Other assets			—				—				686				686
Total assets measured at fair value		$	152,590			$	5,012,708			$	2,109			$	5,167,407
Accounts payable and accrued liabilities		$	—			$	(471	)		$	—			$	(471	)
Total liabilities measured at fair value		$	—			$	(471	)		$	—			$	(471	)

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, tables in thousands except per share data)

		Level 1				Level 2				Level 3				Total
December 31, 2009
Fixed income securities — available for sale
U.S. government and government agency securities		$	178,927			$	134,620			$	—			$	313,547
Fixed income securities of states, municipalities and political subdivisions			—				1,059,426				—				1,059,426
Special purpose revenue bonds of states, municipalities and political subdivisions			—				1,146,334				—				1,146,334
Corporate fixed income securities			—				686,170				151				686,321
Residential mortgage-backed securities			—				944,182				—				944,182
Commercial mortgage-backed securities			—				143,412				2,805				146,217
Asset-backed securities			—				13,059				1,306				14,365
Foreign government securities			—				227,681				—				227,681
Total fixed income securities — available for sale			178,927				4,354,884				4,262				4,538,073
Other investments			14				—				—				14
Other assets			—				—				432				432
Total assets measured at fair value		$	178,941			$	4,354,884			$	4,694			$	4,538,519
Accounts payable and accrued liabilities		$	—			$	(2,367	)		$	—			$	(2,367	)
Total liabilities measured at fair value		$	—			$	(2,367	)		$	—			$	(2,367	)

We excluded from our fair value disclosures our held to maturity investment portfolio, measured at amortized cost, and our other investments, measured at cost, of which $4.1 million were redeemed in the second quarter of 2010.

The following tables present the changes in fair value of our Level 3 assets.

		2010												2009
		Fixed												Fixed
		income				Other								income				Other
		securities				assets				Total				securities				assets				Total
Fair value at beginning of year		$	4,262			$	432			$	4,694			$	6,515			$	16,100			$	22,615
Net redemptions			(572	)			(8,342	)			(8,914	)			(1,590	)			—				(1,590	)
Gains and (losses) — unrealized			276				254				530				1,018				3,469				4,487
Gains and (losses) — realized			—				8,342				8,342				30				—				30
Transfers into Level 3			—				—				—				6,263				—				6,263
Transfers out of Level 3			(2,543	)			—				(2,543	)			(3,661	)			—				(3,661	)
Fair value at September 30		$	1,423			$	686			$	2,109			$	8,575			$	19,569			$	28,144