e10vq
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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, 2011.
     
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 definitions 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 28, 2011, there were approximately 106.5 million shares of common stock outstanding.
 
 

 


 

HCC Insurance Holdings, Inc. and Subsidiaries
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 EX-101 INSTANCE DOCUMENT
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 EX-101 CALCULATION LINKBASE DOCUMENT
 EX-101 LABELS LINKBASE DOCUMENT
 EX-101 PRESENTATION LINKBASE DOCUMENT
 EX-101 DEFINITION LINKBASE DOCUMENT

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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 catastrophe 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 past and future potential credit market downturns, including the potential future ratings downgrade and/or impairment or perceived impairment of debt securities of sovereign issuers, including the United States of America,
 
    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, including defaults, 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,

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    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, 2010.
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.

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HCC Insurance Holdings, Inc. and Subsidiaries
Consolidated Balance Sheets
(unaudited, in thousands except per share data)
                 
    September 30,     December 31,  
    2011     2010  
ASSETS
               
 
               
Investments
               
Fixed income securities — available for sale, at fair value (amortized cost: 2011 — $5,356,333; 2010 — $4,864,806)
  $ 5,651,189     $ 4,999,440  
Fixed income securities — held to maturity, at amortized cost (fair value: 2011 — $170,556; 2010 — $195,811)
    168,614       193,668  
Short-term investments, at cost, which approximates fair value
    197,986       488,002  
Other investments
    34,297       5,985  
 
           
Total investments
    6,052,086       5,687,095  
 
           
Cash
    93,137       97,857  
Restricted cash
    227,562       148,547  
Premium, claims and other receivables
    677,641       635,867  
Reinsurance recoverables
    1,071,266       1,006,855  
Ceded unearned premium
    231,537       278,663  
Ceded life and annuity benefits
    56,868       58,409  
Deferred policy acquisition costs
    225,190       212,786  
Goodwill
    873,375       821,648  
Other assets
    133,326       116,355  
 
           
Total assets
  $ 9,641,988     $ 9,064,082  
 
           
 
               
LIABILITIES
               
 
               
Loss and loss adjustment expense payable
  $ 3,686,570     $ 3,471,858  
Life and annuity policy benefits
    56,868       58,409  
Reinsurance, premium and claims payable
    321,684       345,730  
Unearned premium
    1,071,340       1,045,877  
Deferred ceding commissions
    66,059       72,565  
Notes payable
    493,752       298,637  
Accounts payable and accrued liabilities
    678,576       474,574  
 
           
Total liabilities
    6,374,849       5,767,650  
 
           
 
               
SHAREHOLDERS’ EQUITY
               
 
               
Common stock, $1.00 par value; 250,000 shares authorized (shares issued: 2011 — 122,661 and 2010 — 120,942; outstanding: 2011 — 106,511 and 2010 — 114,968)
    122,661       120,942  
Additional paid-in capital
    998,585       954,332  
Retained earnings
    2,385,638       2,257,895  
Accumulated other comprehensive income
    202,018       97,186  
Treasury stock, at cost (shares: 2011 — 16,150 and 2010 — 5,974)
    (441,763 )     (133,923 )
 
           
Total shareholders’ equity
    3,267,139       3,296,432  
 
           
Total liabilities and shareholders’ equity
  $ 9,641,988     $ 9,064,082  
 
           
See Notes to Consolidated Financial Statements.

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HCC Insurance Holdings, Inc. and Subsidiaries
Consolidated Statements of Earnings
(unaudited, in thousands except per share data)
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
REVENUE
                               
 
                               
Net earned premium
  $ 1,576,987     $ 1,532,138     $ 544,256     $ 516,166  
Net investment income
    158,782       150,603       54,765       51,137  
Other operating income
    23,625       35,035       8,829       7,888  
Net realized investment gain
    3,169       7,897       2,674       1,057  
Other-than-temporary impairment credit losses
    (3,479 )     (300 )           (300 )
 
                       
Total revenue
    1,759,084       1,725,373       610,524       575,948  
 
                       
 
                               
EXPENSE
                               
 
                               
Loss and loss adjustment expense, net
    1,062,240       922,645       380,372       297,138  
Policy acquisition costs, net
    239,160       242,078       71,299       80,748  
Other operating expense
    198,511       189,953       70,451       60,770  
Interest expense
    16,597       15,907       5,610       5,280  
 
                       
Total expense
    1,516,508       1,370,583       527,732       443,936  
 
                       
 
                               
Earnings before income tax expense
    242,576       354,790       82,792       132,012  
Income tax expense
    65,671       106,993       22,355       38,949  
 
                       
Net earnings
  $ 176,905     $ 247,797     $ 60,437     $ 93,063  
 
                       
 
                               
Earnings per common share
                               
 
                               
Basic
  $ 1.58     $ 2.15     $ 0.56     $ 0.81  
 
                       
 
                               
Diluted
  $ 1.57     $ 2.15     $ 0.56     $ 0.81  
 
                       
See Notes to Consolidated Financial Statements.

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HCC Insurance Holdings, Inc. and Subsidiaries
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, 2010
  $ 120,942     $ 954,332     $ 2,257,895     $ 97,186     $ (133,923 )   $ 3,296,432  
 
                                               
Comprehensive income
                                               
 
                                               
Net earnings
                176,905                   176,905  
 
                                               
Other comprehensive income
                                               
Change in net unrealized gain on investments, net of tax
                      104,776             104,776  
Other, net of tax
                      56             56  
 
                                             
Total other comprehensive income
                                            104,832  
 
                                             
 
                                               
Comprehensive income
                                            281,737  
 
                                               
Issuance of 1,458 shares for exercise of options, including tax effect
    1,458       34,787                         36,245  
 
                                               
Purchase of 10,176 common shares
                            (307,840 )     (307,840 )
 
                                               
Stock-based compensation
    261       9,466                         9,727  
 
                                               
Cash dividends declared, $0.445 per share
                (49,162 )                 (49,162 )
 
                                   
Balance at September 30, 2011
  $ 122,661     $ 998,585     $ 2,385,638     $ 202,018     $ (441,763 )   $ 3,267,139  
 
                                   
See Notes to Consolidated Financial Statements.

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HCC Insurance Holdings, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(unaudited, in thousands)
                 
    Nine months ended September 30,  
    2011     2010  
Operating activities
               
Net earnings
  $ 176,905     $ 247,797  
Adjustments to reconcile net earnings to net cash provided by operating activities:
               
Change in premium, claims and other receivables
    (76,927 )     (36,040 )
Change in reinsurance recoverables
    (56,510 )     (32,474 )
Change in ceded unearned premium
    47,477       (15,368 )
Change in loss and loss adjustment expense payable
    196,046       76,829  
Change in unearned premium
    24,655       30,471  
Change in reinsurance, premium and claims payable, excluding restricted cash
    (34,052 )     11,501  
Change in accounts payable and accrued liabilities
    5,082       12,593  
Stock-based compensation expense
    10,017       9,441  
Depreciation and amortization expense
    13,214       12,894  
(Gain) loss on investments
    310       (8,086 )
Other, net
    (18,258 )     5,073  
 
           
Cash provided by operating activities
    287,959       314,631  
 
           
 
               
Investing activities
               
Sales of available for sale fixed income securities
    494,532       132,897  
Maturity or call of available for sale fixed income securities
    318,558       458,495  
Maturity or call of held to maturity fixed income securities
    24,950       25,187  
Cost of available for sale fixed income securities acquired
    (1,243,124 )     (1,048,010 )
Cost of held to maturity fixed income securities acquired
          (115,215 )
Cost of other investments acquired
    (33,060 )      
Change in short-term investments
    288,909       328,951  
Payments for purchase of businesses, net of cash received
    (1,892 )     (36,348 )
Proceeds from sale of subsidiaries and other investments
    2,793       19,855  
Other, net
    (16,977 )     (6,755 )
 
           
Cash used by investing activities
    (165,311 )     (240,943 )
 
           
 
               
Financing activities
               
Advances on line of credit
    210,000        
Payments on line of credit
    (15,000 )      
Payments on convertible notes
          (64,472 )
Sale of common stock
    36,245       18,639  
Purchase of common stock
    (303,311 )     (11,444 )
Dividends paid
    (49,301 )     (46,532 )
Other, net
    (6,001 )     (1,126 )
 
           
Cash used by financing activities
    (127,368 )     (104,935 )
 
           
 
               
Net decrease in cash
    (4,720 )     (31,247 )
Cash at beginning of year
    97,857       129,460  
 
           
Cash at end of period
  $ 93,137     $ 98,213  
 
           
See Notes to Consolidated Financial Statements.

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HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(unaudited, tables in thousands except per share data)
(1) General Information
HCC Insurance Holdings, Inc. (HCC) and its subsidiaries (collectively we, us or our) include domestic and foreign property and casualty and life insurance companies and underwriting agencies with offices in the United States, the United Kingdom, Spain and Ireland. We underwrite a variety of non-correlated specialty insurance products in more than 180 countries, including property and casualty, accident and health, surety, credit and aviation product lines. We market our products through a network of independent agents and brokers, producers, managing general agents and directly to customers.
Basis of Presentation
Our unaudited 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 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 consolidated financial statements should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2010. The consolidated balance sheet at December 31, 2010 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 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 2010 consolidated financial statements to conform to the 2011 presentation. None of our reclassifications had an effect on our consolidated net earnings, shareholders’ equity or cash flows.
Recently Issued Accounting Guidance
A new accounting standard clarifies the definition of acquisition costs incurred by an insurance company and limits capitalization to such costs directly related to renewing or acquiring new insurance contracts. All costs incurred for unsuccessful marketing or underwriting efforts, along with indirect costs, are to be expensed as incurred. We plan to adopt this guidance on January 1, 2012. The new guidance will have no impact on our cash flows, and we do not expect it to have a significant impact on either our expenses or our pretax earnings. However, our adoption of the new standard will result in a reduction of our deferred policy acquisition costs asset, an adjustment to deferred income taxes, and a corresponding decrease in consolidated shareholders’ equity. We expect to adopt the new standard retrospectively and estimate that the adjustment to our consolidated shareholders’ equity at adoption will be less than $20.0 million.
New accounting guidance provides a consistent definition of fair value and ensures that fair value measurements and required disclosures are similar between GAAP and International Financial Reporting Standards. The new guidance also expands required disclosures for fair value measurements that are estimated using significant unobservable (Level 3) inputs. We will apply the new guidance prospectively beginning January 1, 2012. We do not expect adoption of the new guidance to have a material impact on our consolidated financial position, results of operations or cash flows.
A new accounting standard changes the disclosure of comprehensive income. The new guidance permits entities to present total comprehensive income, net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The current option of reporting other comprehensive income and its components in the statement of changes in shareholders’ equity will be eliminated. This guidance is effective on January 1, 2012 and must be applied retrospectively. The consolidated financial statements included in our 2010 Form 10-K comply with the new guidance; however, our interim consolidated financial statements have been prepared using the disclosure option that is being eliminated. While the format of our interim consolidated financial statements will change beginning in the first quarter of 2012, this change will not impact our consolidated financial position, results of operations or cash flows.

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HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(unaudited, tables in thousands except per share data)
A new accounting standard simplifies how entities test goodwill for impairment. The new standard permits an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. Previous guidance required an entity to test goodwill for impairment, at least on an annual basis, by first comparing the fair value of a reporting unit with its carrying amount, including goodwill. If the fair value of a reporting unit is less than its carrying amount, then the second step of the test must be performed to measure the amount of the impairment loss, if any. Under the new rules, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount. The new rules are effective on January 1, 2012. Since we perform our annual goodwill impairment test as of June 30 each year, we will first have the option of using the qualitative approach at June 30, 2012. We do not expect application of the new guidance to have a material impact on our consolidated financial position, results of operations or cash flows.
(2) Fair Value Measurements
We carry 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 consist of U.S. Treasuries and equity securities traded in an active exchange market. We use unadjusted 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. 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 approximately 99% of our 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. No markets for our investments were judged to be inactive at period end. Based on these procedures, we did not adjust the prices or quotes provided by our independent pricing services or third party investment manager as of September 30, 2011 or December 31, 2010.
Our Level 3 securities include certain fixed income securities and an insurance contract, classified in other assets, that we account for as a derivative. In the first quarter of 2010, we terminated our interest in a similar insurance contract and recognized an $8.0 million gain. We determine fair value of our Level 3 securities based on internally developed models that use assumptions or other data that are not readily observable from objective sources.
We exclude from our fair value disclosures our held to maturity investment portfolio measured at amortized cost.

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HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(unaudited, tables in thousands except per share data)
The following tables present our assets that were measured at fair value at September 30, 2011 and December 31, 2010. No liabilities were measured at fair value at either balance sheet date.
                                 
    Level 1     Level 2     Level 3     Total  
September 30, 2011
                               
Fixed income securities — available for sale
                               
U.S. government and government agency securities
  $ 185,530     $ 107,814     $     $ 293,344  
Fixed income securities of states, municipalities and political subdivisions
          1,079,859             1,079,859  
Special purpose revenue bonds of states, municipalities and political subdivisions
          1,815,959             1,815,959  
Corporate fixed income securities
          813,450       156       813,606  
Residential mortgage-backed securities
          1,111,321             1,111,321  
Commercial mortgage-backed securities
          249,051             249,051  
Asset-backed securities
          33,555       1,062       34,617  
Foreign government securities
          253,432             253,432  
 
                       
Total fixed income securities — available for sale
    185,530       5,464,441       1,218       5,651,189  
Other investments
    34,088                   34,088  
Other assets
                1,373       1,373  
 
                       
Total assets measured at fair value
  $ 219,618     $ 5,464,441     $ 2,591     $ 5,686,650  
 
                       
 
December 31, 2010
                               
Fixed income securities — available for sale
                               
U.S. government and government agency securities
  $ 148,217     $ 176,050     $     $ 324,267  
Fixed income securities of states, municipalities and political subdivisions
          1,082,057             1,082,057  
Special purpose revenue bonds of states, municipalities and political subdivisions
          1,628,059             1,628,059  
Corporate fixed income securities
          570,152       242       570,394  
Residential mortgage-backed securities
          995,108             995,108  
Commercial mortgage-backed securities
          145,228             145,228  
Asset-backed securities
          11,370       1,196       12,566  
Foreign government securities
          241,761             241,761  
 
                       
Total fixed income securities — available for sale
    148,217       4,849,785       1,438       4,999,440  
Other investments
    5,575                   5,575  
Other assets
                857       857  
 
                       
Total assets measured at fair value
  $ 153,792     $ 4,849,785     $ 2,295     $ 5,005,872  
 
                       

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HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(unaudited, tables in thousands except per share data)
The following tables present the changes in fair value of our Level 3 assets.
                                                 
    2011     2010  
    Fixed                     Fixed              
    income     Other             income     Other        
    securities     assets     Total     securities     assets     Total  
Balance at beginning of year
  $ 1,438     $ 857     $ 2,295     $ 4,262     $ 432     $ 4,694  
Settlements
                            (8,342 )     (8,342 )
Sales
    (144 )           (144 )     (100 )           (100 )
Gains and (losses) — unrealized
    (11 )     263       252       62       (141 )     (79 )
Gains and (losses) — realized
    (2 )           (2 )           8,342       8,342  
 
                                   
Balance at March 31
    1,281       1,120       2,401       4,224       291       4,515  
Sales
    (55 )           (55 )     (395 )           (395 )
Gains and (losses) — unrealized
    18       122       140       144       179       323  
 
                                   
Balance at June 30
    1,244       1,242       2,486       3,973       470       4,443  
Sales
    (43 )           (43 )     (77 )           (77 )
Gains and (losses) — unrealized
    17       131       148       70       216       286  
Transfers out of Level 3
                      (2,543 )           (2,543 )
 
                                   
Balance at September 30
  $ 1,218     $ 1,373     $ 2,591     $ 1,423     $ 686     $ 2,109  
 
                                   
Unrealized gains and losses on our Level 3 fixed income securities are reported in other comprehensive income within shareholders’ equity, and unrealized gains and losses on our Level 3 other assets are reported in other operating income. There were no transfers between Level 1, Level 2 or Level 3 in the first nine months of 2011. We transferred investments from Level 3 to Level 2 in 2010 because we were able to determine their fair value using inputs based on observable market data in the period transferred.
(3) Investments
Substantially all of our fixed income securities are investment grade. The cost or amortized cost, gross unrealized gain or loss, and fair value of our fixed income securities were as follows:
                                 
    Available for sale  
    Cost or     Gross     Gross        
    amortized     unrealized     unrealized        
    cost     gain     loss     Fair value  
September 30, 2011
                               
U.S. government and government agency securities
  $ 281,758     $ 11,587     $ (1 )   $ 293,344  
Fixed income securities of states, municipalities and political subdivisions
    1,005,837       74,210       (188 )     1,079,859  
Special purpose revenue bonds of states, municipalities and political subdivisions
    1,717,307       99,279       (627 )     1,815,959  
Corporate fixed income securities
    785,733       34,635       (6,762 )     813,606  
Residential mortgage-backed securities
    1,045,247       69,261       (3,187 )     1,111,321  
Commercial mortgage-backed securities
    245,651       9,180       (5,780 )     249,051  
Asset-backed securities
    34,489       179       (51 )     34,617  
Foreign government securities
    240,311       13,268       (147 )     253,432  
 
                       
Total fixed income securities — available for sale
  $ 5,356,333     $ 311,599     $ (16,743 )   $ 5,651,189  
 
                       

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Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(unaudited, tables in thousands except per share data)
                                 
    Available for sale  
    Cost or     Gross     Gross        
    amortized     unrealized     unrealized        
    cost     gain     loss     Fair value  
December 31, 2010
                               
U.S. government and government agency securities
  $ 315,339     $ 9,097     $ (169 )   $ 324,267  
Fixed income securities of states, municipalities and political subdivisions
    1,050,969       38,825       (7,737 )     1,082,057  
Special purpose revenue bonds of states, municipalities and political subdivisions
    1,614,554       34,764       (21,259 )     1,628,059  
Corporate fixed income securities
    545,883       26,436       (1,925 )     570,394  
Residential mortgage-backed securities
    958,404       40,949       (4,245 )     995,108  
Commercial mortgage-backed securities
    136,746       8,518       (36 )     145,228  
Asset-backed securities
    12,563       78       (75 )     12,566  
Foreign government securities
    230,348       11,537       (124 )     241,761  
 
                       
Total fixed income securities — available for sale
  $ 4,864,806     $ 170,204     $ (35,570 )   $ 4,999,440  
 
                       
                                 
    Held to maturity  
    Cost or     Gross     Gross        
    amortized     unrealized     unrealized        
    cost     gain     loss     Fair value  
September 30, 2011
                               
U.S. government securities
  $ 6,998     $ 112     $     $ 7,110  
Corporate fixed income securities
    113,015       1,552       (569 )     113,998  
Foreign government securities
    48,601       896       (49 )     49,448  
 
                       
Total fixed income securities — held to maturity
  $ 168,614     $ 2,560     $ (618 )   $ 170,556  
 
                       
                                 
December 31, 2010
                               
U.S. government securities
  $ 12,993     $ 264     $     $ 13,257  
Corporate fixed income securities
    113,296       1,205       (277)       114,224  
Foreign government securities
    67,379       995       (44)       68,330  
 
                       
Total fixed income securities — held to maturity
  $ 193,668     $ 2,464     $ (321)     $ 195,811  
 
                       

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Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(unaudited, tables in thousands except per share data)
All fixed income securities were income producing in 2011. The following table displays the gross unrealized losses and fair value of all available for sale fixed income securities that were in a continuous unrealized loss position for the periods indicated.
                                                 
    Less than 12 months     12 months or more     Total  
            Unrealized             Unrealized             Unrealized  
    Fair value     losses     Fair value     losses     Fair value     losses  
September 30, 2011
                                               
U.S. government and government agency securities
  $ 2,250     $ (1 )   $     $     $ 2,250     $ (1 )
Fixed income securities of states, municipalities and political subdivisions
    15,360       (119 )     1,476       (69 )     16,836       (188 )
Special purpose revenue bonds of states, municipalities and political subdivisions
    73,022       (441 )     29,074       (186 )     102,096       (627 )
Corporate fixed income securities
    192,727       (6,322 )     16,964       (440 )     209,691       (6,762 )
Residential mortgage-backed securities
    50,867       (2,180 )     8,031       (1,007 )     58,898       (3,187 )
Commercial mortgage-backed securities
    94,516       (5,780 )                 94,516       (5,780 )
Asset-backed securities
    17,816       (51 )                 17,816       (51 )
Foreign government securities
    6,602       (147 )                 6,602       (147 )
 
                                   
Total
  $ 453,160     $ (15,041 )   $ 55,545     $ (1,702 )   $ 508,705     $ (16,743 )
 
                                   
 
December 31, 2010
                                               
U.S. government and government agency securities
  $ 20,976     $ (169 )   $     $     $ 20,976     $ (169 )
Fixed income securities of states, municipalities and political subdivisions
    228,228       (7,621 )     2,279       (116 )     230,507       (7,737 )
Special purpose revenue bonds of states, municipalities and political subdivisions
    689,190       (21,156 )     6,344       (103 )     695,534       (21,259 )
Corporate fixed income securities
    66,029       (1,925 )                 66,029       (1,925 )
Residential mortgage-backed securities
    123,782       (3,081 )     22,152       (1,164 )     145,934       (4,245 )
Commercial mortgage-backed securities
                3,084       (36 )     3,084       (36 )
Asset-backed securities
    9,174       (75 )                 9,174       (75 )
Foreign government securities
    10,699       (124 )                 10,699       (124 )
 
                                   
Total
  $ 1,148,078     $ (34,151 )   $ 33,859     $ (1,419 )   $ 1,181,937     $ (35,570 )
 
                                   
A security has an impairment loss when its fair value is less than its cost or amortized cost at the balance sheet date. We evaluate the securities in our fixed income securities portfolio for possible other-than-temporary impairment losses at each quarter end. Our reviews cover all impaired securities where the loss exceeds $0.5 million and the loss either exceeds 10% of cost or the security had been in a loss position for longer than twelve consecutive months. For other-than-temporary impairment losses, we recognize an other-than-temporary impairment loss in earnings in the period that we determine: 1) we intend to sell the security, 2) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis or 3) the security has a credit loss. Any non-credit portion of the other-than-temporary impairment loss is recognized in shareholders’ equity.

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Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(unaudited, tables in thousands except per share data)
Our other-than-temporary impairment losses were as follows:
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Total other-than-temporary impairment loss
  $ (4,677 )   $ (316 )   $     $ (316 )
Portion recognized in other comprehensive income
    1,198       16             16  
 
                       
Net other-than-temporary impairment loss recognized in earnings
  $ (3,479 )   $ (300 )   $     $ (300 )
 
                       
We have recognized credit losses on certain impaired fixed income securities, for which each security also had an impairment loss recorded in other comprehensive income. The rollforward of these credit losses was as follows:
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Balance at beginning of period
  $ 4,273     $ 3,848     $ 3,847     $ 3,848  
Credit losses recognized in earnings
                               
Securities previously impaired
    1,597       300             300  
Securities previously not impaired
    1,882                    
Securities sold
    (3,905 )                  
 
                       
Balance at September 30
  $ 3,847     $ 4,148     $ 3,847     $ 4,148  
 
                       
We had $1.2 million of after-tax other-than-temporary impairment losses, related to mortgage-backed securities, included in accumulated other comprehensive income within shareholders’ equity at September 30, 2011. This amount includes the after-tax unrealized gains and losses on these impaired securities resulting from changes in their fair value subsequent to their initial other-than-temporary impairment measurement dates.
We do not consider the $16.7 million of gross unrealized losses in our fixed income securities portfolio at September 30, 2011 to be other-than-temporary impairments because: 1) we received substantially all contractual interest and principal payments on these securities as of September 30, 2011, 2) we do not intend to sell the securities, 3) it is more likely than not that we will not be required to sell the securities before recovery of their amortized cost bases and 4) the unrealized loss relates to non-credit factors, such as interest rate changes and market conditions.
The amortized cost and fair value of our fixed income securities at September 30, 2011, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. The weighted-average life of our mortgage-backed and asset-backed securities was 4.3 years at September 30, 2011.
                                 
    Available for sale     Held to maturity  
    Cost or                    
    amortized cost     Fair value     Amortized cost     Fair value  
Due in 1 year or less
  $ 247,391     $ 251,201     $ 56,204     $ 56,501  
Due after 1 year through 5 years
    1,084,679       1,135,759       111,560       113,123  
Due after 5 years through 10 years
    1,080,746       1,161,310       850       932  
Due after 10 years through 15 years
    740,889       791,922              
Due after 15 years
    877,241       916,008              
 
                       
Securities with fixed maturities
    4,030,946       4,256,200       168,614       170,556  
Mortgage-backed and asset-backed securities
    1,325,387       1,394,989              
 
                       
Total fixed income securities
  $ 5,356,333     $ 5,651,189     $ 168,614     $ 170,556  
 
                       

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Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(unaudited, tables in thousands except per share data)
The sources of net investment income were as follows:
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Fixed income securities
  $ 158,941     $ 150,001     $ 54,896     $ 50,921  
Short-term investments
    420       631       99       271  
Other
    2,992       3,053       962       1,011  
 
                       
Total investment income
    162,353       153,685       55,957       52,203  
Investment expense
    (3,571 )     (3,082 )     (1,192 )     (1,066 )
 
                       
Net investment income
  $ 158,782     $ 150,603     $ 54,765     $ 51,137  
 
                       
Realized pretax gains (losses) on the sale of investments, which exclude other-than-temporary impairment credit losses, were as follows:
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Fixed income securities
                               
Gains
  $ 8,532     $ 8,875     $ 4,217     $ 1,282  
Losses
    (5,359 )     (824 )     (1,545 )     (225 )
 
                       
Net fixed income securities
  $ 3,173     $ 8,051     $ 2,672     $ 1,057  
 
                       
Other investments
                               
Gains
  $ 6     $ 2     $ 2     $  
Losses
    (10 )     (156 )            
 
                       
Net other investments
  $ (4 )   $ (154 )   $ 2     $  
 
                       
Total
                               
Gains
  $ 8,538     $ 8,877     $ 4,219     $ 1,282  
Losses
    (5,369 )     (980 )     (1,545 )     (225 )
 
                       
Net realized investment gain
  $ 3,169     $ 7,897     $ 2,674     $ 1,057  
 
                       
 
(4) Goodwill
The goodwill balances by reportable segment and the changes in goodwill are shown in the table below.
                                                 
    U.S. Property     Professional     Accident &     U.S. Surety              
    & Casualty     Liability     Health     & Credit     International     Total  
Balance at beginning of year
  $ 223,000     $ 249,820     $ 144,128     $ 79,700     $ 125,000     $ 821,648  
Earnout and other
          51,727                         51,727  
 
                                   
Balance at September 30, 2011
  $ 223,000     $ 301,547     $ 144,128     $ 79,700     $ 125,000     $ 873,375  
 
                                   
We conducted our 2011 goodwill impairment test as of June 30, 2011, which is consistent with the timeframe for our annual assessment in prior years. Based on our latest impairment test, the fair value of each of our reporting units exceeded its carrying amount.

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Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(unaudited, tables in thousands except per share data)
We acquired HCC Global Financial Products (HCC Global), which underwrites our U.S. and International directors’ and officers’ liability business, in 2002. The purchase agreement, as amended, includes a contingency for future earnout payments. The earnout is based on HCC Global’s pretax earnings from the acquisition date through September 30, 2007, with no maximum amount due to the former owners. When conditions specified under the purchase agreement are met, we record a net amount owed to or due from the former owners based on our estimate, at that point in time, of how claims will ultimately be settled. This net amount will fluctuate in the future, and the ultimate total net earnout payments cannot be finally determined until all claims are settled or paid. In March 2011, certain amendments were made to the purchase agreement, which resulted in an adjustment to our estimate of the ultimate amounts to be settled under the agreement. As a result, we increased goodwill by $20.0 million as of March 31, 2011. In September 2011, we increased goodwill by $31.3 million for additional earnout earned and accrued in the quarter.
(5) Reinsurance
In the normal course of business, our insurance companies cede a portion of their premium to domestic and foreign reinsurers through treaty and facultative reinsurance agreements. Although ceding for reinsurance purposes does not discharge the direct insurer from liability to its policyholder, our insurance companies participate in such agreements in order to limit their loss exposure, protect them against catastrophic loss and diversify their business. The following tables present the effect of such reinsurance transactions on our premium, loss and loss adjustment expense and policy acquisition costs.
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Direct written premium
  $ 1,724,869     $ 1,697,054     $ 555,427     $ 565,417  
Reinsurance assumed
    295,268       257,676       73,420       75,239  
Reinsurance ceded
    (359,046 )     (415,239 )     (116,513 )     (146,218 )
 
                       
Net written premium
  $ 1,661,091     $ 1,539,491     $ 512,334     $ 494,438  
 
                       
 
                               
Direct earned premium
  $ 1,728,082     $ 1,714,252     $ 574,571     $ 575,216  
Reinsurance assumed
    255,293       217,621       96,799       76,473  
Reinsurance ceded
    (406,388 )     (399,735 )     (127,114 )     (135,523 )
 
                       
Net earned premium
  $ 1,576,987     $ 1,532,138     $ 544,256     $ 516,166  
 
                       
 
                               
Direct loss and loss adjustment expense
  $ 1,197,225     $ 1,059,094     $ 410,573     $ 340,225  
Reinsurance assumed
    186,805       131,202       44,600       25,413  
Reinsurance ceded
    (321,790 )     (267,651 )     (74,801 )     (68,500 )
 
                       
Net loss and loss adjustment expense
  $ 1,062,240     $ 922,645     $ 380,372     $ 297,138  
 
                       
 
Policy acquisition costs
  $ 338,625     $ 330,174     $ 114,778     $ 111,216  
Ceding commissions
    (99,465 )     (88,096 )     (43,479 )     (30,468 )
 
                       
Net policy acquisition costs
  $ 239,160     $ 242,078     $ 71,299     $ 80,748  
 
                       

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Table of Contents

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(unaudited, tables in thousands except per share data)
The table below shows the components of our reinsurance recoverables in our consolidated balance sheets.
                 
    September 30,     December 31,  
    2011     2010  
Reinsurance recoverable on paid losses
  $ 55,778     $ 75,262  
Reinsurance recoverable on outstanding losses
    475,671       452,882  
Reinsurance recoverable on incurred but not reported losses
    542,049       481,204  
Reserve for uncollectible reinsurance
    (2,232 )     (2,493 )
 
           
Total reinsurance recoverables
  $ 1,071,266     $ 1,006,855  
 
           
At each quarter end, we review our financial exposure to the reinsurance market based on our individual reinsurance recoverable balances as of the prior quarter-end. We take actions to collect outstanding balances or to mitigate our exposure to possible loss, including offsetting past due amounts against letters of credit and other payables. There was no material change in recoverables on paid losses that were outstanding for over 90 days as of September 30, 2011 compared to December 31, 2010. We have a reserve for potentially uncollectible amounts as follows:
                 
    Nine months ended September 30,  
    2011     2010  
Balance at beginning of year
  $ 2,493     $ 2,945  
Provision expense (recovery)
    (261 )      
 
           
Balance at September 30
  $ 2,232     $ 2,945  
 
           
If we collect cash from or resolve a dispute with the reinsurer, we reduce the allowance account. While we believe the reserve is adequate based on information currently available, market conditions may change or additional information might be obtained that may require us to change the reserve in the future.
Reinsurers not authorized by the respective states of domicile of our U.S. domiciled insurance companies are required to collateralize reinsurance obligations due to us. The table below shows the amounts of letters of credit and cash deposits held by us as collateral, plus other credits available for potential offset at September 30, 2011 and December 31, 2010.
                 
    September 30,     December 31,  
    2011     2010  
Payables to reinsurers
  $ 230,503     $ 243,990  
Letters of credit
    135,299       145,914  
Cash deposits
    91,380       81,966  
 
           
Total credits
  $ 457,182     $ 471,870  
 
           
The tables below show the calculation of net reserves, net unearned premium and net deferred policy acquisition costs.
                 
    September 30,     December 31,  
    2011     2010  
Loss and loss adjustment expense payable
  $ 3,686,570     $ 3,471,858  
Reinsurance recoverable on outstanding losses
    (475,671 )     (452,882 )
Reinsurance recoverable on incurred but not reported losses
    (542,049 )     (481,204 )
 
           
Net reserves
  $ 2,668,850     $ 2,537,772  
 
           
 
               
Unearned premium
  $ 1,071,340     $ 1,045,877  
Ceded unearned premium
    (231,537 )     (278,663 )
 
           
Net unearned premium
  $ 839,803     $ 767,214  
 
           
 
               
Deferred policy acquisition costs
  $ 225,190     $ 212,786  
Deferred ceding commissions
    (66,059 )     (72,565 )
 
           
Net deferred policy acquisition costs
  $ 159,131     $ 140,221  
 
           

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HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(unaudited, tables in thousands except per share data)
(6) Notes Payable
Notes payable were as follows:
                 
    September 30,     December 31,  
    2011     2010  
6.30% Senior Notes
  $ 298,752     $ 298,637  
$600.0 million Revolving Loan Facility
    195,000        
             
Total notes payable
  $ 493,752     $ 298,637  
 
           
On March 8, 2011, we entered into a new agreement for a four-year $600.0 million Revolving Loan Facility (Facility). The Facility replaced our $575.0 million Revolving Loan Facility, which was due to expire on December 19, 2011. The Facility allows us to borrow up to the maximum allowed on a revolving basis until the Facility expires on March 8, 2015. The borrowing rate is LIBOR plus 137.5 basis points, subject to increase or decrease based on changes in our debt rating. The contractual interest rate on borrowings under the Facility at September 30, 2011 was 1.63%. In addition, we pay a commitment fee of 20 basis points. Letters of credit issued under the Facility further reduced our available borrowing capacity on the remaining Facility to $392.2 million at September 30, 2011. The Facility contains restrictive financial covenants that require HCC to maintain a minimum consolidated net worth (excluding accumulated other comprehensive income) and a leverage ratio of less than or equal to 35%.
We were in compliance with debt covenants related to our Senior Notes, the Facility, and a Standby Letter of Credit Facility at September 30, 2011.
(7) Earnings Per Share
The following table details the numerator and denominator used in our earnings per share calculations.
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Net earnings
  $ 176,905     $ 247,797     $ 60,437     $ 93,063  
Less: net earnings attributable to unvested restricted stock awards and restricted stock units
    (2,551 )     (2,746 )     (950 )     (1,067 )
 
                       
Net earnings available to common stock
  $ 174,354     $ 245,051     $ 59,487     $ 91,996  
 
                       
Weighted-average common shares outstanding
    110,665       113,872       106,919       114,002  
Dilutive effect of outstanding options (determined using treasury stock method)
    245       254       129       156  
 
                       
Weighted-average common shares and potential common shares outstanding
    110,910       114,126       107,048       114,158  
 
                       
 
                               
Anti-dilutive stock options not included in treasury stock method computation
    2,279       4,431       2,744       4,978  
 
                       

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HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(unaudited, tables in thousands except per share data)
(8) Stock-based Compensation
In 2011, we granted the following shares of common stock, restricted stock awards, restricted stock units and 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 awards, 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
    28     $ 32.54     $ 920        
Restricted stock awards
    337       30.74       10,345     3-5 years
Restricted stock units
    65       30.25       1,952     4 years
Stock options
    291       8.42       2,450     1-5 years
(9) Segments
We report HCC’s results in six operating segments, each of which reports to an HCC executive who is responsible for the segment results. Each of our 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 incurs insurance losses, acquisition costs and other administrative expenses related to our insurance companies and underwriting agencies. We monitor and assess each segment’s pretax results based on underwriting profit, gross and net written premium, and its combined ratio, consisting of the net loss ratio and expense ratio.
Included in the portfolio of products for each underwriting 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, difference in conditions, occupational accident and brown water marine written in the United States.
    Professional Liability — directors’ and officers’ (D&O) liability, large account errors and omissions liability, fiduciary liability, fidelity, bankers’ blanket bonds and, for some D&O policyholders, employment practices liability 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 surety bonds, commercial surety bonds, and bail bonds written in the United States and credit insurance managed in the United States.
    International — energy, property treaty, liability, surety, credit, property (direct and facultative), ocean marine, accident and health and other smaller product lines written outside the United States.
The Investing segment includes our total investment portfolio, as well as all investment income, investment related expenses, realized investment gains and losses, and other-than-temporary impairment credit losses on investments. All investment activity is reported as revenue, consistent with our consolidated presentation.

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HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(unaudited, tables in thousands except per share data)
In addition to our segments, we include a Corporate & Other category to reconcile segment results to consolidated totals. The Corporate & Other category 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 these six product lines that we no longer write and do not expect to write in the future: 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.
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, 2011
                                                               
 
                                                               
Net earned premium
  $ 245,121     $ 307,240     $ 603,656     $ 153,309     $ 267,458     $     $ 203     $ 1,576,987  
Other revenue
    16,556       358       3,471       955       2,791       158,472       (506 )     182,097  
 
                                               
Segment revenue
    261,677       307,598       607,127       154,264       270,249       158,472       (303 )     1,759,084  
 
                                               
 
                                                               
Loss and LAE
    148,783       257,632       438,883       42,351       175,635             (1,044 )     1,062,240  
Other expense
    82,202       40,055       92,882       82,909       99,754             56,466       454,268  
 
                                               
Segment expense
    230,985       297,687       531,765       125,260       275,389             55,422       1,516,508  
 
                                               
Segment pretax earnings (loss)
  $ 30,692     $ 9,911     $ 75,362     $ 29,004     $ (5,140 )   $ 158,472     $ (55,725 )   $ 242,576  
 
                                               
 
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
    164,684       196,154       412,438       38,157       107,601             3,611       922,645  
Other expense
    75,890       57,171       89,967       81,699       89,559             53,652       447,938  
 
                                               
Segment expense
    240,574       253,325       502,405       119,856       197,160             57,263       1,370,583  
 
                                               
 
                                                               
Segment pretax earnings (loss)
  $ 41,981     $ 68,982     $ 68,164     $ 29,026     $ 43,488     $ 158,200     $ (55,051 )   $ 354,790  
 
                                               

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HCC Insurance Holdings, Inc. and Subsidiaries
Notes to 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, 2011
                                                               
 
                                                               
Net earned premium
  $ 85,946     $ 104,066     $ 202,999     $ 51,906     $ 99,294     $     $ 45     $ 544,256  
Other revenue
    6,890       109       1,277       254       889       57,439       (590 )     66,268  
 
                                               
Segment revenue
    92,836       104,175       204,276       52,160       100,183       57,439       (545 )     610,524  
 
                                               
 
                                                               
Loss and LAE
    56,355       119,617       147,278       12,664       45,242             (784 )     380,372  
Other expense
    26,627       6,023       30,887       27,657       35,734             20,432       147,360  
 
                                               
Segment expense
    82,982       125,640       178,165       40,321       80,976             19,648       527,732  
 
                                               
Segment pretax earnings (loss)
  $ 9,854     $ (21,465 )   $ 26,111     $ 11,839     $ 19,207     $ 57,439     $ (20,193 )   $ 82,792  
 
                                               
 
                                                               
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
    61,883       63,212       138,869       10,296       23,227             (349 )     297,138  
Other expense
    21,289       18,866       30,908       28,007       29,654             18,074       146,798  
 
                                               
Segment expense
    83,172       82,078       169,777       38,303       52,881             17,725       443,936  
 
                                               
Segment pretax earnings (loss)
  $ 6,663     $ 21,638     $ 24,588     $ 11,631     $ 33,124     $ 51,894     $ (17,526 )   $ 132,012  
 
                                               
The Professional Liability segment’s 2011 pretax earnings were impacted by the combined effect of net adverse loss development incurred by the segment and an increase in the 2011 accident year loss ratio for the diversified financial products line of business, which is included in the Professional Liability segment. The combined impact reduced pretax earnings by $75.1 million in the first nine months and $58.1 million in the third quarter of 2011. Catastrophe losses reduced the International segment’s pretax earnings by $101.7 million and $29.4 million in the first nine months and third quarter of 2011, respectively, and $15.6 million in the first nine months of 2010.
(10) Commitments and Contingencies
Catastrophe Exposure
We have exposure to catastrophe losses caused by natural perils (such as hurricanes, earthquakes, floods, tsunamis and tornados), as well as from man-made events (such as terrorist attacks). The incidence, timing and severity of catastrophe losses are unpredictable. We assess our exposures in areas most vulnerable to natural catastrophes and apply procedures to ascertain our probable maximum loss from a single event. We maintain reinsurance protection that we believe is sufficient to limit our exposure to a foreseeable event. In 2011, we recognized gross losses of $168.0 million from catastrophic events primarily in Japan, New Zealand, the United States and Denmark. After reinsurance and reinstatement premium, our pretax loss was $107.9 million. In 2010, we recognized gross losses from catastrophic events, primarily the Chilean earthquake, of $26.9 million. After reinsurance, our pretax loss was $15.6 million.

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HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(unaudited, tables in thousands except per share data)
Litigation
We are a party to lawsuits, arbitrations and other proceedings that arise in the normal course of our business. Many of such lawsuits, arbitrations and other proceedings involve claims under policies that we underwrite as an insurer or reinsurer, the liabilities for which, we believe, have been adequately included in our loss reserves. Also, from time to time, we are a party to lawsuits, arbitrations and other proceedings that relate to disputes with third parties, or that involve alleged errors and omissions on the part of our subsidiaries. We have provided accruals for these items to the extent we deem the losses probable and reasonably estimable. Although the ultimate outcome of these matters cannot be determined at this time, based on present information, the availability of insurance coverage and advice received from our outside legal counsel, we believe the resolution of any such matters will not, individually or in the aggregate, have a material adverse effect on our consolidated financial position, results of operations or cash flows.
Indemnifications
In conjunction with the sales of business assets and subsidiaries, we have provided indemnifications to the buyers. Certain indemnifications cover typical representations and warranties related to our responsibilities to perform under the sales contracts. Under other indemnifications, we agree to reimburse the purchasers for taxes or ERISA-related amounts, if any, assessed after the sale date but related to pre-sale activities. We cannot quantify the maximum potential exposure covered by all of our indemnifications because the indemnifications cover a variety of matters, operations and scenarios. Certain of these indemnifications have no time limit. For those with a time limit, the longest such indemnification expires in 2025. We accrue a loss when a valid claim is made by a purchaser and we believe we have potential exposure. At September 30, 2011, we have recorded a liability of $9.0 million and have provided a $3.0 million escrow account and $5.2 million of letters of credit to cover our obligations or anticipated payments under these indemnifications.
(11) Supplemental Information
Supplemental information was as follows:
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Income taxes paid
  $ 88,973     $ 101,164     $ 31,366     $ 34,949  
Interest paid
    12,937       9,714       785       151  
Cash paid for commutations
    37,849             4,210        
Comprehensive income
    281,737       337,068       116,568       154,317  

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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 Consolidated Financial Statements and the related Notes as of December 31, 2010 and September 30, 2011.
Overview
We are a specialty insurance group with offices in the United States, the United Kingdom, Spain and Ireland, transacting business in approximately 180 countries. Our shares trade on the New York Stock Exchange and closed at $27.35 on October 28, 2011, resulting in market capitalization of $2.9 billion.
We underwrite a variety of relatively non-correlated specialty insurance products, including property and casualty, accident and health, surety, credit and aviation product lines. We market our insurance products through a network of independent agents and brokers, managing general agents and directly to consumers. In addition, we assume insurance written by other insurance companies. We manage our businesses through five underwriting segments and our Investing segment. Our underwriting segments are U.S. Property & Casualty, Professional Liability, Accident & Health, U.S. Surety & Credit and International.
Our business philosophy is to maximize underwriting profit while managing risk in order to preserve shareholders’ equity, grow book value and maximize earnings. We concentrate our insurance writings in selected specialty insurance lines of business in which we believe we can achieve meaningful underwriting profit. We also rely on our experienced underwriting personnel and our access to and expertise in the reinsurance marketplace to limit or reduce risk. Our business plan is shaped by our underlying business philosophy. As a result, our primary objective is to increase net earnings and grow book value, rather than to grow our market share or our gross written premium.
Our major domestic and international insurance companies have financial strength ratings of AA (Very Strong) from Standard & Poor’s Corporation, A+ (Superior) from A.M. Best Company, Inc., AA (Very Strong) from Fitch Ratings and A1 (Good Security) from Moody’s Investors Service, Inc.
Key facts about our consolidated group as of and for the nine months and quarter ended September 30, 2011 were as follows:
    Our common shares closed at $27.05 per share.
 
    We had consolidated shareholders’ equity of $3.3 billion, with a book value per share of $30.67.
 
    We generated year-to-date net earnings of $176.9 million, or $1.57 per diluted share. Our third quarter earnings were $60.4 million, or $0.56 per diluted share.
 
    We produced revenue of $1.8 billion and $610.5 million in the first nine months and third quarter, respectively.
 
    In the first nine months, we recognized gross losses of $168.0 million and net losses, after reinsurance and reinstatement premium, of $107.9 million from catastrophes primarily in Japan, New Zealand, the United States and Denmark, mainly in our International segment. The third quarter included net catastrophe losses of $34.6 million.
 
    Our year-to-date net loss ratio, including the 2011 catastrophe losses, was 67.4% and our combined ratio was 92.2%. The catastrophe losses increased the net loss ratio by 6.5 percentage points and the combined ratio by 6.7 percentage points.
 
    We recorded net adverse (favorable) loss development of $21.6 million and $(0.6) million in the first nine months and third quarter, respectively. We also recognized an additional $28.2 million of losses in the third quarter related to the 2011 accident year, virtually all of which related to the diversified financial products line of business in our Professional Liability segment.

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    In the third quarter, we recognized $13.0 million of profit commissions due from reinsurers related to the U.S. D&O and International D&O lines of business.
 
    In the third quarter, we borrowed an additional $100.0 million against our new four-year $600.0 million Revolving Loan Facility, primarily to fund share repurchases.
 
    We purchased $307.8 million, or 10.2 million shares, of our common stock at an average cost of $30.25 per share in the first nine months of 2011.
 
    We declared dividends of $0.445 per share and paid $49.3 million of dividends in the first nine months of 2011.
Comparisons in the following sections refer to the first nine months of 2011 compared to the same period of 2010, unless otherwise noted. Amounts in tables are in thousands, except for earnings per share, percentages, ratios and number of employees.
Results of Operations
Our results and key metrics for the nine months and quarter ended September 30, 2011 and 2010 were as follows:
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Net earnings
  $ 176,905     $ 247,797     $ 60,437     $ 93,063  
 
                       
Earnings per diluted share
  $ 1.57     $ 2.15     $ 0.56     $ 0.81  
 
                       
 
Net loss ratio
    67.4 %     60.2 %     69.9 %     57.6 %
Expense ratio
    24.8       25.2       22.9       24.6  
 
                       
Combined ratio
    92.2 %     85.4 %     92.8 %     82.2 %
 
                       
Our 2011 and 2010 results include the impact of world-wide catastrophic events. We experienced catastrophe losses primarily from the Japan earthquake and tsunami, New Zealand earthquakes, the United States tornados and Hurricane Irene, and the Denmark storms in 2011 and the Chile earthquake in 2010. We reinsure a portion of our exposure to such catastrophic events, although we incur some additional cost for reinstatement premium to continue our reinsurance coverage for future loss events. The following table summarizes our catastrophe losses, as well as the impact on our net earnings and key metrics in 2011 and 2010:
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Gross losses
  $ 167,968     $ 26,900     $ 47,709     $ (5,000 )
Net losses, after reinsurance and reinstatement premium
  $ 107,915     $ 15,588     $ 34,587     $ (5,000 )
Impact of net catastrophe losses on:
                               
Net earnings per diluted share
  $ (0.63 )   $ (0.09 )   $ (0.21 )   $ 0.03  
Net loss ratio (percentage points)
    6.5 %     1.0 %     6.2 %     (0.9 )%
Combined ratio (percentage points)
    6.7 %     1.0 %     6.3 %     (0.9 )%
Our third quarter 2011 catastrophe losses primarily related to Hurricane Irene in the United States. These catastrophe losses were incurred in our U.S. Property and Casualty and International segments. In the third quarter of 2010, we released $5.0 million of reserves related to the first quarter 2010 catastrophic events, based on revised information related to our ultimate loss exposures.
In addition to the catastrophe losses, we increased our loss reserves by $27.5 million in the third quarter of 2011 to reflect the impact of net favorable prior year loss development and additional accident year 2011 losses. The following table summarizes the impact of these items on our pretax earnings in 2011, compared to 2010:
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Adverse (favorable) loss development in:
                               
Diversified financial products line of business
  $ 104,159     $     $ 87,395     $  
All other lines of business
    (82,536 )     1,259       (88,038 )     (907 )
 
                       
Total adverse (favorable) loss development
    21,623       1,259       (643 )     (907 )
Accident year 2011 additional losses
    28,180             28,180        
 
                       
Decrease (increase) in pretax earnings
  $ 49,803     $ 1,259     $ 27,537     $ (907 )
 
                       

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In the third quarter of 2011, we experienced $87.4 million of adverse loss development in the diversified financial products line of business in our Professional Liability segment. In the same quarter, we increased certain ultimate loss ratios for accident year 2011, primarily for the diversified financial products line of business, which generated $28.2 million of additional losses. The adverse loss development was offset by $88.0 million of net favorable loss development, primarily in the U.S. D&O and International D&O lines of business in our Professional Liability segment and in the U.K. professional liability line of business in our International segment. See the “Segment Operations” section below for further discussion of loss activity within each segment. We also recognized $13.0 million of profit commissions due from reinsurers in the U.S. D&O and International D&O lines of business in the third quarter of 2011.
Revenue
Total revenue increased $33.7 million in the first nine months of 2011, compared to the same period in 2010, primarily due to higher net earned premium and net investment income, offset by lower other operating income and net realized investment gains.
Gross written premium, net written premium and net earned premium are detailed below by segment.
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
U.S. Property & Casualty
  $ 409,733     $ 415,139     $ 144,222     $ 146,010  
Professional Liability
    392,903       414,436       130,631       144,920  
Accident & Health
    600,584       567,785       202,761       194,377  
U.S. Surety & Credit
    169,368       173,142       55,415       55,972  
International
    447,355       381,975       95,774       99,197  
Exited Lines
    194       2,253       44       180  
 
                       
Total gross written premium
  $ 2,020,137     $ 1,954,730     $ 628,847     $ 640,656  
 
                       
 
U.S. Property & Casualty
  $ 273,212     $ 247,717     $ 92,776     $ 84,250  
Professional Liability
    287,494       277,956       96,846       99,131  
Accident & Health
    600,143       567,520       202,643       194,301  
U.S. Surety & Credit
    155,761       159,626       50,660       52,067  
International
    344,286       285,763       69,364       64,644  
Exited Lines
    195       909       45       45  
 
                       
Total net written premium
  $ 1,661,091     $ 1,539,491     $ 512,334     $ 494,438  
 
                       
 
U.S. Property & Casualty
  $ 245,121     $ 258,427     $ 85,946     $ 84,802  
Professional Liability
    307,240       321,849       104,066       103,696  
Accident & Health
    603,656       567,739       202,999       193,252  
U.S. Surety & Credit
    153,309       148,427       51,906       49,807  
International
    267,458       234,471       99,294       84,539  
Exited Lines
    203       1,225       45       70  
 
                       
Total net earned premium
  $ 1,576,987     $ 1,532,138     $ 544,256     $ 516,166  
 
                       

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Related to the 2011 catastrophe losses, we recorded a net $14.0 million of reinstatement premium ($15.6 million ceded net of $1.6 million assumed) for continued reinsurance coverage, which reduced the International segment’s 2011 net written and net earned premium. Growth in written premium occurred primarily in the International segment, directly related to our property treaty business, and in the Accident & Health segment related to our medical stop-loss product. See the “Segment Operations” section below for further discussion of the changes in premium revenue within each segment.
Net investment income, which is included in our Investing segment, increased 5% year-over-year primarily due to higher income from fixed income securities, generated from an increased amount of investments. Our fixed income securities portfolio increased 9% from $5.4 billion at September 30, 2010 to $5.8 billion at September 30, 2011. The growth in fixed income securities resulted primarily from cash flow from operations and long-term investment of short-term funds.
The sources of net investment income are detailed below.
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Fixed income securities
                               
Taxable
  $ 84,228     $ 82,416     $ 30,009     $ 27,613  
Exempt from U.S. income taxes
    74,713       67,585       24,887       23,308  
 
                       
Total fixed income securities
    158,941       150,001       54,896       50,921  
Short-term investments
    420       631       99       271  
Other
    2,992       3,053       962       1,011  
 
                       
Total investment income
    162,353       153,685       55,957       52,203  
Investment expense
    (3,571 )     (3,082 )     (1,192 )     (1,066 )
 
                       
Net investment income
  $ 158,782     $ 150,603     $ 54,765     $ 51,137  
 
                       
The following table details the components of our other operating income.
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Fee and commission income
  $ 18,658     $ 21,465     $ 7,391     $ 6,311  
Financial instruments
    516       8,595       131       216  
Other
    4,451       4,975       1,307       1,361  
 
                       
Other operating income
  $ 23,625     $ 35,035     $ 8,829     $ 7,888  
 
                       
Our fee and commission income in 2010 included deferred revenue from a subsidiary sold in late 2009. The financial instruments line relates to derivative contracts denominated in British pound sterling and includes the effect of foreign currency fluctuations compared to the U.S. dollar. In the first quarter of 2010, we terminated our interest in a long-term mortgage impairment insurance contract that had been accounted for as a derivative financial instrument and recognized a $5.0 million pretax gain. We received £5.6 million ($8.3 million) of cash, which was included in other operating income, and incurred related expenses of $3.0 million, which were included in other operating expense. The gain was included in our U.S. Property & Casualty segment’s 2010 results.

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Loss and Loss Adjustment Expense
The tables below detail, by segment, our net loss and loss adjustment expense, the amount of loss development included in our net loss and loss adjustment expense, and our net loss ratios.
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
U.S. Property & Casualty
  $ 148,783     $ 164,684     $ 56,355     $ 61,883  
Professional Liability
    257,632       196,154       119,617       63,212  
Accident & Health
    438,883       412,438       147,278       138,869  
U.S. Surety & Credit
    42,351       38,157       12,664       10,296  
International
    175,635       107,601       45,242       23,227  
Exited Lines
    (1,044 )     3,611       (784 )     (349 )
 
                       
Net loss and loss adjustment expense
  $ 1,062,240     $ 922,645     $ 380,372     $ 297,138  
 
                       
 
Adverse (favorable) loss development:
                               
U.S. Property & Casualty
  $ (4,613 )   $ 9,751     $ (7,163 )   $ 4,427  
Professional Liability
    48,137       2,202       31,153       (22 )
Accident & Health
    2,540       2,642       230       186  
U.S. Surety & Credit
    (2,767 )     (7,853 )     (2,786 )     (3,654 )
International
    (20,623 )     (8,415 )     (21,287 )     (1,724 )
Exited Lines
    (1,051 )     2,932       (790 )     (120 )
 
                       
Total adverse (favorable) loss development
    21,623       1,259       (643 )     (907 )
Catastrophe losses
    93,907       15,588       32,187       (5,000 )
All other net loss and loss adjustment expense
    946,710       905,798       348,828       303,045  
 
                       
Net loss and loss adjustment expense
  $ 1,062,240     $ 922,645     $ 380,372     $ 297,138  
 
                       
 
U.S. Property & Casualty
    60.7 %     63.7 %     65.6 %     73.0 %
Professional Liability
    83.9       60.9       114.9       61.0  
Accident & Health
    72.7       72.6       72.6       71.9  
U.S. Surety & Credit
    27.6       25.7       24.4       20.7  
International
    65.7       45.9       45.6       27.5  
 
                       
Consolidated net loss ratio
    67.4 %     60.2 %     69.9 %     57.6 %
 
                       
Consolidated accident year net loss ratio
    66.0 %     60.0 %     70.0 %     57.7 %
 
                       
Loss development represents an increase or decrease in estimates of ultimate losses related to prior accident years. Deficiencies and redundancies in ultimate loss estimates occur as we review our loss exposure with our actuaries, increasing or reducing estimates of our ultimate losses as a result of such reviews and as losses are finally settled or claims exposures change. We recognized adverse (favorable) loss development of $21.6 million and $1.3 million in the first nine months of 2011 and 2010, respectively, and $(0.6) million and $(0.9) million in the third quarter of 2011 and 2010, respectively. In the third quarter of 2011, we increased reserves for our diversified financial products line of business, included in the Professional Liability segment, by $114.7 million, which includes $87.4 million related to prior years, due to revised assumptions with respect to claims frequency and severity in the 2009 — 2011 accident years. This adverse development was offset by net favorable development of $88.0 million, primarily in our U.S. D&O and International D&O lines of business in our Professional Liability segment and in the U.K. professional liability

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line of business in our International segment. The favorable development in these lines of business related to lower than expected reported loss development for accident years 2002 — 2005 for the D&O lines of business and primarily for accident years 2004 — 2009 for the U.K. professional liability line of business. See the “Segment Operations” section below for further discussion of the changes in our net loss and loss adjustment expense and net loss ratios within each segment. Our consolidated accident year net loss ratio was higher in 2011, primarily due to the higher amount of catastrophe losses and $28.2 million of additional losses related to our third-quarter increase in certain ultimate loss ratios for accident year 2011, primarily related to the diversified financial products line of business.
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.
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Net reserves for loss and loss adjustment expense payable at beginning of period
  $ 2,537,772     $ 2,555,840     $ 2,612,945     $ 2,568,317  
Net reserve additions from acquired businesses
    645       8,110              
Foreign currency adjustment
    5,364       (11,677 )     (22,622 )     36,109  
Net loss and loss adjustment expense
    1,062,240       922,645       380,372       297,138  
Net loss and loss adjustment expense payments
    (937,171 )     (872,838 )     (301,845 )     (299,484 )
 
                       
Net reserves for loss and loss adjustment expense
                               
payable at end of period
  $ 2,668,850     $ 2,602,080     $ 2,668,850     $ 2,602,080  
 
                       
Net paid loss ratio
    59.4 %     57.0 %     55.5 %     58.0 %
 
                       
The net paid loss ratio was higher year-to-date in 2011 primarily due to higher claims payments for our directors’ and officers’ (D&O) lines of businesses and our property treaty and property (direct and facultative) product lines, including $20.2 million related to the 2011 catastrophic events. These increases were partially offset by lower claims payments for our medical stop-loss and aviation businesses, as well as higher subrogation received related to our U.S. credit line of business. In addition, in 2011 we commuted certain loss reserves included in our Exited Lines for $37.8 million. These commutations increased our year-to-date net paid loss ratio by 2.4 percentage points. The amount of claims paid fluctuates period to period due to our mix of business and the timing of claims settlement and catastrophic events.
Our gross loss ratio was 69.8% and 61.6% in the first nine months of 2011 and 2010, respectively, and 67.8% and 56.1% in the third quarter of 2011 and 2010, respectively. The 2011 catastrophe losses increased our reported gross loss ratios by 8.4 percentage points in the first nine months and 7.0 percentage points in the third quarter of 2011, while the 2010 catastrophe losses increased our reported gross loss ratio by 1.4 percentage points in the first nine months of 2010.
Policy Acquisition Costs
Our policy acquisition cost percentage was 15.2% and 15.8% in the first nine months of 2011 and 2010, respectively, and 13.1% and 15.6% in the third quarter of 2011 and 2010, respectively. The 2011 year-to-date policy acquisition cost percentage was reduced 0.9 percentage points due to $15.3 million of profit commissions due from reinsurers (recorded as an offset to policy acquisition costs) and increased 0.2 percentage points due to $14.0 million of reinstatement premium (recorded as a reduction of net earned premium). The 2011 third quarter policy acquisition cost percentage was reduced 2.8 percentage points due to $15.3 million of profit commissions due from reinsurers and increased 0.1 percentage points due to $2.4 million of reinstatement premium. Profit commissions and reinstatement premium had minimal impact on the 2010 policy acquisition cost percentage. The remaining increase in our policy acquisition cost percentage primarily related to higher average commission and premium tax expense in 2011 due to changes in the mix of business.
Other Operating Expense
Other operating expense increased 5% year-over-year and 16% quarter-over-quarter in 2011, primarily due to the combined effect of higher salary, employee benefits and information technology expense in 2011, fluctuations in foreign currency rates period-over-period, and certain non-recurring costs in 2010. We recognized currency conversion benefit (expense) of $2.5 million in the first nine months and $0.5 million in the third quarter of 2011, compared to $(1.5) million in the first nine months and $1.2 million in the third

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quarter of 2010. The first nine months of 2010 included $3.0 million of direct costs incurred in the first quarter to terminate a derivative contract.
For the first nine months of 2011, 67% of our other operating expense related to compensation and benefits of our employees. We had 1,869 employees at September 30, 2011 compared to 1,878 a year earlier. Other operating expense included year-to-date stock-based compensation expense of $10.4 million in 2011 and $9.9 million in 2010. At September 30, 2011, there was approximately $26.8 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 3.6 years.
Interest Expense
Interest expense on debt and short-term borrowings was $16.6 million and $15.9 million in the first nine months of 2011 and 2010, respectively, and $5.6 million and $5.3 million in the third quarter of 2011 and 2010, respectively, primarily related to our fixed rate Senior Notes. The increase in 2011 related to $195.0 million of borrowings on our Revolving Loan Facility.
Income Tax Expense
Our effective income tax rate was 27.1% for the first nine months of 2011, compared to 30.2% for the first nine months of 2010. The lower effective rate in 2011 related to the increased benefit from tax-exempt investment income relative to a lower pretax income base.
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. The insurance 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 events. 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 underwriting segments and our Investing segment.
U.S. Property & Casualty Segment
The following tables summarize the operations of the U.S. Property & Casualty segment.
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Net earned premium
  $ 245,121     $ 258,427     $ 85,946     $ 84,802  
Other revenue
    16,556       24,128       6,890       5,033  
 
                       
Segment revenue
    261,677       282,555       92,836       89,835  
 
                       
 
                               
Loss and loss adjustment expense, net
    148,783       164,684       56,355       61,883  
Other expense
    82,202       75,890       26,627       21,289  
 
                       
Segment expense
    230,985       240,574       82,982       83,172  
 
                       
Segment pretax earnings
  $ 30,692     $ 41,981     $ 9,854     $ 6,663  
 
                       
 
                               
Net loss ratio
    60.7 %     63.7 %     65.6 %     73.0 %
Expense ratio
    31.4       26.9       28.7       23.7  
 
                       
Combined ratio
    92.1 %     90.6 %     94.3 %     96.7 %
 
                       

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    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Aviation
  $ 83,879     $ 87,248     $ 29,279     $ 28,950  
E&O
    56,354       74,079       17,997       23,013  
Public Risk
    36,523       34,526       13,344       11,600  
Other
    68,365       62,574       25,326       21,239  
 
                       
Total net earned premium
  $ 245,121     $ 258,427     $ 85,946     $ 84,802  
 
                       
Aviation
    64.9 %     62.7 %     67.1 %     69.7 %
E&O
    73.7       84.9       108.6       133.8  
Public Risk
    84.5       58.8       115.1       37.3  
Other
    32.1       42.8       7.1       31.1  
 
                       
Total net loss ratio
    60.7 %     63.7 %     65.6 %     73.0 %
 
                       
 
                               
Aviation
  $ 116,933     $ 121,600     $ 37,877     $ 44,692  
E&O
    52,961       63,316       15,963       19,018  
Public Risk
    55,724       50,397       21,426       15,706  
Other
    184,115       179,826       68,956       66,594  
 
                       
Total gross written premium
  $ 409,733     $ 415,139     $ 144,222     $ 146,010  
 
                       
 
                               
Aviation
  $ 88,786     $ 84,097     $ 29,701     $ 30,347  
E&O
    52,035       63,256       15,449       19,019  
Public Risk
    43,926       36,635       17,530       12,985  
Other
    88,465       63,729       30,096       21,899  
 
                       
Total net written premium
  $ 273,212     $ 247,717     $ 92,776     $ 84,250  
 
                       
Our U.S. Property & Casualty segment 2011 pretax earnings declined year-over-year, primarily due to lower net earned premium, higher operating expenses, and the effect of a $5.0 million gain in 2010 related to termination of a derivative contract. The impact of these items was partially offset by favorable loss development in 2011, compared to adverse development in 2010. The 2011 pretax earnings increased quarter-to-quarter, primarily due to a similar trend in loss development.
Gross written premium was lower in 2011 due to competition and other business factors that particularly affected the E&O product line. E&O premium was also impacted by our more restrictive underwriting of this product line starting in 2009. Total net written premium increased in certain other product lines, as changes in the timing and amount of our reinsurance program costs offset the decrease in E&O premium. Net earned premium was lower in 2011 mainly due to reduced E&O premium.
The segment’s lower net loss ratios in 2011, compared to 2010, primarily reflect the change in loss development year-over-year. The segment had favorable development of $4.6 million in the first nine months of 2011, compared to adverse development of $9.8 million in the same period of 2010. The third quarter development was a favorable $7.2 million in 2011 and an adverse $4.4 million in 2010. Both years experienced adverse development in our E&O and employment practices liability (included in Other) lines of business. In addition, 2011 experienced offsetting favorable development in our disability, contingency and other lines of business (included in Other). Our Public Risk product line incurred $5.0 million of catastrophe losses in the third quarter of 2011.
The segment’s expense ratios were higher year-over-year, primarily due to higher compensation costs and lower segment revenue in 2011 compared to 2010. During 2010, we terminated our interest in a derivative contract, which generated $5.0 million of pretax earnings. We recognized a gain of $8.0 million, which was included in other revenue, and incurred reinsurance and other direct costs of $3.0 million, which were included in other expense.

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Professional Liability Segment
The following tables summarize the operations of the Professional Liability segment.
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Net earned premium
  $ 307,240     $ 321,849     $ 104,066     $ 103,696  
Other revenue
    358       458       109       20  
 
                       
Segment revenue
    307,598       322,307       104,175       103,716  
 
                       
 
                               
Loss and loss adjustment expense, net
    257,632       196,154       119,617       63,212  
Other expense
    40,055       57,171       6,023       18,866  
 
                       
Segment expense
    297,687       253,325       125,640       82,078  
 
                       
Segment pretax earnings (loss)
  $ 9,911     $ 68,982     $ (21,465 )   $ 21,638  
 
                       
 
                               
Net loss ratio
    83.9 %     60.9 %     114.9 %     61.0 %
Expense ratio
    13.0       17.7       5.8       18.2  
 
                       
Combined ratio
    96.9 %     78.6 %     120.7 %     79.2 %
 
                       
 
                               
U.S. D&O
  $ 270,408     $ 285,100     $ 90,154     $ 92,721  
International D&O
    36,832       36,749       13,912       10,975  
 
                       
Total net earned premium
  $ 307,240     $ 321,849     $ 104,066     $ 103,696  
 
                       
 
                               
U.S. D&O
    96.6 %     61.0 %     151.3 %     61.0 %
International D&O
    (10.0 )     60.5       (120.8 )     60.3  
 
                       
Total net loss ratio
    83.9 %     60.9 %     114.9 %     61.0 %
 
                       
 
                               
U.S. D&O
  $ 312,881     $ 344,510     $ 112,220     $ 124,366  
International D&O
    80,022       69,926       18,411       20,554  
 
                       
Total gross written premium
  $ 392,903     $ 414,436     $ 130,631     $ 144,920  
 
                       
 
                               
U.S. D&O
  $ 239,894     $ 249,882     $ 86,202     $ 90,871  
International D&O
    47,600       28,074       10,644       8,260  
 
                       
Total net written premium
  $ 287,494     $ 277,956     $ 96,846     $ 99,131  
 
                       
Our Professional Liability segment earnings declined in 2011, compared to 2010, due to adverse loss development, partially offset by increased income related to profit commissions due from reinsurers. The segment’s gross written premium decreased in 2011 because we wrote less D&O business in the United States due to competition. Net written premium as a percentage of gross written premium was higher in 2011 due to a change in our reinsurance programs.
The segment had adverse loss development of $48.1 million and $31.2 million for the first nine months and third quarter of 2011, respectively, compared to $2.2 million and none in the same periods of 2010. The 2011 development relates to the diversified financial products line of business (included in U.S. D&O), which provides coverage for private equity partnerships, hedge funds and investment managers.

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In the third quarter of 2011, this line of business recorded $87.4 million of adverse development, as well as $27.3 million of additional losses due to the increase in its 2011 accident year loss ratio. This adverse development resulted primarily from revised assumptions in the quarter with regards to the frequency and severity of claims in the 2009 — 2011 accident years. For year-to-date 2011, the diversified financial products line of business had $104.2 million of adverse development.
Our U.S. D&O and International D&O lines of business had favorable development of $32.1 million and $24.1 million, respectively, in the third quarter of 2011, which partially offset the adverse development described above. The favorable development related to lower than expected reported loss development in accident years 2002 — 2005. The higher 2011 loss ratios for U.S. D&O, shown above, include the impact of the adverse development for the diversified financial products line of business, partially offset by the favorable development for the U.S. D&O line of business. The negative 2011 loss ratios for International D&O reflect the favorable development on that line of business.
The segment’s lower expense ratios in 2011 primarily relate to prior years’ profit commissions due from reinsurers, recorded by the U.S. D&O and International D&O lines of business in the third quarter of 2011. The profit commissions, which offset the segment’s other expense, reduced the 2011 year-to-date and third quarter expense ratios by 4.3 percentage points and 12.5 percentage points, respectively.
Accident & Health Segment
The following tables summarize the operations of the Accident & Health segment.
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Net earned premium
  $ 603,656     $ 567,739     $ 202,999     $ 193,252  
Other revenue
    3,471       2,830       1,277       1,113  
 
                       
Segment revenue
    607,127       570,569       204,276       194,365  
 
                       
 
                               
Loss and loss adjustment expense, net
    438,883       412,438       147,278       138,869  
Other expense
    92,882       89,967       30,887       30,908  
 
                       
Segment expense
    531,765       502,405       178,165       169,777  
 
                       
Segment pretax earnings
  $ 75,362     $ 68,164     $ 26,111     $ 24,588  
 
                       
 
                               
Net loss ratio
    72.7 %     72.6 %     72.6 %     71.9 %
Expense ratio
    15.3       15.8       15.1       15.9  
 
                       
Combined ratio
    88.0 %     88.4 %     87.7 %     87.8 %
 
                       
 
                               
Medical Stop-loss
  $ 527,255     $ 488,256     $ 176,199     $ 164,698  
Other
    76,401       79,483       26,800       28,554  
 
                       
Total net earned premium
  $ 603,656     $ 567,739     $ 202,999     $ 193,252  
 
                       

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    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Medical Stop-loss
    74.2 %     74.0 %     74.5 %     74.1 %
Other
    62.6       64.4       59.8       59.1  
 
                       
Total net loss ratio
    72.7 %     72.6 %     72.6 %     71.9 %
 
                       
 
                               
Medical Stop-loss
  $ 527,401     $ 488,256     $ 176,247     $ 164,698  
Other
    73,183       79,529       26,514       29,679  
 
                       
Total gross written premium
  $ 600,584     $ 567,785     $ 202,761     $ 194,377  
 
                       
 
                               
Medical Stop-loss
  $ 527,255     $ 488,256     $ 176,199     $ 164,698  
Other
    72,888       79,264       26,444       29,603  
 
                       
Total net written premium
  $ 600,143     $ 567,520     $ 202,643     $ 194,301  
 
                       
Our Accident & Health segment pretax earnings increased 11% in 2011, primarily due to higher medical stop-loss premium from rate increases and writing new business. The segment had adverse loss development of $2.5 million in the first nine months of 2011 and $2.6 million in the same period of 2010. The adverse development primarily related to our short-term medical insurance and HMO reinsurance lines of business (both included in Other).
U.S. Surety & Credit Segment
The following tables summarize the operations of the U.S. Surety & Credit segment.
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Net earned premium
  $ 153,309     $ 148,427     $ 51,906     $ 49,807  
Other revenue
    955       455       254       127  
 
                       
Segment revenue
    154,264       148,882       52,160       49,934  
 
                       
 
                               
Loss and loss adjustment expense, net
    42,351       38,157       12,664       10,296  
Other expense
    82,909       81,699       27,657       28,007  
 
                       
Segment expense
    125,260       119,856       40,321       38,303  
 
                       
Segment pretax earnings
  $ 29,004     $ 29,026     $ 11,839     $ 11,631  
 
                       
 
                               
Net loss ratio
    27.6 %     25.7 %     24.4 %     20.7 %
Expense ratio
    53.7       54.9       53.0       56.1  
 
                       
Combined ratio
    81.3 %     80.6 %     77.4 %     76.8 %
 
                       
 
                               
Surety
  $ 121,093     $ 119,325     $ 40,284     $ 39,777  
Credit
    32,216       29,102       11,622       10,030  
 
                       
Total net earned premium
  $ 153,309     $ 148,427     $ 51,906     $ 49,807  
 
                       

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    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Surety
    25.2 %     22.2 %     25.1 %     15.9 %
Credit
    36.6       40.3       21.8       39.4  
 
                       
Total net loss ratio
    27.6 %     25.7 %     24.4 %     20.7 %
 
                       
 
                               
Surety
  $ 127,219     $ 132,137     $ 40,257     $ 43,437  
Credit
    42,149       41,005       15,158       12,535  
 
                       
Total gross written premium
  $ 169,368     $ 173,142     $ 55,415     $ 55,972  
 
                       
 
                               
Surety
  $ 119,780     $ 127,348     $ 37,037     $ 42,038  
Credit
    35,981       32,278       13,623       10,029  
 
                       
Total net written premium
  $ 155,761     $ 159,626     $ 50,660     $ 52,067  
 
                       
Our U.S. Surety & Credit segment pretax earnings were flat year-over-year. The segment had favorable loss development of $2.8 million and $7.9 million in the first nine months of 2011 and 2010, respectively, and $2.8 million and $3.7 million in the third quarter of 2011 and 2010, respectively. The 2011 favorable development related to lower than expected reported loss development in our Credit product line. The 2010 development related to revised loss estimates for both our Surety and Credit product lines.
International Segment
The following tables summarize the operations of the International segment.
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Net earned premium
  $ 267,458     $ 234,471     $ 99,294     $ 84,539  
Other revenue
    2,791       6,177       889       1,466  
 
                       
Segment revenue
    270,249       240,648       100,183       86,005  
 
                       
 
                               
Loss and loss adjustment expense, net
    175,635       107,601       45,242       23,227  
Other expense
    99,754       89,559       35,734       29,654  
 
                       
Segment expense
    275,389       197,160       80,976       52,881  
 
                       
Segment pretax income (loss)
  $ (5,140 )   $ 43,488     $ 19,207     $ 33,124  
 
                       
 
                               
Net loss ratio
    65.7 %     45.9 %     45.6 %     27.5 %
Expense ratio
    36.9       37.2       35.7       34.5  
 
                       
Combined ratio
    102.6 %     83.1 %     81.3 %     62.0 %
 
                       
 
                               
Energy
  $ 47,369     $ 39,566     $ 18,686     $ 12,777  
Property Treaty
    64,528       32,533       26,563       16,924  
Liability
    60,181       60,478       20,283       19,929  
Surety & Credit
    56,009       53,800       19,952       17,916  
Other
    39,371       48,094       13,810       16,993  
 
                       
Total net earned premium
  $ 267,458     $ 234,471     $ 99,294     $ 84,539  
 
                       

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    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Energy
    52.5 %     25.4 %     41.2 %     3.3 %
Property Treaty
    95.9       47.0       85.2       (5.2 )
Liability
    18.1       55.4       (47.1 )     55.9  
Surety & Credit
    40.9       38.1       40.2       37.5  
Other
    140.0       58.8       119.0       34.3  
 
                       
Total net loss ratio
    65.7 %     45.9 %     45.6 %     27.5 %
 
                       
 
                               
Energy
  $ 113,410     $ 97,053     $ 17,029     $ 16,731  
Property Treaty
    124,750       71,404       20,635       16,309  
Liability
    68,713       68,501       20,642       19,464  
Surety & Credit
    65,853       57,019       18,664       16,774  
Other
    74,629       87,998       18,804       29,919  
 
                       
Total gross written premium
  $ 447,355     $ 381,975     $ 95,774     $ 99,197  
 
                       
 
                               
Energy
  $ 68,329     $ 51,716     $ 5,432     $ 4,251  
Property Treaty
    100,139       61,994       14,013       12,948  
Liability
    63,248       63,410       18,815       17,663  
Surety & Credit
    62,155       51,278       18,689       14,605  
Other
    50,415       57,365       12,415       15,177  
 
                       
Total net written premium
  $ 344,286     $ 285,763     $ 69,364     $ 64,644  
 
                       
Our International segment’s pretax earnings were impacted by losses from world-wide catastrophic events in 2011 and 2010. We experienced catastrophe losses primarily from the Japan earthquake and tsunami, New Zealand earthquakes, the United States tornados and Hurricane Irene, and the Denmark storms in 2011 and the Chile earthquake in 2010. The catastrophic events impacted our energy and property treaty product lines, as well as our property (direct and facultative) and accident and health lines of business (both included in Other). We reinsured a portion of our exposure to these catastrophic events and incurred net reinstatement premium for continued reinsurance coverage, which reduced the segment’s 2011 net written and net earned premium. The following table summarizes the segment’s catastrophe losses, as well as the impact on key metrics in 2011 and 2010:
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Loss and loss adjustment expense (benefit), after reinsurance
  $ 87,672     $ 15,588     $ 27,000     $ (5,000 )
Reinstatement premium, net
    14,008             2,400        
 
                       
Total net catastrophe losses (benefit)
  $ 101,680     $ 15,588     $ 29,400     $ (5,000 )
 
                       
 
                               
Impact of net catastrophe losses (benefit):
                               
Net loss ratio (in percentage points)
    34.4 %     6.7 %     27.7 %     (5.9) %
Expense ratio (in percentage points)
    1.8             0.9        
 
                       
Combined ratio
    36.2 %     6.7 %     28.6 %     (5.9) %
 
                       
The increase in gross written, net written and net earned premium year-over-year principally related to our new property treaty business, which we began to write in late 2009. In 2011, we wrote more energy business due to industry rate increases and expansion of our wind storm aggregates and retained a higher percentage of this business. Written and earned premium in our international Surety & Credit and Other product lines fluctuated year-over-year due to changes in market rate pricing and our reinsurance programs. Other revenue in 2010 included third party revenue earned by our reinsurance broker, which we sold in late 2009.

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The segment had $20.6 million and $21.3 million of favorable loss development in the first nine months of 2011 and 2010 respectively, and $8.4 million and $1.7 million of favorable development in the same period of 2010. The 2011 development included $18.9 million of favorable development for our U.K. professional liability line of business (included in Liability). This business experienced lower than expected reported loss development for accident years 2004 — 2010, with approximately half of the favorable development in accident year 2009. The 2011 and 2010 year-to-date development included $5.5 million and $9.1 million, respectively, of favorable development related to prior years’ catastrophe losses.
The Liability net loss ratios reflect the 2011 favorable development. The Energy, Property Treaty and Other net loss ratios reflect the catastrophe losses in the first nine months of 2011 and 2010, as well as the favorable development related to prior years’ catastrophe losses.
The segment’s expense ratio was lower for the first nine months of 2011, primarily due to higher segment revenue in 2011 compared to 2010, as well as currency conversion expense in 2010.
Investing Segment
We invest substantially all of our funds in highly-rated fixed income securities, the majority of which are designated as available for sale securities. We held $5.8 billion of fixed income securities at September 30, 2011, compared to $5.2 billion at December 31, 2010. At September 30, 2011, 99% of our fixed income securities were investment grade, of which 81% were rated AAA or AA. The average rating of our fixed income securities portfolio was AA at September 30, 2011, compared to AA+ at June 30, 2011. The decline in the average rating was a direct result of Standard & Poor’s Corporation’s downgrade of the U.S. government debt rating in August 2011. The average long-term tax equivalent yield of our fixed income securities portfolio was 4.8% on September 30, 2011. The portfolio has a weighted-average life of 7.7 years and a weighted-average duration of 5.2 years.
The following tables summarize the investment results and key metrics related to our Investing segment.
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Fixed income securities
  $ 158,941     $ 150,001     $ 54,896     $ 50,921  
Short-term investments
    420       631       99       271  
Other investments
    2,992       3,053       962       1,011  
Net realized investment gain
    3,169       7,897       2,674       1,057  
Other-than-temporary impairment credit losses
    (3,479 )     (300 )           (300 )
Investment expense
    (3,571 )     (3,082 )     (1,192 )     (1,066 )
 
                       
Segment pretax earnings
  $ 158,472     $ 158,200     $ 57,439     $ 51,894  
 
                       
 
                               
Average investments, at cost
  $ 5,646,500     $ 5,334,463     $ 5,701,695     $ 5,350,244  
Average long-term yield *
    4.0 %     4.1 %     4.0 %     4.1 %
Average long-term tax equivalent yield *
    4.8 %     4.9 %     4.8 %     4.9 %
Average combined tax equivalent yield *
    4.6 %     4.5 %     4.7 %     4.6 %
Weighted-average life of fixed income securities
  7.7 years     6.7 years                  
Weighted-average duration of fixed income securities
  5.2 years   4.6 years                
Weighted-average combined duration
  5.0 years   4.4 years                
Average rating of fixed income securities
  AA     AA+                  
 
*   Excluding realized and unrealized gains and losses.

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The ratings of our fixed income securities at September 30, 2011 were as follows:
                                 
    Available for sale     Held to maturity  
    at fair value     at amortized cost  
    Amount     %     Amount     %  
AAA
  $ 849,992       15 %   $ 53,195       31 %
AA
    3,754,273       66       35,421       21  
A
    838,381       15       78,717       47  
BBB
    181,819       3       1,281       1  
BB and below
    26,724       1              
 
                       
Total fixed income securities
  $ 5,651,189       100 %   $ 168,614       100 %
 
                       
This table summarizes our investments by type, substantially all of which were reported at fair value, at September 30, 2011 and December 31, 2010.
                                 
    September 30, 2011     December 31, 2010  
    Amount     %     Amount     %  
U.S. government and government agency securities
  $ 300,342       5 %   $ 337,260       6 %
Fixed income securities of states, municipalities and political subdivisions
    1,079,859       18       1,082,057       19  
Special purpose revenue bonds of states, municipalities and political subdivisions
    1,815,959       30       1,628,059       29  
Corporate fixed income securities
    926,621       15       683,690       12  
Residential mortgage-backed securities
    1,111,321       18       995,108       17  
Commercial mortgage-backed securities
    249,051       4       145,228       3  
Asset-backed securities
    34,617       1       12,566        
Foreign government securities
    302,033       5       309,140       5  
Short-term investments
    197,986       3       488,002       9  
Other investments
    34,297       1       5,985        
 
                       
Total investments
  $ 6,052,086       100 %   $ 5,687,095       100 %
 
                       
Our total investments increased $365.0 million in 2011, principally from operating cash flow and a $160.2 million increase in the net unrealized gain at September 30, 2011 compared to December 31, 2010. In the past twelve months, we substantially reduced our short-term investments, and re-invested the funds in long-term fixed income securities, in order to maximize our investment return.
The methodologies used to determine the fair value of our investments are described in Note 2, “Fair Value Measurements”, to the Consolidated Financial Statements. At September 30, 2011, the net unrealized gain on our available for sale fixed income securities portfolio was $294.9 million, compared to $194.0 million at June 30, 2011 and $134.6 million at December 31, 2010. The change in the net unrealized gain or loss, net of the related income tax effect, is recorded in other comprehensive income. Our general policy has been to hold our available for sale fixed income securities through periods of fluctuating interest rates.
A security has an impairment loss when its fair value is less than its cost or amortized cost at the balance sheet date. The gross unrealized losses of individual securities within our available for sale fixed income securities was $16.7 million at September 30, 2011 and $35.6 million at December 31, 2010. We evaluate the securities in our fixed income securities portfolio for possible other-than-temporary impairment losses at each quarter end. We recognized $3.5 million of other-than-temporary impairment credit losses in the first nine months of 2011, and $0.3 million in the same period of 2010. For additional disclosures about these credit losses and a description of the accounting polices and procedures that we use to determine our other-than-temporary impairment losses, see Note 3, “Investments” to the Consolidated Financial Statements and “Critical Accounting Policies — Other-than-temporary Impairments in Investments” in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2010.

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At September 30, 2011, we held $1.8 billion of special purpose revenue bonds, as well as $1.1 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+ at September 30, 2011. Within our municipal bond portfolio, we held $226.1 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. At September 30, 2011, the percentages of our special purpose revenue bond portfolio supported by these major revenue sources were as follows: 1) water and sewer — 24%, 2) education — 21%, 3) transportation — 19% and pre-refunded bonds — 6%.
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, on an ongoing basis, thereafter. The underlying average credit rating of our special purpose revenue bond issuers, excluding any bond insurance, was AA at September 30, 2011. Although recent economic conditions in the United States may reduce the sources 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.
At September 30, 2011, we held a commercial MBS securities portfolio with a fair value of $249.1 million, an average rating of AA+ and an average loan-to-value ratio of 70%. We owned no collateralized debt obligations (CDOs) or collateralized loan obligations (CLOs), and we are not counterparty to any credit default swap transactions.
At September 30, 2011, we held $168.6 million of fixed income securities that we designated as held to maturity. We maintain these securities, which are denominated in currencies other than the functional currency of the investing subsidiary, to hedge the currency conversion risk associated with insurance claims that we will pay in these same currencies. Effective in 2011, we discontinued designating new investment purchases as held to maturity securities and plan to designate future investment purchases as available for sale securities. Any unrealized currency conversion gains and losses on available for sale securities must be recorded in other comprehensive income within shareholders’ equity, rather than in net earnings. The pretax income statement benefit related to this change in our investment management philosophy approximated $2.5 million in the first nine months of 2011. This change will create greater volatility in our currency conversion benefit or expense in future periods. All currency conversion benefit or expense, except for the conversion gains and losses on available for sale securities, is recorded in Corporate & Other beginning in 2011.
Realized gains and losses from sales of securities are usually minimal, unless we sell securities for investee credit-related reasons, or because we can reinvest the proceeds at a higher effective yield. We recognized $3.2 million of net realized investment gains in the first nine months of 2011, compared to $7.9 million of net gain in the same period of 2010.
Corporate & Other
The following table summarizes Corporate & Other activity.
                                 
    Nine months ended September 30,     Three months ended September 30,  
    2011     2010     2011     2010  
Net earned premium
  $ 203     $ 1,225     $ 45     $ 70  
Other revenue
    (506 )     987       (590 )     129  
 
                       
Total revenue
    (303 )     2,212       (545 )     199  
 
                       
 
                               
Loss and loss adjustment expense
    (1,044 )     3,611       (784 )     (349 )
Other expense — Exited Lines
    3,285       3,124       1,183       1,049  
Other expense — Corporate
    37,000       35,152       13,802       11,909  
Interest expense
    16,181       15,376       5,447       5,116  
 
                       
Total expense
    55,422       57,263       19,648       17,725  
 
                       
Pretax loss
  $ (55,725 )   $ (55,051 )   $ (20,193 )   $ (17,526 )
 
                       

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Our Corporate expenses not allocable to the segments increased $1.8 million year-over-year, primarily due to higher information technology costs related to implementation of a new company-wide financial reporting system and higher employee benefit costs, partially offset by a $2.5 million currency conversion benefit in the first nine months of 2011. Interest expense increased due to accelerated recognition of capitalized debt issuance costs in the first quarter of 2011 related to our previous Revolving Loan Facility, which we replaced in March 2011 (see further discussion below).
Liquidity and Capital Resources
Credit market disruptions in recent years have resulted in a tightening of available sources of credit and significant liquidity concerns for many companies. We believe we have sufficient sources of liquidity at a reasonable cost at the present time, based on the following:
    We held $291.1 million of unrestricted cash and liquid short-term investments at September 30, 2011.
 
    Our available for sale bond portfolio, of which $113.3 million was held directly by the parent company, had a fair value of $5.7 billion at September 30, 2011, compared to $5.0 billion at December 31, 2010. We intend to hold these securities until their maturity, but we would be able to sell securities to generate cash if the need arises.
 
    In March 2011, we replaced our $575.0 million Revolving Loan Facility with a four-year $600.0 million Revolving Loan Facility that matures on March 8, 2015, of which $392.2 million of borrowing capacity remained at September 30, 2011.
 
    Our long-term debt consists of $300.0 million principal amount of unsecured 6.30% Senior Notes due November 15, 2019. Our debt to total capital ratio was 13.1% at September 30, 2011 and 8.3% December 31, 2010, with the increase related to our borrowings under the Revolving Loan Facility.
 
    We have a $90.0 million Standby Letter of Credit Facility that expires on December 31, 2014, which is used to guarantee our performance in two Lloyd’s of London syndicates.
 
    Our domestic insurance subsidiaries have the ability to pay $183.6 million in dividends to the parent company in the fourth quarter of 2011 without obtaining special permission from state regulatory authorities. Our underwriting agencies have no restrictions on the amount of dividends that can be paid. HCC can utilize these dividends for any purpose, including to pay down debt, pay dividends to shareholders, fund acquisitions, purchase our common stock and pay operating expenses.
 
    We have a “Universal Shelf” registration statement that provides for the issuance of an aggregate of $1.0 billion of securities, of which we have $700.0 million of remaining capacity. These securities may be debt securities, equity securities, or a combination thereof. The shelf registration statement provides us the means to access the debt and equity markets relatively quickly, if we are satisfied with the current pricing in the financial market.
Capital Management
Revolving Loan Facility
On March 8, 2011, we entered into a new agreement for a four-year $600.0 million Revolving Loan Facility (Facility). The Facility replaced our $575.0 million Revolving Loan Facility, which was due to expire on December 19, 2011. The Facility allows us to borrow up to the maximum allowed on a revolving basis until the Facility expires on March 8, 2015. As of September 30, 2011, we had borrowed $195.0 million under the Facility, primarily to fund repurchases of our common stock. The borrowing rate is LIBOR plus 137.5 basis points, subject to increase or decrease based on changes in our debt rating. The contractual interest rate on borrowings under the Facility at September 30, 2011 was 1.63%. In addition, we pay a commitment fee of 20 basis points. Letters of credit issued under the Facility further reduced our available borrowing capacity on the remaining Facility to $392.2 million at September 30, 2011. The Facility contains restrictive financial covenants that require HCC to maintain a minimum consolidated net worth (excluding accumulated other comprehensive income) and a leverage ratio of less than or equal to 35%. We were in compliance with these covenants at September 30, 2011.

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Senior Notes
In 2009, we issued $300.0 million of 6.30% Senior Notes due 2019. The Senior Notes were priced at a discount of $1.5 million, for an effective interest rate of 6.37%. We pay interest semi-annually in arrears on May 15 and November 15 of each year. The Senior Notes may be redeemed in whole at any time or in part from time to time, at our option, at the redemption price determined in the manner described in the indenture governing the Senior Notes. The indenture contains restrictive covenants that impose conditions on our ability to create liens on any capital stock of our restricted subsidiaries (as defined in the indenture) or to engage in sales of the capital stock of our restricted subsidiaries. We were in compliance with the requirements of these covenants at September 30, 2011.
Standby Letter of Credit Facility
In 2010, we entered into a $90.0 million Standby Letter of Credit Facility (Standby Facility) that is used to guarantee our performance in two Lloyds’s of London syndicates. The Standby Facility expires on December 31, 2014. We pay an annual fee of 90 basis points. The Standby Facility contains restrictive financial covenants that require HCC to maintain a minimum consolidated net worth (excluding accumulated other comprehensive income) and a leverage ratio of less than or equal to 35%. We were in compliance with these covenants at September 30, 2011.
Share Repurchases
On March 10, 2011, the Board approved the purchase of up to $300.0 million of our common stock. This plan was exhausted in September and, on September 23, 2011, the Board approved purchases of an additional $300.0 million (the Plan). Purchases 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 opportunistically from time-to-time, 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 third quarter of 2011, we purchased $106.2 million, or 3.8 million shares, at an average cost of $27.73 per share, of which $7.8 million, or 0.3 million shares, were purchased under the Plan. We purchased $307.8 million, or 10.2 million shares, at an average cost of $30.25 in the first nine months of 2011.
Earnouts
We acquired HCC Global Financial Products (HCC Global), which underwrites our U.S. and International directors’ and officers’ liability business, in 2002. The purchase agreement, as amended, includes a contingency for future earnout payments. The earnout is based on HCC Global’s pretax earnings from the acquisition date through September 30, 2007, with no maximum amount due to the former owners. When conditions specified under the purchase agreement are met, we record a net amount owed to or due from the former owners based on our estimate, at that point in time, of how claims will ultimately be settled. This net amount will fluctuate in the future, and the ultimate total net earnout payments cannot be finally determined until all claims are settled or paid. In March 2011, certain amendments were made to the purchase agreement, which resulted in an adjustment to our estimate of the ultimate amounts to be settled under the agreement. As a result, we increased goodwill by $20.0 million as of March 31, 2011. In September, 2011, we increased goodwill by $31.3 million for additional earnout earned and accrued in the quarter related to favorable loss development in the U.S. D&O and International D&O lines of business.
Cash Flow
We receive substantial cash from premiums, reinsurance recoverables, surety collateral, outward commutations, proceeds from sales and redemptions of investments and investment income. Our 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, debt service, policy acquisition costs, operating expenses, taxes, dividends 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.

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We generated cash from operations of $288.0 million and $314.6 million in the first nine months of 2011 and 2010, respectively. The components of our net operating cash flows are summarized in the following table.
                 
    Nine months ended September 30,  
    2011     2010  
Net earnings
  $ 176,905     $ 247,797  
Change in premium, claims and other receivables, net of reinsurance, premium and claims payables and excluding restricted cash
    (110,979 )     (24,539 )
Change in unearned premium, net
    72,132       15,103  
Change in loss and loss adjustment expense payable, net of reinsurance recoverables
    139,536       44,355  
(Gain) loss on investments
    310       (8,086 )
Other, net
    10,055       40,001  
 
           
Cash provided by operating activities
  $ 287,959     $ 314,631  
 
           
Cash provided by operating activities was lower in 2011 than in 2010 primarily due to higher claims payments, activity related to surety collateral funds, and inward commutations completed in 2011. We paid $26.5 million more claims in 2011 compared to 2010, of which $20.2 million related to the 2011 catastrophic events, and had a $4.2 million net outflow of surety collateral funds. In 2011, we also paid $37.8 million to commute certain loss reserves in our Exited lines, which reduced our 2011 operating cash flow.
Recent Accounting Guidance
See Note 1, “General Information” to the Consolidated Financial Statements for a description of recently issued accounting guidance that will impact our consolidated financial statements in future periods.
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 ended December 31, 2010. We have made no changes in the identification or methods of application of these policies.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
There have been no material changes in market risk from the information provided in Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” in our Annual Report on Form 10-K for the year ended December 31, 2010.
Item 4. Controls and Procedures
(a) Evaluation of Disclosure Controls and Procedures
We maintain disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Act)) that are designed to ensure that required information is recorded, processed, summarized and reported within the required timeframe, as specified in rules set forth by the Securities and Exchange Commission. Our disclosure controls and procedures are also designed to ensure that information required to be disclosed is accumulated and communicated to management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO), to allow timely decisions regarding required disclosures.
Our management, with the participation of our CEO and CFO, evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2011. Based on this evaluation, our CEO and CFO concluded that our disclosure controls and procedures were effective as of September 30, 2011.
(b) Changes in Internal Control over Financial Reporting
During the third quarter of 2011, we identified no changes in our internal control over financial reporting that occurred during the quarter ended September 30, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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Part II — Other Information
Item 1. Legal Proceedings
We are a party to lawsuits, arbitrations and other proceedings that arise in the normal course of our business. Many of such lawsuits, arbitrations and other proceedings involve claims under policies that we underwrite as an insurer or reinsurer, the liabilities for which, we believe, have been adequately included in our loss reserves. Also, from time to time, we are a party to lawsuits, arbitrations and other proceedings that relate to disputes with third parties, or that involve alleged errors and omissions on the part of our subsidiaries. We have provided accruals for these items to the extent we deem the losses probable and reasonably estimable. Although the ultimate outcome of these matters cannot be determined at this time, based on present information, the availability of insurance coverage and advice received from our outside legal counsel, we believe the resolution of any such matters will not, individually or in the aggregate, have a material adverse effect on our consolidated financial position, results of operations or cash flows.
Item 1A. Risk Factors
There have been no material changes in the risk factors described in our Annual Report on Form 10-K for the year ended December 31, 2010.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
On September 23, 2011, the Board approved the purchase of up to an aggregate of $300.0 million of our common stock (the Plan). This new authorization follows the completion of a $300.0 million share repurchase program approved on March 10, 2011. 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 will be made opportunistically from time to, 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.
During the third quarter of 2011, we purchased our common stock, as follows:
                                 
                    Total number of shares     Approximate dollar  
                    purchased as part of     value of shares that may  
    Total number of     Average price     publicly announced     yet be purchased under  
Period   shares purchased     paid per share     plans or programs     the plans or programs  
March 2011 Plan
                               
July 1 - July 31, 2011
    314,379     $ 30.96       314,379     $ 88,619,230  
August 1 - August 31, 2011
    3,227,237     $ 27.46       3,227,237     $ 36  
September 1 - September 30, 2011
                       
 
                               
September 2011 Plan
                               
September 1 - September 30, 2011
    287,711     $ 27.23       287,711     $ 292,166,062  
Item 3. Defaults Upon Senior Securities
None.
Item 4. [Removed and Reserved]
Item 5. Other Information
None.

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Item 6. Exhibits
a. Exhibits
3.1   Restated Certificate of Incorporation and Certificate of Amendment of Certificate of Incorporation of HCC Insurance Holdings, Inc., filed with the Secretary of State of Delaware on July 23, 1996 and May 21, 1998, respectively (incorporated by reference to Exhibit 4.1 to the Company’s Registration Statement on Form S-8 (Registration No. 333-61687) filed on August 17, 1998).
 
3.2   Amended and Restated Bylaws of HCC Insurance Holdings, Inc. (incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed on April 3, 2008).
 
4.1   Indenture, dated August 23, 2001, between HCC Insurance Holdings, Inc. and First Union National Bank related to Debt Securities (incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K filed on August 24, 2001).
 
4.2   Form of Fourth Supplemental Indenture, dated November 16, 2009, between HCC Insurance Holdings, Inc. and U.S. Bank National Association related to the 6.30% Senior Notes due 2019 (incorporated by reference to Exhibit 4.2 to the Company’s Current Report on Form 8-K filed on November 13, 2009).
 
10.1   Separation Agreement, dated September 13, 2011, between HCC Insurance Holdings, Inc. and W. Tobin Whamond (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on September 13, 2011).
 
10.2   First Amendment to Loan Agreement, dated September 22, 2011, among HCC Insurance Holdings, Inc., Wells Fargo Bank, National Association, as Administrative Agent, Barclays Bank PLC and Bank of America, N.A., as Co-Syndication Agents, JPMorgan Chase Bank, N.A. and The Royal Bank of Scotland PLC, as Co-Documentation Agents, and the other lenders party thereto (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on September 28, 2011).
 
12   Statement of Ratios
 
31.1   Certification by Chief Executive Officer.
 
31.2   Certification by Chief Financial Officer.
 
32   Certification with Respect to Quarterly Report.
 
101   The following financial statements from our Quarterly Report on Form 10-Q for the quarter ended Septmeber 30, 2011, formatted in XBRL: (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Earnings, (iii) Consolidated Statement of Changes in Shareholders’ Equity, (iv) Consolidated Statements of Cash Flows and (v) Notes to Consolidated Financial Statements.*
 
*   The XBRL related information in Exhibit 101 shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to liability of that section and shall not be incorporated by reference into any filing or other document pursuant to the Securities Act of 1933, as amended, except as shall be expressly set forth by specific reference in such filing or document.

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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
             
 
      HCC Insurance Holdings, Inc.    
 
     
 
(Registrant)
   
 
           
November 7, 2011
      /s/ John N. Molbeck, Jr.    
(Date)
     
 
John N. Molbeck, Jr.,
   
 
      Chief Executive Officer    
 
           
November 7, 2011
      /s/ Pamela J. Penny    
(Date)
     
 
Pamela J. Penny, Executive Vice President
   
 
      and Chief Accounting Officer    

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