Edgar Filing: HCC INSURANCE HOLDINGS INC/DE/

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549-1004

FORM 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934.

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934.

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 (IRS Employer
incorporation or organization) 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)

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
------------------- -----------------------------------------

Common Stock, $1.00 Par Value New York Stock Exchange

SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: NONE

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 (the "Act") 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 [X] No [ ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K (sec. 229.405 of this chapter) is not contained herein and
will not be contained, to the best of Registrant's knowledge, in definitive
proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K. [X]

Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [ ]

The aggregate market value on June 30, 2003 (the last business day of the
Registrant's most recently completed second fiscal quarter), of the voting stock
held by non-affiliates of the Registrant was approximately $1.8 billion. For
purposes of the determination of the above stated amount, only directors and
executive officers are presumed to be affiliates, but neither the Registrant nor
any such person concede that they are affiliates of the Registrant.

The number of shares outstanding of the Registrant's Common Stock, $1.00
par value, as of February 27, 2004, was 64,368,384.

DOCUMENTS INCORPORATED BY REFERENCE

Information called for in Part III of this Form 10-K is incorporated by
reference to the Registrant's definitive Proxy Statement to be filed within 120
days of the close of the Registrant's fiscal year in connection with the
Registrant's annual meeting of shareholders.

HCC INSURANCE HOLDINGS, INC.

TABLE OF CONTENTS

PAGE
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PART I.
Item 1. Business.................................................... 2
Item 2. Properties.................................................. 30
Item 3. Legal Proceedings........................................... 30
Item 4. Submission of Matters to a Vote of Security Holders......... 31
PART II.
Item 5. Market for the Registrant's Common Equity and Related
Stockholder Matters......................................... 31
Item 6. Selected Financial Data..................................... 32
Item 7. Management's Discussion and Analysis of Financial Condition
and Results
of Operations............................................... 34
Item 7A. Quantitative and Qualitative Disclosure About Market Risk... 50
Item 8. Financial Statements and Supplementary Data................. 52
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosures................................... 52
Item 9A. Controls and Procedures..................................... 52
PART III.
Item 10. Directors and Executive Officers of the Registrant.......... 53
Item 11. Executive Compensation...................................... 53
Item 12. Security Ownership of Certain Beneficial Owners and
Management and Related Shareholder Matters.................. 53
Item 13. Certain Relationships and Related Transactions.............. 53
Item 14. Principal Accountant Fees and Services...................... 53
PART IV.
Item 15. Exhibits, Financial Statement Schedules and Reports on Form
8-K......................................................... 54
SIGNATURES............................................................ 55

This report on Form 10-K 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 future capital expenditures,
business strategy, competitive strengths, goals, growth of our business and
operations, plans 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 impact the matters addressed in these forward-looking
statements.

Many possible events or factors could affect our future financial results
and performance. These 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 which are included in this report, our inclusion of this information
is not a representation by us or any other person that our objectives and plans
will be achieved.

Our forward-looking statements speak only as of 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.

PART I

ITEM 1. BUSINESS

TERMINOLOGY

HCC Insurance Holdings, Inc. is a Delaware corporation, which was formed in
1991. Its predecessor corporation was formed in 1974. Our principal executive
offices are located at 13403 Northwest Freeway, Houston, Texas 77040 and our
telephone number is (713) 690-7300. We maintain an Internet web-site at
www.hcch.com. The reference to our Internet web-site address in this report does
not constitute the incorporation by reference of the information contained at
this site in this report. We will make available, free of charge through
publication on our Internet web-site, a copy of our Annual Report on Form 10-K
and quarterly reports on Form 10-Q and any current reports on Form 8-K or
amendments to those reports, filed or furnished to the Securities and Exchange
Commission as soon as reasonably practicable after we have filed or furnished
such materials with the Securities and Exchange Commission.

As used in this report, unless otherwise required by the context, the terms
"we," "us" and "our" refer to HCC Insurance Holdings, Inc. and its consolidated
subsidiaries and the term "HCC" refers only to HCC Insurance Holdings, Inc. All
trade names or trademarks appearing in this report are the property of their
respective holders.

RISK FACTORS

The following factors as well as other information contained in this report
should be considered.

IF WE CANNOT OBTAIN ADEQUATE REINSURANCE PROTECTION FOR SOME OF THE RISKS WE
HAVE UNDERWRITTEN, WE WILL EITHER BE EXPOSED TO GREATER LOSSES FROM THESE
RISKS OR WE WILL REDUCE THE LEVEL OF BUSINESS WE UNDERWRITE, WHICH WILL REDUCE
OUR REVENUES.

We purchase reinsurance for significant amounts of risk underwritten by our
insurance companies, especially volatile and catastrophic risks. Market
conditions beyond our control determine the availability and cost of the
reinsurance protection we purchase, which may affect the level of our business
and profitability. For instance, the natural attrition of reinsurers who exit
lines of business, or who curtail their writings, for economic or other reasons,
reduces the capacity of the reinsurance market, causing rates to rise. In
addition, the historical results of reinsurance programs and the availability of
capital also affect the availability of reinsurance. Our reinsurance facilities
are generally subject to annual renewal. We cannot assure you that we can
maintain our current reinsurance facilities or that we can obtain other
reinsurance facilities in adequate amounts and at favorable rates. Further, we
cannot determine what effect catastrophic losses will have on the reinsurance
market in general and on our ability to obtain reinsurance in adequate amounts
and at favorable rates in particular. If we are unable to renew our expiring
facilities or to obtain new reinsurance facilities, either our net exposures
would increase or, if we are unwilling to bear an increase in net exposures, we
would have to reduce the level of our underwriting commitments, especially
catastrophe-exposed risks. Either of these potential developments could have a
material adverse effect on our business. The lack of available reinsurance may
also adversely affect our ability to generate fee and commission income in our
underwriting agency and reinsurance intermediary operations.

IF THE COMPANIES THAT PROVIDE OUR REINSURANCE DO NOT PAY ALL OF OUR CLAIMS, WE
COULD INCUR SEVERE LOSSES.

We purchase reinsurance by transferring, or ceding, part of the risk we
have assumed to a reinsurance company in exchange for part of the premium we
receive in connection with the risk. The part of the risk we retain for our own
account is known as the retention. Through reinsurance, we have the contractual
right to collect the amount above our retention from our reinsurers. Although
reinsurance makes the reinsurer liable to us to the extent the risk is
transferred or ceded to the reinsurer, it does not relieve us, the reinsured, of
our full liability to our policyholders. Accordingly, we bear credit risk with
respect to our reinsurers. We cannot assure you that our reinsurers will pay all
of our reinsurance claims, or that they will pay our claims on a timely basis.
2

If we become liable for risks we have ceded to reinsurers or if our
reinsurers cease to meet their obligations to us, whether because they are in a
weakened position as a result of incurred losses or otherwise, our financial
position, results of operations and cash flows could be materially adversely
affected.

IF WE ARE UNSUCCESSFUL IN COMPETING AGAINST LARGER OR MORE WELL-ESTABLISHED
BUSINESS RIVALS, OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION WILL BE
ADVERSELY AFFECTED.

In our specialty insurance operations, we compete in narrowly-defined niche
classes of business such as the insurance of private aircraft (aviation),
directors' and officers' liability (diversified financial products) and employer
sponsored, self-insured medical plans (medical stop-loss), as distinguished from
such general lines of business as automobile or homeowners insurance. We compete
with a large number of other companies in our selected lines of business,
including: American International Group and U.S. Aviation Insurance Group (a
subsidiary of Berkshire Hathaway, Inc.) in our aviation line of business; SAFECO
Corporation and Hartford Life, Inc. in our group life, accident and health line
of business; The Chubb Corporation and American International Group in our
diversified financial products line of business. We face competition both from
specialty insurance companies, underwriting agencies and intermediaries as well
as from diversified financial services companies that are larger than we are and
that have greater financial, marketing and other resources than we do. Some of
these competitors also have longer experience and more market recognition than
we do. In addition to competition in the operation of our business, we face
competition from a variety of sources in attracting and retaining qualified
employees.

We cannot assure you that we will maintain our current competitive position
in the markets in which we operate, or that we will be able to expand our
operations into new markets. If we fail to do so, our business could be
materially adversely affected.

BECAUSE WE ARE A PROPERTY AND CASUALTY INSURER, UNFORESEEN CATASTROPHIC LOSSES
MAY ADVERSELY AFFECT OUR RESULTS OF OPERATIONS, LIQUIDITY AND FINANCIAL
CONDITION.

Property and casualty insurers are subject to claims arising out of
catastrophes that may have a significant effect on their results of operations,
liquidity and financial condition. Catastrophic losses have had a significant
impact on our results. Catastrophes can be caused by various events, including
hurricanes, windstorms, earthquakes, hailstorms, explosions, severe winter
weather and fires and may include man-made events, such as the September 11,
2001 terrorist attacks. The incidence, frequency and severity of catastrophes
are inherently unpredictable. The extent of losses from a catastrophe is a
function of both the total amount of insured exposure in the area affected by
the event and the severity of the event. Most catastrophes are restricted to
small geographic areas; however, hurricanes, earthquakes and terrorist attacks
may produce significant damage in large, heavily populated areas. Catastrophes
can cause losses in a variety of our property and casualty lines and most of our
past catastrophe-related claims have resulted from hurricanes and earthquakes;
however, as a result of the September 11, 2001 terrorist attack, we experienced
the largest single loss to our insurance company operations in our history.
Insurance companies are not permitted to reserve for a catastrophe until it has
occurred. In 2004, we estimate that approximately 7% of our current business
(based on gross written premium) may be affected by catastrophes. It is
therefore possible that a catastrophic event or multiple catastrophic events
could have material adverse effect upon our results of operations, liquidity and
financial condition.

BECAUSE WE OPERATE INTERNATIONALLY, FLUCTUATIONS IN CURRENCY EXCHANGE RATES
MAY AFFECT OUR RECEIVABLE AND PAYABLE BALANCES AND OUR RESERVES, WHICH MAY
ADVERSELY AFFECT OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION.

We underwrite insurance coverages which are denominated in a number of
foreign currencies and we establish and maintain our loss reserves with respect
to these policies in their respective currencies. Our net earnings could be
adversely affected by exchange rate fluctuations, which would adversely affect
receivable and payable balances and reserves. Our principal area of exposure
relates to fluctuations in exchange rates between the major European currencies
(particularly the British pound sterling and the

Euro) and the U.S. dollar. Consequently, a change in the exchange rate between
the U.S. dollar and the British pound sterling or the Euro could have an adverse
effect on our net earnings.

IF WE FAIL TO COMPLY WITH EXTENSIVE STATE, FEDERAL AND FOREIGN REGULATIONS, WE
WILL BE SUBJECT TO PENALTIES, WHICH MAY INCLUDE FINES AND SUSPENSION AND WHICH
MAY ADVERSELY AFFECT OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION.

We are subject to extensive governmental regulation and supervision. Most
insurance regulations are designed to protect the interests of policyholders
rather than shareholders and other investors. This regulation, generally
administered by a department of insurance in each state in which we do business,
relates to, among other things:

- approval of policy forms and premium rates;

- standards of solvency, including risk-based capital measurements (which
are a measure developed by the National Association of Insurance
Commissioners and used by state insurance regulators to identify
insurance companies that potentially are inadequately capitalized);

- licensing of insurers and their agents;

- restrictions on the nature, quality and concentration of investments;

- restrictions on the ability of our insurance companies to pay dividends
to us;

- restrictions on transactions between insurance companies and their
affiliates;

- restrictions on the size of risks insurable under a single policy;

- requiring deposits for the benefit of policyholders;

- requiring certain methods of accounting;

- periodic examinations of our operations and finances;

- prescribing the form and content of records of financial condition
required to be filed; and

- requiring reserves for unearned premium, losses and other purposes.

State insurance departments also conduct periodic examinations of the
affairs of insurance companies and require the filing of annual and other
reports relating to the financial condition of insurance companies, holding
company issues and other matters.

Recently adopted federal legislation to modernize financial services may
lead to additional federal regulation of the insurance industry in the coming
years. Also, foreign governments regulate our international operations. Our
business depends on compliance with applicable laws and regulations and our
ability to maintain valid licenses and approvals for our operations.

Some regulatory authorities have relatively broad discretion to grant,
renew, or revoke licenses and approvals. Regulatory authorities may deny or
revoke licenses for various reasons, including the violation of regulations. In
some instances, we follow practices based on our interpretations of regulations,
or those we believe to be generally followed by the industry, which may be
different from the requirements or interpretations of regulatory authorities. If
we do not have the requisite licenses and approvals and do not comply with
applicable regulatory requirements, the insurance regulatory authorities could
preclude or temporarily suspend us from carrying on some or all of our
activities or otherwise penalize us. That type of action could have a material
adverse effect on our business. Also, changes in the level of regulation of the
insurance industry (whether federal, state or foreign), or changes in laws or
regulations themselves or interpretations by regulatory authorities, could have
a material adverse effect on our business.

IF THE RATING AGENCIES DOWNGRADE OUR COMPANY OR OUR INSURANCE COMPANIES, OUR
RESULTS OF OPERATIONS AND COMPETITIVE POSITION IN THE INDUSTRY MAY SUFFER.

Ratings have become an increasingly important factor in establishing the
competitive position of insurance companies. Our insurance companies are rated
by A.M. Best Company, Inc. and Standard & Poor's Corporation, whose ratings
reflect their opinions of an insurance company's and insurance holding company's
financial strength, operating performance, strategic position and ability to
meet its obligations to policyholders and are not evaluations directed to
investors. Our ratings are subject to periodic review by those entities and the
continued retention of those ratings cannot be assured. If our ratings are
reduced from their current levels by those entities, our results of operations
could be adversely affected.

OUR LOSS RESERVES ARE BASED ON AN ESTIMATE OF OUR FUTURE LIABILITY. IF ACTUAL
CLAIMS PROVE TO BE GREATER THAN OUR RESERVES, OUR RESULTS OF OPERATIONS AND
FINANCIAL CONDITION MAY BE ADVERSELY AFFECTED.

We maintain loss reserves to cover our estimated liability for unpaid
losses and loss adjustment expenses, including legal and other fees as well as a
portion of our general expenses, for reported and unreported claims incurred as
of the end of each accounting period. Reserves do not represent an exact
calculation of liability. Rather, reserves represent an estimate of what we
expect the ultimate settlement and administration of claims will cost. These
estimates, which generally involve actuarial projections, are based on our
assessment of facts and circumstances then known, as well as estimates of future
trends in claims severity, frequency, judicial theories of liability and other
factors. These variables are affected by both internal and external events, such
as changes in claims handling procedures, inflation, judicial trends and
legislative changes. Many of these items are not directly quantifiable in
advance. Additionally, there may be a significant reporting delay between the
occurrence of the insured event and the time it is reported to us. The inherent
uncertainties of estimating reserves are greater for certain types of
liabilities, particularly those in which the various considerations affecting
the type of claim are subject to change and in which long periods of time may
elapse before a definitive determination of liability is made. Reserve estimates
are continually refined in a regular and ongoing process as experience develops
and further claims are reported and settled. Adjustments to reserves are
reflected in the results of the periods in which such estimates are changed.
Because setting reserves is inherently uncertain, there can be no assurance that
current reserves will prove adequate in light of subsequent events.

WE INVEST A SIGNIFICANT AMOUNT OF OUR ASSETS IN FIXED INCOME SECURITIES THAT
HAVE EXPERIENCED MARKET FLUCTUATIONS. FLUCTUATIONS IN THE FAIR MARKET VALUE OF
FIXED INCOME SECURITIES MAY GREATLY REDUCE THE VALUE OF OUR INVESTMENT
PORTFOLIO AND AS A RESULT, OUR FINANCIAL CONDITION MAY SUFFER.

As of December 31, 2003, $1.2 billion of our $1.7 billion investment
portfolio was invested in fixed income securities. The fair market value of
these fixed income securities and the related investment income fluctuate
depending on general economic and market conditions. With respect to our
investments in fixed income securities, the fair market value of these
investments generally increases or decreases in an inverse relationship with
fluctuations in interest rates, while net investment income realized by us from
future investments in fixed income securities will generally increase or
decrease with interest rates. In addition, actual net investment income and/or
cash flows from investments that carry prepayment risk (such as mortgage-backed
and other asset-backed securities) may differ from those anticipated at the time
of investment as a result of interest rate fluctuations. An investment has
prepayment risk when there is a risk that the timing of cash flows that result
from the repayment of principal might occur earlier than anticipated because of
declining interest rates or later than anticipated because of rising interest
rates. Although we maintain an investment grade portfolio (97% are rated "A" or
better), our fixed income securities are also subject to credit risk. If any of
the issuers of our fixed income securities suffer financial setbacks the ratings
on the fixed income securities could fall (with a concurrent fall in market
value) and, in a worse case scenario, the issuer could default on its financial
obligations. Historically, the impact of market fluctuations has affected our
financial statements. Because all of our fixed income securities are classified
as available for sale, changes in the fair market value of our securities are
reflected in our other comprehensive income. Similar treatment is not available
for liabilities. Therefore, interest rate fluctuations

could adversely affect our shareholders' equity, total comprehensive income
and/or our cash flows. Unrealized pre-tax net investment gains (losses) on
investments in fixed-income securities were $(3.7) million, $22.0 million and
$0.7 million for the years ended December 31, 2003, 2002 and 2001, respectively.

IF STATES DRASTICALLY INCREASE THE ASSESSMENT OUR INSURANCE COMPANIES ARE
REQUIRED TO PAY, OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION WILL
SUFFER.

Our insurance companies are subject to assessments in most states where we
are licensed for the provision of funds necessary for the settlement of covered
claims under certain policies provided by impaired, insolvent or failed
insurance companies or for the issuance of insurance policies to "high risk" or
otherwise uninsured individuals. Maximum contributions required by law in any
one year vary by state and have historically been between 1% and 2% of annual
premiums written. We cannot predict with certainty the amount of future
assessments. Significant assessments could have a material adverse effect on our
financial condition or results of operations.

IF WE ARE UNABLE TO OBTAIN DIVIDENDS IN NEEDED AMOUNTS FROM OUR INSURANCE
COMPANIES AS A RESULT OF REGULATORY RESTRICTIONS AND THE CASH FLOW FROM OUR
NON-INSURANCE OPERATIONS IS NOT SUFFICIENT, WE MAY NOT BE ABLE TO MEET OUR
DEBT, DIVIDEND AND EXPENSE OBLIGATIONS.

Historically, we have had sufficient cash flow from our non-insurance
company subsidiaries to meet our corporate cash flow requirements for paying
principal and interest on outstanding debt obligations, dividends to
shareholders and corporate expenses. However, in the future we may rely on
dividends from our insurance companies to meet these requirements. The payment
of dividends by our insurance companies is subject to regulatory restrictions
and will depend on the surplus and future earnings of these subsidiaries, as
well as the regulatory restrictions. As a result, should our other sources of
funds prove to be inadequate, we may not be able to receive dividends from our
insurance companies at times and in amounts necessary to meet our obligations.

BUSINESS OVERVIEW

We provide group life, accident and health and property and casualty
insurance coverages, underwriting agency and intermediary services both to
commercial customers and individuals. We concentrate our activities in selected,
narrowly defined, specialty lines of business. We operate primarily in the
United States, the United Kingdom, Spain and Bermuda, although some of our
operations have a broader international scope. We underwrite insurance both on a
direct basis, where we insure a risk in exchange for a premium and on a
reinsurance basis, where we insure all or a portion of another insurance
company's risk in exchange for all or a portion of the premium. We market our
insurance products both directly to customers and through independent or
affiliated agents and brokers.

Since our founding, we have been consistently profitable, generally
reporting annual increases in gross written premium and total revenue. During
the period 1999 through 2002, which is the latest period for which industry
information is available, we had an average statutory combined ratio of 103.9%
versus the less favorable 110.3% (source: A.M. Best Company, Inc.) recorded by
the U.S. property and casualty insurance industry overall. During the period
1999 through 2003, our gross written premium increased from $568.3 million to
$1.7 billion, an increase of 206%, while net written premium increased 519% from
$139.9 million to $865.5 million. During this period, our revenue increased from
$338.1 million to $942.0 million, an increase of 179%.

During the period December 31, 1999 through December 31, 2003, our
shareholders' equity increased from $458.4 million to $1.0 billion, a 128%
increase. During the same period, our assets increased from $2.7 billion to $4.9
billion, an 81% increase.

Our insurance companies are risk-bearing and focus their underwriting
activities on providing insurance and/or reinsurance in the following lines of
business:

- Group life, accident and health

- Diversified financial products

- London market account

- Aviation

- Other specialty lines

In the United States, American Contractors Indemnity Company (acquired in
January, 2004), Avemco Insurance Company, U.S. Specialty Insurance Company and
HCC Life Insurance Company operate on an admitted, or licensed, basis. Houston
Casualty Company and HCC Specialty Insurance Company operate on a surplus lines
basis as a non-admitted, or unlicensed, insurer offering insurance coverage not
otherwise available from an admitted insurer in the relevant state. Houston
Casualty Company operates a registered branch office in London and offers
insurance in the United Kingdom and selected other countries. Houston Casualty
Company Europe Seguros y Reaseguros S.A., which does business as HCC Europe,
operates from its Madrid, Spain offices and offers insurance throughout the
European Union.

Our operating insurance companies are rated "A+ (Superior)" (2nd of 16
ratings) by A.M. Best Company, Inc. and "AA (Very Strong)" (3rd of 22 ratings)
by Standard and Poor's Corporation, two nationally recognized independent rating
agencies. These ratings are intended to provide an independent opinion of an
insurer's ability to meet its obligations to policyholders and are not
evaluations directed at investors.

Our underwriting agencies underwrite on behalf of our insurance companies
and other non-affiliated insurance companies. They receive fees for these
services and do not bear any of the insurance risk of the companies for which
they underwrite. Our underwriting agencies generate revenues based entirely on
fee income and profit commissions and specialize in contingency (including
contest indemnification, event cancellation and weather coverages); directors'
and officers' liability; errors and omissions; individual disability (for
athletes and other high profile individuals); kidnap and ransom; life, accident
and health; marine; professional indemnity; and other specialty lines of
business. Our principal underwriting agencies are ASU International, Inc.,
Covenant Underwriters, Ltd., HCC Benefits Corporation, HCC Global Financial
Products, LLC, HCC Diversified Financial Products, Limited and Professional
Indemnity Agency, Inc.

Our intermediaries provide insurance and reinsurance brokerage services for
our insurance companies and our clients and receive fees for their services. A
reinsurance intermediary structures and arranges reinsurance between insurers
seeking to cede insurance risks and reinsurers willing to assume such risks. Our
intermediaries do not bear any of the insurance risks of their client companies.
They earn commission income and to a lesser extent fees for certain services,
generally paid by the insurance and reinsurance companies with whom the business
is placed. These operations consist of consulting with clients by providing
information about insurance coverage and marketing, placing and negotiation
particular insurance risks. Our intermediaries specialize in placing reinsurance
for life, accident and health and property and casualty lines of business. Our
principal intermediaries are HCC Risk Management, Inc. and Rattner Mackenzie
Limited.

OUR STRATEGY

Our business philosophy as an insurer is to maximize underwriting profits
while limiting risk in order to preserve shareholders' equity and maximize
earnings. We concentrate our insurance writings in selected, narrowly defined,
specialty lines of business where we believe we can achieve an underwriting
profit. We market our insurance products both directly to customers and through
independent or affiliated agents and brokers.
7

The property and casualty insurance industry and individual lines of
business within the industry are cyclical in that there are times when a large
number of companies offer insurance on certain lines of business, causing
premiums to trend downward and other times where insurance companies decide to
limit their writings in certain lines of business or suffer from excessive
losses, which results in an increase in premiums for those companies that
continue to write insurance in those lines of business. In our insurance company
operations, we believe our operational flexibility, which permits us to shift
the focus of our insurance underwriting activity amongst our various lines of
business and also to shift the emphasis from our insurance risk-bearing business
to our non-insurance fee-based business, as well as our experienced underwriting
personnel and access to and expertise in, the reinsurance marketplace allow us
to implement a strategy of emphasizing more profitable lines of business during
periods of increased premium rates and de-emphasizing less profitable lines of
business during periods of increased competition. In addition, we believe that
our underwriting agencies and intermediaries complement our insurance
underwriting activities. Our ability to utilize affiliated insurers,
underwriting agencies and intermediaries permits us to retain a greater portion
of the gross revenue derived from written premium.

Reinsurance enables us to transfer part of the risk we have underwritten
through the process of ceding this risk to a reinsurance company in exchange for
part of the premium we receive in connection with the risk. We purchase
reinsurance to limit the net loss to our insurance companies from both
individual and catastrophic risks. The amount of reinsurance we purchase varies
by, among other things, the particular risks inherent in the policies
underwritten, the pricing of reinsurance and the competitive conditions within
the relevant line of business.

In 2003, due to a continuing hardening of the insurance market, premium
rates increased in varying amounts across all of our lines of business,
substantially improving our overall underwriting profitability. We anticipate
continued underwriting profitability during 2004. In response to these changing
market conditions, we plan to continue to expand the underwriting activities in
our insurance company operations and retain more of the risks and applicable
premiums.

We also acquire or make strategic investments in companies that present an
opportunity for future profits or for enhancement of our business. We expect to
continue to acquire complementary businesses. We believe that we can enhance
acquired businesses through the synergies created by our underwriting
capabilities and our other operations. However, our business plan is shaped by
our underlying business philosophy, which is to maximize underwriting profit and
net earnings, while preserving shareholders' equity. As a result, our primary
objective is to increase net earnings rather than market share or gross written
premium.

In our ongoing operations, we will continue to:

- emphasize the underwriting of lines of business in which premium rates,
the availability and cost of reinsurance, and market conditions warrant;

- limit our net loss exposure to our insurance companies from a
catastrophic loss through the use of reinsurance; and

- review the potential acquisition of specialty insurance operations and
other strategic investments.

INDUSTRY SEGMENT INFORMATION

Financial information concerning our operations by industry segment is set
forth in the Consolidated Financial Statements and the Notes thereto.

RECENT ACQUISITIONS

We have made a series of acquisitions that have furthered our overall
business strategy. Our recent transactions are described below:

On October 1, 2002, we acquired all of the outstanding member interests of
MAG Global Financial Products, LLC, an underwriting agency specializing in
directors' and officers' liability and professional
8

liability insurance. The total purchase price of the acquisition is based in
part on future earnings. We paid an initial $6.9 million for the acquisition in
2002 and paid an additional $4.1 million during 2003. We may pay additional
amounts in the future based upon the attainment of certain earnings benchmarks
through September, 2007. MAG Global Financial Products, LLC has been renamed HCC
Global Financial Products, LLC.

On December 24, 2002, we acquired all of the outstanding shares of
Manchester Dickson Holdings Limited, the parent Company of Dickson Manchester &
Company, Limited, an underwriting agency and Lloyd's broker specializing in U.K.
professional indemnity products. We paid $17.0 million as an initial amount and
during 2004, will pay an additional GBP6.8 million ($12.0 million at December
31, 2003 rate of exchange) in final payment for the acquisition. Dickson
Manchester & Company, Limited's underwriting operations have been renamed HCC
Diversified Financial Products Limited and its brokerage operations have been
consolidated with Rattner Mackenzie Limited.

On December 31, 2002, we acquired all of the outstanding shares of St. Paul
Holdings Limited. St. Paul Holdings Limited was a holding company for St. Paul
Espana Compania de Seguros y Reaseguros S.A., a Spanish insurer which now
operates as HCC Europe. Following adjustments, we paid $8.1 million for the
acquisition. HCC Europe writes surety, directors' and officers' liability and
professional liability insurance in Spain and other countries in the European
Union.

On July 1, 2003, we acquired all of the outstanding shares of Covenant
Underwriters Limited and Continental Underwriters Limited, an underwriting
agency and an intermediary, respectively, specializing in commercial marine
insurance. We paid $11.6 million and issued 314,537 shares of our common stock
in connection with the acquisition and may pay additional amounts if certain
earnings targets are reached through December 31, 2006.

On January 31, 2004, we acquired all of the shares of Surety Associates
Holding Co., Inc., the parent company of American Contractors Indemnity Company,
a California insurer specializing in court, specialty contract, license and
permit bonds. We paid $46.5 million for the acquisition.

We continue to evaluate possible acquisition candidates and we may complete
additional acquisitions during 2004. Any future acquisitions will be designed to
expand and strengthen our existing lines of business and perhaps provide access
to additional specialty sectors, which we expect to contribute to our overall
growth.

RECENT DISPOSITION

On December 31, 2003, we sold the business of our retail insurance agency
subsidiary, HCC Employee Benefits, Inc. We received $62.5 million in proceeds
from such sale and may receive additional amounts based upon the 2004 earnings
of the disposed operations.

INSURANCE COMPANY OPERATIONS

LINES OF BUSINESS

This table shows our insurance companies' total premium written, otherwise
known as gross written premium, by line of business and the percentage of each
line to total gross written premium for the years indicated (dollars in
thousands):

2003 2002 2001
---------------- ---------------- ----------------

Group life, accident and
health....................... $ 565,494 32% $ 503,263 44% $ 502,086 49%
Diversified financial
products..................... 553,501 32 178,653 15 46 --
London market account.......... 223,149 13 199,816 17 133,579 13
Aviation....................... 214,718 12 212,518 18 198,015 20
Other specialty lines.......... 148,239 9 32,563 3 15,556 2
---------- --- ---------- --- ---------- ---
1,705,101 98 1,126,813 97 849,282 84
Discontinued lines of
business..................... 34,793 2 32,436 3 160,793 16
---------- --- ---------- --- ---------- ---
Total gross written
premium................... $1,739,894 100% $1,159,249 100% $1,010,075 100%
========== === ========== === ========== ===

This table shows our insurance companies' actual premium retained,
otherwise known as net written premium, by line of business and the percentage
of each line to total net written premium for the years indicated (dollars in
thousands):

2003 2002 2001
-------------- -------------- --------------

Group life, accident and health.... $299,913 35% $244,554 45% $146,220 39%
Diversified financial products..... 183,560 21 43,731 8 44 --
London market account.............. 155,987 18 113,925 21 54,056 15
Aviation........................... 99,447 11 99,826 18 98,249 26
Other specialty lines.............. 109,408 13 25,621 5 14,346 4
-------- --- -------- --- -------- ---
848,315 98 527,657 97 312,915 84
Discontinued lines of business..... 17,187 2 18,254 3 60,043 16
-------- --- -------- --- -------- ---
Total net written premium........ $865,502 100% $545,911 100% $372,958 100%
======== === ======== === ======== ===

UNDERWRITING

We underwrite direct business produced through independent agents and
brokers, affiliated underwriting agencies and intermediaries and by direct
marketing efforts. We also write facultative, or individual account,
reinsurance, as well as some treaty reinsurance business.

GROUP LIFE, ACCIDENT AND HEALTH

We write medical stop-loss business for employer-sponsored, self-insured
health plans. Our medical stop-loss insurance provides coverages to companies,
associations and public entities that elect to self-insure their employee's
medical coverage for losses within specified levels, allowing them to manage the
risk of excessive health insurance exposure by limiting aggregate and specific
losses to a predetermined amount. We also underwrite a small program of group
life insurance offered to our insureds as a complement to our medical stop-loss
products. Our underwriting agency, HCC Benefits Corporation, produces and
underwrites this business on behalf of two of our insurance companies: HCC Life
Insurance Company and Avemco Insurance Company. HCC Benefits Corporation began
underwriting this business in 1980 and has grown both internally and through
acquisitions. HCC Benefits Corporation is considered a market leader in medical
stop-loss insurance. We first began writing this business in our insurance
companies in 1997. In 1999, we acquired The Centris Group, Inc., doubling our
gross written premium at that time to approximately $400.0 million. We maintain
reinsurance on a proportional basis, where we

share a proportional part of the original premium and losses with reinsurers and
believe that these risks carry a relatively low level of catastrophe exposure.

We began writing alternative workers' compensation and occupational
accident insurance in 1996. The business is currently written through U.S.
Specialty Insurance Company. We maintain specific reinsurance on an excess of
loss basis and we believe there is a relatively low level of catastrophe
exposure in this business.

DIVERSIFIED FINANCIAL PRODUCTS

We underwrite a variety of financial insurance risks in our diversified
financial products line of business. These risks include:

- directors' and officers' liability

- employment practices liability

- errors and omissions or professional indemnity

- surety

We began to underwrite this line of business with our acquisition of
Professional Indemnity Agency, Inc. in October, 2001. We have substantially
increased our level of business in this area through our October, 2002
acquisition of HCC Global Financial Products, LLC and December, 2002
acquisitions of Dickson Manchester & Company, Limited and HCC Europe. In January
2004, we acquired American Contractors Indemnity Company, a California based
surety insurer. Each of the acquired entities has substantial experience in
their respective specialty within this line of business.

In 2002, we experienced substantial rate increases throughout this line of
business, particularly directors' and officers' liability, which were generally
caused by high profile corporate governance issues in U.S. public companies.
Gross written premium rose dramatically to $553.5 million in 2003 compared to
$178.7 million in 2002. We maintain reinsurance on our diversified financial
products line of business on both a proportional and excess of loss basis.
Although individual losses may have potential severity, there is a relatively
low risk of catastrophe exposure.

LONDON MARKET ACCOUNT

Our London market account business consists of marine, energy, property and
accident and health business and is underwritten by Houston Casualty Company's
London branch office and to a lesser extent by HCC Europe.

We underwrite marine risks for ocean-going vessels including hull,
liabilities, protection and indemnity and marine cargo.

We have underwritten marine risks on both a direct and reinsurance basis
since 1984 and currently write a relatively small book of business due to the
competitive state of the market. In 2003, our gross written premium was $18.9
million.

We have been underwriting energy risks since 1988, which include:

- drilling rigs

- natural gas facilities

- petrochemical plants

- pipelines

- gas production and gathering platforms

- refineries

In our energy business, we underwrite physical damage and business
interruption.

Rates have been relatively low in the past at levels where underwriting
profitability has been difficult to obtain. As a result, we have underwritten
energy risks on a very selective basis, striving for quality rather than
quantity. Since 2002, we have seen rates increase and gross written premium in
2003 was $69.6 million.

We underwrite property business specializing in risks of large, often
multinational, corporations, covering a variety of commercial properties
including:

- factories

- hotels

- industrial plants

- office buildings

- retail locations

- utilities

The property insurance we offer includes business interruption, physical
damage and catastrophe risks including flood and earthquake.

We have written property business since 1986 and due to severe competition,
our gross written premium declined to $40.8 million in 2002 and has increased to
$47.3 million in 2003.

We began writing London market accident and health risks in 1996 including:
trip accident, medical and disability and have steadily increased premiums. Our
gross written premium was $87.4 million in 2003.

Our London market account business is reinsured both proportionally and on
an excess of loss basis, where we transfer to reinsurers premium and loss on a
non-proportional basis, for individual and catastrophe risks, above our net
retention of risk. Catastrophe exposure is more concentrated in our energy and
property lines of business.

AVIATION

We are a market leader in the general aviation insurance industry. We
insure aviation risks, both domestically and internationally, including:

- antique and vintage military aircraft

- cargo operations

- commuter airlines

- corporate aircraft

- fixed base operations

- military and law enforcement aircraft

- private aircraft owners and pilots

- rotor wing aircraft

We offer coverages that include hulls, engines, avionics and other systems,
liabilities, cargo and other ancillary coverages. We do not generally insure
major airlines, major manufacturers or satellites. Insurance claims related to
general aviation business tend to be seasonal, with the majority of the claims
being incurred during the spring and summer months.

We have been underwriting aviation risks through Houston Casualty Company
since 1981 and in 1997 acquired Avemco Insurance Company and its subsidiary U.S.
Specialty Insurance Company. Avemco

Insurance Company is one of the largest writers of personal aircraft insurance
in the United States and has been insuring aviation risks since 1959. Our
aviation premium has remained relatively stable since 1998. Our aviation gross
written premium for 2003 was $214.7 million.

We maintain reinsurance on both a proportional and excess of loss basis and
believe that the aviation risks we underwrite carry a relatively low level of
catastrophe exposures.

OTHER SPECIALTY LINES

In addition to the above, we underwrite various other specialty lines of
business, of which individual premiums by line of business are not at this time
significant to our overall results of operations.

PRINCIPAL INSURANCE COMPANIES

HOUSTON CASUALTY COMPANY

Houston Casualty Company is our principal insurance company subsidiary.
Houston Casualty Company operates worldwide and is domiciled and licensed in
Texas and operates on a surplus lines basis in 49 states. Houston Casualty
Company receives business through independent agents and brokers, our
underwriting agencies and intermediaries and other insurance and reinsurance
companies. Houston Casualty Company writes aviation, London market account,
diversified financial products and other specialty lines of business. Houston
Casualty Company's 2003 gross written premium was $907.5 million (including
Houston Casualty Company-London amounts). Houston Casualty Company is an issuing
carrier for HCC Global Financial Products, LLC and ASU International, LLC.

HOUSTON CASUALTY COMPANY-LONDON

Houston Casualty Company operates a full branch office in London, England.
Houston Casualty Company established its London branch operation in order to
more closely align its underwriting operations with the London market, a
historical focal point for some of the business that Houston Casualty Company
underwrites. Houston Casualty Company-London underwrites diversified financial
products and London market account business. Houston Casualty Company-London is
an issuing carrier for HCC Global Financial Products, LLC and HCC Diversified
Financial Products, Limited. Houston Casualty Company-London's 2003 gross
written premium was $306.7 million.

U.S. SPECIALTY INSURANCE COMPANY

U.S. Specialty Insurance Company is a Texas-domiciled property and casualty
insurance company. It is a direct subsidiary of Houston Casualty Company. U.S.
Specialty Insurance Company operates on an admitted basis throughout the United
States, primarily writing aviation, accident and health and diversified
financial products business. U.S. Specialty Insurance Company acts as an issuing
carrier for certain business underwritten by our underwriting agencies. U.S.
Specialty Insurance Company's gross written premium in 2003 was $232.2 million.

HCC LIFE INSURANCE COMPANY

HCC Life Insurance Company is an Indiana-domiciled life insurance company
and a subsidiary of Houston Casualty Company. It operates as a group life,
accident and health insurer on an admitted basis in 42 states and the District
of Columbia. HCC Life Insurance Company is an issuing carrier for HCC Benefits
Corporation. HCC Life Insurance Company's gross written premium in 2003 was
$388.4 million.

AVEMCO INSURANCE COMPANY

Avemco Insurance Company is a Maryland-domiciled property and casualty
insurer and operates as a direct market underwriter of aviation business on an
admitted basis throughout the United States. Avemco Insurance Company is also an
issuing carrier for accident and health business underwritten by our
underwriting agencies and an unaffiliated underwriting agency. Avemco Insurance
Company's gross written premium in 2003 was $179.9 million.

HCC EUROPE

HCC Europe is a Spanish insurer and underwrites diversified financial
products business throughout the European Union. HCC Europe is also an issuing
carrier for business underwritten by our underwriting agencies and has been in
operation since 1978. HCC Europe's gross written premium in 2003 was $84.1
million.

AMERICAN CONTRACTORS INDEMNITY COMPANY

American Contractors Indemnity Company was acquired on January 31, 2004 and
is a California-domiciled surety company. The results of operations of American
Contractors Indemnity Company will be included in our financial results as of
the date of acquisition. American Contractors Indemnity Company writes court,
specialty contract, license and permit bonds and operates on an admitted basis
in 44 states, the District of Columbia and two U.S. Territories and has been in
operation since 1990. American Contractors Indemnity Company's 2003 gross
written premium was $57.9 million.

HCC REINSURANCE COMPANY LIMITED

HCC Reinsurance Company Limited is a Bermuda-domiciled reinsurance company
which writes assumed reinsurance from our insurance companies and from
unaffiliated insurance companies. HCC Reinsurance Company Limited's gross
written premium in 2003 was $14.7 million. We expect to increase the
underwriting activity of HCC Reinsurance Company Limited in 2004.

HCC SPECIALTY INSURANCE COMPANY

HCC Specialty Insurance Company is an Oklahoma domiciled property and
casualty insurance company. HCC Specialty Insurance Company operates on a
surplus lines basis in Texas and writes diversified financial products and other
specialty lines business produced by our underwriting agencies. HCC Specialty
Insurance Company's gross written premium in 2003 was $9.5 million.

UNDERWRITING AGENCY OPERATIONS

Our underwriting agencies act on behalf of affiliated and non-affiliated
insurance companies and provide insurance underwriting management and claims
administration services. Our underwriting agencies do not assume any insurance
or reinsurance risk themselves and generate revenues based entirely on fee
income and profit commissions. These subsidiaries are in a position to direct
and control business that they produce. Our insurance companies serve as policy
issuing companies for the majority of the business written by our underwriting
agencies. In instances where our insurance companies are not the policy issuing
company, our insurance companies may reinsure the business written by the
underwriting agencies. Total segment revenue generated by our underwriting
agencies in 2003 amounted to $174.7 million.

HCC BENEFITS CORPORATION

HCC Benefits Corporation has its home office in Atlanta, Georgia and
regional offices in Costa Mesa, California; Wakefield, Massachusetts;
Minneapolis, Minnesota; and Dallas, Texas. HCC Benefits Corporation underwrites
group life, accident and health business on behalf of affiliated insurance
companies and has been in operation since 1980.

PROFESSIONAL INDEMNITY AGENCY, INC.

Professional Indemnity Agency, Inc., with its home office in Mount Kisco,
New York and a branch office in San Francisco, California, acts as an
underwriting manager for diversified financial products, specializing in
directors' and officers' liability, errors and omissions liability, kidnap and
ransom and other specialty lines of business on behalf of affiliated and
unaffiliated insurance companies and has been in operation since 1977.

ASU INTERNATIONAL, LLC

ASU International, LLC, with its home office in Woburn, Massachusetts and a
branch office in London, England acts as an underwriting manager for group life,
accident and health and other specialty lines of business on behalf of
affiliated and unaffiliated insurance companies and has been in operation since
1982.

HCC GLOBAL FINANCIAL PRODUCTS, LLC

HCC Global Financial Products, LLC has offices in Farmington, Connecticut,
Houston, Texas, Jersey City, New Jersey, Barcelona, Spain and London, England.
HCC Global Financial Products, LLC acts as an underwriting manager for
diversified financial products, specializing in directors' and officers'
liability business on behalf of affiliated insurance companies.

HCC DIVERSIFIED FINANCIAL PRODUCTS LIMITED

HCC Diversified Financial Products Limited is an underwriting agency based
in London, England and underwrites diversified financial products, specializing
in professional indemnity business in the European Union, on behalf of
affiliated insurance companies and has been in operation since 1997. Its Lloyd's
broker operations have been consolidated into Rattner Mackenzie Limited.

COVENANT UNDERWRITERS LIMITED

We acquired Covenant Underwriters Limited in July, 2003. Covenant
Underwriters Limited is an underwriting agency based in Covington, Louisiana,
specializing in commercial marine insurance underwritten on behalf of affiliated
and unaffiliated insurance companies and has been in operation through
predecessor entities since 1970.

INTERMEDIARY OPERATIONS

Our intermediaries provide a variety of services, including marketing,
placing, consulting on and servicing insurance risks for their clients, which
include medium to large corporations, unaffiliated and affiliated insurance and
reinsurance companies and other risk taking entities. The intermediaries earn
commission income and to a lesser extent fees for certain services, generally
paid by the underwriters with whom the business is placed. Some of these risks
may be initially underwritten by our insurance companies, which may retain a
portion of the risk. Total segment revenue generated by our intermediaries in
2003 amounted to $48.6 million.

RATTNER MACKENZIE LIMITED

Rattner Mackenzie Limited is an intermediary based in London, England with
other operations in Bermuda and New York. Rattner Mackenzie Limited specializes
in group life, accident and health reinsurance and some specialty property and
casualty lines of business. Rattner Mackenzie Limited operates as a Lloyd's
broker for reinsurance business placed on behalf of unaffiliated and affiliated
insurance companies, reinsurance companies and underwriting agencies and has
been in operation since 1989.

CONTINENTAL UNDERWRITERS LIMITED

We acquired Continental Underwriters Limited in July, 2003. Continental
Underwriters Limited is an intermediary based in Covington, Louisiana
specializing in commercial marine insurance placed on behalf of affiliated and
unaffiliated insurance companies and has been in operation since 1970.

HCC RISK MANAGEMENT, INC.

HCC Risk Management, Inc., based in Houston, Texas, is an intermediary
specializing in placing reinsurance on behalf of affiliated and unaffiliated
insurance companies.

OTHER OPERATIONS

Other operating income consists of equity in the earnings of insurance
related companies in which we invest, dividends from certain other insurance
related investments and gains or losses from the disposition of these
investments and the profit or loss from an inventory of insurance related
trading securities. Other operating revenue was $13.2 million in 2003, but can
vary considerably from period to period depending on investment or disposition
activity.

REINSURANCE CEDED

We purchase reinsurance to reduce our net liability on individual risks, to
protect against catastrophe losses and to achieve a desired ratio of net written
premium to policyholders' surplus. We purchase reinsurance on both a
proportional and an excess of loss basis. The type, cost and limits of
reinsurance we purchase can vary from year to year based upon our desired
retention levels and the availability of quality reinsurance at an acceptable
price. Our reinsurance programs renew throughout the year and during 2003 some
of those renewed contained price increases, which are not material to our
underwriting results.

We structure a specific reinsurance program for each line of business we
underwrite. We place reinsurance proportionally to cover loss frequency and
catastrophe exposure. We obtain reinsurance on an excess of loss basis to cover
individual risk severity of loss and catastrophe exposure. Additionally, we may
also obtain facultative reinsurance protection on a single risk. Our reinsurance
generally does not cover war or terrorism risks, which are excluded from many of
our policies.

In our proportional reinsurance programs, we generally receive an
overriding (ceding) commission on the premium ceded to reinsurers. This
compensates our insurance companies for the direct costs associated with the
production of the business, the servicing of the business during the term of the
policies ceded and the costs associated with the placement of the related
reinsurance. In addition, certain of our reinsurance treaties allow us to share
with the reinsurers in any net profits generated under such treaties. Various
intermediaries, including HCC Risk Management, Inc. and Rattner Mackenzie
Limited, arrange for the placement of this reinsurance coverage on our behalf
and are compensated, directly or indirectly, by the reinsurers.

We have a reserve of $14.9 million as of December 31, 2003 for potential
collectibility issues and associated expenses related to reinsurance
recoverables. This includes the exposure we have with respect to disputed
amounts. While we believe that the reserve is adequate based on currently
available information, conditions may change or additional information might be
obtained which may result in a future change in the reserve. We periodically
review our financial exposure to the reinsurance market and the level of our
reserve and continue to take actions in an attempt to mitigate our exposure to
possible loss.

OPERATING RATIOS

PREMIUM TO SURPLUS RATIO

This table shows, for the years indicated, the ratio of statutory gross
written premium and net written premium to statutory policyholders' surplus for
our property and casualty insurance companies (dollars in thousands):

2003 2002 2001 2000 1999
---------- ---------- ---------- -------- --------

Gross written premium....... $1,746,413 $1,163,397 $1,014,833 $972,154 $576,184
Net written premium......... 867,795 545,475 371,409 283,947 150,261
Policyholders' surplus...... 591,889 523,807 401,393 326,249 315,474
Gross written premium
ratio..................... 295.1% 222.1% 252.8% 298.0% 182.6%
Gross written premium
industry average(1)....... * 244.4% 210.8% 174.1% 154.1%
Net written premium ratio... 146.6% 104.1% 92.5% 87.0% 47.6%
Net written premium industry
average(1)................ * 130.3% 112.0% 94.4% 85.5%

---------------

(1) Source: A.M. Best Company, Inc.

* Not available

While there is no statutory requirement regarding a permissible premium to
policyholders' surplus ratio, guidelines established by the National Association
of Insurance Commissioners provide that a property and casualty insurer's annual
statutory gross written premium should not exceed 900% and net written premium
should not exceed 300% of its policyholders' surplus. However, industry
standards and rating agency criteria place these ratios at 300% and 200%,
respectively. Our property and casualty insurance companies have maintained net
written premium to surplus ratios substantially lower than such guidelines.

COMBINED RATIO IN ACCORDANCE WITH GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

The underwriting experience of a property and casualty insurance company is
indicated by its combined ratio. Under generally accepted accounting principles,
the combined ratio is a combination of the loss ratio in accordance with
generally accepted accounting principles, or the ratio of incurred losses and
loss adjustment expenses to net earned premium and the expense ratio in
accordance with generally accepted accounting principles, which is the ratio of
policy acquisition costs and other underwriting expenses, net of ceding
commissions, to net earned premium. Our insurance companies' loss ratios,
expense ratios and combined ratios in accordance with generally accepted
accounting principles are shown in the following table for the years indicated:

2003 2002 2001 2000 1999
---- ---- ----- ---- -----

Loss ratio....................................... 66.2%* 60.6% 78.0% 74.2% 77.6%
Expense ratio.................................... 24.8 25.4 25.7 21.0 51.7
---- ---- ----- ---- -----
Combined ratio................................... 91.0%* 86.0% 103.7% 95.2% 129.3%
==== ==== ===== ==== =====

---------------

* Includes 3.9% related to a commutation loss.

COMBINED RATIO IN ACCORDANCE WITH STATUTORY ACCOUNTING PRINCIPLES

The combined ratio in accordance with statutory accounting principles is a
combination of the loss ratio in accordance with statutory accounting
principles, or the ratio of incurred losses and loss adjustment expenses to net
earned premium and the expense ratio in accordance with statutory accounting
principles, which is the ratio of policy acquisition costs and other
underwriting expenses, net of ceding commissions,

to net written premium. Our insurance companies' loss ratios, expense ratios and
combined ratios in accordance with statutory accounting principles are shown in
the following table for the years indicated:

2003 2002 2001 2000 1999
---- ----- ----- ----- -----

Loss ratio..................................... 66.8%* 62.0% 78.0% 71.1% 107.1%
Expense ratio.................................. 23.0 23.9 23.8 27.0 22.8
---- ----- ----- ----- -----
Combined ratio................................. 89.8%* 85.9% 101.8% 98.1% 129.9%
==== ===== ===== ===== =====
Industry average............................... ** 107.5% 115.9% 110.1% 107.8%

---------------

* Includes 3.9% related to a commutation loss.

** Not available

The ratio data in accordance with statutory accounting principles is not
intended to be a substitute for results of operations in accordance with
generally accepted accounting principles. Including this information is
meaningful and useful to allow a comparison of our operating results with those
of other companies in the insurance industry. The source of the industry average
is A.M. Best Company, Inc. A.M. Best Company, Inc. reports on insurer
performance on the basis of statutory accounting principles to provide for more
standardized comparisons among individual companies, as well as overall industry
performance.

RESERVES

Applicable insurance laws require us to maintain reserves to cover our
estimated ultimate liability for reported and incurred but not reported losses
under insurance and reinsurance policies that we wrote and for loss adjustment
expenses relating to the investigation and settlement of policy claims. In most
cases, we estimate such losses and claims costs through an evaluation of
individual claims. However, for some types of claims, we use an average
reserving method until more information becomes available to permit an
evaluation of individual claims.

We establish loss reserves for individual claims by evaluating reported
claims on the basis of:

- jurisdiction of the occurrence;

- our experience with the insured and the line of business and policy
provisions relating to the particular type of claim;

- our knowledge of the circumstances surrounding the claim;

- the information and reports received from ceding insurance companies
where applicable;

- the potential for ultimate exposure;

- the severity of injury or damage; and

- the type of loss.

We establish loss reserves for incurred but not reported losses based in
part on statistical information and in part on industry experience with respect
to the probable number and nature of claims arising from occurrences that have
not been reported. We also establish our reserves based on predictions of future
events, our estimates of future trends in claims severity and other subjective
factors. Insurance companies are not permitted to reserve for a catastrophe
until it has occurred. Reserves are recorded on an undiscounted basis, except
for reserves acquired in transactions recorded using the purchase method of
accounting. The reserves of each of our insurance companies are established in
conjunction with and reviewed by our in-house actuarial staff and our reserves
in accordance with statutory accounting principles are certified annually by our
independent actuaries. PricewaterhouseCoopers LLP certified the reserves of our
insurance companies in accordance with statutory accounting principles as of
December 31, 2003.

With respect to some classes of risks, the period of time between the
occurrence of an insured event and the final settlement of a claim may be many
years and during this period it often becomes necessary to adjust the claim
estimates either upward or downward. Certain classes of diversified financial
products, marine and offshore energy and workers' compensation insurance which
are or were underwritten by our insurance companies have historically had longer
elapsed times between the occurrence of an insured event, reporting of the claim
and final settlement. In such cases, we are forced to estimate reserves over
long periods of time with the possibility of several adjustments to reserves.
Other classes of insurance that we underwrite, such as most aviation, property
and medical stop-loss, historically have shorter lead times between the
occurrence of an insured event, reporting of the claim and final settlement.
Reserves with respect to these classes are, therefore, less likely to be
adjusted.

The reserving process is intended to reflect the impact of inflation and
other factors affecting loss payments by taking into account changes in
historical payment patterns and perceived trends. However, there is no precise
method for the subsequent evaluation of the adequacy of the consideration given
to inflation, or to any other specific factor, or to the way one factor may
impact another.

We underwrite, directly and through reinsurance, risks which are
denominated in a number of foreign currencies and therefore maintain loss
reserves with respect to these policies in the respective currencies. These
reserves are subject to exchange rate fluctuations, which may have an effect on
our earnings.

The loss development triangles below show changes in our reserves in
subsequent years from the prior loss estimates based on experience as of the end
of each succeeding year on the basis of generally accepted accounting
principles. The estimate is increased or decreased as more information becomes
known about the frequency and severity of losses for individual years. A
redundancy means the original estimate was higher than the current estimate; a
deficiency means that the current estimate is higher than the original estimate.

The first line of each loss development triangle presents, for the years
indicated, our gross or net reserve liability including the reserve for incurred
but not reported losses. The first section of each table shows, by year, the
cumulative amounts of loss and loss adjustment expense paid as of the end of
each succeeding year. The second section sets forth the re-estimates in later
years of incurred losses, including payments, for the years indicated. The
"cumulative redundancy (deficiency)" represents, as of the date indicated, the
difference between the latest re-estimated liability and the reserves as
originally estimated.

This loss development triangle shows development in loss reserves on a
gross basis (in thousands):

2003 2002 2001 2000 1999 1998 1997 1996
---------- ---------- ---------- ---------- -------- -------- -------- --------

Balance sheet reserves:....... $1,535,288 $1,155,290 $1,130,748 $ 944,117 $871,104 $460,511 $275,008 $229,049
Reserve adjustments from
acquisition and disposition
of subsidiaries............. 5,587 -- (66,571) (32,437) (136) -- --
Effects of changes in foreign
currency rates of
exchange.................... 22,966 -- -- -- -- -- --
---------- ---------- ---------- ---------- -------- -------- -------- --------
Adjusted reserves......... 1,535,288 1,183,843 1,130,748 877,546 838,667 460,375 275,008 229,049
Cumulative paid as of:
One year later.............. 438,802 388,722 400,279 424,379 229,746 160,324 119,453
Two years later............. 610,619 537,354 561,246 367,512 209,724 179,117
Three years later........... 667,326 611,239 419,209 241,523 193,872
Four years later............ 686,730 435,625 259,067 212,097
Five years later............ 453,691 262,838 223,701
Six years later............. 267,038 225,595
Seven years later........... 227,177
Eight years later...........
Nine years later............
Ten years later.............
Re-estimated liability as of:
End of year................. 1,535,288 1,183,843 1,130,748 877,546 838,667 460,375 275,008 229,049
One year later.............. 1,306,996 1,107,588 922,080 836,775 550,409 308,501 252,236
Two years later............. 1,239,751 925,922 868,438 545,955 316,250 249,013
Three years later........... 1,099,657 854,987 547,179 304,281 250,817
Four years later............ 900,604 537,968 305,022 247,245
Five years later............ 522,183 295,975 249,853
Six years later............. 296,816 243,015
Seven years later........... 242,655
Eight years later...........
Nine years later............
Ten years later.............
Cumulative redundancy
(deficiency)................ $ (123,153) $ (109,003) $ (222,111) $(61,937) $(61,808) $(21,808) $(13,606)

1995 1994 1993
-------- -------- --------

Balance sheet reserves:....... $200,756 $170,957 $144,178
Reserve adjustments from
acquisition and disposition
of subsidiaries............. -- -- --
Effects of changes in foreign
currency rates of
exchange.................... -- -- --
-------- -------- --------
Adjusted reserves......... 200,756 170,957 144,178
Cumulative paid as of:
One year later.............. 118,656 97,580 82,538
Two years later............. 167,459 143,114 126,290
Three years later........... 207,191 166,541 157,509
Four years later............ 214,046 192,540 176,472
Five years later............ 226,762 195,930 195,269
Six years later............. 233,831 202,844 197,147
Seven years later........... 235,236 208,112 203,075
Eight years later........... 235,950 209,056 207,474
Nine years later............ 209,351 208,049
Ten years later............. 208,299
Re-estimated liability as of:
End of year................. 200,756 170,957 144,178
One year later.............. 243,259 186,898 163,967
Two years later............. 248,372 207,511 183,015
Three years later........... 247,053 214,738 203,137
Four years later............ 248,687 220,695 211,546
Five years later............ 248,559 217,892 218,182
Six years later............. 250,176 219,196 214,498
Seven years later........... 246,661 219,002 216,820
Eight years later........... 246,159 219,478 216,627
Nine years later............ 219,024 216,542
Ten years later............. 216,199
Cumulative redundancy
(deficiency)................ $(45,403) $(48,067) $(72,021)

The gross deficiencies reflected in the above table for years after 1998
result from the following:

- During 2003 we recorded $132.9 million in gross losses related to 1999
and 2000 accident years on certain assumed accident and health
reinsurance contracts reported in discontinued lines of business due to
our processing of additional information received and our continuing
evaluation of reserves on this business.

- The 2000 and 1999 years in the table are also negatively affected by late
reporting loss information received during 2001 for certain discontinued
business.

As the losses related to the above two items were substantially reinsured,
there was no material effect to our net earnings.

The gross deficiencies reflected in the table for the years prior to 1999
result from three principal conditions:

- The development of large claims on individual policies which were either
reported late or for which reserves were increased as subsequent
information became available. However, as these policies were
substantially reinsured, there was no material effect to our net
earnings.

- During 1999, in connection with the insolvency of one of our reinsurers
and the commutation of all liabilities with another, we re-evaluated all
loss reserves and incurred but not reported loss reserves related to
business placed with these reinsurers to determine the ultimate losses we
might conservatively expect. These reserves were then used as the basis
for the determination of the provision for reinsurance recorded in 1999.

- For the years prior to 1997, the runoff of the retrocessional excess of
loss business, which we underwrote between 1988 and 1991, experienced
gross development. This development was due primarily to the delay in
reporting of losses by the London insurance market, coupled with the
unprecedented number of catastrophe losses during that period. This
business was substantially reinsured and there was no material effect to
our net earnings.

The following table provides a reconciliation of the gross liability of
loss and loss adjustment expenses on the basis of generally accepted accounting
principles for the three years ended December 31, 2003 (in thousands):

2003 2002 2001
---------- ---------- ----------

Reserves for loss and loss adjustment expense at
beginning of year.............................. $1,155,290 $1,130,748 $ 944,117
Reserve adjustments from acquisition and
disposition of subsidiaries.................... 5,587 82,289 (69,725)
Effects of changes in foreign currency rates
of exchange.................................... 22,966 -- --
Incurred loss and loss adjustment expense:
Provision for loss and loss adjustment expense
for claims occurring in the current year.... 922,838 627,412 1,019,311
Increase (decrease) in estimated loss and loss
adjustment expense for claims occurring in
prior years(1).............................. 123,153 (23,160) 44,534
---------- ---------- ----------
Incurred loss and loss adjustment expense...... 1,045,991 604,252 1,063,845
---------- ---------- ----------
Loss and loss adjustment expense payments for
claims occurring during:
Current year................................... 255,744 273,277 407,210
Prior years.................................... 438,802 388,722 400,279
---------- ---------- ----------
Loss and loss adjustment expense payments........ 694,546 661,999 807,489
---------- ---------- ----------
Reserves for loss and loss adjustment expense at
end of the year................................ $1,535,288 $1,155,290 $1,130,748
========== ========== ==========

---------------

(1) Changes in loss and loss adjustment expense reserves (on the basis of
generally accepted accounting principles) for losses occurring in prior
years reflect the gross effect of the resolution of losses for other than
the reserve value and the subsequent adjustments of loss reserves.
21

This loss development triangle shows development in loss reserves on a net
basis (in thousands):

2003 2002 2001 2000 1999 1998 1997 1996
---------- ---------- ---------- -------- -------- -------- -------- --------

Gross reserves.................... $1,535,288 $1,155,290 $1,130,748 $944,117 $871,104 $460,511 $275,008 $229,049
Less reinsurance recoverables..... 830,088 697,972 817,651 694,245 597,498 341,599 155,374 111,766
---------- ---------- ---------- -------- -------- -------- -------- --------
Reserves, net of reinsurance...... 705,200 457,318 313,097 249,872 273,606 118,912 119,634 117,283
Reserve adjustments from
acquisition and disposition of
subsidiaries.................... 5,587 -- (6,048) (3,343) (410) -- --
Effects of changes in foreign
currency rates of exchange...... 20,892 -- -- -- -- -- --
Effect on loss reserves of 1999
write off of reinsurance
Recoverables...................... -- -- -- -- 63,851 15,008 2,636
---------- ---------- ---------- -------- -------- -------- -------- --------
Adjusted reserves, net of
Reinsurance..................... 705,200 483,797 313,097 243,824 270,263 182,353 134,642 119,919
Cumulative paid, net of
reinsurance, as of:
One year later.................... 135,829 126,019 102,244 145,993 56,052 48,775 47,874
Two years later................... 131,244 139,659 174,534 103,580 64,213 66,030
Three years later................. 118,894 185,744 113,762 80,227 72,863
Four years later.................. 180,714 121,293 81,845 81,620
Five years later.................. 120,452 84,986 81,968
Six years later................... 87,626 82,681
Seven years later................. 84,108
Eight years later.................
Nine years later..................
Ten years later...................
Re-estimated liability, net of
reinsurance, as of:
End of year....................... 705,200 483,797 313,097 243,824 270,263 182,353 134,642 119,919
One year later.................... 507,563 306,318 233,111 260,678 186,967 120,049 116,145
Two years later................... 338,194 222,330 254,373 175,339 116,745 101,595
Three years later................. 259,160 244,650 171,165 110,673 97,353
Four years later.................. 258,122 163,349 107,138 95,118
Five years later.................. 155,931 103,243 93,528
Six years later................... 101,538 91,413
Seven years later................. 90,951
Eight years later.................
Nine years later..................
Ten years later...................
Cumulative redundancy
(deficiency).................... $ (23,766) $ (25,097) $(15,336) $ 12,141 $ 26,422 $ 33,104 $ 28,968

1995 1994 1993
-------- -------- --------

Gross reserves.................... $200,756 $170,957 $144,178
Less reinsurance recoverables..... 101,497 95,279 82,289
-------- -------- --------
Reserves, net of reinsurance...... 99,259 75,678 61,889
Reserve adjustments from
acquisition and disposition of
subsidiaries.................... -- -- --
Effects of changes in foreign
currency rates of exchange...... -- -- --
Effect on loss reserves of 1999
write off of reinsurance
Recoverables...................... 1,442 51 --
-------- -------- --------
Adjusted reserves, net of
Reinsurance..................... 100,701 75,729 61,889
Cumulative paid, net of
reinsurance, as of:
One year later.................... 41,947 36,500 29,258
Two years later................... 56,803 49,283 41,207
Three years later................. 64,798 56,919 46,576
Four years later.................. 67,355 60,441 51,536
Five years later.................. 72,627 61,781 53,110
Six years later................... 73,501 66,591 53,879
Seven years later................. 73,792 66,410 58,353
Eight years later................. 74,836 66,749 58,713
Nine years later.................. 66,804 60,658
Ten years later................... 60,718
Re-estimated liability, net of
reinsurance, as of:
End of year....................... 100,701 75,729 61,889
One year later.................... 95,764 72,963 59,659
Two years later................... 94,992 74,887 60,079
Three years later................. 85,484 76,474 62,224
Four years later.................. 80,890 73,660 64,377
Five years later.................. 79,626 69,528 64,103
Six years later................... 79,968 70,642 59,408
Seven years later................. 78,614 70,278 60,960
Eight years later................. 78,810 70,060 60,729
Nine years later.................. 69,965 62,874
Ten years later................... 62,857
Cumulative redundancy
(deficiency).................... $ 21,891 $ 5,764 $ (968)

The net deficiencies reflected in the above table for years after 1999 are
due to a commutation loss of $28.8 million recorded in 2003, which primarily
affected the 1999 and 2000 accident years.

This table below provides a reconciliation of the liability for loss and
loss adjustment expense, net of reinsurance ceded, on the basis of generally
accepted accounting principles for the three years ended December 31, 2003 (in
thousands):

2003 2002 2001
-------- -------- --------

Reserves for loss and loss adjustment expense at
beginning of year.................................. $457,318 $313,097 $249,872
Reserve adjustments from acquisition and disposition
of subsidiaries.................................... 5,587 79,558 285
Effects of changes in foreign currency rates of
exchange........................................... 20,892 -- --
Incurred loss and loss adjustment expense:
Provision for loss and loss adjustment expense for
claims occurring in the current year............ 464,886 313,270 278,103
Increase (decrease) in estimated loss and loss
adjustment expense for claims occurring in prior
years(1)........................................ 23,766 (6,779) (10,713)
-------- -------- --------
Incurred loss and loss adjustment expense.......... 488,652 306,491 267,390
-------- -------- --------
Loss and loss adjustment expense payments for claims
occurring during:
Current year....................................... 131,420 115,809 102,206
Prior years........................................ 135,829 126,019 102,244
-------- -------- --------
Loss and loss adjustment expense payments............ 267,249 241,828 204,450
-------- -------- --------
Reserves for loss and loss adjustment expense at end
of the year........................................ $705,200 $457,318 $313,097
======== ======== ========

---------------

(1) Changes in loss and loss adjustment expense reserves (on the basis of
generally accepted accounting principles) for losses occurring in prior
years reflect the net effect of the resolution of losses for other than the
reserve value and the subsequent adjustments of loss reserves.

During 2003, we had net loss and loss adjustment expense deficiency of
$23.8 million relating to prior year losses compared to redundancies of $6.8
million in 2002 and $10.7 million in 2001. The 2003 deficiency resulted from a
commutation charge of $28.8 million related to certain accident and health
business included in discontinued lines offset by a net redundancy of $5.0
million from all other sources. The 2002 redundancy resulted from a deficiency
of $7.7 million due to a third quarter charge related to certain business
included in discontinued lines offset by a net redundancy of $14.5 million from
all other sources. Deficiencies and redundancies in the reserves occur as we
continually review our loss reserves with our actuaries, increasing or reducing
loss reserves as a result of such reviews and as losses are finally settled and
claims exposures are reduced. We believe we have provided for all material net
incurred losses.

We have no material exposure to environmental pollution losses because
Houston Casualty Company only began writing business in 1981 and its policies
normally contain pollution exclusion clauses which limit pollution coverage to
"sudden and accidental" losses only, thus excluding intentional (dumping) and
seepage claims. Policies issued by our other insurance company subsidiaries,
because of the types of risks covered, are not considered to have significant
environmental exposures. We do not expect to experience any material development
in reserves for environmental pollution claims. Likewise, we have no material
exposure to asbestos claims.

INVESTMENTS

Insurance company investments must comply with applicable regulations which
prescribe the type, quality and concentration of investments. These regulations
permit investments, within specified limits and subject to certain
qualifications, in federal, state and municipal obligations, corporate bonds and
preferred and common equity securities. As of December 31, 2003, we had $1.7
billion of investment assets. The majority of our investment assets are held by
our insurance companies. All of our securities are classified as available for
sale and are recorded at market value.

Our investment policy is determined by our Board of Directors and our
Investment and Finance Committee and is reviewed on a regular basis. We engage a
nationally prominent investment advisor, General Re-New England Asset
Management, a subsidiary of Berkshire Hathaway, Inc., to oversee our investments
and to make recommendations to our Board's Investment and Finance Committee.
Although we generally intend to hold fixed income securities to maturity, we
regularly re-evaluate our position based upon market conditions. As of December
31, 2003, our fixed income securities had a weighted average maturity of 4.5
years and a weighted average duration of 3.7 years. Our financial statements
reflect an unrealized gain of $30.0 million on fixed income securities available
for sale as of December 31, 2003.

We have maintained a substantial level of cash and liquid short-term
instruments in our insurance companies in order to maintain the ability to fund
losses of our insureds. Our underwriting agencies and intermediaries typically
have short-term investments, which are fiduciary funds held on behalf of others.
As of December 31, 2003, we had cash and short-term investments of approximately
$614.9 million, of which $264.0 million were in our underwriting agencies and
intermediaries.

This table shows a profile of our investments. The table shows the average
amount of investments, income earned and the yield thereon for the periods
indicated (dollars in thousands):

2003 2002 2001
---------- ---------- --------

Average investments, at cost...................... $1,403,690 $1,005,541 $789,860
Net investment income before reclassification to
discontinued operations(1)...................... 47,347 37,769 39,638
Average short-term yield(1)....................... 1.8% 2.2% 4.3%
Average long-term yield(1)........................ 4.2% 4.8% 5.6%
Average long-term tax equivalent yield(1)......... 5.0% 5.4% 6.4%
Weighted average combined tax equivalent
yield(1)........................................ 3.8% 4.6% 5.6%

---------------

(1) Excluding realized and unrealized capital gains and losses.

This table summarizes, by type, the estimated market value of our
investments as of December 31, 2003 (dollars in thousands):

AMOUNT PERCENT OF TOTAL
---------- ----------------

Short-term investments.................................... $ 518,482 30%
U.S. Treasury securities.................................. 69,140 4
Obligations of states, municipalities and political
subdivisions............................................ 102,048 6
Special revenue fixed income securities................... 305,301 18
Corporate fixed income securities......................... 334,825 19
Asset-backed and mortgage-backed securities............... 152,759 9
Foreign government securities............................. 200,093 12
Marketable equity securities.............................. 12,002 1
Other investments......................................... 8,696 1
---------- ---
TOTAL INVESTMENTS....................................... $1,703,346 100%
========== ===

This table summarizes, by rating, the market value of our investments in
fixed income securities as of December 31, 2003 (dollars in thousands):

AMOUNT PERCENT OF TOTAL
---------- ----------------

AAA....................................................... $ 652,133 56%
AA........................................................ 270,123 23
A......................................................... 212,124 18
BBB....................................................... 28,416 2
BB and below.............................................. 1,370 1
---------- ---
TOTAL FIXED INCOME SECURITIES........................... $1,164,166 100%
========== ===

The table set forth below indicates the expected maturity distribution of
the estimated market value of our fixed income securities as of December 31,
2003 (dollars in thousands):

AMOUNT PERCENT OF TOTAL
---------- ----------------

One year or less.......................................... $ 84,130 7%
One year to five years.................................... 451,998 39
Five years to ten years................................... 243,663 21
Ten years to fifteen years................................ 158,531 14
More than fifteen years................................... 73,085 6
---------- ---
Securities with fixed maturities........................ 1,011,407 87
Asset-backed and mortgage-backed securities............... 152,759 13
---------- ---
TOTAL FIXED INCOME SECURITIES........................... $1,164,166 100%
========== ===

The weighted average life of our structured securities is 2.8 years. The
value of our portfolio of fixed income securities is inversely correlated to
changes in market interest rates. In addition, some of our fixed income
securities have call or prepayment options. This could subject us to a
reinvestment risk should interest rates fall or issuers call their securities
and we are forced to invest the proceeds at lower interest rates. We mitigate
this risk by investing in securities with varied maturity dates, so that only a
portion of the portfolio will mature at any point in time. Some of our
asset-backed securities are subject to re-evaluation and additional specialized
impairment tests. Under this guidance, these securities have to be written down
in value if certain tests are met. Any write down is recouped prospectively
through net investment income, if contractual cash flows are ultimately
received. The total amount of securities held by us as of December 31, 2003 that
would be subject to these tests and potential write downs is $1.4 million.

REGULATION

The business of insurance is extensively regulated by the government. At
this time, the insurance business in the United States is regulated primarily by
the individual states. However, a form of federal financial services
modernization legislation enacted in 1999 is expected to result in additional
federal regulation of the insurance industry. In addition, some insurance
industry trade groups are actively lobbying for legislation that would allow an
option for a separate federal charter for insurance companies. The full extent
to which the federal government will determine to directly regulate the business
of insurance has not been determined by lawmakers. Also, various foreign
governments regulate our international operations.

Our business depends on our compliance with applicable laws and regulations
and our ability to maintain valid licenses and approvals for our operations. We
devote a significant effort toward obtaining and maintaining our licenses and
compliance with a diverse and complex regulatory structure. In all
jurisdictions, the applicable laws and regulations are subject to amendment or
interpretation by regulatory authorities. Generally, regulatory authorities are
vested with broad discretion to grant, renew and revoke

licenses and approvals and to implement regulations governing the business and
operations of insurers and insurance agents.

INSURANCE COMPANIES

Our insurance companies, in common with other insurers, are subject to
regulation and supervision by the states and by other jurisdictions in which
they do business. Regulation by the states varies, but generally involves
regulatory and supervisory powers of a state insurance official. The regulation
and supervision of our insurance operations relates primarily to:

- approval of policy forms and premium rates;

- licensing of insurers and their agents;

- periodic examinations of our operations and finances;

- prescribing the form and content of records of financial condition
required to be filed;

- requiring deposits for the benefit of policyholders;

- requiring certain methods of accounting;

- requiring reserves for unearned premium, losses and other purposes;

- restrictions on the ability of our insurance companies to pay dividends
to us;

- restrictions on the nature, quality and concentration of investments;

- restrictions on transactions between insurance companies and their
affiliates;

- restrictions on the size of risks insurable under a single policy; and

- standards of solvency, including risk-based capital measurements (which
is a measure developed by the National Association of Insurance
Commissioners and used by state insurance regulators to identify
insurance companies that potentially are inadequately capitalized.)

In general, state insurance regulations are intended primarily for the
protection of policyholders rather than shareholders. The state insurance
departments monitor compliance with regulations through periodic reporting
procedures and examinations. The quarterly and annual financial reports to the
state insurance regulators utilize accounting principles which are different
from the generally accepted accounting principles we use in our reports to
shareholders. Statutory accounting principles, in keeping with the intent to
assure the protection of policyholders, are generally based on a liquidation
concept while generally accepted accounting principles are based on a
going-concern concept.

Houston Casualty Company is domiciled in Texas. It operates on an admitted
basis in Texas and may write reinsurance on all lines of business that it may
write on a direct basis. Houston Casualty Company is an accredited reinsurer in
39 states and an approved surplus lines insurer or is otherwise permitted to
write surplus lines insurance in 49 states, three United States territories and
the District of Columbia. When a reinsurer obtains accreditation from a
particular state, insurers within that state are permitted to obtain statutory
credit for risks ceded to the reinsurer. Surplus lines insurance is offered by
non-admitted companies on risks which are not insured by admitted companies. All
surplus lines insurance is required to be written through licensed surplus lines
insurance brokers, who are required to be knowledgeable of and follow specific
state laws prior to placing a risk with a surplus lines insurer.

Houston Casualty Company's branch office in London, England is subject to
regulation by regulatory authorities in the United Kingdom. Avemco Insurance
Company is domiciled in Maryland and operates as a licensed admitted insurer in
all states and the District of Columbia. U.S. Specialty Insurance Company is
domiciled in Texas and operates as a licensed admitted insurer in all states and
the District of Columbia. HCC Life Insurance Company is domiciled in Indiana and
operates as a licensed admitted insurer in 42 states and the District of
Columbia. HCC Specialty Insurance Company is domiciled in Oklahoma and operates
on a surplus lines basis in Texas. American Contractors Indemnity Company is

domiciled in California and operates on an admitted basis in 44 states, the
District of Columbia and two U.S. Territories. HCC Europe is domiciled in Spain
and operates on the equivalent of an "admitted" basis throughout the European
Union.

State insurance regulations also affect the payment of dividends and other
distributions by insurance companies to their shareholders. Generally, insurance
companies are limited by these regulations to the payment of dividends above a
specified level. Dividends in excess of those thresholds are "extraordinary
dividends" and subject to prior regulatory approval.

UNDERWRITING AGENCIES AND INTERMEDIARIES

In addition to the regulation of insurance companies, the states impose
licensing and other requirements on the insurance agency and service operations
of our other subsidiaries. These regulations relate primarily to:

- advertising and business practice rules;

- contractual requirements;

- financial security;

- licensing as agents, brokers, intermediaries, managing general agents or
third party administrators;

- limitations on authority; and

- recordkeeping requirements.

The manner of operating our underwriting agency and intermediary activities
in particular states may vary according to the licensing requirements of the
particular state, which may require, among other things, that we operate in the
state through a local corporation. In a few states, licenses are issued only to
individual residents or locally-owned business entities. In such cases, we may
have arrangements with residents or business entities licensed to act in the
state. The majority of states, however, have recently enacted legislation in
response to the Federal Gramm-Leach-Bliley Act that streamlines and makes more
uniform the licensing requirements.

STATUTORY ACCOUNTING PRINCIPLES

The principal differences between statutory accounting principles and
generally accepted accounting principles, the method by which we report our
financial results to our shareholders, are:

- a liability is recorded for certain reinsurance recoverables under
statutory accounting principles, whereas under generally accepted
accounting principles there is no such provision unless the recoverables
are deemed to be doubtful of collectibility;

- under statutory accounting principles, life insurance companies record
investment related liabilities, the asset valuation reserve and interest
maintenance reserve, whereas there is no such liability under generally
accepted accounting principles;

- certain assets which are considered "non-admitted assets" are eliminated
from a balance sheet prepared in accordance with statutory accounting
principles but are included in a balance sheet prepared in accordance
with generally accepted accounting principles;

- only some of the deferred tax assets are recognized under statutory
accounting principles;

- fixed-income investments classified as available for sale are recorded at
market value for generally accepted accounting principles and at
amortized cost under statutory accounting principles;

- outstanding losses and unearned premium are recorded on a gross basis
under generally accepted accounting principles and on a net basis under
statutory accounting principles; and

- under statutory accounting principles, policy acquisition costs are
expensed as incurred and under generally accepted accounting principles
such costs are deferred and amortized to expense as the related premium
is earned.

INSURANCE HOLDING COMPANY ACTS

Because we are an insurance holding company, we are subject to the
insurance holding company system regulatory requirements of a number of states.
Under these regulations, we are required to report information regarding our
capital structure, financial condition and management. We are also required to
provide prior notice to, or seek the prior approval of insurance regulatory
authorities of certain agreements and transactions between our affiliated
companies. These agreements and transactions must satisfy certain regulatory
requirements.

RISK-BASED CAPITAL

The National Association of Insurance Commissioners has developed a formula
for analyzing insurance companies called risk-based capital. The risk-based
capital formula is intended to establish minimum capital thresholds that vary
with the size and mix of a company's business and assets. It is designed to
identify companies with capital levels that may require regulatory attention. As
of December 31, 2003, each of our domestic insurance companies' total adjusted
capital is significantly in excess of the authorized control level risk-based
capital.

INSURANCE REGULATORY INFORMATION SYSTEM

The National Association of Insurance Commissioners has developed a rating
system, the Insurance Regulatory Information System, primarily intended to
assist state insurance departments in overseeing the financial condition of all
insurance companies operating within their respective states. The Insurance
Regulatory Information System consists of eleven key financial ratios that
address various aspects of each insurer's financial condition and stability. Our
insurance companies' Insurance Regulatory Information System ratios generally
fall within the usual prescribed ranges except in satisfactorily explainable
circumstances such as when there is a large reinsurance transaction, capital
change, merger or planned growth.

TERRORISM RISK INSURANCE ACT

In 2002, the Federal Terrorism Risk Insurance Act was enacted for the
purpose of ensuring the availability of insurance coverage for terrorist acts in
the United States. The law establishes a financial "backstop" program through
the end of 2005 to assist the commercial property and casualty insurance
industry in providing coverage related to future acts of terrorism within the
United States.

Under the Federal Terrorism Risk Insurance Act of 2002, we are required to
offer terrorism coverage to our commercial policyholders in certain lines of
business written in the United States, for which we may, when warranted, charge
an additional premium. The policyholders may or may not accept such coverage.
This law also established a deductible that each insurer would have to meet
before U.S. Federal reimbursement would occur. For 2004, our deductible is
approximately $37.4 million based on 10% of 2003 subject premium as defined
under the applicable regulations. Thereafter, the Federal government would
provide reimbursement for 90% of our covered losses up to the maximum amount set
out in the Act.

PENDING OR PROPOSED LEGISLATION

In recent years, state legislatures have considered or enacted laws that
modify and, in many cases, increase state authority to regulate insurance
companies and insurance holding company systems. State insurance regulators are
members of the National Association of Insurance Commissioners, which seeks to

promote uniformity of and to enhance the state regulation of, insurance. In
addition, the National Association of Insurance Commissioners and state
insurance regulators, as part of the National Association of Insurance
Commissioners' state insurance department accreditation program and in response
to new federal laws, have re-examined existing state laws and regulations,
specifically focusing on insurance company investments, issues relating to the
solvency of insurance companies, licensing and market conduct issues,
streamlining agent licensing and policy form approvals, adoption of privacy
rules for handling policyholder information, interpretations of existing laws,
the development of new laws and the definition of extraordinary dividends.

In recent years, a variety of measures have been proposed at the federal
level to reform the current process of federal and state regulation of the
financial services industries in the United States, which include the banking,
insurance and securities industries. These measures, which are often referred to
as financial services modernization, have as a principal objective the
elimination or modification of current regulatory barriers to cross-industry
combinations involving banks, securities firms and insurance companies. A form
of financial services modernization legislation was enacted at the federal level
in 1999 through the Gramm-Leach-Bliley Act. That federal legislation was
expected to have significant implications on the banking, insurance and
securities industries and to result in more cross-industry consolidations among
banks, insurance companies and securities firms and increased competition in
many of the areas of our operations. Such wide-spread cross-industry
consolidation has not occurred to date. It also mandated the adoption of laws
allowing reciprocity among the states in the licensing of agents and, along with
other federal laws, mandated the adoption of laws and regulations dealing with
the protection of the privacy of policyholder information. Also, the federal
government has conducted investigations of the current condition of the
insurance industry in the United States to determine whether to impose overall
federal regulation of insurers. In the past several years there have been a
number of recommendations that the industry's anti-trust exemption be removed
and the industry placed under federal regulation. If so, we believe state
regulation of the insurance business would likely continue. This could result in
an additional layer of federal regulation.

We do not know at this time the full extent to which these federal or state
legislative or regulatory initiatives will or may affect our operations and no
assurance can be given that they would not, if adopted, have a material adverse
effect on our business or its results of operations.

EMPLOYEES

As of December 31, 2003 we had 1,105 employees. The employees include five
executive officers, 23 senior management, 92 management and 985 other personnel.
Of this number, 337 are employed by our insurance companies, 561 are employed by
our underwriting agencies, 81 are employed by our intermediaries and 126 are
employed at the corporate headquarters and elsewhere. We are not a party to any
collective bargaining agreement and have not experienced work stoppages or
strikes as a result of labor disputes. We consider our employee relations to be
good.

ITEM 2. PROPERTIES

Our principal and executive offices are located in Houston, Texas, in
buildings owned by Houston Casualty Company. We also maintain offices in over 25
locations elsewhere in the United States, the United Kingdom, Spain and Bermuda.
The majority of these additional locations are in leased facilities.

Our principal office facilities are as follows:

SUBSIDIARY LOCATION SQ. FT. TERMINATION DATE OF LEASE
---------- -------- ------- -------------------------

HCC Insurance Holdings, Inc. Houston, Texas 51,000 Owned
and Houston Casualty
Company.....................
Houston Casualty Company...... Houston, Texas 77,000 Owned
Avemco Insurance Company...... Frederick, Maryland 40,000 Owned
U.S. Specialty Insurance Dallas, Texas 40,000 August 31, 2013
Company Aviation Division...
Professional Indemnity Agency, Mount Kisco, New York 38,000 Owned
Inc. .......................

ITEM 3. LEGAL PROCEEDINGS

We are party to numerous 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 which relate to disputes over
contractual relationships with third parties, or which involve alleged errors
and omissions on the part of our subsidiaries. A subsidiary has been named along
with several other defendants in legal proceedings by certain of the insurance
company members of a discontinued workers' compensation reinsurance facility
commonly known as the Unicover Pool. During 1997 and 1998, our subsidiary was
one of two co-intermediaries for the facility. Other defendants in the current
proceedings include the other reinsurance intermediary, the former managing
underwriter for the facility and various individuals, none of whom are
affiliated with us. The proceedings claim that the actions of the various
defendants resulted in the rescission of certain reinsurance contracts in an
arbitration to which we were not a party and include allegations of breach of
fiduciary duty, negligence, fraud and other allegations. The proceedings claim
unspecified or substantial compensatory and punitive damages. We believe that we
have meritorious defenses to the allegations and intend to vigorously defend
against the claims made in the proceedings. In addition, we are presently
engaged in litigation initiated by the appointed liquidator of a former
reinsurer concerning payments made to us prior to the date of the appointment of
the liquidator. The disputed payments were made by the now insolvent reinsurer
in connection with a commutation agreement. Our understanding is that such
litigation is one of a number of similar actions brought by the liquidator. We
intend to vigorously contest the action. Although the ultimate outcome of these
matters may not be determined at this time, based upon present information, the
availability of insurance coverage and legal advice received, we do not believe
the resolution of any of these matters, some of which include allegations of
damages of material amounts, will have a material adverse effect on our
financial condition, results of operations or cash flows.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

There were no matters submitted to a vote of security holders during the
fourth quarter of 2003.

PART II

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS

PRICE RANGE OF COMMON STOCK

Our common stock trades on the New York Stock Exchange under the ticker
symbol "HCC".

The intra-day high and low sales prices for quarterly periods from January
1, 2002 through December 31, 2003, as reported by the New York Stock Exchange
were as follows:

2003 2002
--------------- ---------------
HIGH LOW HIGH LOW
------ ------ ------ ------

First quarter...................................... $26.46 $22.30 $28.95 $24.90
Second quarter..................................... 30.19 25.65 28.50 24.70
Third quarter...................................... 31.26 28.70 26.60 19.11
Fourth quarter..................................... 32.09 28.10 25.70 22.37

On February 27, 2004, the last reported sales price of our common stock as
reported by the New York Stock Exchange was $32.39 per share.

SHAREHOLDERS

We have one class of authorized capital stock: 250.0 million shares of
common stock, par value $1.00 per share. As of February 27, 2004, there were
64.4 million shares of issued and outstanding common stock held by 1,002
shareholders of record; however, we estimate there are approximately 20,000
beneficial owners.

DIVIDEND POLICY

Cash dividends declared on a quarterly basis for the three years ended
December 31, 2003 were as follows:

2003 2002 2001
----- ------ ------

First quarter............................................... $.065 $.0625 $.06
Second quarter.............................................. .065 .0625 .06
Third quarter............................................... .075 .065 .0625
Fourth quarter.............................................. .075 .065 .0625

Beginning in June, 1996, we announced a planned quarterly program of paying
cash dividends to shareholders. Our Board of Directors may review our dividend
policy from time to time and any determination with respect to future dividends
will be made in light of regulatory and other conditions at that time, including
our earnings, financial condition, capital requirements, loan covenants and
other related factors. Under the terms of our bank loan, we are prohibited from
paying dividends in excess of an agreed upon maximum amount in any fiscal year.
That limitation should not affect our ability to pay dividends in a manner
consistent with our past practice and current expectations.

ITEM 6. SELECTED FINANCIAL DATA

The selected consolidated financial data set forth below has been derived
from the Consolidated Financial Statements. All information contained herein
should be read in conjunction with the Consolidated Financial Statements, the
related notes thereto and Management's Discussion and Analysis of Financial
Condition and Results of Operations included elsewhere in this Report.

FOR THE YEARS ENDED DECEMBER 31,
----------------------------------------------------
2003 2002 2001 2000 1999
-------- -------- -------- -------- --------
(IN THOUSANDS, EXCEPT PER SHARE DATA)(1)

STATEMENT OF EARNINGS DATA:
Revenue
Net earned premium........................ $738,272 $505,521 $342,787 $267,647 $141,362
Fee and commission income................. 142,615 115,919 111,016 146,999 141,481
Net investment income..................... 47,335 37,755 39,562 39,804 30,940
Net realized investment gain (loss)....... 527 453 393 (5,321) (4,164)
Other operating income.................... 13,215 6,985 17,451 25,499 28,499
-------- -------- -------- -------- --------
Total revenue........................ 941,964 666,633 511,209 474,628 338,118
Expense
Loss and loss adjustment expense, net..... 488,652 306,491 267,390 198,470 109,650
Operating expense:
Policy acquisition costs, net.......... 138,212 99,521 66,313 57,934 27,277
Compensation expense................... 82,947 58,567 50,806 62,275 64,419
Provision for reinsurance.............. -- -- -- -- 43,462
Other operating expense................ 57,966 41,357 63,000 47,712 47,917
-------- -------- -------- -------- --------
Total operating expense........... 279,125 199,445 180,119 167,921 183,075
Interest expense............................ 7,453 8,301 8,875 20,249 12,741
-------- -------- -------- -------- --------
Total expense.......................... 775,230 514,237 456,384 386,640 305,466
-------- -------- -------- -------- --------
Earnings from continuing operations
before income tax provision.......... 166,734 152,396 54,825 87,988 32,652
Income tax provision from continuing
operations................................ 59,857 52,933 27,764 34,400 9,911
-------- -------- -------- -------- --------
Earnings from continuing operations before
accounting change...................... 106,877 99,463 27,061 53,588 22,741
Gain from sale of discontinued
operations(5).......................... 30,141 -- -- -- --
Earnings from discontinued
operations(5).......................... 6,543 6,365 3,136 3,893 3,831
Cumulative effect of accounting
change(2).............................. -- -- -- (2,013) --
-------- -------- -------- -------- --------
Net earnings.............................. $143,561 $105,828 $ 30,197 $ 55,468 $ 26,572
======== ======== ======== ======== ========
BASIC EARNINGS PER SHARE DATA:
Earnings from continuing operations before
accounting change...................... $ 1.69 $ 1.60 $ 0.47 $ 1.05 $ 0.45
Gain from sale of discontinued
operations(5).......................... 0.48 -- -- -- --
Earnings from discontinued
operations(5).......................... 0.10 0.10 0.05 0.08 0.08
Cumulative effect of accounting
change(2).............................. -- -- -- (0.04) --
-------- -------- -------- -------- --------
Net earnings.............................. $ 2.27 $ 1.70 $ 0.52 $ 1.09 $ 0.53
======== ======== ======== ======== ========
Weighted average shares outstanding....... 63,279 62,225 58,321 50,742 50,058
======== ======== ======== ======== ========

FOR THE YEARS ENDED DECEMBER 31,
----------------------------------------------------
2003 2002 2001 2000 1999
-------- -------- -------- -------- --------
(IN THOUSANDS, EXCEPT PER SHARE DATA)(1)

DILUTED EARNINGS PER SHARE DATA:
Earnings from continuing operations before
accounting change...................... $ 1.66 $ 1.58 $ 0.46 $ 1.04 $ 0.45
Gain from sale of discontinued
operations(5).......................... 0.47 -- -- -- --
Earnings from discontinued
operations(5).......................... 0.10 0.10 0.05 0.07 0.07
Cumulative effect of accounting
change(2).............................. -- -- -- (0.04) --
-------- -------- -------- -------- --------
Net earnings.............................. $ 2.23 $ 1.68 $ 0.51 $ 1.07 $ 0.52
======== ======== ======== ======== ========
Weighted average shares outstanding....... 64,383 62,936 59,619 51,619 50,646
======== ======== ======== ======== ========
Cash dividends declared, per share.......... $ 0.28 $ 0.255 $ 0.245 $ 0.22 $ 0.20
======== ======== ======== ======== ========
Amounts adjusted for the non-amortization of
goodwill(3):
Adjusted net earnings..................... $143,561 $105,828 $ 41,584 $ 67,302 $ 31,980
======== ======== ======== ======== ========
Adjusted basic earnings per share......... $ 2.27 $ 1.70 $ 0.71 $ 1.33 $ 0.64
======== ======== ======== ======== ========
Adjusted diluted earnings per share....... $ 2.23 $ 1.68 $ 0.70 $ 1.30 $ 0.63
======== ======== ======== ======== ========

DECEMBER 31,
--------------------------------------------------------------
2003 2002 2001 2000 1999
---------- ---------- ---------- ---------- ----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)

BALANCE SHEET DATA:
Total investments................ $1,703,346 $1,167,636 $ 885,659 $ 711,113 $ 581,322
Premium, claims and other
receivables.................... 899,031 753,527 665,965 609,716 636,671
Reinsurance recoverables......... 916,190 798,934 899,128 789,412 736,485
Ceded unearned premium........... 291,591 164,224 71,140 114,469 133,657
Goodwill and intangible assets... 406,000 349,286 328,815 266,015 263,687
Total assets..................... 4,864,296 3,704,151 3,219,120 2,790,755 2,679,737
Loss and loss adjustment expense
payable........................ 1,535,288 1,155,290 1,130,748 944,117 871,104
Unearned premium................. 592,311 331,050 179,530 190,550 188,524
Notes payable.................... 310,404 230,027 181,928 212,133 242,546
Shareholders' equity............. 1,046,920 882,907 763,453 530,930 458,439
Book value per share(4).......... 16.37 14.15 12.40 10.29 9.12

---------------

(1) Certain amounts in the 2002, 2001, 2000 and 1999 selected consolidated
financial data have been reclassified to conform to the 2003 presentation.
Among these reclassifications, proceeds from ceded reinsurance (ceding
commissions in excess of acquisition costs) have been classified as fee and
commission income rather than a reduction of operating expenses. Also,
compensation and other operating expenses of our underwriting agency
subsidiaries representing acquisition costs have been classified as policy
acquisition costs to be offset by the portion of ceding commission which
represents the reimbursement of those acquisition costs. Such
reclassifications had no effect on our net earnings, shareholders' equity or
cash flows.

(2) During 2000, we changed certain of our revenue recognition methods for our
underwriting agencies and intermediaries to agree to guidance contained in
Securities and Exchange Commission's Staff Accounting Bulletin Number 101
entitled "Revenue Recognition in Financial Statements".

(3) During 2002, we adopted Statement of Financial Accounting Standards ("SFAS")
No. 142 entitled "Goodwill and Other Intangible Assets", which required that
goodwill and indefinite-lived intangible assets no longer be amortized. The
adjusted amounts presented are amounts that we would have reported had we
adopted SFAS No. 142 on January 1, 1999.

(4) Book value per share is calculated by dividing the sum of outstanding shares
plus contractually issuable shares into total shareholders' equity.

(5) We sold our retail brokerage operation, HCC Employee Benefits, Inc., in
December 2003. The net earnings of HCC Employee Benefits, Inc. and the gain
on its sale have been classified as discontinued operations in our
consolidated statements of earnings. Consistent with this presentation, all
revenue and expense of HCC Employee Benefits, Inc. have been reclassified
from continuing operations in our consolidated statement of earnings.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

OVERVIEW

We primarily receive our revenue from earned premium derived from our
insurance company operations, fee income generated by our underwriting agency
operations, commission income produced by our intermediary operations, proceeds
from ceded reinsurance (ceding commissions in excess of acquisition costs)
earned by our insurance company subsidiaries, investment income from all of our
operations and other operating income. Our core underwriting activities involve
providing group life, accident and health, diversified financial products,
London market account, aviation and other specialty lines of business, each of
which is marketed by our insurance companies and our underwriting agencies
either directly to customers or through a network of independent or affiliated
agents, third party administrators and brokers.

During the past several years, we have substantially increased our
shareholders' equity through the issuance of equity securities and through
retaining our earnings, thereby enabling us to increase the underwriting
capacity of our insurance companies and make acquisitions. With this additional
equity, we increased underwriting activity across many of our businesses and
added new lines of business, emphasizing lines of business and individual
opportunities with the most favorable underwriting characteristics at a
particular point in the insurance cycle. As an insurer, we also purchase
reinsurance for each of our lines of business. We purchase different types of
reinsurance in amounts we consider appropriate for each of our lines of business
based upon market conditions and the level of risk we wish to retain.

Market conditions improved across all of our lines of business during the
period 2000 through 2003. This improvement accelerated after the September 11,
2001 terrorist attack and highly publicized corporate governance failures and
continued throughout 2003 with significant rate increases particularly evident
in our diversified financial products line of business. We have expanded our
underwriting activities and increased our retentions in response to these
hardening market conditions and plan to continue these actions as long as market
conditions warrant.

During the period 2001 through 2003, we acquired the following companies in
transactions that were recorded using the purchase method of accounting.
Accordingly, the results of operations and cash flows of these companies are
included in our operations beginning on the effective date of each transaction.

COMPANY SEGMENT EFFECTIVE DATE ACQUIRED
------- ------- -----------------------

Professional Indemnity Agency, Inc. Underwriting Agency October 22, 2001
ASU International, LLC Underwriting Agency October 30, 2001
HCC Global Financial Products, LLC Underwriting Agency October 1, 2002
(formerly MAG Global Financial Products,
LLC)
HCC Diversified Financial Products Limited Underwriting Agency/Intermediary December 24, 2002
(formerly Dickson Manchester & Company,
Limited)
HCC Europe (formerly St. Paul Espana) Insurance Company December 31, 2002
Covenant Underwriters Limited and Underwriting Agency/Intermediary July 1, 2003
Continental Underwriters Limited

RESULTS OF OPERATIONS

The following table sets forth certain premium revenue information for the
three years ended December 31, 2003 (in thousands):

2003 2002 2001
---------- ---------- ----------

Direct........................................... $1,377,999 $ 904,737 $ 783,124
Reinsurance assumed.............................. 361,895 254,512 226,951
---------- ---------- ----------
Gross written premium.......................... 1,739,894 1,159,249 1,010,075
Reinsurance ceded................................ (874,392) (613,338) (637,117)
---------- ---------- ----------
Net written premium............................ 865,502 545,911 372,958
Change in unearned premium....................... (127,230) (40,390) (30,171)
---------- ---------- ----------
Net earned premium............................. $ 738,272 $ 505,521 $ 342,787
========== ========== ==========

The following table sets forth the relationships of certain income
statement items as a percent of total revenue for the three years ended December
31, 2003:

2003 2002 2001
----- ----- -----

Net earned premium.......................................... 78.4% 75.8% 67.1%
Fee and commission income................................... 15.1 17.4 21.7
Net investment income....................................... 5.0 5.7 7.7
Net realized investment gain................................ 0.1 0.1 0.1
Other operating income...................................... 1.4 1.0 3.4
----- ----- -----
Total revenue............................................. 100.0 100.0 100.0
Loss and loss adjustment expense, net....................... 51.9 46.0 52.3
Total operating expense..................................... 29.6 29.9 35.2
Interest expense............................................ 0.8 1.2 1.8
----- ----- -----
Earnings from continuing operations before income tax
provision.............................................. 17.7 22.9 10.7
Income tax provision........................................ 6.4 8.0 5.4
----- ----- -----
Earnings from continuing operations....................... 11.3% 14.9% 5.3%
===== ===== =====

YEAR ENDED DECEMBER 31, 2003 VERSUS YEAR ENDED DECEMBER 31, 2002

Total revenue increased 41% to $942.0 million for 2003 from $666.6 million
in 2002, driven by significant increases in net earned premium and, to a lesser
extent, fee and commission income and investment income. We anticipate continued
revenue growth in 2004.

Net earned premium grew 46% to $738.3 million in 2003, primarily due to
increased rates, a reduction in ceded reinsurance, organic growth and higher
renewal retentions.

Fee and commission income increased 23% to $142.6 million in 2003 due to
increased rates, organic growth and acquisitions made in late 2002.

Net investment income increased 25% to $47.3 million in 2003 due to higher
investment assets, which increased 46% to $1.7 billion in 2003 as a result of
increased loss reserves due to higher retentions and growth in lines of business
where losses take longer to settle, as well as significant cash flow from
operations. Net investment income increased despite lower yields on our short
duration, high quality investment portfolio of fixed income securities and on
our short-term investments. We expect investment assets to continue to increase
and produce additional growth in investment income in 2004, even if interest
rates do not increase significantly. If market interest rates were to rise, the
growth in investment income would be accelerated as our current portfolio has a
relatively short duration and would be available to be invested on a longer-term
basis to take advantage of higher rates. Our weighted average tax equivalent
yield was 3.8% in 2003 compared to 4.6% in 2002. The weighted average duration
of our fixed income portfolio was 3.7 years and the weighted average maturity
was 4.5 years.

Other operating income increased 89% to $13.2 million in 2003, principally
due to increased gains on our portfolio of insurance related trading securities
and income from a real estate partnership that was first included in our
consolidated financial statements in 2003.

Compensation expense increased to $82.9 million during 2003 from $58.6
million in 2002. Subsidiaries acquired during the past year accounted for the
majority of the increase, with the remaining amount primarily due to larger
incentive based compensation accruals as a result of increased earnings.

Other operating expense increased to $58.0 million during 2003 compared to
$41.4 million in 2002. The reasons for this increase are as follows:

INCREASE
2003 2002 (DECREASE)
------- ------- ----------

Subsidiaries acquired in 2002 and 2003................. $12,925 $ 334 $12,591
Guaranty fund and other special assessments............ 6,815 4,696 2,119
Provision to increase reserve for reinsurance
recoverables......................................... 7,671 3,183 4,488
Foreign currency gains................................. (4,122) (1,230) (2,892)
Other.................................................. 34,677 34,374 303
------- ------- -------
$57,966 $41,357 $16,609
======= ======= =======

The guaranty fund and other assessments that our insurance companies
incurred in 2003 were higher than normal due to one particular state assessment
and assessments in a line of business that has been discontinued. The foreign
currency gains included a gain of $1.3 million in 2003 from the settlement of an
advance of funds to an unaffiliated entity.

The income tax provision related to continuing operations was $59.9 million
for 2003 compared to $52.9 million in 2002. The effective tax rate was 35.9% in
2003 compared to 34.7% in 2002. The increased rate results from higher expenses,
which are not deductible for tax purposes and higher state income taxes. The tax
rate on the gain on the sale of our discontinued operations is higher than the
statutory rate due to non-deductible goodwill of $8.3 million, which was
included in the cost of the discontinued operations sold.

We sold our retail brokerage operation, HCC Employee Benefits, Inc., in
December, 2003. The net earnings of HCC Employee Benefits, Inc. and the gain on
its sale have been classified as discontinued

operations in our consolidated statements of earnings. Consistent with this
presentation, all revenue and expense of HCC Employee Benefits, Inc. have been
reclassified from continuing operations in our consolidated statement of
earnings. The net cash received from the sale was utilized to acquire American
Contractors Indemnity Company, a surety company, in January, 2004. We believe
that the results of operations of American Contractors Indemnity Company will at
least replace the earnings from discontinued operations.

Net earnings increased 36% to $143.6 million, or $2.23 per diluted share,
in 2003. Net earnings in 2003 includes a $30.1 million (net of income tax), or
$0.47 per share, gain on sale of a subsidiary and an $18.7 million (net of
income tax), or $0.29 per share, loss due to the discount related to a
commutation. The increase in net earnings resulted from increasing operating
revenue and profits and an increase in investment income.

Our book value per share was $16.37 as of December 31, 2003, up from $14.15
as of December 31, 2002.

SEGMENTS

INSURANCE COMPANIES

The following tables provide information by line of business (in
thousands):

GROSS NET NET NET
WRITTEN WRITTEN EARNED LOSS
PREMIUM PREMIUM PREMIUM RATIO
---------- -------- -------- -----

For the year ended December 31, 2003:
Group life, accident and health............. $ 565,494 $299,913 $290,009 61.6%
Diversified financial products.............. 553,501 183,560 123,562 47.8
London market account....................... 223,149 155,987 137,572 53.2
Aviation.................................... 214,718 99,447 97,536 61.5
Other specialty lines....................... 148,239 109,408 57,551 81.0
---------- -------- -------- -----
1,705,101 848,315 706,230 59.1
Discontinued lines.......................... 34,793 17,187 32,042 222.0
---------- -------- -------- -----
TOTALS.................................... $1,739,894 $865,502 $738,272 66.2%
========== ======== ========
Expense ratio 24.8
-----
Combined ratio 91.0%
-----
For the year ended December 31, 2002:
Group life, accident and health............. $ 503,263 $244,554 $240,070 62.2%
Diversified financial products.............. 178,653 43,731 23,102 46.4
London market account....................... 199,816 113,925 89,260 51.5
Aviation.................................... 212,518 99,826 100,960 46.3
Other specialty lines....................... 32,563 25,621 22,337 101.1
---------- -------- -------- -----
1,126,813 527,657 475,729 57.8
Discontinued lines.......................... 32,436 18,254 29,792 105.0
---------- -------- -------- -----
TOTALS.................................... $1,159,249 $545,911 $505,521 60.6%
========== ======== ========
Expense ratio 25.4
-----
Combined ratio 86.0%
=====

Gross written premium increased 50% to $1.7 billion in 2003 due to
increased rates, organic growth and higher percentage of renewals. Gross written
premium is expected to continue to increase in 2004.

Net written premium in 2003 increased 59% to $865.5 million due to our
insurance companies increasing retentions together with the factors discussed
above. Net earned premium also increased 46% to $738.3 million for the same
reasons. Growth in net written and net earned premium is expected to continue in
2004.

Net loss and loss adjustment expense was $488.7 million for 2003 compared
to $306.5 million in 2002. The net loss ratio was 66.2% for 2003 compared to
60.6% in 2002. Our net loss and loss adjustment expense deficiency relating to
prior year losses was $23.8 million in 2003 compared to a redundancy of $6.8
million in 2002. The deficiency for 2003 included a commutation loss of $28.8
million, which represents the discount on the reinsurance recoverables commuted.
The commutation increased the net loss ratio for 2003 by 3.9%. The overall loss
ratio for the continuing lines was virtually unchanged. The net loss ratio in
the aviation line of business increased due to unusually good loss experience in
2002 compared to a loss ratio in 2003 that was more in line with expectations,
producing an excellent underwriting profit. Loss experience in the other
specialty lines improved in 2003 as it approached its expected level. The loss
ratio in the discontinued lines of business increased in 2003 following reserve
additions resulting from our ongoing review of outstanding claims and the $28.8
million commutation loss recorded in the fourth quarter of 2003, somewhat offset
by a $7.7 million charge recorded in the third quarter of 2002.

The gross loss ratio was 70.3% in 2003 compared to 58.6% in 2002. Our gross
loss and loss adjustment expense deficiency relating to prior year losses was
$151.1 million in 2003 compared to a redundancy of $23.2 million in 2002. During
2003, we increased our gross losses related to prior accident years by $132.9
million on certain assumed accident and health reinsurance contracts reported in
our discontinued line of business due to our processing of additional
information received and our continuing evaluation of reserves related to this
business. Also during 2003, we incurred a $30.0 million gross loss on a large
warehouse fire and reduced gross losses related to prior accident years on a
discontinued aggregate program by $14.3 million based on revised current
information. On this same program in 2002, we recorded $36.2 million of adverse
gross development. Also, during 2002 we reduced our gross losses from the
September 11 terrorist attacks by $21.5 million and our gross loss from the
Total Oil Company loss by $14.0 million to its ultimate settlement amount,
thereby lowering the 2002 gross loss ratio. As all these losses were
substantially reinsured, they had no material effect on our net losses or
earnings.

The tables below show the composition of net and gross incurred loss and
loss adjustment expense (amounts in thousands):

NET INCURRED LOSS AND LOSS ADJUSTMENT EXPENSE
---------------------------------------------
2003 2002
--------------------- ---------------------
AMOUNT LOSS RATIO AMOUNT LOSS RATIO
-------- ---------- -------- ----------

2003 effect of commutation................. $ 28,751 3.9% $ -- --%
2002 third quarter charge.................. -- -- 7,674 1.5
Other prior year development............... (4,985) (0.7) (14,453) (2.9)
All other incurred loss and loss adjustment
expense.................................. 464,886 63.0 313,270 62.0
-------- ---- -------- ----
Net incurred loss and loss adjustment
expense............................. $488,652 66.2% $306,491 60.6%
======== ==== ======== ====

GROSS INCURRED LOSS AND LOSS ADJUSTMENT EXPENSE
-----------------------------------------------
2003 2002
----------------------- ---------------------
AMOUNT LOSS RATIO AMOUNT LOSS RATIO
---------- ---------- -------- ----------

September 11 terrorist attack............ $ -- --% $(21,500) (2.1)%
2003 discontinued accident and health
adjustments............................ 132,924 8.2 -- --
Total Oil Company loss................... -- -- (14,000) (1.4)
Large warehouse fire..................... 30,000 2.0 -- --
2002 third quarter charge................ -- -- 7,674 0.8
Discontinued aggregate program........... (14,332) (1.0) 36,170 3.5
Other prior year development............. 4,561 2.9 (31,504) (3.1)
All other incurred loss and loss
adjustment expense..................... 892,838 58.2 627,412 60.9
---------- ---- -------- ----
Gross incurred loss and loss adjustment
expense................................ $1,045,991 70.3% $604,252 58.6%
========== ==== ======== ====

The expense ratio for 2003 is slightly lower than 2002 due to the effects
of greater premium volume. After removing the effect of the commutation loss,
the combined ratios for 2003 and 2002 are virtually the same.

Policy acquisition costs, which are net of reimbursement with respect to
reinsurance ceded, increased to $138.2 million due to higher earned premium. The
ratio of policy acquisition costs to earned premium was 18.7% in 2003 compared
to 19.7% in 2002. The decrease in percentages is due to changes in the mix of
business and spreading certain costs over a larger premium volume.

Net earnings of our insurance companies increased to $74.4 million for 2003
from $68.2 million for 2002 due to continued favorable underwriting results on
increased premium volume and despite an after-tax loss of $18.7 million due to a
commutation. We expect growth in earnings of this segment to continue in 2004.

UNDERWRITING AGENCIES

Revenue from our underwriting agencies (primarily fee income) increased 56%
to $174.7 million in 2003 due to acquisitions made beginning in the fourth
quarter of 2002 as well as organic growth in our existing underwriting agencies.
Subsidiaries acquired during 2002 and 2003 accounted for an increase in segment
revenue in 2003 of $59.1 million when compared to periods prior to their
acquisition in 2002. Net earnings in this segment increased 79% to $45.3 million
in 2002 for the same reasons. We expect the underwriting agency segment to
continue to grow in 2004.

INTERMEDIARIES

Revenue from our intermediaries (primarily commission income) increased 12%
to $48.6 million in 2003 due to general market conditions and organic growth.
Net earnings of our intermediaries increased 31% to $9.9 million in 2003 for the
same reasons. There was also a reduction in intergroup interest and a lower
effective tax rate in 2003 compared to 2002 due to the negative effects of a tax
allocation true-up during 2002. The operations of HCC Employee Benefits, Inc.,
which are included in the intermediary segment, were sold in December 2003 and
are classified as discontinued operations in our consolidated statement of
earnings. It accounted for $22.9 million and $21.9 million in revenue and $5.5
million and $5.3 million in net earnings in 2003 and 2002, respectively. These
segment earnings of HCC Employee Benefits, Inc. include allocated general
corporate overhead expenses (net of income tax) of $1.0 million and $1.1
million, respectively, in 2003 and 2002. The remaining subsidiaries in the
intermediary segment are expected to continue to grow in 2004.

OTHER OPERATIONS

Revenue and net income of other operations increased to $64.4 million and
$36.2 million, respectively. Most of this increase came from the $52.7 million
gain ($30.1 million net of income tax) on the sale of HCC Employee Benefits,
Inc. The segment also saw an increase in revenue and net income due to income
from our March 2003 strategic investment in Argonaut Group, Inc. and income from
our strategic investment and trading accounts. Also, segment revenue increased
as a result of the initial consolidation of a real estate partnership to comply
with Financial Accounting Standards Board Interpretation No. 46. Period to
period comparisons may vary substantially depending on strategic investments,
trading activities or dispositions in any given period.

CORPORATE

The net loss of the corporate segment was $5.4 million for 2003 compared to
net income of $2.9 million in 2002. The decrease in segment earnings between
years resulted primarily from the increase in incentive compensation. The
segment results in 2002 were positively affected by inter-segment income tax
adjustments, additional intergroup interest charged to subsidiaries and the
adjustment of certain accruals to their ultimate liabilities. The 2003 results
were positively affected by a one-time currency conversion gain in the amount of
$1.3 million.

YEAR ENDED DECEMBER 31, 2002 VERSUS YEAR ENDED DECEMBER 31, 2001

Total revenue increased 30% to $666.6 million for 2002 from $511.2 million
in 2001. The revenue increase in the insurance company segment resulted from
organic growth in our existing lines of business, the addition of our new
diversified financial products line of business and increased premium retention.
The revenue in the underwriting agency segment increased due to organic growth
and acquisitions made in 2002 and late 2001, but the increase was partially
offset by reduced revenue in the intermediary and other operations segments as a
result of market conditions and the sale or other disposition of various
operations in 2001.

Net investment income decreased to $37.8 million for 2002 from $39.6
million in 2001. This decrease was due to the reduction in interest rates,
substantially offset by the higher level of invested assets which resulted from
cash flow provided by operating activities and capital contributions made to our
insurance company subsidiaries.

The year 2001 was adversely affected as we experienced the largest loss to
our insurance company operations in our history due to the terrorist attack on
September 11, with incurred net losses of $35.0 million. In 2001, we also
recorded a charge totaling $37.3 million related to our primary workers'
compensation line of business and other lines of business that we decided to
cease writing. Included in this charge was $15.0 million related to the
impairment of goodwill associated with our primary workers' compensation line of
business.

Compensation expense increased to $58.6 million during 2002 from $50.8
million in 2001. Much of this increase was due to the underwriting agency
subsidiaries acquired in 2002 and late 2001, somewhat offset by a decrease from
operations sold or otherwise disposed of during late 2001 and efficiencies
gained from the consolidation of certain of our underwriting agencies into our
insurance company operations.

Other operating expense decreased to $41.4 million during 2002 compared to
$63.0 million in 2001, primarily as a result of the reduction in the
amortization of goodwill, operations sold or disposed of and the goodwill
impairment charge in 2001. These decreases were offset by the effect of
acquisitions in 2002 and late 2001. Currency conversion gains amount to $1.2
million in 2002 compared to $0.3 million in 2001.

The income tax provision related to continuing operations was $52.9 million
for 2002 compared to $27.8 million in 2001. Our effective tax rate was 34.7% in
2002. The unusually high tax rate for 2001 results from the write off related to
the impairment of goodwill, which was not deductible for income tax purposes.

Net earnings increased to $105.8 million, or $1.68 per diluted share, for
2002 from $30.2 million, or $0.51 per diluted share, in 2001. The increase in
net earnings resulted from increased revenue and an improved underwriting
performance by the insurance company segment, net of a charge in 2002 related to
a discontinued line of business ($5.0 million or $0.08 per share). Other events
affecting the comparison include losses from the September 11 terrorist attack
recorded during 2001 ($22.8 million or $0.38 per share), the charge for lines of
business we decided to cease writing during 2001 ($29.6 million or $0.50 per
share) and the amortization of goodwill in 2001, ($11.4 million or $0.19 per
share) prior to our adoption of SFAS No. 142.

Our book value per share was $14.15 as of December 31, 2002, up from $12.40
as of December 31, 2001. Net earnings and the unrealized gain on available for
sale securities contributed to the increase in book value per share.

SEGMENTS

INSURANCE COMPANIES

The following tables provide information by line of business (in
thousands):

GROSS NET NET NET
WRITTEN WRITTEN EARNED LOSS
PREMIUM PREMIUM PREMIUM RATIO
------- -------- -------- -----

For the year ended December 31, 2002:
Group life, accident and health............. $ 503,263 $244,554 $240,070 62.2%
Diversified financial products.............. 178,653 43,731 23,102 46.4
London market account....................... 199,816 113,925 89,260 51.5
Aviation.................................... 212,518 99,826 100,960 46.3
Other specialty lines....................... 32,563 25,621 22,337 101.1
---------- -------- -------- -----
1,126,813 527,657 475,729 57.8
Discontinued lines.......................... 32,436 18,254 29,792 105.0
---------- -------- -------- -----
TOTALS...................................... $1,159,249 $545,911 $505,521 60.6%
========== ======== ========
Expense ratio 25.4
-----
Combined ratio 86.0%
=====
For the year ended December 31, 2001:
Group life, accident and health............. $ 502,086 $146,220 $143,851 67.5%
Diversified financial products.............. 46 44 4 25.0
London market account....................... 133,579 54,056 43,360 59.4
Aviation.................................... 198,015 98,249 91,377 62.5
Other specialty lines....................... 15,556 14,346 15,120 73.5
---------- -------- -------- -----
849,282 312,915 293,712 65.1
Discontinued lines.......................... 160,793 60,043 49,075 155.5
---------- -------- -------- -----
TOTALS...................................... $1,010,075 $372,958 $342,787 78.0%
========== ======== ========
Expense ratio 25.7
-----
Combined ratio 103.7%
=====

Gross written premium increased 15% to $1.2 billion for 2002 from $1.0
billion in 2001. This increase was 33% before the discontinued lines of
business. The increase resulted from organic growth and premium rate increases
in our London market account line of business, plus our diversified financial
products line of business not previously written, offset by the decrease in
discontinued lines of business.

Net written premium for 2002 increased 46% to $545.9 million from $373.0
million in 2001, as our insurance companies have increased their overall
retentions, in addition to the effect of the changes in gross premium described
above. Net earned premium also increased 47% to $505.5 million for the same

reasons. Increases in net written and net earned premiums were 69% and 62%,
respectively, before the discontinued lines of business.

Net loss and loss adjustment expense was $306.5 million for 2002 compared
to $267.4 million in 2001. The 2001 net loss expense included $35.0 million from
the September 11 terrorist attack and $18.8 million from the charge for lines of
business we decided to cease writing. Because of these items and generally
better underwriting results in 2002 as a result of higher pricing and improved
policy terms and conditions, the net loss ratio was greatly improved at 60.6%
for 2002 compared to 78.0% in 2001, on substantially increased earned premiums.
The loss ratios for the continuing lines, with the exception of the specialty
lines, also improved for these reasons. The loss ratio in the other specialty
lines increased as a result of some adverse development on policies, which were
subsequently not renewed. During the third quarter of 2002, we also recorded a
charge in the amount of $7.7 million related to certain business included in
discontinued lines. This business was acquired as part of our purchase of The
Centris Group, Inc. in 1999 and was of a type that we have not historically
written. The gross loss ratio was 58.6% in 2002 compared to 105.5% in 2001. The
2001 gross loss ratio was high because we recorded gross losses of $55.0 million
due to the Petrobras production platform, $141.0 million due to the September 11
terrorist attack and $49.0 million due to the Total Oil Company loss.
Additionally, in 2002, as a result of further evaluation, we reduced our gross
losses from the September 11 terrorist attack by $21.5 million and reduced the
gross losses from the Total loss by $14.0 million. Offsetting this positive
gross development was $36.2 million of negative development due to late
reporting of an aggregate program that we no longer write. As the adjustments
related to gross losses that were substantially reinsured, there was no material
net effect.

During 2002, we had net loss and loss adjustment expense redundancy of $6.8
million relating to prior year losses compared to a redundancy of $10.7 million
in 2001 and we had gross loss and loss adjustment expense redundancy of $23.2
million compared to a deficiency of $44.5 million in 2001. The gross deficiency
for 2001 resulted from late reported loss information received during 2001,
primarily from assumed reinsurance business written by one of our insurance
companies. There was no material net effect on our earnings as that business was
substantially reinsured. The deficiencies and redundancies result from our
continued review of our loss reserves with our actuaries and the increase or
reduction of reserves as losses are finally settled and claims exposures are
reduced. We continue to believe we have provided for all material net incurred
losses.

The tables below show the composition of net and gross incurred loss and
loss adjustment expense (amounts in thousands):

NET INCURRED LOSS AND LOSS ADJUSTMENT EXPENSE
---------------------------------------------
2002 2001
--------------------- ---------------------
AMOUNT LOSS RATIO AMOUNT LOSS RATIO
-------- ---------- -------- ----------

September 11 terrorist attack.............. $ -- --% $ 35,000 10.2%
2001 charge for lines of business we ceased
writing.................................. -- -- 18,799 5.5
2002 third quarter discontinued line
charge................................... 7,674 1.5 -- --
Other prior year development............... (14,453) (2.9) (11,963) (3.5)
All other incurred loss and loss adjustment
expense.................................. 313,270 62.0 225,554 65.8
-------- ---- -------- ----
Net incurred loss and loss adjustment
expense............................... $306,491 60.6% $267,390 78.0%
======== ==== ======== ====

GROSS INCURRED LOSS AND LOSS ADJUSTMENT EXPENSE
-----------------------------------------------
2002 2001
--------------------- -----------------------
AMOUNT LOSS RATIO AMOUNT LOSS RATIO
-------- ---------- ---------- ----------

September 11 terrorist attack............ $(21,500) (2.1)% $ 140,962 14.0%
Petrobras production platform............ -- -- 55,000 5.4
Total Oil Company loss................... (14,000) (1.4) 49,000 4.9
2001 charge for lines of business we
ceased writing......................... -- -- 36,784 3.6
2002 third quarter discontinued line
charge................................. 7,674 0.8 -- --
Development on an aggregate program...... 36,170 3.5 -- --
Other prior year development............. (31,504) (3.1) 40,367 4.0
All other incurred loss and loss
adjustment expense..................... 627,412 60.9 741,732 73.6%
-------- ---- ---------- -----
Gross incurred loss and loss adjustment
expense............................. $604,252 58.6% $1,063,845 105.5%
======== ==== ========== =====

Policy acquisition costs, which are net of reimbursement with respect to
reinsurance ceded, increased to $99.5 million or 19.7% of earned premium during
2002, from $66.3 million or 19.3% of earned premium in 2001. This increase is
due to the higher earned premium and the reduction in ceding commissions as a
result of our retaining more business. Included in the 2001 amount is $2.2
million from the charge for lines of business we decided to cease writing. The
expense ratio was substantially unchanged at 25.4% for 2002 compared to 2001
which, when added to our greatly improved loss ratio, produced a substantially
lower combined ratio of 86.0% for 2002 compared to 103.7% in 2001.

Net earnings of our insurance companies increased to $68.2 million in 2002
from a net loss of $2.9 million in 2001, due to increased revenue and improved
underwriting results in 2002. The 2001 results include the effects from the
terrorist attack on September 11 and the charge for lines of business we decided
to cease writing. There was $2.1 million (net of income tax) of goodwill
amortization recorded in 2001.

UNDERWRITING AGENCIES

Revenue from our underwriting agencies (primarily fee income) increased 25%
to $112.0 million for 2002, compared to $89.8 million in 2001. The underwriting
agencies acquired in 2002 and late 2001 accounted for much of the increase
together with organic growth, partially offset by a decrease in fee income from
our other underwriting agencies as we continued the consolidation of certain
other underwriting agency operations into our insurance companies. Net earnings
of our underwriting agencies increased to $25.3 million for 2002 from $17.2
million in 2001 as a result of increased revenue and the adoption of SFAS No.
142, somewhat offset by the integration of certain underwriting agencies into
our insurance companies. There was $5.9 million (net of income tax) of goodwill
amortization recorded in 2001.

INTERMEDIARIES

Revenue from our intermediaries (primarily commission income) decreased to
$43.6 million for 2002, compared to $46.7 million in 2001 due to general market
conditions and less ceded reinsurance being placed on behalf of our insurance
companies as they increased their retentions. Net earnings of our intermediaries
decreased to $7.6 million for 2002 compared to $8.7 million in 2001. There was
$3.4 million (net of income tax) of goodwill amortization recorded in 2001
compared to none in 2002 due to the adoption of SFAS No. 142. HCC Employee
Benefits, Inc. accounted for $21.9 million and $18.4 million in revenue and $5.3
million and $2.6 million in net earnings in 2002 and 2001, respectively. These
segment earnings of HCC Employee Benefits, Inc. include allocated general
corporate overhead expenses (net of income tax) of $1.1 million and $0.5
million, respectively, in 2002 and 2001.

OTHER OPERATIONS

The decrease in other operating income to $7.0 million during 2002 from
$17.5 million in 2001 was principally due to the disposition or closure of
certain operations during 2001 and the resultant gains totaling $8.2 million
from certain of those dispositions. Net earnings of other operations decreased
to $3.1 million in 2002 from $7.1 million in 2001 for the same reasons. Period
to period comparisons may vary substantially depending on other operating
investments or dispositions thereof in any given period.

CORPORATE

The net income of the corporate segment was $2.9 million for 2002 compared
to a net loss of $1.0 million in 2001. This improvement resulted from lower
interest expense due primarily to lower interest rates.

LIQUIDITY AND CAPITAL RESOURCES

We receive substantial cash from premiums, reinsurance recoverables and
management fee and commission income and, to a lesser extent, investment income
and proceeds from sales and redemptions of investments and other assets. Our
principal cash outflows are for the payment of claims and loss adjustment
expenses, payment of premiums to reinsurers, purchase of investments, debt
service and payment of policy acquisition costs, operating expenses, income and
other taxes and dividends. Variations in operating cash flows can occur due to
timing differences in either the payment of claims and the collection of related
recoverables or the collection of receivables and the payment of related payable
amounts. We limit our liquidity exposure by holding funds, letters of credit and
other security such that net balances due to us are less than the gross balances
shown in our condensed consolidated balance sheets.

We maintain a substantial level of cash and liquid short-term investments
which are used to meet anticipated payment obligations. Our consolidated cash
and investment portfolio increased $591.8 million, or 49% during 2003 and
totaled $1.8 billion as of December 31, 2003, of which $614.9 million was cash
and short-term investments. The increase in investments resulted primarily from
operating cash flows. Total assets increased to $4.9 billion as of December 31,
2003.

Our investment portfolio includes a high percentage of liquid investments
and generates a significant amount of investment income, which serves as a
source of cash flow. The average tax equivalent yield on investments was 3.8% in
2003, compared to 4.6% in 2002. The weighted average maturity of our fixed
income securities is 4.5 years and weighted average duration of the portfolio
was 3.7 years, both as of December 31, 2003. During 2003, over 97% of our fixed
income securities were rated "A" or better by Standard & Poor's Corporation. The
value of our portfolio of fixed income securities is inversely correlated to
changes in market interest rates. In addition, some of our fixed income
securities have call or prepayment options. This could subject us to
reinvestment risk should interest rates fall or issuers call their securities
and we reinvest the proceeds at lower interest rates. We mitigate this risk by
investing in securities with varied maturity dates, so that only a portion of
our portfolio will mature at any point in time.

On December 31, 2001 we filed Form S-3 with the United States Securities
and Exchange Commission, which provides a shelf registration for an aggregate of
$750.0 million of our securities available to be issued. These securities may be
debt securities, equity securities or a combination thereof.

On March 25, 2003, we sold an aggregate $125.0 million principal amount of
1.3% Convertible Notes due in 2023 in a public offering. We pay interest on
April 1 and October 1 of each year. Each one thousand dollar principal amount of
notes is convertible into 29.4377 shares of our common stock, which represents
an initial conversion price of $33.97 per share. Holders may surrender notes for
conversion into shares of our common stock if, as of the last day of the
preceding calendar quarter, the closing sale price of our common stock for at
least 20 consecutive trading days during the period of 30 consecutive trading
days ending on the last trading day of that quarter is more than 130% ($44.16
per

share) of the conversion price per share of our common stock. Holders of the
notes may require us to repurchase the notes on April 1, 2009, 2014 and 2019. If
the holders exercise this option, we may choose to pay the purchase price in
cash, in shares of our common stock, or in a combination thereof, although our
intent is to pay in cash.

Our 2% Convertible Notes are due in 2021. Each one thousand dollar
principal amount is convertible into 31.25 shares of our common stock, which
represents an initial conversion price of $32.00 per share. The initial
conversion price is subject to change under certain conditions. We pay interest
on March 1 and September 1 of each year. Holders may surrender notes for
conversion into shares of our common stock in any calendar quarter if, as of the
last day of the preceding calendar quarter, the closing sale price of our common
stock for at least 20 trading days in the period of 30 consecutive trading days
ending on the last trading day of the quarter is more than 120% ($38.40 per
share) of the conversion price per share of our common stock on the last trading
day of the quarter. We can redeem the notes for cash at any time on or after
September 1, 2006. Holders of the notes may require us to repurchase the notes
on September 1, 2004, 2006, 2008, 2011 and 2016. If the holders exercise this
option, we may choose to pay the purchase price in cash, in shares of our common
stock, or a combination thereof, although our intent is to pay in cash.

Our debt securities are rated "A" by Standard & Poor's Corporation (3rd of
10 ratings).

Our $200.0 million Revolving Loan Facility allows us to borrow up to the
maximum amount allowed by the facility on a revolving basis until the facility
expires on December 17, 2004. The facility is collateralized in part by the
pledge of our insurance companies' stock and guarantees entered into by our
underwriting agencies and intermediaries. The facility agreement contains
certain restrictive covenants, which we believe are typical for similar
financing arrangements. As of December 31, 2003, there were no borrowings on
this facility. We intend to replace the facility at expiration with another
facility.

At December 31, 2003, certain of our subsidiaries maintained revolving
lines of credit with a bank in the combined maximum amount of $31.8 million
available through December 17, 2004. Advances under the lines of credit are
limited to amounts required to fund draws, if any, on letters of credit issued
by the bank on behalf of the subsidiaries and short-term direct cash advances.
The lines of credit are collateralized by securities having an aggregate market
value of up to $39.8 million, the actual amount of collateral at any one time
being 125% of the aggregate amount outstanding. Interest on the lines is payable
at the bank's prime rate of interest (4.0% at December 31, 2003) for draws on
the letters of credit and prime less 1% on short-term cash advances. As of
December 31, 2003, letters of credit totaling $16.7 million had been issued to
insurance companies by the bank on behalf of our subsidiaries, with total
securities of $20.9 million collateralizing the lines.

The following is a summary of our contractual cash payment obligations as
of December 31, 2003 (in thousands):

PAYMENTS BY DUE DATE
---------------------------------------------
TOTAL 2004 2005-2006 2007-2008 THEREAFTER
-------- -------- --------- --------- ----------

1.3% Convertible notes........... $125,000 $ -- $ -- $ -- $125,000
2% Convertible notes............. 172,451 172,451 -- -- --
Bank facility.................... -- -- -- -- --
Other notes payable.............. 12,953 358 10,973 248 1,374
Operating leases................. 32,682 8,434 13,453 6,949 3,846
-------- -------- ------- ------ --------
Total obligations.............. $343,086 $181,243 $24,426 $7,197 $130,220
======== ======== ======= ====== ========

The 2% Convertible notes due 2021 are shown in the 2004 column in the above
table because of the put option on September 1, 2004. Both convertible notes
have various put and redemption dates as discussed in the paragraphs above. See
Notes (5) and (9) in Notes to the Consolidated Financial Statements for
additional information concerning these obligations.

We have sold businesses in the past. In connection with these sales, we
have provided indemnifications to the buyers, which we believe are typical for
transactions of this nature, based upon the type of business sold. Certain of
these indemnifications have no limit. It is not possible to estimate the maximum
potential amount under these indemnifications as our performance under the
indemnifications and our ultimate liability are based upon the occurrence of
future events which may or may not occur. We currently have a liability in the
amount of $5.9 million recorded for performance under one such indemnification.
This indemnification was given by a company we acquired, prior to its
acquisition, in connection with a sale of one of its subsidiaries.

The principal assets of HCC Insurance Holdings, Inc. are the shares of
capital stock of our insurance companies. Historically, we have not relied on
dividends from our insurance companies to meet the obligations of the parent
holding company, which are primarily outstanding debt and debt service
obligations, dividends to shareholders and corporate expenses, but, rather, we
have had sufficient cash flow from our underwriting agencies and intermediaries
to meet our cash flow requirements. The payment of dividends by our insurance
companies is subject to regulatory restrictions and will depend on the surplus
and future earnings of these subsidiaries. HCC Insurance Holdings, Inc.'s two
direct insurance company subsidiaries can pay an aggregate of $40.9 million in
dividends in 2004 without obtaining special permission from state regulatory
authorities.

A number of reinsurers have delayed or suspended the payment of amounts
recoverable under certain reinsurance contracts to which we are a party. Such
delays have affected, although not materially to date, the investment income of
our insurance companies, but not to any extent their liquidity. We limit our
liquidity exposure by holding funds, letters of credit or other security such
that net balances due are significantly less than the gross balances shown in
our consolidated balance sheets. We expect to collect the full amounts
recoverable and, if necessary, we may seek collection through judicial or
arbitral proceedings.

Regulatory guidelines suggest that a property and casualty insurer's annual
statutory gross written premium should not exceed 900% of its statutory
policyholders' surplus and net written premium should not exceed 300% of its
statutory policyholders' surplus. However, industry standards and rating agency
criteria place these ratios at 300% and 200%, respectively. Our property and
casualty insurance companies have maintained premium to surplus ratios generally
lower than such guidelines. For the year ended December 31, 2003, our statutory
gross written premium to policyholders' surplus was 295.1%. For the year ended
December 31, 2003, our statutory net written premium to policyholders' surplus
was 146.6%. As of December 31, 2003, each of our domestic insurance companies'
total adjusted capital was significantly in excess of the authorized control
level risk-based capital level prescribed by the National Association of
Insurance Commissioners.

We believe that our operating cash flows, investments, bank facility and
shelf registration on file with the United States Securities and Exchange
Commission will provide sufficient sources of liquidity and capital to meet our
operating and capital needs for the foreseeable future.

IMPACT OF INFLATION

Our operations, like those of other property and casualty insurers, are
susceptible to the effects of inflation, as premiums are established before the
ultimate amounts of loss and loss adjustment expense are known. Although we
consider the potential effects of inflation when setting premium rates, for
competitive reasons, such premiums may not fully offset the effects of
inflation. However, because the majority of our

business is comprised of lines which have relatively short lead times between
the occurrence of an insured event, reporting of the claims to us and the final
settlement of the claims, the effects of inflation are minimized.

A portion of our revenue is related to healthcare insurance and reinsurance
products that are subject to the effects of the underlying inflation of
healthcare costs. Such inflation in the costs of healthcare tends to generate
increases in premiums for medical stop-loss coverage, resulting in greater
revenue, but also higher claim payments. Inflation also may have a negative
impact on insurance and reinsurance operations by causing higher claim
settlements than may originally have been estimated without an immediate
increase in premiums to a level necessary to maintain profit margins. We do not
specifically provide for inflation when setting underwriting terms and claim
reserves, although we do consider trends. We continually review claim reserves
to assess their adequacy and make necessary adjustments.

Inflation can also affect interest rates. Any significant increase in
interest rates could have a material adverse effect on the market value of our
investments. In addition, the interest rate payable under our $200.0 million
bank loan fluctuates with that of the market. Any significant increase in
interest rates could have a material adverse effect on our earnings, depending
on the amount borrowed on our bank facility.

FOREIGN EXCHANGE RATE FLUCTUATIONS

We underwrite risks which are denominated in a number of foreign
currencies. As a result, we have receivables and payables in foreign currencies
and we establish and maintain loss reserves with respect to our insurance
policies in their respective currencies. Our net earnings could be impacted by
exchange rate fluctuations affecting these balances. Our principal area of
exposure is with respect to fluctuations in the exchange rates between the
British pound sterling, the Euro and the U.S. dollar. We constantly monitor the
balance between our receivables and payables and loss reserves to mitigate the
potential exposure should an imbalance be expected to exist for other than a
short period of time. For the year ended December 31, 2003, our gain from
currency conversion was $4.1 million compared to a gain of $1.2 million in 2002
and a gain of $0.3 million in 2001. Included in the 2003 amount was a one-time
gain of $1.3 million from the settlement of an advance of funds to an
unaffiliated entity.

CRITICAL ACCOUNTING POLICIES

The preparation of our consolidated financial statements in conformity with
generally accepted accounting principles requires us to make estimates and
assumptions when applying our accounting policies. Those of our accounting
policies that we consider to be most significant and the estimates and
assumptions we make in the application of those accounting policies are
discussed below.

EARNED PREMIUM, POLICY ACQUISITION COSTS AND CEDING COMMISSIONS

All of the property and casualty policies written by our insurance
companies qualify as short-duration contracts as defined by current accounting
literature. Written premium, net of reinsurance, is primarily included in
earnings on a pro rata basis over the lives of the related policies. However,
for certain types of business, it is recognized over the period of risk in
proportion to the amount of insurance risk provided. Policy acquisition costs,
including commissions, taxes, fees and other direct costs of underwriting
policies less amounts reimbursed by reinsurers, are deferred and charged or
credited to earnings proportionate to the premium earned. Historical and current
loss and loss adjustment expense experience and anticipated investment income
are considered in determining premium deficiencies and the recoverability of
deferred policy acquisition costs.

LOSS AND LOSS ADJUSTMENT EXPENSE

Our net loss and loss adjustment expense reserves are composed of reserves
for reported losses and reserves for incurred but not reported losses less a
reduction for reinsurance recoverable related to those reserves. Reserves are
recorded on an undiscounted basis, except for reserves acquired in transactions
recorded using the purchase method of accounting. The reserves for reported
losses related to our direct

business and certain reinsurance assumed are initially set by our claims
personnel or independent claims adjusters hired by us and subject to our review
with a goal of setting the reserves at the ultimate expected loss amount as soon
as possible as information becomes available. Reserves for reported losses with
respect to other reinsurance assumed are recorded based upon information
supplied to us by the ceding company. Our claims personnel monitor these
reinsurance assumed reserves on a current basis and audit ceding companies'
claims to ascertain that claims are being recorded currently and that net
reserves are being set at levels that properly reflect the liability related to
the claims. Our actuaries, in conjunction with our claims personnel, determine
the amount of our incurred but not reported reserves as well as review the
reported claim reserves for positive or adverse development. Reserves are
estimates and changed conditions can cause changes in the estimates. However, we
believe that our review process is effective such that any required changes are
recognized in the period of change as soon as the need for the change is
evident. Reinsurance recoverables offset our gross reserves based upon the
contractual terms of our reinsurance agreements.

Losses in our group life and accident and health, aviation, London market
accounts and other specialty lines of business are recorded and paid relatively
quickly. There is not a significant amount of long-tailed liability exposure in
these lines of business. Therefore, reserves can be determined and recorded with
a higher degree of accuracy and significant development should not be expected
with respect to losses in these lines of business. There is some reinsurance
assumed in these lines of business, but, as discussed above, we monitor the
assumed reported losses closely. Losses related to our diversified financial
products line of business are reported relatively quickly but can develop over
time as, especially with respect to directors' and officers' liability business
where we write excess of loss risks, reported losses which are adjusted by the
primary underwriter on the risk may not initially appear to be serious but can
develop and affect our excess layer over time. We believe that we have
adequately reserved for this eventuality. Our discontinued line of business
contains both direct business and assumed business. Some of the losses in this
line are administered by others, subject to our review. It is possible that
there can be development in the loss reserves in this line of business as the
business is in run off and some of it is subject to late reporting by those
administering the claims. We monitor these reserves carefully on a current basis
and believe that they are properly set based upon the information we have at
this time.

We have insignificant exposure to asbestos and environment policy
liabilities as we did not begin business until 1981 and the type of business we
wrote contained pollution exclusions or was not of the type that subjected us to
those types of risks.

The table below shows our recorded reserves as of December 31, 2003 (in
thousands) by line of business compared to the high and low ends of the reserve
range as determined by our reserving actuaries. Based upon our historical
reserving techniques and the fact that our net reserves have historically shown
positive development, except for the effects of losses on commutations, which
losses represent the discount

on the reinsurance recoverables commuted, we believe that there will not be any
negative development in our consolidated reserves:

RECORDED LOW END OF HIGH END OF
RESERVES ACTUARIAL RANGE ACTUARIAL RANGE
---------- --------------- ---------------

Total net reserves.......................... $ 705,200 $610,992 $735,449
========== ======== ========
Individual lines of business:
Group life, accident and health........... $ 106,046 $ 73,263 $122,161
Diversified financial products............ 92,367 79,820 100,038
London market accounts.................... 119,755 102,417 124,179
Aviation.................................. 80,144 64,854 85,123
Other specialty lines..................... 46,227 39,787 47,436
----------
444,539
Discontinued lines........................ 260,661 214,083 308,977
----------
TOTAL NET RESERVES..................... $ 705,200
==========

The sum of the individual lines of business for the low end of the
actuarial range and the high end of the actuarial range will not equal the total
net reserves. Moreover, it would not be appropriate to add the ranges for each
line of business to obtain a range around the total net reserves because this
would not reflect the diversification effects across our various lines of
business. The diversification effects result from the fact that losses across
the different lines of business are not completely correlated.

REINSURANCE RECOVERABLES

We constantly review the collectibility of the reinsurance recoverables of
our insurance companies and record a reserve for potentially uncollectible
reinsurance. Our estimates utilized to calculate the reserve are evaluated on a
current basis but are subject to change and this could affect the level of the
reserve required. We believe, based upon periodic detail reviews of our disputed
and aged recoverables, that we have sufficiently provided for potential losses
that are currently evident.

FEE AND COMMISSION INCOME

When there is no significant future servicing obligation, fee and
commission income from our underwriting agencies and intermediaries are
recognized on the later of the effective date of policy, the date when the
premium can be reasonably established, or the date when substantially all the
services relating to the insurance placement have been rendered to the client.
Profit commissions based upon the profitability of business written are recorded
as revenue at the end of each accounting period based upon the respective
formula calculation. Such amounts are adjusted should experience change. When
additional services are require, the service revenue is deferred and recognized
over the service period. We also record an allowance for estimated return
commissions that may be required to be paid upon the early termination of
policies. Proceeds from ceded reinsurance (ceding commissions in excess of
acquisition costs) are also earned pro rata over the term of the underlying
policies.

DEFERRED TAXES

We recognize deferred tax assets and liabilities based on the differences
between the financial statement carrying amounts and the tax bases of assets and
liabilities. We regularly review our deferred tax assets for recoverability and
establish a valuation allowance based on our history of earnings, expectations
for future earnings, taxable income in carry back years and the expected timing
of the reversals of existing temporary differences. Although realization is not
assured, we believe it is more likely than not that we will be able to realize
the benefit of our deferred tax assets, with the exception of the benefit of
certain pre-acquisition tax loss carryforwards for which valuation allowances
have been provided. If there is a

material change in the tax laws such that the actual effective tax rate changes
or the time periods within which the underlying temporary differences become
taxable or deductible change, we will need to reevaluate our assumptions which
could result in a change in the valuation allowance required.

VALUATION OF GOODWILL

We assess the impairment of goodwill annually or sooner if an event occurs
or circumstances change that would more likely than not reduce the fair value of
a reporting unit below its carrying amount. In determining the fair value of a
reporting unit, we utilize the expected cash flow approach as set forth in FASB
Concepts Statement No. 7. This approach utilizes a risk-free rate of interest,
estimates of future cash flows and probabilities as to the occurrence of the
future cash flows. We utilize our budgets and projection of future operations
based upon historical and expected industry trends to estimate our future cash
flows and the probability of their occurring as projected. Based upon our last
impairment test, the fair value of each of our reporting units exceeded its
carrying amount by a satisfactory margin.

OTHER THAN TEMPORARY IMPAIRMENTS ON INVESTMENTS

Declines in the market value of invested assets below cost are evaluated
for other than temporary impairment losses on a quarterly basis. Impairment
losses for declines in value of fixed maturity investments and equity securities
below cost attributable to issuer-specific events are based upon all relevant
facts and circumstances for each investment and are recognized when appropriate.
For fixed maturity investments with unrealized losses due to market conditions
or industry-related events where we have the positive intent and ability to hold
the investment for a period of time sufficient to allow a market recovery or to
maturity, declines in value below cost are not assumed to be other than
temporary. Our policy for equity securities is to recognize impairment losses on
specific securities that have had continuous material unrealized losses for more
than three consecutive quarters or less, due to market conditions or
industry-related events. As of December 31, 2003, we had gross unrealized losses
on fixed income and marketable equity securities of $3.8 million (0.3% of
aggregate market value) compared to $1.5 million (0.2% of aggregate market
value) as of December 31, 2002.

The following table displays the gross unrealized losses and fair value of
investments as of December 31, 2003 that were in a continuous unrealized loss
position for the periods indicated (dollars in thousands):

LESS THAN 12 MONTHS 12 MONTHS OR MORE TOTAL
----------------------- ----------------------- -----------------------
UNREALIZED UNREALIZED UNREALIZED
DESCRIPTION OF SECURITIES FAIR VALUE LOSSES FAIR VALUE LOSSES FAIR VALUE LOSSES
------------------------------------ ---------- ---------- ---------- ---------- ---------- ----------

U.S. Treasury obligations and direct
obligations of U.S. government
agencies.......................... $ 31,709 $ (25) $ -- $ -- $ 31,709 $ (25)
Federal agency mortgage-backed
securities........................ 16,354 (372) -- -- 16,354 (372)
Corporate fixed income securities... 46,711 (618) 1,580 (312) 48,291 (930)
Municipal fixed income securities... 69,054 (1,087) 572 (12) 69,626 (1,099)
Foreign securities.................. 65,061 (906) -- -- 65,061 (906)
Other............................... 15,069 (420) -- -- 15,069 (420)
-------- ------- ------ ----- -------- -------
Total temporarily impaired
securities...................... $243,958 $(3,428) $2,152 $(324) $246,110 $(3,752)
======== ======= ====== ===== ======== =======

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

Our principal assets and liabilities are financial instruments which are
subject to the market risk of potential losses from adverse changes in market
rates and prices. Our primary market risk exposures are: interest rate risk on
fixed income securities and interest expense on variable rate debt, equity risk
on

marketable equity securities, credit risk on reinsurance recoverables and
foreign currency exchange rate risk.

To manage the exposures of our investment risks, we generally invest in
investment grade securities with characteristics of duration and liquidity to
reflect the underlying characteristics of the insurance liabilities of our
insurance companies. We have not historically used derivatives to manage any of
our investment related market risks.

Caution should be used in evaluating overall market risk utilizing the
information below. Actual results could differ materially from estimates below
for a variety of reasons, including, among other things:

- amounts and balances on which the estimates are based are likely to
change over time;

- assumptions used in the models may prove to be inaccurate;

- market changes could be different from market changes assumed below; and

- not all factors and balances are taken into account.

INTEREST RATE RISK

The value of our portfolio of fixed income securities is inversely
correlated to changes in the market interest rates. In addition, some of our
fixed income securities have call or prepayment options. This could subject us
to reinvestment risk should interest rates fall or issuers call their securities
and we reinvest the proceeds at lower interest rates. We attempt to mitigate
this risk by investing in securities with varied maturity dates, so that only a
portion of the portfolio will mature at any point in time. The fair value of our
fixed income securities as of December 31, 2003 was $1.2 billion and was $841.5
million as of December 31, 2002. If market interest rates were to change 1%,
(e.g. from 5% to 6%) the fair value of our fixed income securities would change
approximately $43.1 million as of December 31, 2003. This compares to change in
value of $29.5 million as of December 31, 2002 for the same 1% change in market
interest rates. The change in fair value was determined using duration modeling
assuming no prepayments.

Our $200.0 million bank loan is subject to variable interest rates. Thus,
our interest expense on this loan is directly correlated to market interest
rates. As of December 31, 2002, we had $53.0 million in debt outstanding under
the bank loan. At that debt level, the 1% change in market interest rates would
have changed interest expense by $0.5 million. As of December 31, 2003, there
was no balance outstanding under our bank loan and our 2% and 1.3% convertible
notes are not subject to interest rate changes.

EQUITY RISK

Our portfolio of marketable equity securities is subject to equity price
risk due to market changes. The fair value of our marketable equity securities
(including the amounts, if any, of insurance related equity securities
designated as trading securities and included in other assets) as of December
31, 2003 was $16.0 million, compared to $25.7 million as of December 31, 2002.
The balances include mutual fund securities with a value of $11.0 million and
$10.5 million, respectively, as of December 31, 2003 and 2002. These mutual
funds are invested heavily in fixed income securities but represent marketable
equity securities for reporting purposes. If the market price of all marketable
equity securities were to change by 10% as of these dates, the fair value of our
portfolio of marketable equity securities would have changed $1.6 million as of
December 31, 2003 and $2.6 million as of December 31, 2002.

FOREIGN EXCHANGE RISK

The table below shows the net amounts of significant foreign currency
balances at December 31, 2003 and 2002 converted to U.S. dollars. It also shows
the expected dollar change in fair value that would occur if exchange rates
changed 10% from exchange rates in effect at those times (in thousands):

2003 2002
------------------------------ ------------------------------
HYPOTHETICAL 10% HYPOTHETICAL 10%
U.S. DOLLAR CHANGE IN FAIR U.S. DOLLAR CHANGE IN FAIR
EQUIVALENT VALUE EQUIVALENT VALUE
----------- ---------------- ----------- ----------------

Euro............................. $5,580 $558 $3,518 $352
Canadian dollar.................. 1,778 178 1,815 182
British pound sterling........... 182 18 7,617 762

The gross balances in British pound sterling as of December 31, 2003 are
comparable to amounts of prior years. See Foreign Exchange Rate Fluctuations
section contained in Item 7, Management's Discussion and Analysis and Note (1)
in the Notes to Consolidated Financial Statements for additional information.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The financial statements and financial statement schedules listed in the
accompanying index are filed as part of this Report.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURES

None.

ITEM 9A. CONTROLS AND PROCEDURES

(a) Evaluation of disclosure controls and procedures.

The term "disclosure controls and procedures" is defined in Rules 13a-15(e)
and 15d-15(e) of the Securities Exchange Act of 1934, or the Exchange Act. This
term refers to the controls and procedures of a company that are designed to
ensure that information required to be disclosed by a company in the reports
that it files or submits under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified by the Securities and
Exchange Commission. Our management, including our Chief Executive Officer and
Chief Financial Officer, has evaluated the effectiveness of our disclosure
controls and procedures as of the end of the period covered by this annual
report. Based upon the evaluation, our Chief Executive Officer and Chief
Financial Officer have concluded that our disclosure controls and procedures
were effective as of the end of the period covered by this annual report. The
Company restated its financial statements for the quarters ended September 30,
June 30 and March 31, 2003 to reflect a revised method for recognizing revenue
associated with fee and commission income. In management's opinion, the revision
did not result from any deficiency in the Company's disclosure controls and
procedures.

(b) Changes in internal controls.

There were no changes to our internal control over financial reporting
during our last fiscal quarter that have materially affected, or are reasonably
likely to materially affect, our internal control over financial reporting.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

CODE OF ETHICS

We have adopted a Code of Ethics which applies to the Chief Executive
Officer and the Senior Financial Officers of the Company. The complete text of
our Code of Ethics will be provided to any person free of charge upon request
made to: HCC Insurance Holdings, Inc., Investor Relations Department, 13403
Northwest Freeway, Houston, Texas 77040.

For information regarding Directors and Executive Officers of the
Registrant, reference is made to the Registrant's definitive proxy statement for
its Annual Meeting of Shareholders, which will be filed with the Securities and
Exchange Commission within 120 days after December 31, 2003 and which is
incorporated herein by reference.

ITEM 11. EXECUTIVE COMPENSATION

For information regarding Executive Compensation, reference is made to the
Registrant's definitive proxy statement for its Annual Meeting of Shareholders,
which will be filed with the Securities and Exchange Commission within 120 days
after December 31, 2003 and which is incorporated herein by reference.

ITEM 12. SECURITY OWNERS OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED SHAREHOLDER MATTERS

For information regarding Security Ownership of Certain Beneficial Owners
and Management and Related Shareholder Matters, reference is made to the
Registrant's definitive proxy statement for its Annual Meeting of Shareholders,
which will be filed with the Securities and Exchange Commission within 120 days
after December 31, 2003 and which is incorporated herein by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

For information regarding Certain Relationships and Related Transactions,
reference is made to the Registrant's definitive proxy statement for its Annual
Meeting of Shareholders, which will be filed with the Securities and Exchange
Commission within 120 days after December 31, 2003 and which is incorporated
herein by reference.

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

For information regarding Principal Accountant Fees and Services, reference
is made to the Registrant's definitive proxy statement for its Annual Meeting of
Shareholders, which will be filed with the Securities and Exchange Commission
within 120 days after December 31, 2003 and which is incorporated herein by
reference.

PART IV

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a) Exhibits

The exhibits listed on the accompanying Index to Exhibits are filed as
part of this Report.

(b) Financial Statement Schedules

The financial statements and financial statement schedules listed in
the accompanying Index to Consolidated Financial Statements and Schedules
are filed as part of this Report.

On November 6, 2003, we furnished our announcement of operating
results for the third quarter of 2003 on Form 8-K.

On December 8, 2003, we furnished the text material used for an
investors' conference on Form 8-K.

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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)

Dated: March 12, 2004 By: /s/ STEPHEN L. WAY
----------------------------------------------
(Stephen L. Way)
Chairman of the Board
and Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.

NAME TITLE DATE
---- ----- ----

/s/ STEPHEN L. WAY Chairman of the Board of March 12, 2004
-------------------------------------- Directors, Chief Executive Officer
(Stephen L. Way) and President
(Principal Executive Officer)

/s/ FRANK J. BRAMANTI* Director March 12, 2004
--------------------------------------
(Frank J. Bramanti)

/s/ PATRICK B. COLLINS* Director March 12, 2004
--------------------------------------
(Patrick B. Collins)

/s/ JAMES R. CRANE* Director March 12, 2004
--------------------------------------
(James R. Crane)

/s/ J. ROBERT DICKERSON* Director March 12, 2004
--------------------------------------
(J. Robert Dickerson)

/s/ EDWARD H. ELLIS, JR. Director, Executive Vice President March 12, 2004
-------------------------------------- and Chief Financial Officer
(Edward H. Ellis, Jr.) (Chief Accounting Officer)

/s/ JAMES C. FLAGG, PH.D.* Director March 12, 2004
--------------------------------------
(James C. Flagg, Ph.D.)

/s/ ALLAN W. FULKERSON* Director March 12, 2004
--------------------------------------
(Allan W. Fulkerson)

/s/ WALTER J. LACK* Director March 12, 2004
--------------------------------------
(Walter J. Lack)

/s/ MICHAEL A. F. ROBERTS* Director March 12, 2004
--------------------------------------
(Michael A. F. Roberts)

*By: /s/ STEPHEN L. WAY
------------------------------
Stephen L. Way
Attorney-in-fact

INDEX TO EXHIBITS

(Items denoted by a letter are incorporated by reference to other documents
previously filed with the Securities and Exchange Commission as set forth at the
end of this index. Items not denoted by a letter are being filed herewith.)

EXHIBIT
NUMBER
-------

(A)3.1 -- Bylaws of HCC Insurance Holdings, Inc., as amended.
(B)3.2 -- Restated Certificate of Incorporation and Amendment of
Certificate of Incorporation of HCC Insurance Holdings,
Inc., filed with the Delaware Secretary of State on July 23,
1996 and May 21, 1998, respectively.
(A)4.1 -- Specimen of Common Stock Certificate, $1.00 par value, of
HCC Insurance Holdings, Inc.
(C)10.1 -- Share Purchase Agreement dated January 29, 1999, among HCC
Insurance Holdings, Inc. and Gerald Axel, Barry J. Cook,
Gary J. Lockett, Christopher F.B. Mays, Mark E. Rattner,
Marshall Rattner, Inc., John Smith and Keith W. Steed.
(D)10.2 -- Agreement and Plan of Merger dated as of October 11, 1999
among HCC Insurance Holdings, Inc., Merger Sub of Delaware,
Inc. and The Centris Group, Inc.
(E)10.3 -- Agreement and Plan of Merger dated as of January 19, 2001
among HCC Insurance Holdings, Inc., HCC Employee Benefits,
Inc. and James Scott Schanen, Lisa Rae Schanen, Conor
Schanen qsst, Austin Schanen qsst, Kevin Tolbert and Schanen
Consulting Corporation.
(F)10.4 -- Loan Agreement ($300,000,000 Revolving Loan Facility) dated
as of December 17, 1999 among HCC Insurance Holdings, Inc.;
Wells Fargo Bank (Texas), National Association; Bank of
America, N.A.; Bank of New York; Bank One, N.A.; First Union
National Bank; and Dresdner Bank AG, New York and Grand
Cayman Branches.
(G)10.5 -- Amendment to Loan Agreement dated as of August 11, 2000
among HCC Insurance Holdings, Inc.; Wells Fargo Bank
(Texas), National Association; First Union National Bank;
Bank of America, N.A.; The Bank of New York; Bank One, N.A.;
and Dresdner Bank AG, New York and Grand Cayman Branches.
(G)10.6 -- Second Amendment to Loan Agreement dated as of June 6, 2001
among HCC Insurance Holdings, Inc.; Wells Fargo Bank
(Texas), National Association; First Union National Bank;
Bank of America, N.A.; and The Bank of New York.
(H)10.7 -- Third Amendment to Loan Agreement dated as of March 21, 2003
among HCC Insurance Holdings, Inc.; Wells Fargo Bank
(Texas), National Association; First Union National Bank;
Bank of America, N.A.; and The Bank of New York.
(I)10.8 -- HCC Insurance Holdings, Inc. 1994 Nonemployee Director Stock
Option Plan.
(J)10.9 -- HCC Insurance Holdings, Inc. 1992 Incentive Stock Option
Plan, as amended and restated.
(J)10.10 -- HCC Insurance Holdings, Inc. 1995 Flexible Incentive Plan,
as amended and restated.
(J)10.11 -- HCC Insurance Holdings, Inc. 1997 Flexible Incentive Plan,
as amended and restated.
(J)10.12 -- HCC Insurance Holdings, Inc. 1996 Nonemployee Director Stock
Option Plan, as amended and restated.
(K)10.13 -- HCC Insurance Holdings, Inc. 2001 Flexible Incentive Plan,
as amended and restated.
(H)10.14 -- Form of Incentive Stock Option Agreement under the HCC
Insurance Holdings, Inc. 2001 Flexible Incentive Plan.
(H)10.15 -- Employment Agreement effective as of January 1, 2003,
between HCC Insurance Holdings, Inc. and Stephen L. Way.
10.16 -- Employment Agreement Addendum 3(a)(2) effective as of
December 31, 2003 between HCC Insurance Holdings, Inc. and
Stephen L. Way.
10.17 -- HCC Insurance Holdings, Inc. nonqualified deferred
compensation plan for Stephen L. Way effective January 1,
2003.
(H)10.18 -- Employment Agreement effective as of January 10, 2002,
between HCC Insurance Holdings, Inc. and Craig J. Kelbel.

EXHIBIT
NUMBER
-------

(H)10.19 -- Employment Agreement effective as of June 3, 2002, between
HCC Insurance Holdings, Inc. and Michael J. Schell.
(G)10.20 -- Employment Agreement effective as of January 1, 2002,
between HCC Insurance Holdings, Inc. and Edward H. Ellis,
Jr.
(H)10.21 -- Employment Agreement effective as of January 1, 2003 between
HCC Insurance Holdings, Inc. and Christopher L. Martin.
12 -- Statement Regarding Computation of Ratios.
14 -- Form of HCC Insurance Holdings, Inc. Code of Ethics
Statement by Chief Executive Officer and Senior Financial
Officers.
21 -- Subsidiaries of HCC Insurance Holdings, Inc.
23 -- Consent of Independent Accountants -- PricewaterhouseCoopers
LLP dated March 10, 2004.
24 -- Powers of Attorney.
31.1 -- Certification by Chief Executive Officer.
31.2 -- Certification by Chief Financial Office
32.1 -- Certification with respect to annual report.

---------------

(A)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Registration Statement on Form S-1 (Registration No. 33-48737) filed October
27, 1992.

(B)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Registration Statement on Form S-8 (Registration No. 333-61687) filed August
17, 1998.

(C)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Form 10-Q for the fiscal quarter ended March 31, 1999.

(D)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Schedule 14D-1 Tender Offer Statement in respect to shares of The Centris
Group, Inc. filed October 18, 1999.

(E)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Form 10-K for the fiscal year ended December 31, 2000.

(F)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Form 8-K filed December 20, 1999.

(G)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Form 10-K for the fiscal year ended December 31, 2001.

(H)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Form 10-K for the fiscal year ended December 31, 2002.

(I)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Registration Statement on Form S-8 (Registration No. 33-94472) filed July 11,
1995.

(J)Incorporated by reference to Exhibits to HCC Insurance Holdings, Inc.'s Form
10-K for the fiscal year ended December 31, 1999.

(K)Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Definitive Proxy Statement for the May 22, 2002 Annual Meeting of
Shareholders filed April 26, 2002.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES

Report of Independent Accountants........................... F-1
Consolidated Balance Sheets at December 31, 2003 and 2002... F-2
Consolidated Statements of Earnings for the three years
ended December 31, 2003................................... F-3
Consolidated Statements of Comprehensive Income for the
three years ended December 31, 2003....................... F-4
Consolidated Statements of Changes in Shareholders' Equity
for the three years ended December 31, 2003............... F-5
Consolidated Statements of Cash Flows for the three years
ended December 31, 2003................................... F-6
Notes to Consolidated Financial Statements.................. F-7
SCHEDULES:
Report of Independent Accountants on Financial Statement
Schedules................................................. S-1
Schedule 1 Summary of Investments other than Investments in
Related Parties........................................... S-2
Schedule 2 Condensed Financial Information of Registrant... S-3
Schedule 3 Supplementary Insurance Information............. S-8
Schedule 4 Reinsurance..................................... S-9
Schedule 5 Valuation and Qualifying Accounts............... S-10

Schedules other than those listed above have been omitted because they are
either not required, not applicable, or the required information is shown in the
Consolidated Financial Statements and related notes thereto or other Schedules.

REPORT OF INDEPENDENT AUDITORS

To the Board of Directors and Shareholders
HCC Insurance Holdings, Inc.

In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of earnings, comprehensive income, changes in
shareholders' equity and cash flows present fairly, in all material respects,
the financial position of HCC Insurance Holdings, Inc. and its subsidiaries at
December 31, 2003 and 2002 and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 2003, in
conformity with accounting principles generally accepted in the United States of
America. These financial statements are the responsibility of the Company's
management; our responsibility is to express an opinion on these financial
statements based on our audits. We conducted our audits of these statements in
accordance with auditing standards generally accepted in the United States of
America, which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.

As discussed in Note 2 to the consolidated financial statements, effective
January 1, 2002, the Company changed its method of accounting for goodwill as
prescribed by Statement of Financial Accounting Standards No. 142 entitled
"Goodwill and Other Intangible Assets".

/s/ PRICEWATERHOUSECOOPERS LLP

Houston, Texas
March 10, 2004

F-1

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE DATA)

DECEMBER 31,
-----------------------
2003 2002
---------- ----------

ASSETS
Investments:
Fixed income securities, at market (cost:
2003 -- $1,134,128; 2002 -- $807,772).................. $1,164,166 $ 841,548
Marketable equity securities, at market (cost:
2003 -- $12,007; 2002 -- $15,815)...................... 12,002 15,609
Short-term investments, at cost, which approximates
market................................................. 518,482 307,215
Other investments, at cost, which approximates fair
value.................................................. 8,696 3,264
---------- ----------
Total investments...................................... 1,703,346 1,167,636
Cash........................................................ 96,416 40,306
Restricted cash and cash investments........................ 210,301 189,396
Premium, claims and other receivables....................... 899,031 753,527
Reinsurance recoverables.................................... 916,190 798,934
Ceded unearned premium...................................... 291,591 164,224
Ceded life and annuity benefits............................. 77,548 78,951
Deferred policy acquisition costs........................... 106,943 68,846
Goodwill.................................................... 386,507 335,288
Other assets................................................ 176,423 107,043
---------- ----------
TOTAL ASSETS........................................... $4,864,296 $3,704,151
========== ==========

LIABILITIES
Loss and loss adjustment expense payable.................... $1,535,288 $1,155,290
Life and annuity policy benefits............................ 77,548 78,951
Reinsurance balances payable................................ 296,916 166,659
Unearned premium............................................ 592,311 331,050
Deferred ceding commissions................................. 88,129 49,963
Premium and claims payable.................................. 745,559 730,801
Notes payable............................................... 310,404 230,027
Accounts payable and accrued liabilities.................... 171,221 78,503
---------- ----------
Total liabilities...................................... 3,817,376 2,821,244

SHAREHOLDERS' EQUITY
Common stock, $1.00 par value; 250.0 million shares
authorized (shares issued and outstanding: 2003 -- 63,964;
2002 -- 62,358)........................................... 63,964 62,358
Additional paid-in capital.................................. 447,671 416,406
Retained earnings........................................... 509,159 383,378
Accumulated other comprehensive income...................... 26,126 20,765
---------- ----------
Total shareholders' equity............................. 1,046,920 882,907
---------- ----------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY............. $4,864,296 $3,704,151
========== ==========

See Notes to Consolidated Financial Statements.
F-2

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF EARNINGS
(IN THOUSANDS, EXCEPT PER SHARE DATA)

FOR THE YEARS ENDED DECEMBER 31,
---------------------------------
2003 2002 2001
--------- --------- ---------

REVENUE
Net earned premium.......................................... $738,272 $505,521 $342,787
Fee and commission income................................... 142,615 115,919 111,016
Net investment income....................................... 47,335 37,755 39,562
Net realized investment gain................................ 527 453 393
Other operating income...................................... 13,215 6,985 17,451
-------- -------- --------
Total revenue.......................................... 941,964 666,633 511,209
EXPENSE
Loss and loss adjustment expense, net....................... 488,652 306,491 267,390
Operating expense:
Policy acquisition costs, net............................. 138,212 99,521 66,313
Compensation expense...................................... 82,947 58,567 50,806
Other operating expense................................... 57,966 41,357 63,000
-------- -------- --------
Total operating expense................................ 279,125 199,445 180,119
Interest expense............................................ 7,453 8,301 8,875
-------- -------- --------
Total expense.......................................... 775,230 514,237 456,384
-------- -------- --------
Earnings from continuing operations before income tax
provision............................................ 166,734 152,396 54,825
Income tax provision from continuing operations............. 59,857 52,933 27,764
-------- -------- --------
Earnings from continuing operations....................... 106,877 99,463 27,061
Gain from sale of discontinued operations, net of income
taxes of $22,540....................................... 30,141 -- --
Earnings from discontinued operations, net of income taxes
of $3,749 in 2003, $4,418 in 2002 and $2,422 in 2001... 6,543 6,365 3,136
-------- -------- --------
NET EARNINGS.............................................. $143,561 $105,828 $ 30,197
======== ======== ========
BASIC EARNINGS PER SHARE DATA:
Earnings from continuing operations....................... $ 1.69 $ 1.60 $ 0.47
Gain from sale of discontinued operations................. 0.48 -- --
Earnings from discontinued operations..................... 0.10 0.10 0.05
-------- -------- --------
Net earnings.............................................. $ 2.27 $ 1.70 $ 0.52
======== ======== ========
Weighted average shares outstanding....................... 63,279 62,225 58,321
======== ======== ========
DILUTED EARNINGS PER SHARE DATA:
Earnings from continuing operations....................... $ 1.66 $ 1.58 $ 0.46
Gain from sale of discontinued operations................. 0.47 -- --
Earnings from discontinued operations..................... 0.10 0.10 0.05
-------- -------- --------
Net earnings.............................................. $ 2.23 $ 1.68 $ 0.51
======== ======== ========
Weighted average shares outstanding....................... 64,383 62,936 59,619
======== ======== ========

See Notes to Consolidated Financial Statements.
F-3

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(IN THOUSANDS, EXCEPT PER SHARE DATA)

FOR THE YEARS ENDED DECEMBER 31,
----------------------------------
2003 2002 2001
----------- --------- --------

Net earnings................................................ $ 143,561 $105,828 $30,197
Other comprehensive income, net of tax:
Foreign currency translation adjustment................... 8,149 50 (279)
Investment gains (losses):
Investment gains (losses) during the year, net of
income tax charge (benefit) of $(1,048) in 2003,
$8,040 in 2002 and $1,137 in 2001.................... (1,962) 14,533 2,297
Less reclassification adjustment for gains included in
net earnings, net of income tax charge of $184 in
2003, $159 in 2002 and $138 in 2001.................. (343) (294) (255)
Other, net of income tax charge (benefit) of $(260) in
2003, $(13) in 2002 and $13 in 2001.................... (483) (24) 24
---------- -------- -------
Other comprehensive income................................ 5,361 14,265 1,787
---------- -------- -------
COMPREHENSIVE INCOME................................... $ 148,922 $120,093 $31,984
========== ======== =======

See Notes to Consolidated Financial Statements.
F-4

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY

FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001
(IN THOUSANDS, EXCEPT PER SHARE DATA)

ACCUMULATED
ADDITIONAL OTHER TOTAL
COMMON PAID-IN RETAINED COMPREHENSIVE SHAREHOLDERS'
STOCK CAPITAL EARNINGS INCOME EQUITY
------- ---------- -------- ------------- -------------

BALANCE AS OF DECEMBER 31, 2000.... $51,342 $196,999 $277,876 $ 4,713 $ 530,930
Net earnings......................... -- -- 30,197 -- 30,197
Other comprehensive income........... -- -- -- 1,787 1,787
6,900 shares of common stock issued
in public offering, net of costs... 6,900 145,505 -- -- 152,405
2,715 shares of common stock issued
upon exercise of options including
income tax benefit of $12,312...... 2,715 50,023 -- -- 52,738
300 shares of common stock issued for
purchased companies................ 300 8,031 -- -- 8,331
Issuance of 114 shares of
contractually issuable common
stock.............................. 114 (114) -- -- --
Issuance of 67 shares of contingently
issuable common stock.............. 67 1,645 -- -- 1,712
Cash dividends declared, $0.245 per
share.............................. -- -- (14,647) -- (14,647)
------- -------- -------- ------- -------------
BALANCE AS OF DECEMBER 31, 2001.... 61,438 402,089 293,426 6,500 763,453
Net earnings......................... -- -- 105,828 -- 105,828
Other comprehensive income........... -- -- -- 14,265 14,265
817 shares of common stock issued for
exercise of options, including tax
benefit of $4,030.................. 817 14,420 -- -- 15,237
Issuance of 103 shares of
contractually issuable common
stock.............................. 103 (103) -- -- --
Cash dividends declared, $0.255 per
share.............................. -- -- (15,876) -- (15,876)
------- -------- -------- ------- -------------
BALANCE AS OF DECEMBER 31, 2002.... 62,358 416,406 383,378 20,765 882,907
Net earnings......................... -- -- 143,561 -- 143,561
Other comprehensive income........... -- -- -- 5,361 5,361
1,240 shares of common stock issued
for exercise of options, including
tax benefit of $4,320.............. 1,240 23,359 -- -- 24,599
Issuance of 52 shares of
contractually issuable common
stock.............................. 52 (52) -- -- --
314 shares of common stock issued for
purchased companies................ 314 7,958 -- -- 8,272
Cash dividends declared, $0.28 per
share.............................. -- -- (17,780) -- (17,780)
------- -------- -------- ------- -------------
BALANCE AS OF DECEMBER 31, 2003.... $63,964 $447,671 $509,159 $26,126 $ 1,046,920
======= ======== ======== ======= =============

See Notes to Consolidated Financial Statements.
F-5

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS, EXCEPT PER SHARE DATA)

FOR THE YEARS ENDED DECEMBER 31,
---------------------------------
2003 2002 2001
--------- --------- ---------

Cash flows from operating activities:
Net earnings............................................ $ 143,561 $ 105,828 $ 30,197
Adjustments to reconcile net earnings to net cash
provided by operating activities:
Change in premium, claims and other receivables...... (122,312) (41,330) (33,976)
Change in reinsurance recoverables................... (117,256) 103,870 (191,552)
Change in ceded unearned premium..................... (127,367) (88,940) 28,254
Change in loss and loss adjustment expense payable... 379,998 (57,747) 262,056
Change in reinsurance balances payable............... 130,257 70,672 (29,837)
Change in unearned premium........................... 261,261 122,811 (1,676)
Change in premium and claims payable, net of
restricted cash.................................... (34,063) (76,039) 22,530
Gains on dispositions of subsidiaries and other
operating investments.............................. (52,681) -- (8,171)
Depreciation, amortization and impairments........... 12,828 10,808 34,926
Other, net........................................... 53,872 25,189 (7,011)
--------- --------- ---------
Cash provided by operating activities................ 528,098 175,122 105,740
Cash flows from investing activities:
Sales of fixed income securities........................ 167,357 217,370 140,763
Maturity or call of fixed income securities............. 142,652 53,918 45,754
Sales of equity securities.............................. 4,165 3,958 5,408
Dispositions of subsidiaries and other operating
investments.......................................... 82,618 -- 19,965
Change in short-term investments........................ (202,904) 84,799 (43,986)
Cost of securities acquired............................. (694,211) (505,099) (292,926)
Payments for purchase of subsidiaries, net of cash
received............................................. (16,680) (39,227) (95,952)
Purchases of property and equipment..................... (21,820) (5,782) (12,283)
--------- --------- ---------
Cash used by investing activities.................... (538,823) (190,063) (233,257)
Cash flows from financing activities:
Issuance of notes payable, net of costs................. 174,845 76,000 174,058
Sale of common stock, net of costs...................... 20,279 11,207 192,831
Payments on notes payable............................... (108,813) (31,969) (222,116)
Dividends paid and other, net........................... (19,476) (16,882) (14,356)
--------- --------- ---------
Cash provided by financing activities................ 66,835 38,356 130,417
--------- --------- ---------
Net change in cash................................... 56,110 23,415 2,900
Cash as of beginning of year......................... 40,306 16,891 13,991
--------- --------- ---------
CASH AS OF END OF YEAR............................... $ 96,416 $ 40,306 $ 16,891
========= ========= =========

See Notes to Consolidated Financial Statements.
F-6

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)

(1) GENERAL INFORMATION AND SIGNIFICANT ACCOUNTING AND REPORTING POLICIES

HCC Insurance Holdings, Inc. and its subsidiaries ("we" or "our"), include
domestic and foreign property and casualty and life insurance companies,
underwriting agencies and intermediaries. Through our subsidiaries, we provide
specialized property and casualty and life and health insurance to commercial
customers in the areas of group life, accident and health, diversified financial
products (which includes directors' and officers' liability, errors and
omissions, employment practices liability and surety), our London market account
(which includes energy, marine, property and accident and health), aviation and
other specialty lines of insurance. Our principal insurance companies are
Houston Casualty Company in Houston, Texas and London, England; HCC Life
Insurance Company in Houston, Texas; U.S. Specialty Insurance Company in
Houston, Texas; Avemco Insurance Company in Frederick, Maryland; HCC Reinsurance
Company in Hamilton, Bermuda; HCC Europe in Madrid, Spain; and, in early 2004,
American Contractors Indemnity Company in Los Angeles, California. Our
underwriting agencies provide underwriting management and claims servicing for
insurance and reinsurance companies, in specialized lines of business within the
life, accident and health and property and casualty insurance sectors. Our
principal agencies are HCC Benefits Corporation in Atlanta, Georgia, Costa Mesa,
California, Wakefield, Massachusetts, Minneapolis, Minnesota and Dallas, Texas;
ASU International, LLC in Woburn, Massachusetts and London, England; HCC Global
Financial Products, LLC in Farmington, Connecticut, Barcelona, Spain and London,
England; HCC Diversified Financial Products Limited in London, England;
Professional Indemnity Agency, Inc. in Mount Kisco, New York; and Covenant
Underwriters Limited and Continental Underwriters Limited in Covington,
Louisiana. Effective January 1, 2001 and 2002, we consolidated the operations of
three and one of our agencies, respectively, with certain of our insurance
companies. Our intermediaries provide brokerage, consulting and other
intermediary services to insurance and reinsurance companies, commercial
customers and individuals in the same lines of business as the insurance
companies and underwriting agencies operate. Our principal intermediaries are
HCC Risk Management Corporation in Houston, Texas and Rattner Mackenzie Limited
in London, England and Hamilton, Bermuda.

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires us to make estimates
and assumptions. This affects amounts reported in our financial statements and
the disclosure of contingent assets and liabilities. Actual results could differ
from those estimates.

A description of the significant accounting and reporting policies we
utilize in preparing our consolidated financial statements is as follows:

PRINCIPLES OF CONSOLIDATION

Our consolidated financial statements include the accounts of all our
subsidiaries. All significant intercompany balances and transactions have been
eliminated in consolidation.

INVESTMENTS

Fixed income securities and marketable equity securities are classified as
available for sale and are carried at quoted market value, if readily
marketable, or at management's estimated fair value, if not readily marketable.
The change in unrealized gain or loss with respect to these securities is
recorded as a component of other comprehensive income, net of the related
deferred income tax effects, if any. Fixed income securities available for sale
are purchased with the original intent to hold to maturity, but they may be
available for sale if market conditions warrant, or if our investment policies
dictate, in order to maximize our investment yield. Short-term investments and
restricted short-term investments are carried at cost, which approximates market
value.
F-7

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

For the asset-backed and mortgage-backed securities portion of the fixed
income portfolio, we recognize income using a constant effective yield based on
anticipated prepayments and the estimated economic life of the securities. When
actual prepayments differ significantly from anticipated prepayments, the
estimated economic life is recalculated and the remaining unamortized premium or
discount is amortized prospectively over the remaining economic life. Some of
our asset-backed securities are subject to re-evaluation and additional
specialized impairment tests. Under this guidance, these securities have to be
written down in value if certain tests are met. Any write down is recouped
prospectively through net investment income, if contractual cash flows are
ultimately received. The total amount of securities we hold as of December 31,
2003 that would be subject to these tests and potential write down is $1.4
million.

The realized gain or loss on investment transactions is determined on an
average cost basis and included in earnings on the trade date. When impairment
of the value of an investment is considered other than temporary, the decrease
in value is reported in earnings as a realized investment loss and a new cost
basis is established.

EARNED PREMIUM, POLICY ACQUISITION COSTS AND CEDING COMMISSIONS

All of the property and casualty policies written by our insurance
companies qualify as short-duration contracts as defined by current accounting
literature. Written premium, net of reinsurance, is primarily included in
earnings on a pro rata basis over the lives of the related policies. However,
for certain types of business, it is recognized over the period of risk in
proportion to the amount of insurance risk provided. Policy acquisition costs,
including commissions, taxes, fees and other direct costs of underwriting
policies, less amounts reimbursed by reinsurers, are deferred and charged or
credited to earnings proportionate to the premium earned. Historical and current
loss and loss adjustment expense experience and anticipated investment income
are considered in determining premium deficiencies and the recoverability of
deferred policy acquisition costs.

FEE AND COMMISSION INCOME

When there is no significant future servicing obligation, fee and
commission income from our underwriting agencies and intermediaries are
recognized on the later of the effective date of policy, the date when the
premium can be reasonably established, or the date when substantially all the
services relating to the insurance placement have been rendered to the client.
Profit commissions based upon the profitability of business written are recorded
as revenue at the end of each accounting period based upon the respective
formula calculation. Such amounts are adjusted should experience change. When
additional services are required, the service revenue is deferred and recognized
over the service period. We also record an allowance for estimated return
commissions that may be required to be paid upon the early termination of
policies. Proceeds from ceded reinsurance (ceding commissions in excess of
acquisition costs) are also earned pro rata over the term of the underlying
policies.

STRATEGIC INVESTMENTS AND OTHER OPERATING INCOME

Included in other assets are certain investments in insurance related
companies, the earnings from which are included in other operating income. Such
investments designated as trading securities are carried at market value and
dividends and unrealized and realized gains from these investments are included
in income. When we own a 20% to 50% equity interest, investments and income are
recorded using the equity method of accounting. We carry the remaining
investments that are marketable at market value, recording any interest,
dividends and realized gains or losses in the income statement and recording
unrealized gains or losses in other comprehensive income. The remaining
investments are not readily marketable and are carried at cost, which
approximates market value, and reviewed for impairments.

F-8

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

Other operating income in 2001 also includes revenue from a claims
adjusting service which was sold during 2001. This revenue was recorded when the
service was performed.

PREMIUM, CLAIMS AND OTHER RECEIVABLES

We use the gross method for reporting receivables and payables on brokered
transactions. We review the collectibility of our receivables on a current basis
and provide an allowance for doubtful accounts if we deem that there are
accounts that are doubtful of collection. The amount of the allowance as of
December 31, 2003 and 2002 was $2.5 million and $2.3 million, respectively. Our
estimate of the level of the allowance could change as conditions change in the
future.

LOSS AND LOSS ADJUSTMENT EXPENSE PAYABLE

Loss and loss adjustment expense payable by our insurance companies is
based on estimates of payments to be made for reported losses, incurred but not
reported losses and anticipated receipts from salvage and subrogation. Reserves
are recorded on an undiscounted basis, except for reserves acquired in
transactions recorded using the purchase method of accounting. The discount on
those reserves is not material. Estimates for reported losses are based on all
available information, including reports received from ceding companies on
assumed business. Estimates for incurred but not reported losses are based both
on our experience and the industry's experience. While we believe that amounts
included in our financial statements are adequate, such estimates may be more or
less than the amounts ultimately paid when the claims are settled. We
continually review the estimates with our actuaries and any changes are
reflected in the period of the change.

REINSURANCE

We record all reinsurance recoverables and ceded unearned premiums as
assets and deferred ceding commissions as a liability. All such amounts are
recorded in a manner consistent with the underlying reinsured contracts. We also
record a reserve for uncollectible reinsurance. Our estimates utilized to
calculate the reserve are subject to change and this could affect the level of
the reserve required.

GOODWILL AND INTANGIBLE ASSETS

In connection with our acquisition of subsidiaries prior to July 1, 2001,
accounted for as purchases, the excess of cost over fair value of net assets
acquired was being amortized using the straight-line method over periods from
twenty to forty years. This amortization was discontinued effective December 31,
2001 in accordance with Statement of Financial Accounting Standards ("SFAS") No.
142 entitled "Goodwill and Other Intangible Assets." Goodwill resulting from
acquisitions completed on or after July 1, 2001 was not being amortized in
accordance with SFAS No. 142. See Note (2) for the effects of these changes.
Other identified intangible assets are amortized over their respective useful
lives.

Prior to our adoption of SFAS No. 142, our accounting policy regarding the
assessment of the recoverability of the carrying value of goodwill was to review
the carrying value of the assets if the facts and circumstances suggested that
it might be impaired. If this review indicated that the carrying value would not
be recoverable, as determined based on projected undiscounted future cash flows,
the carrying value was reduced to its estimated fair value.

With our adoption of SFAS No. 142, beginning January 1, 2002, we assess the
impairment of goodwill annually or sooner if an event occurs or circumstances
change that would more likely than not reduce the fair value of a reporting unit
below its carrying amount. With respect to our underwriting agency and
intermediary segments, the reporting units are the individual subsidiaries. In
the insurance

F-9

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

company segment, the reporting units are either individual subsidiaries or
groups of subsidiaries that share common licensing and other characteristics.
When we acquire a new subsidiary, goodwill is either allocated to that
particular subsidiary or, if there are synergies with other subsidiaries,
allocated to the different reporting units based on their respective shares of
our estimates of future cash flows. In determining the fair value of a reporting
unit, we utilize the expected cash flow approach as set forth in FASB Concepts
Statement No. 7. This approach utilizes a risk-free rate of interest, estimates
of future cash flows and probabilities as to the occurrence of the future cash
flows. We utilize our budgets and projection of future operations based upon
historical and expected industry trends to estimate our future cash flows and
the probability of their occurring as projected. Based upon our last impairment
test, the fair value of each of our reporting units exceeded its carrying amount
by a satisfactory margin.

CASH AND SHORT-TERM INVESTMENTS

Cash consists of cash in banks, generally in operating accounts. We
classify certificates of deposit, corporate demand notes receivable, commercial
paper and money market funds as short-term investments. Short-term investments
are classified as investments in our consolidated balance sheets as they relate
principally to our investment activities.

As of December 31, 2003 and 2002 we included $188.7 million and $175.7
million, respectively, of certain fiduciary funds in short-term investments.
These are funds held by underwriting agencies or intermediaries for the benefit
of insurance or reinsurance clients. We earn the interest on these funds.

As of December 31, 2003 we also have a $56.1 million deposit at Lloyds to
serve as security for our participation in a Lloyd's syndicate which began
operations on January 1, 2004. This deposit is currently included in short-term
investments as we earn interest on funds so deposited. There are withdrawal and
other restrictions on this deposit but we can direct how the deposit is
invested.

We generally maintain our cash deposits in major banks and invest our
short-term investments in institutional money-market funds and in investment
grade commercial paper and repurchase agreements. These securities typically
mature within ninety days and, therefore, bear minimal risk. We have not
experienced any losses on our cash deposits or our short-term investments.

RESTRICTED CASH AND CASH INVESTMENTS

Our agencies withhold premium funds for the payment of claims. These funds
are shown as restricted cash and cash investments in our consolidated balance
sheets. The corresponding liability is included within premium and claims
payable in our consolidated balance sheets. These amounts are considered
fiduciary funds and interest earned on these funds accrues to the benefit of the
insurance companies for whom the agencies write business. Therefore, we do not
include these amounts as cash in our consolidated statements of cash flows.

FOREIGN CURRENCY

The functional currency of some of our foreign subsidiaries and branches is
the U.S. dollar. Assets and liabilities recorded in foreign currencies are
translated into U.S. dollars at exchange rates in effect at the balance sheet
date. Transactions in foreign currencies are translated at the rates of exchange
in effect on the date the transaction occurs. Transaction gains and losses are
recorded in earnings and included in other operating expenses. Our foreign
currency transactions are principally denominated in British pound sterling and
the Euro. For the years ended December 31, 2003, 2002 and 2001, the gain from
currency conversion was $4.1 million, $1.2 million and $0.3 million,
respectively. Included in the 2003 amount was a one-time gain of $1.3 million
from the settlement of an advance of funds to an unaffiliated entity.

F-10

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

The Euro, the British pound sterling and the Canadian dollar are utilized
as the functional currency of other of our foreign operations. The cumulative
translation adjustment, representing the effect of translating these
subsidiaries' assets and liabilities into U.S. dollars, is included in the
foreign currency translation adjustment within accumulated other comprehensive
income.

INCOME TAX

We file a consolidated Federal income tax return and include the foreign
subsidiaries' income to the extent required by law. Deferred income tax is
accounted for using the liability method, which reflects the tax impact of
temporary differences between the bases of assets and liabilities for financial
reporting purposes and such bases as measured by tax laws and regulations. Due
to our history of earnings, expectations for future earnings and taxable income
in carryback years, we expect to be able to fully realize the benefit of any net
deferred tax asset.

EARNINGS PER SHARE

Basic earnings per share is based on the weighted average number of common
shares outstanding during the year divided into net earnings. Diluted earnings
per share is based on the weighted average number of common shares outstanding
plus the potential common shares outstanding during the year divided into net
earnings. Outstanding common stock options, when dilutive, are considered to be
potential common stock for the purpose of the diluted calculation. The treasury
stock method is used to calculate potential common stock outstanding due to
options. Contingent shares to be issued are included in the earnings per share
computation when the underlying conditions for issuance have been met.

STOCK OPTIONS

We account for stock options granted to employees using the intrinsic value
method of APB Opinion No. 25 entitled "Accounting for Stock Issued to
Employees". All options have been granted at fixed exercise prices at the market
price of our common stock at the grant date. Because of that, no stock-based
employee compensation cost is reflected in our reported net income. Options vest
over a period of up to seven years and expire four to ten years after grant
date. The following table illustrates the effects on net income and earnings per
share if we had used the fair value method of SFAS No. 123 entitled "Accounting
for Stock-Based Compensation" for the three years ended December 31, 2003:

2003 2002 2001
-------- -------- -------

Reported net earnings................................. $143,561 $105,828 $30,197
Stock-based compensation using the fair value method,
net of income tax................................... (7,705) (6,159) (4,426)
-------- -------- -------
Pro forma net earnings................................ $135,856 $ 99,669 $25,771
======== ======== =======
Reported basic earnings per share..................... $ 2.27 $ 1.70 $ 0.52
Fair value stock-based compensation................... (0.12) (0.10) (0.08)
-------- -------- -------
Pro forma basic earnings per share.................... $ 2.15 $ 1.60 $ 0.44
======== ======== =======
Reported diluted earnings per share................... $ 2.23 $ 1.68 $ 0.51
Fair value stock-based compensation................... (0.12) (0.10) (0.08)
-------- -------- -------
Pro forma diluted earnings per share.................. $ 2.11 $ 1.58 $ 0.43
======== ======== =======

F-11

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

For the purposes of the above presentation, we estimate the fair value of
each option grant on the grant date using the Black-Scholes single option
pricing model. The table below shows the average fair value of options granted
for the three years ended December 31, 2003 and the related assumptions used in
the model:

2003 2002 2001
---------- ---------- ----------

Fair value of options granted..................... $ 6.67 $ 7.05 $ 7.66
Risk free interest rate........................... 2.8% 3.5% 4.4%
Expected volatility factor........................ 30% 30% 30%
Dividend yield.................................... 1.07% 1.14% 0.91%
Expected option life.............................. 4.4 years 5.5 years 4.6 years

GUARANTEE FUND AND OTHER ASSESSMENTS

Certain of our insurance companies are subject to guarantee fund and other
assessments in states where we are licensed. In some cases, the states allow for
recoveries of assessments as premium tax offsets, but only over a period of
years. We generally accrue the liability when an insolvency or other event
occurs that indicates a liability exists and the premium on which the assessment
will be based has been written. We recognize an asset for the premium tax offset
based on in-force policies. During the years ended December 31, 2003, 2002 and
2001, we incurred a net expense for guarantee fund and other assessments of $6.8
million, $4.7 million and $4.5 million, respectively.

LARGE LOSS EVENTS

During 2003, we reached an agreement with various reinsurers to commute
certain reinsurance recoverables relating to our discontinued accident and
health line of business. We received a cash payment from the reinsurers in
consideration for discounting the recoverables and reassuming the losses. The
pre-tax amount of the discount, $28.8 million, is included in loss and loss
adjustment expense.

During 2001, we experienced three significant gross losses. The first loss
was the September 11 terrorist attack which produced the largest loss to our
insurance company operations in our history. We recorded gross and net loss
reserves of $141.0 million and $35.0 million, respectively. The other two losses
were the Petrobras (Brazilian offshore energy production platform) and Total
(chemical factory near Toulouse, France) incidents, which produced gross losses
of $55.0 million and $49.0 million, respectively. Because these two losses were
substantially reinsured, the net losses were not material to our results of
operations. The Petrobras loss was paid during 2001 and the Total loss was paid
during 2002. All reinsurance recoverables related to both losses have been
collected.

OTHER INFORMATION

During 2001, we recorded a charge totaling $37.3 million related to lines
of business that we decided to cease writing, mainly our primary workers'
compensation line of business. The composition of this charge is $18.8 million
for loss and loss adjustment expense, $2.2 million for net policy acquisition
costs and $16.3 million for other operating expense. Included in other operating
expense is $15.0 million related to the impairment of goodwill. The fair value
of this line of business was calculated based upon the present value of future
expected cash flows.

F-12

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

RECLASSIFICATIONS

Certain amounts in the 2002 and 2001 consolidated financial statements have
been reclassified to conform with the 2003 presentation. Among these
reclassifications, proceeds from ceded reinsurance (ceding commissions in excess
of acquisition costs) have been classified as fee and commission income rather
than a reduction of operating expenses and compensation and other operating
expenses of our underwriting agency subsidiaries representing acquisition costs
have been classified as policy acquisition costs to be offset by the portion of
ceding commissions which represent the reimbursement of those acquisition costs.
Such reclassifications had no effect on our shareholders' equity, net earnings
or cash flows.

(2) GOODWILL AND INTANGIBLE ASSETS

SFAS No. 142 entitled "Goodwill and Other Intangible Assets" was issued in
June, 2001 and became effective for us on January 1, 2002. SFAS No. 142 requires
goodwill to be tested for impairment at a level referred to as a reporting unit.
After the initial adoption, goodwill of a reporting unit will be tested for
impairment on an annual basis and between annual tests if an event occurs or
circumstances change that would more likely than not reduce the fair value of a
reporting unit below its carrying amount. SFAS No. 142 also required the
discontinuance of the amortization of goodwill effective January 1, 2002 and
that goodwill recognized for acquisitions consummated after July 1, 2001 not be
amortized.

The tables below reconcile net earnings and earnings per share we reported
for the three years ended December 31, 2003 to adjusted amounts that we would
have reported had we adopted SFAS No. 142 on January 1, 2001 instead of January
1, 2002:

2003 2002 2001
-------- -------- -------

Net earnings:
Reported net earnings............................... $143,561 $105,828 $30,197
Add back goodwill amortization...................... -- -- 11,924
Add back license amortization....................... -- -- 555
Less tax benefit from goodwill amortization......... -- -- (1,092)
-------- -------- -------
ADJUSTED NET EARNINGS............................ $143,561 $105,828 $41,584
======== ======== =======
Basic earnings per share:
Reported basic earnings per share................... $ 2.27 $ 1.70 $ 0.52
Add back amortization, net of tax effect............ -- -- 0.19
-------- -------- -------
ADJUSTED BASIC EARNINGS PER SHARE................ $ 2.27 $ 1.70 $ 0.71
======== ======== =======
Diluted earnings per share:
Reported diluted earnings per share................. $ 2.23 $ 1.68 $ 0.51
Add back amortization, net of tax effect............ -- -- 0.19
-------- -------- -------
ADJUSTED BASIC EARNINGS PER SHARE................ $ 2.23 $ 1.68 $ 0.70
======== ======== =======

F-13

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

The following tables show the balances of our intangible assets, which are
included in other assets on our consolidated balance sheets:

2003 2002
------- -------

Intangible assets not subject to amortization -- insurance
company and other licenses................................ $ 5,992 $ 5,992
======= =======
Intangible assets subject to amortization:
Gross amounts recorded.................................... $20,414 $12,080
Less accumulated amortization............................. (6,913) (4,074)
------- -------
NET INTANGIBLE ASSETS SUBJECT TO AMORTIZATION.......... $13,501 $ 8,006
======= =======

Amortization of intangible assets which are subject to amortization under
SFAS No. 142 amounted to $3.2 million, $3.4 million and $0.5 million for the
years ended December 31, 2003, 2002 and 2001, respectively. Estimated
amortization expense for 2004 and future years is as follows:

2004........................................................ $ 4,055
2005........................................................ 3,458
2006........................................................ 2,829
2007........................................................ 1,361
2008........................................................ 750
Thereafter.................................................. 1,048
-------
TOTAL ESTIMATED AMORTIZATION.............................. $13,501
=======

(3) ACQUISITIONS AND DISPOSITION

ACQUISITIONS

During recent years, we have completed several acquisitions. The acquired
companies are well known in their respective lines of business, having excellent
reputations and workforces with significant expertise. They were generally
acquired to diversify into new specialty lines of business or grow existing
lines of business. These business combinations have been recorded using the
purchase method of accounting. The results of operations of these businesses
have been included in our consolidated financial statements

F-14

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

beginning on the effective date of each transaction. The following table
provides some additional information on these transactions:

GOODWILL
DEDUCTIBLE
INITIAL CASH INITIAL GOODWILL FOR INCOME
EFFECTIVE DATE CONSIDERATION RECOGNIZED TAX PURPOSES
----------------- ------------- ---------------- ------------

Professional Indemnity Agency,
Inc.............................. October 22, 2001 $63.0 million $53.6 million No
ASU International, LLC............. October 30, 2001 29.2 million 23.7 million Yes
HCC Global Financial Products, LLC
(formerly MAG Global Financial
Products, LLC)................... October 1, 2002 6.9 million -- Yes
HCC Diversified Financial Products
Limited (formerly Dickson
Manchester & Company, Limited)... December 24, 2002 17.0 million 9.2 million No
HCC Europe (formerly St. Paul
Espana).......................... December 31, 2002 8.1 million 3.2 million No
Covenant Underwriters Limited and
Continental Underwriters
Limited.......................... July 1, 2003 11.6 million 12.3 million Yes

The initial consideration given for Professional Indemnity Agency, Inc. and
Covenant Underwriters Limited also included 0.3 million shares of our common
stock for each acquisition. The value of our common stock given as consideration
was determined based on closing market price on the day the acquisition was
completed. In the case of the acquisition of Covenant Underwriters Limited, this
value was then reduced by the estimated discount due to the restrictions on the
sale of the common stock. The amounts above represent initial consideration paid
for each respective acquisition. Subsequent to the acquisition dates through
December 31, 2003, we have paid an aggregate of $4.8 million and at December 31,
2003 we have accrued $46.5 million in additional consideration based on the
terms of the respective agreements. In addition, we will pay up to a maximum of
$9.2 million with respect to one of the acquisitions if certain earnings targets
are reached through December 31, 2004 and for another of the acquisitions we
will pay up to a maximum of $15.0 million if certain earnings targets are
reached through December 31, 2006. The purchase agreements for two of the
acquisitions include terms requiring additional consideration based on pre-tax
earnings through September 30, 2007 and December 31, 2005, respectively. Any
contingent consideration paid will be recorded as an increase to goodwill.

F-15

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

The following table summarizes the combined estimated fair values of assets
acquired and liabilities assumed at the respective dates of acquisition for the
2002 and 2001 acquisitions. The assets and liabilities acquired with the 2003
acquisition are immaterial to our consolidated financial statements.

2002 2001
-------- --------

Total investments........................................... $131,280 $ 47,650
Premium, claims and other receivables....................... 46,232 30,506
Reinsurance recoverables.................................... 3,676 --
Other policy related assets................................. 5,808 --
Goodwill and intangible assets.............................. 23,816 83,957
All other assets............................................ 6,937 33,710
-------- --------
Total assets acquired..................................... 217,749 195,823
Loss and loss adjustment expense payable.................... 82,289 --
Premium and claims payable.................................. 39,816 44,883
Other policy related liabilities............................ 37,419 --
Notes payable............................................... 3,530 12,735
All other liabilities....................................... 11,813 37,724
-------- --------
Total liabilities......................................... 174,867 95,342
-------- --------
Net assets acquired....................................... $ 42,882 $100,481
======== ========

Identified intangible assets from the 2003 and 2002 acquisitions consisted
of employment and non-compete agreements and value of renewals with an assigned
value of $6.9 million and $4.7 million, respectively, and with ten and four year
average amortization periods.

The following unaudited pro forma summary presents information as if the
2002 and 2001 acquisitions had occurred at the beginning of 2002 and 2001 after
giving effect to certain adjustments, including amortization of goodwill (for
2001 pro forma only), amortization of intangible assets, increased interest
expense from debt issued to fund the acquisitions and income taxes. The pro
forma summary is for information purposes only, does not necessarily reflect the
actual results that would have occurred, nor is it necessarily indicative of
future results of the combined companies. During 2002, HCC Europe reported a net
underwriting loss of approximately $16.7 million due to increases in their loss
reserves. During 2001, Professional Indemnity Agency, Inc. paid approximately
$33.0 million in bonuses to employees and related employment taxes immediately
prior to the completion of the acquisition. The effects of the 2003 acquisition
are immaterial to the pro forma information.

UNAUDITED PRO FORMA INFORMATION 2002 2001
------------------------------- -------- --------

Revenue..................................................... $731,468 $591,908
Net earnings................................................ 102,960 13,318
Basic earnings per share.................................... 1.65 0.23
Diluted earnings per share.................................. 1.64 0.22

SUBSEQUENT ACQUISITION

On January 31, 2004, we acquired all of the shares of Surety Associates
Holding Co., Inc., the parent company of American Contractors Indemnity Company,
a California surety company specializing in court, specialty contract, license
and permit bonds. We paid $46.5 million in cash.

F-16

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

DISPOSITION

In December 2003, we sold the business of our retail brokerage subsidiary
HCC Employee Benefits, Inc. for $62.5 million in cash. The disposition of HCC
Employee Benefits, Inc. (included in the intermediary segment) resulted in an
after-tax gain of $30.1 million in the fourth quarter of 2003 with an additional
consideration provision, based upon earnings before income tax that may be
earned in 2004. In the fourth quarter of 2003, we began reporting this business
as discontinued operations and prior year financial information has been
reclassified to reflect this presentation. Goodwill was reduced $8.3 million as
a result of the disposition. Summarized financial data for discontinued
operations for the three years ended December 31, 2003 are outlined below.
Earnings before income tax provision exclude allocated general corporate
overhead expenses of $1.7 million, $1.8 million and $0.8 million, respectively,
for the years ended December 31, 2003, 2002 and 2001.

2003 2002 2001
------- ------- -------

Revenue................................................. $22,926 $21,930 $18,432
Earnings before income tax provision.................... 10,292 10,783 5,558

(4) INVESTMENTS

Substantially all of our fixed income securities are investment grade; 97%
are rated "A" or better. The cost or amortized cost, gross unrealized gain or
loss and estimated market value of investments in fixed income and marketable
equity securities, all of which are classified as available for sale, are as
follows:

COST OR GROSS GROSS ESTIMATED
AMORTIZED UNREALIZED UNREALIZED MARKET
COST GAIN LOSS VALUE
---------- ---------- ---------- ----------

December 31, 2003:
Marketable equity securities................ $ 12,007 $ 20 $ (25) $ 12,002
US Treasury securities...................... 67,125 2,040 (25) 69,140
Obligations of states, municipalities and
political subdivisions.................... 392,595 15,853 (1,099) 407,349
Corporate fixed income securities........... 324,914 10,841 (930) 334,825
Asset-backed and mortgage-backed
securities................................ 149,612 3,914 (767) 152,759
Foreign government securities............... 199,882 1,117 (906) 200,093
---------- ------- ------- ----------
TOTAL SECURITIES.......................... $1,146,135 $33,785 $(3,752) $1,176,168
========== ======= ======= ==========
December 31, 2002:
Marketable equity securities................ $ 15,815 $ 7 $ (213) $ 15,609
US Treasury securities...................... 93,620 2,935 (9) 96,546
Obligations of states, municipalities and
political subdivisions.................... 246,364 13,205 (101) 259,468
Corporate fixed income securities........... 232,216 12,739 (679) 244,276
Asset-backed and mortgage-backed
securities................................ 144,427 5,907 (461) 149,873
Foreign government securities............... 91,145 240 -- 91,385
---------- ------- ------- ----------
TOTAL SECURITIES.......................... $ 823,587 $35,033 $(1,463) $ 857,157
========== ======= ======= ==========

All investments in fixed income securities and other investments were
income producing for the twelve months preceding December 31, 2003, except for
one fixed income security valued at $0.5 million.

F-17

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

The following table displays the gross unrealized losses and fair value of
investments as of December 31, 2003 that were in a continuous unrealized loss
position for the periods indicated:

The amortized cost and estimated market value of fixed income securities at
December 31, 2003, 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 asset-backed and mortgage-backed securities is
three years.

ESTIMATED
AMORTIZED MARKET
COST VALUE
---------- ----------

Due in 1 year or less....................................... $ 83,341 $ 84,130
Due after 1 year through 5 years............................ 442,670 451,998
Due after 5 years through 10 years.......................... 235,992 243,663
Due after 10 years through 15 years......................... 152,348 158,531
Due after 15 years.......................................... 70,165 73,085
---------- ----------
Securities with fixed maturities.......................... 984,516 1,011,407
Asset-backed and mortgage-backed securities................. 149,612 152,759
---------- ----------
TOTAL FIXED INCOME SECURITIES.......................... $1,134,128 $1,164,166
========== ==========

As of December 31, 2003, our insurance companies had deposited fixed income
securities with an amortized cost of approximately $32.3 million (market: $33.7
million) to meet the deposit requirements of various insurance departments.

F-18

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

The sources of net investment income for the three years ended December 31,
2003 are detailed below:

2003 2002 2001
--------- ------- -------

Fixed income securities............................... $ 40,927 $31,773 $27,234
Short-term investments................................ 7,434 6,801 12,789
Marketable equity securities.......................... 250 210 294
Other investments..................................... 238 12 4
--------- ------- -------
Total investment income............................. 48,849 38,796 40,321
Investment expense.................................... (1,502) (1,027) (683)
Amounts reclassified to discontinued operations....... (12) (14) (76)
--------- ------- -------
NET INVESTMENT INCOME............................... $ 47,335 $37,755 $39,562
========= ======= =======

Realized pre-tax gains (losses) on the sale or write down of investments is
as follows:

GAINS LOSSES NET
------ ------- ------

For the year ended December 31, 2003:
Fixed income securities................................... $3,113 $(1,230) $1,883
Marketable equity securities.............................. -- (140) (140)
Other investments......................................... 40 (1,256) (1,216)
------ ------- ------
REALIZED GAIN (LOSS).................................... $3,153 $(2,626) $ 527
====== ======= ======
For the year ended December 31, 2002:
Fixed income securities................................... $3,027 $(1,621) $1,406
Marketable equity securities.............................. 207 (312) (105)
Other investments......................................... 335 (1,183) (848)
------ ------- ------
REALIZED GAIN (LOSS).................................... $3,569 $(3,116) $ 453
====== ======= ======
For the year ended December 31, 2001:
Fixed income securities................................... $3,099 $(1,452) $1,647
Marketable equity securities.............................. 1,224 (1,848) (624)
Other investments......................................... 145 (775) (630)
------ ------- ------
REALIZED GAIN (LOSS).................................... $4,468 $(4,075) $ 393
====== ======= ======

Unrealized pre-tax net gains (losses) on investments for the three years
ended December 31, 2003 are as follows:

2003 2002 2001
------- ------- ------

Fixed income securities.................................. $(3,738) $22,022 $ 731
Marketable equity securities............................. 201 (344) 2,752
Other investments........................................ -- 442 (442)
------- ------- ------
NET UNREALIZED INVESTMENT GAINS (LOSSES)............... $(3,537) $22,120 $3,041
======= ======= ======

F-19

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

(5) NOTES PAYABLE

Notes payable as of December 31, 2003 and 2002 are shown in the table
below. The aggregate estimated fair value of our 1.3% and 2% convertible notes
($324.8 million and $185.2 million at December 31, 2003 and 2002, respectively)
is based on quoted market prices. For the remainder of our notes payable, the
estimated fair value is based on current rates offered to us for debt with
similar terms and conditions and approximates the carrying value at both balance
sheet dates.

2003 2002
-------- --------

1.3% Convertible notes...................................... $125,000 $ --
2% Convertible notes........................................ 172,451 172,451
$200 million revolving loan facility........................ -- 53,000
Other debt.................................................. 12,953 4,576
-------- --------
TOTAL NOTES PAYABLE....................................... $310,404 $230,027
======== ========

In a public offering on March 25, 2003, we sold an aggregate $125.0 million
principal amount of 1.3% convertible notes due in 2023. Each one thousand dollar
principal amount of notes is convertible into 29.4377 shares of our common
stock, which represents an initial conversion price of $33.97 per share. The
initial conversion price is subject to change under certain conditions. We pay
interest on April 1 and October 1 of each year. Holders may surrender notes for
conversion into shares of our common stock if, as of the last day of the
preceding calendar quarter, the closing sale price of our common stock for at
least 20 consecutive trading days during the period of 30 consecutive trading
days ending on the last trading day of that quarter is more than 130% ($44.16
per share) of the conversion price per share of our common stock. We can redeem
the notes for cash at any time on or after April 4, 2009. Holders of the notes
may require us to repurchase the notes on April 1, 2009, 2014 and 2019 at a
price equal to the principal amount of the notes plus accrued and unpaid
interest. If the holders require us to repurchase these notes, we may choose to
pay the purchase price in cash, in shares of our common stock, or in a
combination thereof, although our intent is to pay in cash. We paid $3.2 million
in underwriting discounts and expenses in connection with this offering. The
underwriting discounts and expenses are being amortized from the issue date
until April 1, 2009. We used $66.0 million of the proceeds from this offering to
pay down existing indebtedness under our bank facility, while the remainder was
used to assist in financing acquisitions and strategic investments and for
general corporate purposes.

Our $200.0 million Revolving Loan Facility allows us to borrow up to the
maximum allowed by the facility on a revolving basis until the facility expires
on December 17, 2004. The facility is collateralized in part by the pledge of
our insurance companies' stock and guarantees entered into by our underwriting

F-20

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

agencies and intermediaries. The facility agreement contains certain restrictive
covenants which we believe are typical for similar financing arrangements.

(6) INCOME TAX

As of December 31, 2003 and 2002, we had current income taxes payable of
$26.0 million included in accounts payable and accrued liabilities and current
income taxes receivable of $3.9 million included in other assets in the
consolidated balance sheets, respectively.

F-21

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

The following table summarizes the differences between our effective tax
rate for financial statement purposes and the Federal statutory rate for the
three years ended December 31, 2003:

2003 2002 2001
------- ------- -------

Statutory tax rate...................................... 35% 35% 35%
Federal tax at statutory rate on continuing
operations............................................ $58,356 $53,338 $19,189
Nontaxable municipal bond interest and dividends
received deduction.................................... (4,126) (3,391) (3,314)
Other non deductible expenses........................... 1,979 236 591
Non deductible goodwill amortization.................... -- -- 7,608
State income taxes...................................... 3,164 2,134 3,017
Foreign income taxes.................................... 15,272 2,921 2,915
Foreign tax credit...................................... (14,795) (2,597) (2,968)
Other, net.............................................. 7 292 726
------- ------- -------
Income tax provision from continuing operations......... $59,857 $52,933 $27,764
======= ======= =======
Effective tax rate, continuing operations............... 35.9% 34.7% 50.6%
======= ======= =======
Federal tax at statutory rate on discontinued operations
and gain from sale of discontinued operations......... $22,041 $ 3,774 $ 1,945
Book over tax basis in stock of subsidiary.............. 2,896 -- --
Non deductible goodwill amortization.................... -- 173 173
Other non deductible expenses........................... 41 34 82
Pre-acquisition earnings................................ -- -- (161)
State income taxes...................................... 1,343 293 242
Other, net.............................................. (32) 144 141
------- ------- -------
Income tax provision on discontinued operations and gain
from sale of discontinued operations.................. $26,289 $ 4,418 $ 2,422
======= ======= =======
Effective tax rate, discontinued operations and gain
from sale of discontinued operations............... 41.7% 41.0% 43.6%
======= ======= =======
Total income tax provision.............................. $86,146 $57,351 $30,186
======= ======= =======
Total effective tax rate................................ 37.5% 35.1% 50.0%
======= ======= =======

F-22

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

The components of the income tax provision for the three years ended
December 31, 2003 are as follows:

2003 2002 2001
-------- ------- -------

Federal current........................................ $ 58,020 $35,110 $24,114
Federal deferred....................................... (15,747) 9,024 (150)
-------- ------- -------
Total federal........................................ 42,273 44,134 23,964
State current.......................................... 7,167 3,770 3,841
State deferred......................................... (1,356) 188 11
-------- ------- -------
Total state.......................................... 5,811 3,958 3,852
Foreign current........................................ 11,285 4,920 4,859
Foreign deferred....................................... 488 (79) (4,911)
-------- ------- -------
Total foreign........................................ 11,773 4,841 (52)
-------- ------- -------
Income tax provision from continuing operations........ 59,857 52,933 27,764
======== ======= =======
Federal current........................................ 21,334 -- --
State current.......................................... 1,206 -- --
-------- ------- -------
Income tax provision from gain from sale of
discontinued operations.............................. 22,540 -- --
======== ======= =======
Federal current........................................ 3,704 4,122 1,832
Federal deferred....................................... (815) (71) 204
-------- ------- -------
Total federal........................................ 2,889 4,051 2,036
State current.......................................... 586 189 409
State deferred......................................... 274 178 (23)
-------- ------- -------
Total state.......................................... 860 367 386
-------- ------- -------
Income tax provision from discontinued operations...... 3,749 4,418 2,422
======== ======= =======
Total income tax provision............................. $ 86,146 $57,351 $30,186
======== ======= =======

F-23

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

The net deferred tax liability and asset are included in accounts payable
and accrued liabilities and other assets, respectively, in our consolidated
balance sheets. The composition of deferred tax assets and liabilities as of
December 31, 2003 and 2002, is as follows:

2003 2002
-------- --------

Federal tax net operating loss carryforwards................ $ 2,729 $ 5,370
State tax net operating loss carryforwards.................. 5,183 5,671
Excess of financial unearned premium over tax............... 19,401 9,745
Effect of loss reserve discounting and salvage and
subrogation accrual for tax............................... 16,231 10,544
Excess of financial accrued expenses over tax............... 8,529 3,454
Deferred policy acquisition costs, net of ceding
commissions, deductible for tax........................... 546 --
Allowance for bad debts, not deductible for tax............. 6,308 3,328
Foreign branch net operating loss carryforwards............. 2,371 2,107
Valuation allowance......................................... (17,613) (11,547)
-------- --------
Total assets.............................................. 43,685 28,672
Unrealized gain on increase in value of securities available
for sale (shareholders' equity)........................... 10,552 12,168
Deferred policy acquisition costs, net of ceding
commissions, deductible for tax........................... -- 5,053
Amortizable goodwill for tax................................ 11,603 6,378
Book basis in net assets of foreign subsidiaries in excess
of tax.................................................... 5,291 5,560
Property and equipment depreciation and other items......... 7,530 9,988
-------- --------
Total liabilities......................................... 34,976 39,147
-------- --------
NET DEFERRED TAX ASSET (LIABILITY)........................ $ 8,709 $(10,475)
======== ========

Changes in the valuation allowance account applicable to deferred tax
assets result primarily from the acquisition and expiration of net operating
losses and other tax attributes related to acquired subsidiaries. The changes
for the three years ended December 31, 2003 are as follows:

2003 2002 2001
------- ------- -------

Balance, beginning of year.............................. $11,547 $10,435 $ 9,666
Change during year...................................... 6,066 1,112 769
------- ------- -------
BALANCE, END OF YEAR.................................. $17,613 $11,547 $10,435
======= ======= =======

As of December 31, 2003, we have Federal tax net operating loss
carryforwards of approximately $7.3 million that will expire in varying amounts
through the year 2019. Future use of these carryforwards is subject to statutory
limitations due to prior changes of ownership. There are valuation allowances in
the amount of $2.5 million recorded with respect to these loss carryforwards
that would reduce goodwill if the carryforwards are realized. In addition, we
have approximately $7.2 million of Federal tax loss carryforwards that will
expire in varying amounts through the year 2023, principally from our foreign
insurance companies that can be used only against future taxable income of those
entities. There are valuation allowances in the amount of $0.3 million recorded
with respect to these loss carryforwards. Based upon our history of taxable
income in our domestic insurance and other operations and our projections of

F-24

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

future taxable income in our domestic and foreign insurance operations, we
believe it is more likely than not that the deferred tax assets related to our
loss carryforwards, for which there are no valuation allowances, will be
realized. We have various state tax net operating loss carryforwards for which
we have established valuation allowances of approximately $5.2 million covering
substantially all of the related tax benefit.

(7) SEGMENT AND GEOGRAPHIC DATA

We have classified our activities into four operating business segments
based upon services provided: 1) insurance company operations, 2) underwriting
agency operations, 3) intermediary operations and 4) other operations. See Note
1 for a description of the services provided by and the principal subsidiaries
included in our insurance company, underwriting agency and intermediary
segments. Our other operations segment performed various insurance related
services in 2001 and contains insurance related investments made from time to
time. Corporate includes general corporate operations and those minor operations
not included in an operating segment. Inter-segment revenue consists primarily
of fee and commission income of our underwriting agency and our intermediary
segments charged to our insurance company segment. Inter-segment pricing (either
flat rate fees or as a percentage premium) approximates what is charged to
unrelated parties for similar services.

The performance of each of our segments is evaluated by our management
based upon net earnings. Net earnings is calculated after tax and after all
corporate expense allocations, amortization of goodwill in 2001, interest
expense on debt incurred at the purchase date and intercompany eliminations have
been charged or credited to our individual segments. The following tables show
information by business segment and geographic location. Geographic location is
determined by physical location of our offices and does not represent the
location of insureds or reinsureds from whom the business was generated.

Effective January 1, 2001 and 2002, we consolidated the operations of three
and one of our underwriting agencies, respectively, into the operations of our
insurance companies. Policies incepting on or after the effective dates, along
with associated expenses, will be reported in our insurance company segment. The
administration of all policies incepting before the effective dates, which are
now in run off, along with associated expenses, will continue to be reported in
our underwriting agency segment. This consolidation will affect the
comparability of segment information between periods. The revenues within our
underwriting agency and intermediary segments for 2002 and 2001 have been
reclassified to be consistent with the 2003 presentation. This reclassification
did not change segment total revenue or segment net earnings from amounts
previously reported. Proceeds from ceded reinsurance of our insurance
subsidiaries in excess of acquisition cost reimbursements have also been
reclassified to revenue to be consistent with the classification in our 2003
consolidated financial statements.

SFAS No. 142, which we adopted effective January 1, 2002, required the
discontinuance of the amortization of goodwill and indefinite lived intangible
assets on a prospective basis. This will affect the comparability of certain
segment information between periods. Pro forma segment information is shown in
the tables for the year ended December 31, 2001, as if we had adopted SFAS No.
142 as of January 1, 2001.

F-25

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

INSURANCE UNDERWRITING OTHER
COMPANY AGENCY INTERMEDIARY OPERATIONS CORPORATE TOTAL
--------- ------------ ------------ ---------- --------- ----------

For the year ended December 31, 2003:
Revenue:
Domestic........................................ $606,469 $ 63,141 $25,269 $64,406 $ 790 $ 760,075
Foreign......................................... 219,578 17,488 20,430 -- -- 257,496
Inter-segment................................... -- 94,104 2,917 -- -- 97,021
-------- -------- ------- ------- ------- ----------
Total segment revenue......................... $826,047 $174,733 $48,616 $64,406 $ 790 1,114,592
======== ======== ======= ======= =======
Inter-segment revenue............................. (97,021)
Amounts reclassified to discontinued operations... (75,607)
----------
CONSOLIDATED TOTAL REVENUE.................... $ 941,964
==========
Net earnings (loss):
Domestic........................................ $ 56,534 $ 37,431 $ 5,733 $36,155 $(5,428) $ 130,425
Foreign......................................... 17,911 7,861 4,204 -- -- 29,976
-------- -------- ------- ------- ------- ----------
Total segment net earnings (loss)............. $ 74,445 $ 45,292 $ 9,937 $36,155 $(5,428) 160,401
======== ======== ======= ======= =======
Inter-segment eliminations...................... (16,840)
----------
CONSOLIDATED NET EARNINGS..................... $ 143,561
==========
Other items:
Net investment income........................... $ 42,345 $ 2,991 $ 817 $ 224 $ 970 47,347
Amounts reclassified to discontinued
operations.................................... (12)
----------
Consolidated net investment income............ $ 47,335
==========
Depreciation and amortization................... 3,271 5,910 548 664 2,435 12,828
Interest expense (benefit)...................... 62 6,514 1,363 770 (1,256) 7,453
Capital expenditures............................ 2,618 1,466 1,689 -- 16,047 21,820
Income tax provision............................ 35,033 30,460 5,727 25,239 (73) 96,386
Inter-segment eliminations...................... (10,240)
Amounts reclassified to discontinued
operations.................................... (26,289)
----------
Consolidated income tax provision from
continuing operations....................... $ 59,857
==========

For 2003, earnings before income taxes was $183.2 million for our domestic
subsidiaries and $46.5 million for our foreign subsidiaries and branches. During
2003, the other operations segment recorded a gain of $30.1 million (net of
income tax) from the sale of a subsidiary and the insurance segment recorded a
loss of $18.7 million (net of income tax) due to a commutation.

F-26

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

INSURANCE UNDERWRITING OTHER
COMPANY AGENCY INTERMEDIARY OPERATIONS CORPORATE TOTAL
--------- ------------ ------------ ---------- --------- --------

For the year ended December 31, 2002:
Revenue:
Domestic........................................ $478,279 $ 66,937 $24,051 $4,874 $ 616 $574,757
Foreign......................................... 91,853 3,492 18,461 -- -- 113,806
Inter-segment................................... -- 41,617 1,045 -- -- 42,662
-------- -------- ------- ------ ------ --------
Total segment revenue......................... $570,132 $112,046 $43,557 $4,874 $ 616 731,225
======== ======== ======= ====== ======
Inter-segment revenue............................. (42,662)
Amounts reclassified to discontinued operations... (21,930)
--------
CONSOLIDATED TOTAL REVENUE.................... $666,633
========
Net earnings:
Domestic........................................ $ 62,190 $ 23,180 $ 5,183 $3,052 $2,922 $ 96,527
Foreign......................................... 6,040 2,076 2,390 -- -- 10,506
-------- -------- ------- ------ ------ --------
Total segment net earnings.................... $ 68,230 $ 25,256 $ 7,573 $3,052 $2,922 107,033
======== ======== ======= ====== ======
Inter-segment eliminations...................... (1,205)
--------
CONSOLIDATED NET EARNINGS..................... $105,828
========
Other items:
Net investment income........................... $ 33,587 $ 2,954 $ 993 $ 41 $ 194 37,769
Amounts reclassified to discontinued
operations.................................... (14)
--------
Consolidated net investment income............ $ 37,755
========
Depreciation and amortization................... 3,153 6,190 350 82 1,033 10,808
Interest expense (benefit)...................... (113) 7,767 2,575 -- (1,928) 8,301
Capital expenditures............................ 2,803 1,208 1,491 -- 280 5,782
Income tax provision............................ 33,074 15,499 6,550 1,566 1,368 58,057
Inter-segment eliminations...................... (706)
Amounts reclassified to discontinued
operations.................................... (4,418)
--------
Consolidated income tax provision from
continuing operations....................... $ 52,933
========

For 2002, earnings before income taxes was $144.3 million for our domestic
subsidiaries and $18.8 million for our foreign subsidiaries and branches.

F-27

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

INSURANCE UNDERWRITING OTHER
COMPANY AGENCY INTERMEDIARY OPERATIONS CORPORATE TOTAL
--------- ------------ ------------ ---------- --------- --------

For the year ended December 31, 2001:
Revenue:
Domestic........................................ $362,996 $56,888 $23,386 $14,885 $1,426 $459,581
Foreign......................................... 45,098 2,312 22,650 -- -- 70,060
Inter-segment................................... -- 30,579 623 1,967 -- 33,169
-------- ------- ------- ------- ------ --------
Total segment revenue....................... $408,094 $89,779 $46,659 $16,852 $1,426 562,810
======== ======= ======= ======= ======
Inter-segment revenue............................. (33,169)
Amounts reclassified to discontinued operations... (18,432)
--------
CONSOLIDATED TOTAL REVENUE.................. $511,209
========
Net earnings (loss):
Domestic........................................ $ 1,020 $16,075 $ 4,382 $ 7,149 $ (979) $ 27,647
Foreign......................................... (3,923) 1,137 4,280 -- -- 1,494
-------- ------- ------- ------- ------ --------
Total segment net earnings (loss)........... $ (2,903) $17,212 $ 8,662 $ 7,149 $ (979) 29,141
======== ======= ======= ======= ======
Inter-segment eliminations...................... 1,056
--------
CONSOLIDATED NET EARNINGS................... $ 30,197
========
SFAS No. 142 pro forma adjustments:
Net effect of goodwill and intangible asset
amortization.................................. $ 2,142 $ 5,892 $ 3,353 $ -- $ -- $ 11,387
-------- ------- ------- ------- ------ --------
Pro forma segment net earnings (loss)........... $ (761) $23,104 $12,015 $ 7,149 $ (979) 40,528
======== ======= ======= ======= ======
Inter-segment eliminations...................... 1,056
--------
PRO FORMA CONSOLIDATED NET EARNINGS......... $ 41,584
========
Other items:
Net investment income........................... $ 30,766 $ 5,202 $ 2,771 $ 85 $ 814 39,638
Amounts reclassified to discontinued
operations.................................... (76)
--------
Consolidated net investment income............ $ 39,562
========
Depreciation, amortization and impairments...... 20,685 9,783 3,723 256 479 34,926
Interest expense................................ 37 5,198 3,534 15 100 8,884
Amounts reclassified to discontinued
operations.................................... (9)
--------
Consolidated interest expense................. $ 8,875
========
Capital expenditures............................ 3,049 1,048 1,627 107 6,452 12,283
Income tax provision............................ 2,432 15,604 3,054 3,692 4,756 29,538
Inter-segment eliminations...................... 648
Amounts reclassified to discontinued
operations.................................... (2,422)
--------
Consolidated income tax provision from
continuing operations....................... $ 27,764
========

During 2001, our insurance company segment recorded two large unusual
items: 1) a $22.8 million (net of income tax) loss due to the terrorist attack
on September 11 and 2) a $29.4 million charge (net of income tax) related to
lines of business we decided to cease writing. Included in the latter amount,
was a $15.0 million charge for the impairment of goodwill, which was not
deductible for income tax purposes. Also during 2001, earnings (loss) before
income taxes was $60.4 million for our domestic subsidiaries and $(0.1) million
for our foreign subsidiaries and branches.

F-28

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

The following tables present selected revenue items by line of business for
the three years ended December 31, 2003:

2003 2002 2001
-------- -------- --------

Group life, accident and health...................... $290,009 $240,070 $143,851
Diversified financial products....................... 123,562 23,102 4
London market account................................ 137,572 89,260 43,360
Aviation............................................. 97,536 100,960 91,377
Other specialty lines................................ 57,551 22,337 15,120
-------- -------- --------
706,230 475,729 293,712
Discontinued lines................................... 32,042 29,792 49,075
-------- -------- --------
NET EARNED PREMIUM................................. $738,272 $505,521 $342,787
======== ======== ========
Life, accident and health............................ $ 57,371 $ 66,166 $ 81,272
Property and casualty................................ 85,244 49,753 29,744
-------- -------- --------
FEE AND COMMISSION INCOME.......................... $142,615 $115,919 $111,016
======== ======== ========

Assets by business segment and geographic location are shown in the
following tables:

INSURANCE UNDERWRITING OTHER
COMPANY AGENCY INTERMEDIARY OPERATIONS CORPORATE TOTAL
---------- ------------ ------------ ---------- --------- ----------

December 31, 2003:
Domestic........... $2,585,880 $709,962 $ 99,726 $31,689 $94,983 $3,522,240
Foreign............ 748,234 94,297 499,525 -- -- 1,342,056
---------- -------- -------- ------- ------- ----------
Total assets..... $3,334,114 $804,259 $599,251 $31,689 $94,983 $4,864,296
========== ======== ======== ======= ======= ==========
December 31, 2002:
Domestic........... $2,063,045 $651,786 $ 47,946 $ 5,925 $46,477 $2,815,179
Foreign............ 450,742 61,078 377,152 -- -- 888,972
---------- -------- -------- ------- ------- ----------
Total assets..... $2,513,787 $712,864 $425,098 $ 5,925 $46,477 $3,704,151
========== ======== ======== ======= ======= ==========

The changes in the carrying amount of goodwill for the year ended December
31, 2003 are as follows:

INSURANCE UNDERWRITING
COMPANY AGENCY INTERMEDIARY TOTAL
--------- ------------ ------------ --------

Goodwill as of December 31, 2002........ $144,204 $113,583 $77,501 $335,288
Additions and other adjustments......... 19,514 39,979 -- 59,493
Disposition............................. -- -- (8,274) (8,274)
-------- -------- ------- --------
Goodwill as of December 31, 2003........ $163,718 $153,562 $69,227 $386,507
======== ======== ======= ========

The reduction of goodwill within the intermediary segment resulted from the
sale of a subsidiary contained therein.

F-29

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

(8) 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 the ceding of reinsurance does not discharge
the primary insurer from liability to its policyholder, our insurance companies
participate in such agreements for the purpose of limiting their loss exposure,
protecting them against catastrophic loss and diversifying their business. The
following table represents the effect of such reinsurance transactions on net
premium and loss and loss adjustment expense:

LOSS AND
LOSS
WRITTEN EARNED ADJUSTMENT
PREMIUM PREMIUM EXPENSE
---------- ---------- -------------

For the year ended December 31, 2003:
Direct business................................. $1,377,999 $1,189,356 $ 694,205
Reinsurance assumed............................. 361,895 297,715 351,786
Reinsurance ceded............................... (874,392) (748,799) (557,339)
---------- ---------- ---------
NET AMOUNTS................................... $ 865,502 $ 738,272 $ 488,652
========== ========== =========
For the year ended December 31, 2002:
Direct business................................. $ 904,737 $ 801,851 $ 504,815
Reinsurance assumed............................. 254,512 229,287 99,437
Reinsurance ceded............................... (613,338) (525,617) (297,761)
---------- ---------- ---------
NET AMOUNTS................................... $ 545,911 $ 505,521 $ 306,491
========== ========== =========
For the year ended December 31, 2001:
Direct business................................. $ 783,124 $ 789,893 $ 612,455
Reinsurance assumed............................. 226,951 218,234 451,390
Reinsurance ceded............................... (637,117) (665,340) (796,455)
---------- ---------- ---------
NET AMOUNTS................................... $ 372,958 $ 342,787 $ 267,390
========== ========== =========

Ceding commissions netted with policy acquisition costs in the consolidated
statements of earnings are $113.8 million, $84.5 million and $125.4 million for
the years ended December 31, 2003, 2002 and 2001, respectively.

The table below represents the composition of reinsurance recoverables in
our consolidated balance sheets:

2003 2002
-------- --------

Reinsurance recoverable on paid losses...................... $101,013 $108,104
Reinsurance recoverable on outstanding losses............... 425,609 304,220
Reinsurance recoverable on incurred but not reported
losses.................................................... 404,479 393,752
Reserve for uncollectible reinsurance....................... (14,911) (7,142)
-------- --------
TOTAL REINSURANCE RECOVERABLES............................ $916,190 $798,934
======== ========

F-30

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

Our insurance companies require reinsurers not authorized by our insurance
companies' respective states of domicile to collateralize their reinsurance
obligations to us. The table below shows amounts held by us as collateral plus
other credits available for potential offset as of December 31, 2003 and 2002:

2003 2002
-------- --------

Payables to reinsurers...................................... $393,214 $235,727
Letters of credit........................................... 195,329 141,490
Cash deposits............................................... 11,195 9,384
-------- --------
TOTAL CREDITS............................................. $599,738 $386,601
======== ========

The tables below present the calculation of net reserves, net unearned
premium and net deferred policy acquisition costs as of December 31, 2003
and 2002:

2003 2002
---------- ----------

Loss and loss adjustment expense payable.................... $1,535,288 $1,155,290
Reinsurance recoverable on outstanding losses............... (425,609) (304,220)
Reinsurance recoverable on incurred but not reported
losses.................................................... (404,479) (393,752)
---------- ----------
NET RESERVES.............................................. $ 705,200 $ 457,318
========== ==========
Unearned premium............................................ $ 592,311 $ 331,050
Ceded unearned premium...................................... (291,591) (164,224)
---------- ----------
NET UNEARNED PREMIUM...................................... $ 300,720 $ 166,826
========== ==========
Deferred policy acquisition costs........................... $ 106,943 $ 68,846
Deferred ceding commissions................................. (88,129) (49,963)
---------- ----------
NET DEFERRED POLICY ACQUISITION COSTS..................... $ 18,814 $ 18,883
========== ==========

In order to reduce our exposure to reinsurance credit risk, we evaluate the
financial condition of our reinsurers and place our reinsurance with a diverse
group of companies and syndicates, which we believe to be financially sound. The
following table shows reinsurance balances relating to our reinsurers with a net
recoverable balance greater than $15.0 million as of December 31, 2003 and 2002.
The total recoverables

F-31

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

column includes paid loss recoverable, outstanding loss recoverable, incurred
but not reported loss recoverable and ceded unearned premium.

LETTERS OF
CREDIT, CASH
TOTAL DEPOSITS AND
REINSURER RATING LOCATION RECOVERABLES OTHER PAYABLES NET
--------- ------ -------------- ------------ -------------- -------

December 31, 2003:
Lloyd's Syndicate Number 2488.......... A- United Kingdom $34,824 $ 6,631 $28,193
Arch Reinsurance Company............... A- Nebraska 36,481 8,345 28,136
Hanover Rueckversicherungs AG.......... A Germany 44,095 17,159 26,936
Lloyd's Syndicate Number 1206.......... C+ United Kingdom 26,567 18 26,549
Lloyd's Syndicate Number 0033.......... A- United Kingdom 26,346 271 26,075
Harco National Insurance Company....... A- Illinois 33,072 7,971 25,101
Lloyd's Syndicate Number 1101.......... NR United Kingdom 25,023 91 24,932
American Re-Insurance Company.......... A+ Delaware 22,515 978 21,537
Lloyd's Syndicate Number 1209.......... B+ United Kingdom 20,449 85 20,364
Lloyd's Syndicate Number 1607.......... NR United Kingdom 20,387 61 20,326
Platinum Underwriters Reinsurance
Co. ................................. A Maryland 38,834 18,911 19,923
Lloyd's Syndicate Number 0510.......... A- United Kingdom 18,919 288 18,631
Everest Reinsurance Company............ A+ Delaware 25,874 8,658 17,216
Max Re Ltd. ........................... A- Bermuda 83,707 67,289 16,418
Lloyd's Syndicate Number 0957.......... NR United Kingdom 15,932 140 15,792
December 31, 2002:
Lloyd's Syndicate Number 1101.......... NR United Kingdom $40,450 $ 258 $40,192
Lloyd's Syndicate Number 2488.......... A- United Kingdom 31,640 1,998 29,642
Lloyd's Syndicate Number 1206.......... C+ United Kingdom 29,540 40 29,500
Odyssey American Reinsurance Corp. .... A Connecticut 25,087 843 24,244
American Fidelity Assurance Company.... A+ Oklahoma 23,305 -- 23,305
American Re-Insurance Company.......... A+ Delaware 19,797 229 19,568
Lloyd's Syndicate Number 0957.......... NR United Kingdom 19,403 22 19,381
Lloyd's Syndicate Number 0033.......... A- United Kingdom 19,277 62 19,215
Lloyd's Syndicate Number 0055.......... NR United Kingdom 17,009 65 16,944
Canada Life Assurance Company.......... A+ Canada 16,900 96 16,804
Lloyd's Syndicate Number 0510.......... A- United Kingdom 16,250 562 15,688
Transatlantic Reinsurance Company...... A++ New York 17,288 1,771 15,517
Lloyd's Syndicate Number 0990.......... NR United Kingdom 15,329 58 15,271

Ratings for companies are published by A.M. Best Company, Inc. Ratings for
individual syndicates are published by Moody's Investors Services, Inc. "NR"
indicates that the indicated Lloyd's syndicate has not been rated. Lloyd's of
London is an insurance and reinsurance marketplace composed of many independent
underwriting syndicates financially supported by a central trust fund.

HCC Life Insurance Company previously sold its entire block of individual
life insurance and annuity business to Life Reassurance Corporation of America
(rated A++ by A.M. Best Company, Inc.) in the

F-32

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

form of an indemnity reinsurance contract. Ceded life and annuity benefits
amounted to $77.5 million and $79.0 million as of December 31, 2003 and 2002,
respectively.

(9) COMMITMENTS AND CONTINGENCIES

LITIGATION

We are party to numerous 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 party to
lawsuits, arbitrations and other proceedings that relate to disputes over
contractual relationships with third parties, or which involve alleged errors
and omissions on the part of our subsidiaries. A subsidiary has been named along
with several other defendants in legal proceedings by certain of the insurance
company members of a discontinued workers' compensation reinsurance facility
commonly known as the Unicover Pool. During 1997 and 1998, our subsidiary was
one of two co-intermediaries for the facility. Other defendants in the current
proceedings include the other reinsurance intermediary, the former managing
underwriter for the facility and various individuals, none of whom are
affiliated with us. The proceedings claim that the actions of the various
defendants resulted in the rescission of certain reinsurance contracts in an
arbitration to which we were not a party and include allegations of breach of
fiduciary duty, negligence, fraud and other allegations. The proceedings claim
unspecified or substantial compensatory and punitive damages. We believe that we
have meritorious defenses to the allegations and intend to vigorously defend
against the claims made in the proceedings. In addition, we are presently
engaged in litigation initiated by the appointed liquidator of a former
reinsurer concerning payments made to us prior to the date of the appointment of
the liquidator. The disputed payments were made by the now insolvent reinsurer
in connection with a commutation agreement. Our understanding is that such
litigation is one of a number of similar actions brought by the liquidator. We
intend to vigorously contest the action. Although the ultimate outcome of these
matters may not be determined at this time, based upon present information, the
availability of insurance coverage and legal advice received, we do not believe
the resolution of any of these matters, some of which include allegations of
damages of material amounts, will have a material adverse effect on our
financial condition, results of operations or cash flows.

F-33

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

CATASTROPHE EXPOSURE

We write business in areas exposed to catastrophic losses and have
significant exposures to this type of loss in California, the Atlantic Coast of
the United States, certain United States Gulf Coast states, particularly Florida
and Texas, the Caribbean and Mexico. We assess our overall exposures to a single
catastrophic event and apply procedures that we believe are more conservative
than are typically used by the industry to ascertain our probable maximum loss
from any single event. We maintain reinsurance protection that we believe is
sufficient to cover any foreseeable event.

LEASES

We lease administrative office facilities under long-term non-cancelable
operating lease agreements expiring at various dates through the year 2013. In
addition to rent, the agreements generally require the payment of utilities,
real estate taxes, insurance and repairs. We recognize rent expense on a
straight-line basis over the terms of these leases. In addition, we lease
computer equipment and automobiles under operating leases expiring at various
dates through the year 2008. Rent expense under operating leases amounted to
$8.6 million, $8.4 million and $7.1 million for the years ended December 31,
2003, 2002 and 2001, respectively.

At December 31, 2003, future minimum annual rental payments required under
long-term, non-cancelable operating leases, excluding certain expenses payable
by us, are as follows:

FOR THE YEARS ENDED DECEMBER 31, AMOUNT DUE
-------------------------------- ----------

2004........................................................ $ 8,434
2005........................................................ 7,531
2006........................................................ 5,922
2007........................................................ 3,955
2008........................................................ 2,994
Thereafter.................................................. 3,846
-------
TOTAL FUTURE MINIMUM ANNUAL RENTAL PAYMENTS DUE............. $32,682
=======

INDEMNIFICATION

We have sold businesses in the past. In connection with these sales, we
have provided indemnifications to the buyers, which we believe are typical for
transactions of this nature, based upon the type of business sold. Certain of
these indemnifications have no limit. It is not possible to estimate the maximum
potential amount under these indemnifications as our performance under the
indemnifications and our ultimate liability are based upon the occurrence of
future events, which may or may not occur. We currently have a liability of $5.9
million recorded for performance under one such indemnification. This
indemnification was given by a company we acquired, before its acquisition, in
connection with a sale of one of its subsidiaries.

TERRORIST EXPOSURE

F-34

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

subject premium as defined under the applicable regulations. Thereafter, the
Federal government would provide reimbursement for 90% of our covered losses up
to the maximum amount set out in the Act.

(10) RELATED PARTY TRANSACTIONS

Certain of our Directors are officers, directors or owners of business
entities with which we transact business. Balances with these business entities
and other related parties included in our consolidated balance sheets are as
follows:

2003 2002
------- -------

Short-term investments...................................... $56,082 $ --
Other investments........................................... 7,137 3,264
Premiums, claims and other receivables...................... 200 1,189
Reinsurance recoverables.................................... 1,963 --
Ceded unearned premium...................................... 4,132 --
Deferred policy acquisition costs........................... 5,941 --
Other assets................................................ 54,620 18,252
Loss and loss adjustment expense payable.................... 5,588 --
Reinsurance balances payable................................ 3,465 --
Unearned premium............................................ 21,941 --
Deferred ceding commissions................................. 1,211 --

Transactions with these business entities and other related parties
included in our consolidated statements of earnings are as follows:

2003 2002 2001
------- ----- -----

Assumed earned premium...................................... $10,388 $ -- $ --
Ceded earned premium........................................ 11,429 -- --
Fee and commission income................................... 1,503 91 58
Net realized investment gain (loss)......................... (1,216) (601) 53
Other operating income (loss)............................... 3,363 668 (508)
Assumed loss and loss adjustment expense.................... 6,025 -- --
Ceded loss and loss adjustment expense...................... 5,714 -- --
Policy acquisition costs.................................... 2,825 -- --
Ceding commissions netted with policy acquisition costs..... 2,778 -- --
Other operating expense..................................... 82 -- --
Interest expense............................................ 37 154 217

The amount in short-term investments represents a deposit at Lloyds to
serve as security for our participation in a Lloyd's syndicate which began
operations on January 1, 2004. Additionally, we had $48.9 million and $10.1
million payable at December 31, 2003 and 2002, respectively, to former owners of
businesses we have acquired who are now officers of certain of our subsidiaries.
Such payables represent payments due under the terms of the acquisition
agreements. For the year ended December 31, 2003, we paid $15.2 million related
to such agreements. During February 2004, we acquired additional shares of the
common stock of Argonaut Group, Inc., thereby increasing our beneficial
ownership to 10.3%, which consists of 2.5 million shares of mandatorily
convertible voting preferred stock and 0.7 million shares of common stock. All
of the insurance related amounts shown on the above tables are due to balances
and transactions with insurance company subsidiaries of Argonaut Group, Inc.

F-35

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

We also have entered into an agreement with an entity owned by an officer
and Director, pursuant to which we rent equipment for providing transportation
services to our employees, our Directors and our clients. We provide our own
employees to operate the equipment and pay all expenses related to their
operation. For the years ended December 31, 2003, 2002 and 2001, we paid rentals
of $1.2 million, $1.2 million and $1.0 million, respectively, to this entity.

(11) SHAREHOLDERS' EQUITY

The components of accumulated other comprehensive income are as follows:

ACCUMULATED
UNREALIZED OTHER
FOREIGN CURRENCY INVESTMENT COMPREHENSIVE
TRANSLATION GAIN (LOSS) OTHER INCOME
---------------- ----------- ----- -----------------

Balance December 31, 2000......... $ (655) $ 5,368 $ -- $ 4,713
Net change for year............... (279) 2,042 24 1,787
------ ------- ----- -------
Balance December 31, 2001......... (934) 7,410 24 6,500
Net change for year............... 50 14,239 (24) 14,265
------ ------- ----- -------
Balance December 31, 2002......... (884) 21,649 -- 20,765
Net change for year............... 8,149 (2,305) (483) 5,361
------ ------- ----- -------
Balance December 31, 2003......... $7,265 $19,344 $(483) $26,126
====== ======= ===== =======

Insurance companies are limited to the amount of dividends they can pay to
their parent by the laws of their state of domicile. The maximum dividends that
our direct subsidiaries can pay in 2004 without special permission are as
follows:

MAXIMUM
DIVIDEND
----------------

Houston Casualty Company.................................... $ 40.9 million
Avemco Insurance Company.................................... --

Avemco Insurance Company cannot pay a dividend without special permission
as a result of a special approved dividend it paid in 2003.

(12) STOCK OPTIONS

Our current stock option plan, the 2001 Flexible Incentive Plan, is
administered by the Compensation Committee of the Board of Directors. Options
granted under this Plan may be used to purchase one share of our common stock.
Options cannot be repriced under the plan. As of December 31, 2003, 6.0 million
shares of our common stock were reserved for the exercise of options, of which
5.5 million shares were reserved for options previously granted and 0.5 million
shares were reserved for future issuances of options.

F-36

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

The following table provides an analysis of stock option activity during
the three years ended December 31, 2003:

2003 2002 2001
-------------------- -------------------- --------------------
AVERAGE AVERAGE AVERAGE
NUMBER EXERCISE NUMBER EXERCISE NUMBER EXERCISE
OF SHARES PRICE OF SHARES PRICE OF SHARES PRICE
--------- -------- --------- -------- --------- --------

Outstanding, beginning of
year........................ 6,371 $20.99 3,305 $17.39 5,494 $15.54
Granted at market value....... 475 24.42 4,116 22.45 797 24.54
Forfeitures and expirations... (60) 21.52 (219) 19.84 (251) 17.73
Exercised..................... (1,259) 15.69 (831) 14.01 (2,735) 15.68
------ ------ ----- ------ ------ ------
OUTSTANDING, END OF YEAR...... 5,527 $22.49 6,371 $20.99 3,305 $17.39
====== ====== ===== ====== ====== ======
EXERCISABLE, END OF YEAR...... 1,871 $21.61 1,437 $17.81 1,100 $16.70
====== ====== ===== ====== ====== ======

Options outstanding and exercisable as of December 31, 2003 are shown on
the following schedule:

OPTIONS OUTSTANDING OPTIONS EXERCISABLE
--------------------------------------- --------------------
AVERAGE AVERAGE AVERAGE
NUMBER OF REMAINING EXERCISE NUMBER OF EXERCISE
RANGE OF EXERCISE PRICES SHARES CONTRACTUAL LIFE PRICE SHARES PRICE
------------------------ --------- ---------------- -------- --------- --------

Under $20.50........................... 1,722 4.2 years $19.15 773 $18.14
$20.50 - $22.45........................ 1,441 5.0 years 22.01 426 21.79
$22.46 - $25.20........................ 1,915 5.1 years 24.62 441 24.55
Over $25.20............................ 449 3.7 years 27.70 231 27.27
----- --------- ------ ----- ------
TOTAL OPTIONS.......................... 5,527 4.7 years $22.49 1,871 $21.61
===== ========= ====== ===== ======

(13) EARNINGS PER SHARE

The following table provides reconciliation of the denominators used in the
earnings per share calculations for the three years ended December 31, 2003:

2003 2002 2001
--------- -------- -------

NET EARNINGS......................................... $ 143,561 $105,828 $30,197
========= ======== =======
Average common stock outstanding..................... 63,279 62,173 58,166
Common stock contractually issuable in the future.... -- 52 155
--------- -------- -------
Weighted average common stock outstanding.......... 63,279 62,225 58,321
Additional dilutive effect of outstanding options (as
determined by the application of the treasury stock
method)............................................ 1,104 711 1,298
WEIGHTED AVERAGE COMMON STOCK AND POTENTIAL COMMON
STOCK OUTSTANDING............................... 64,383 62,936 59,619
========= ======== =======
Anti-dilutive shares not included in computation..... 204 1,105 187
========= ======== =======

(14) STATUTORY INFORMATION

Our insurance companies file financial statements prepared in accordance
with statutory accounting practices prescribed or permitted by domestic or
foreign insurance regulatory authorities. Statutory

F-37

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

policyholders' surplus and net income for the three years ended December 31,
2003, after intercompany eliminations, of our insurance companies included in
those companies' respective filings with regulatory authorities are as follows:

2003 2002 2001
-------- -------- --------

Statutory policyholders' surplus..................... $591,889 $523,807 $401,393
Statutory net income................................. 54,784 68,462 16,555

Our statutory policyholders' surplus has been adversely affected by
statutory adjustments for reinsurance recoverable that, although required
statutorily, have no effect on net earnings or shareholders' equity in
accordance with generally accepted accounting principles. Our statutory net
income for 2001 has been reduced by $22.8 million (net of income tax) from the
September 11 terrorist attack and $8.1 million (net of income tax) from charges
related to lines of business we decided to cease writing. The statutory net
income for 2003 was reduced by $18.7 million due to a commutation.

The statutory surplus of each of our insurance companies is significantly
in excess of regulatory risk-based capital requirements.

F-38

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

(15) LIABILITY FOR UNPAID LOSS AND LOSS ADJUSTMENT EXPENSE

The following table provides a reconciliation of the liability of loss and
loss adjustment expense for the three years ended December 31, 2003:

2003 2002 2001
---------- ---------- ----------

Reserves for loss and loss adjustment expense at
beginning of the year........................... $1,155,290 $1,130,748 $ 944,117
Less reinsurance recoverables..................... 697,972 817,651 694,245
---------- ---------- ----------
Net reserves at beginning of the year........... 457,318 313,097 249,872
Net reserve adjustments from acquisition and
disposition of subsidiaries..................... 5,587 79,558 285

Effects of changes in foreign currency rates of
exchange........................................ 20,892 -- --

Incurred loss and loss adjustment expense:
Provision for loss and loss adjustment expense
for claims occurring in the current year..... 464,886 313,270 278,103
Increase (decrease) in estimated loss and loss
adjustment expense for claims occurring in
prior years.................................. 23,766 (6,779) (10,713)
---------- ---------- ----------
Incurred loss and loss adjustment expense, net
of reinsurance............................... 488,652 306,491 267,390
---------- ---------- ----------
Loss and loss adjustment expense payments for
claims occurring during:
Current year.................................... 131,420 115,809 102,206
Prior years..................................... 135,829 126,019 102,244
---------- ---------- ----------
Loss and loss adjustment expense payments, net of
reinsurance..................................... 267,249 241,828 204,450
---------- ---------- ----------
Net reserves at end of the year................... 705,200 457,318 313,097
Plus reinsurance recoverables..................... 830,088 697,972 817,651
---------- ---------- ----------
RESERVES FOR LOSS AND LOSS ADJUSTMENT EXPENSE AT
END OF THE YEAR.............................. $1,535,288 $1,155,290 $1,130,748
========== ========== ==========

During 2003, we had net loss and loss adjustment expense deficiency of
$23.8 million relating to prior year losses compared to redundancies of $6.8
million in 2002 and $10.7 million in 2001. The 2003 deficiency resulted from a
commutation charge of $28.8 million related to certain accident and health
business included in discontinued lines offset by a net redundancy of $5.0
million from all other sources. The 2002 redundancy resulted from a deficiency
of $7.7 million due to a third quarter charge related to certain business
included in discontinued lines, offset by a net redundancy of $14.5 million from
all other sources. Deficiencies and redundancies in the reserves occur as we
continually review our loss reserves with our actuaries, increasing or reducing
loss reserves as a result of such reviews and as losses are finally settled and
claims exposures are reduced. We believe we have provided for all material net
incurred losses.

F-39

HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED, IN THOUSANDS, EXCEPT PER SHARE DATA)

covered, are not considered to have significant environmental exposures.
Therefore, we do not expect to experience any material loss development for
environmental pollution claims. Likewise, we have no material exposure to
asbestos claims.

(16) SUPPLEMENTAL INFORMATION

Supplemental cash flow information for the three years ended December 31,
2003 is summarized below:

2003 2002 2001
------- ------- -------

Interest paid........................................... $ 6,174 $ 4,900 $ 7,980
Income tax paid......................................... 70,573 22,642 28,411
Dividends declared but not paid at year end............. 4,800 4,061 3,848

The unrealized gain or loss on securities available for sale, deferred
taxes related thereto and the issuance of our common stock for the purchase of
subsidiaries are non-cash transactions which have been included as direct
increases or decreases in our shareholders' equity.

(17) QUARTERLY FINANCIAL DATA (UNAUDITED)

FOURTH QUARTER THIRD QUARTER SECOND QUARTER FIRST QUARTER
------------------- ------------------- ------------------- -------------------
2003 2002 2003 2002 2003 2002 2003 2002
-------- -------- -------- -------- -------- -------- -------- --------

Total revenue........ $257,839 $184,362 $246,313 $175,808 $237,868 $154,780 $199,944 $151,683
======== ======== ======== ======== ======== ======== ======== ========
Net earnings......... $ 50,460 $ 31,495 $ 36,366 $ 24,269 $ 32,968 $ 26,782 $ 23,767 $ 23,282
======== ======== ======== ======== ======== ======== ======== ========
BASIC EARNINGS PER
SHARE DATA:
Earnings per share... $ 0.79 $ 0.50 $ 0.57 $ 0.39 $ 0.52 $ 0.43 $ 0.38 $ 0.38
======== ======== ======== ======== ======== ======== ======== ========
Weighted average
shares
outstanding........ 63,875 62,387 63,717 62,335 62,867 62,236 62,637 61,936
======== ======== ======== ======== ======== ======== ======== ========
DILUTED EARNINGS PER
SHARE DATA:
Earnings per share... $ 0.77 $ 0.50 $ 0.56 $ 0.39 $ 0.52 $ 0.43 $ 0.38 $ 0.37
======== ======== ======== ======== ======== ======== ======== ========
Weighted average
shares
outstanding........ 65,110 63,109 64,885 62,871 63,990 62,889 63,335 62,713
======== ======== ======== ======== ======== ======== ======== ========

During the fourth quarter of 2003, we recorded a $30.1 million (net of
income tax) gain on sale of a subsidiary and an $18.7 million (net of income
tax) loss due to a commutation. As discussed in Note (3), in the fourth quarter
of 2003 we began reporting HCC Employee Benefits, Inc. as discontinued
operations and, as a result, revenue amounts disclosed above differ from amounts
previously reported in Form 10-Q/A for 2003. Included in the net earnings for
the first quarter of 2003 is a reduction of $3.9 million due to the prior years'
cumulative effect of a restatement related to our accounting for certain fee and
commission income, for which we filed Form 10-Q/As for the first three quarters
of 2003. The cumulative effect is not material to prior years or the full year
2003. During the third quarter of 2002, we recorded a $5.0 million (net of
income tax) charge to strengthen reserves related to certain business included
in discontinued lines. The sum of earnings per share for the quarters may not
equal the annual amounts due to rounding.

F-40

REPORT OF INDEPENDENT AUDITORS ON
FINANCIAL STATEMENT SCHEDULES

To the Board of Directors and Shareholders
HCC Insurance Holdings, Inc.:

Our audits of the consolidated financial statements of HCC Insurance
Holdings, Inc., referred to in our report dated March 10, 2004, which included
an emphasis paragraph related to a change in method of amortizing for goodwill,
effective January 1, 2002, appearing on page F-1 of this Form 10-K also included
an audit of the financial statements schedules listed in Item 15(a)(2) of this
Form 10-K. In our opinion, these financial statement schedules present fairly,
in all material respects, the information set forth therein when read in
conjunction with the related consolidated financial statements.

/s/ PRICEWATERHOUSECOOPERS LLP

Houston, Texas
March 10, 2004

S-1

SCHEDULE 1
HCC INSURANCE HOLDINGS, INC.

SUMMARY OF INVESTMENTS
OTHER THAN INVESTMENTS IN RELATED PARTIES
(IN THOUSANDS)

DECEMBER 31, 2003
------------------------------------------------------------------------------------------------
COLUMN A COLUMN B COLUMN C COLUMN D
----------------------------------------------------- ---------- ---------- --------------
AMOUNT AT
WHICH SHOWN IN
THE BALANCE
TYPE OF INVESTMENT COST VALUE SHEET
----------------------------------------------------- ---------- ---------- --------------

Fixed maturities:
Bonds -- United States government and government
agencies and authorities........................ $ 67,125 $ 69,140 $ 69,140
Bonds -- states, municipalities and political
subdivisions.................................... 97,182 102,048 102,048
Bonds -- special revenue........................... 295,413 305,301 305,301
Bonds -- corporate................................. 324,914 334,825 334,825
Asset-backed and mortgage-backed securities........ 149,612 152,759 152,759
Bonds -- foreign government........................ 199,882 200,093 200,093
---------- ---------- ----------
Total fixed maturities.......................... 1,134,128 $1,164,166 1,164,166
---------- ========== ----------
Equity securities:
Common stocks -- banks, trusts and insurance
companies....................................... 10,974 $ 10,994 10,994
Common stocks -- industrial, miscellaneous and all
other
Non-redeemable preferred stocks.................... 1,033 1,008 1,008
---------- ---------- ----------
Total equity securities......................... 12,007 $ 12,002 12,002
---------- ========== ----------
Short-term investments............................... 518,482 518,482
Other investments.................................... 8,696 8,696
---------- ----------
TOTAL INVESTMENTS............................... $1,673,313 $1,703,346
========== ==========

S-2

SCHEDULE 2

HCC INSURANCE HOLDINGS, INC.

CONDENSED FINANCIAL INFORMATION OF REGISTRANT
BALANCE SHEETS
(IN THOUSANDS)

DECEMBER 31,
-----------------------
2003 2002
---------- ----------

ASSETS
Cash........................................................ $ 602 $ 56
Short-term investments...................................... 60,823 4,837
Investment in subsidiaries.................................. 1,098,192 915,213
Receivable from subsidiaries................................ 28,141 14,133
Intercompany loans to subsidiaries for acquisitions......... 180,546 190,187
Other assets................................................ 3,827 1,581
---------- ----------
TOTAL ASSETS.............................................. $1,372,131 $1,126,007
========== ==========

LIABILITIES AND SHAREHOLDERS' EQUITY
Notes payable............................................... $ 297,451 $ 225,629
Note payable to related party............................... -- 825
Deferred Federal income tax................................. 7,480 7,129
Accounts payable and accrued liabilities.................... 20,280 9,517
---------- ----------
Total liabilities......................................... 325,211 243,100
Total shareholders' equity................................ 1,046,920 882,907
---------- ----------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY................ $1,372,131 $1,126,007
========== ==========

See Notes to Condensed Financial Information.
S-3

SCHEDULE 2

HCC INSURANCE HOLDINGS, INC.

CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF EARNINGS
(IN THOUSANDS)

FOR THE YEARS ENDED DECEMBER 31,
--------------------------------
2003 2002 2001
--------- --------- --------

Equity in earnings of subsidiaries.......................... $142,853 $108,833 $37,439
Interest income from subsidiaries........................... 6,827 7,277 5,019
Interest income............................................. 953 171 764
Other income................................................ 2,481 10 13
-------- -------- -------
Total revenue............................................. 153,114 116,291 43,235
Interest expense............................................ 6,296 7,880 8,737
Other operating expense..................................... 1,781 2,290 1,600
-------- -------- -------
Total expense............................................. 8,077 10,170 10,337
-------- -------- -------
Earnings before income tax provision...................... 145,037 106,121 32,898
Income tax provision........................................ 1,476 293 2,701
-------- -------- -------
NET EARNINGS.............................................. $143,561 $105,828 $30,197
======== ======== =======

See Notes to Condensed Financial Information.
S-4

SCHEDULE 2

HCC INSURANCE HOLDINGS, INC.

CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF COMPREHENSIVE INCOME
(IN THOUSANDS)

FOR THE YEARS ENDED DECEMBER 31,
--------------------------------
2003 2002 2001
--------- --------- --------

Net earnings................................................ $143,561 $105,828 $30,197
Other comprehensive income, net of tax:
Foreign currency translation adjustment..................... 8,149 50 (279)
Investment gains (losses):
Consolidated subsidiaries' investment gains (losses)
during the year, net of deferred tax charge (benefit)
of $(1,048) in 2003, $8,040 in 2002 and $1,137 in
2001................................................... (1,962) 14,533 2,297
Less consolidated subsidiaries' reclassification
adjustments for gains included in net earnings, net of
deferred tax charge of $184 in 2003, $159 in 2002 and
$138 in 2001........................................... (343) (294) (255)
Other, net of income tax charge (benefit) of $(260) in 2003,
$(13) in 2002 and $13 in 2001............................. (483) (24) 24
-------- -------- -------
Other comprehensive income.................................. 5,361 14,265 1,787
-------- -------- -------
COMPREHENSIVE INCOME...................................... $148,922 $120,093 $31,984
======== ======== =======

See Notes to Condensed Financial Information.
S-5

SCHEDULE 2

HCC INSURANCE HOLDINGS, INC.

CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF CASH FLOWS
(IN THOUSANDS)

FOR THE YEARS ENDED DECEMBER 31,
----------------------------------
2003 2002 2001
--------- --------- ----------

Cash flows from operating activities:
Net earnings.............................................. $143,561 $105,828 $ 30,197
Adjustment to reconcile net earnings to net cash provided
by operating activities:
Undistributed net income of subsidiaries.................. (120,953) (74,864) (20,184)
Amortization and depreciation............................. 841 3,279 2,586
Increase in accrued interest receivable added to
intercompany loan balances............................. (6,317) (7,277) (835)
Change in accounts payable and accrued liabilities........ 10,022 (2,663) 1,181
Tax benefit from exercise of stock options................ 4,320 4,030 12,312
Other, net................................................ (19) 2,088 2,000
-------- -------- ---------
Cash provided by operating activities.................. 31,455 30,421 27,257
Cash flows from investing activities:
Cash contributions to subsidiaries........................ (51,364) (69,007) (84,151)
Purchase of subsidiaries.................................. (11,624) (24,593) (96,405)
Change in short-term investments.......................... (55,986) (3,340) 1,991
Change in receivable from subsidiaries.................... (14,008) (1,379) (11,317)
Intercompany loans to subsidiaries for acquisitions....... (26,838) (16,806) (1,275)
Payments on intercompany loans to subsidiaries............ 54,674 31,964 34,674
-------- -------- ---------
Cash used by investing activities...................... (105,146) (83,161) (156,483)
Cash flows from financing activities:
Proceeds from note payable, net of costs.................. 178,000 76,000 175,401
Payments on notes payable................................. (107,003) (27,467) (216,523)
Sale of common stock...................................... 20,279 11,207 192,831
Dividends paid............................................ (17,039) (15,663) (13,822)
-------- -------- ---------
Cash provided by financing activities.................. 74,237 44,077 137,887
-------- -------- ---------
Net change in cash..................................... 546 (8,663) 8,661
Cash as of beginning of year........................... 56 8,719 58
-------- -------- ---------
CASH AS OF END OF YEAR................................. $ 602 $ 56 $ 8,719
======== ======== =========

See Notes to Condensed Financial Information.
S-6

HCC INSURANCE HOLDINGS, INC.

CONDENSED FINANCIAL INFORMATION OF REGISTRANT
NOTES TO CONDENSED FINANCIAL INFORMATION

(1) The accompanying condensed financial information should be read in
conjunction with the consolidated financial statements and the related notes
thereto of HCC Insurance Holdings, Inc. and Subsidiaries. Investments in
subsidiaries are accounted for using the equity method. Certain amounts in
the 2002 and 2001 condensed financial information have been reclassified to
conform with the 2003 presentation. Such reclassifications had no effect on
our shareholders' equity, net earnings or cash flows.

(2) Intercompany loans to subsidiaries are demand notes issued primarily to fund
the cash portion of acquisitions. They bear interest at a rate set by
management, which approximates the interest rate charged to us for similar
debt. As of December 31, 2003, the interest rate on intercompany loans was
5.0%.

(3) Other income for 2003 includes a one-time foreign currency transaction gain
of $1.3 million in settlement of an advance to an unaffiliated entity and
income from our strategic investment in Argonaut Group, Inc.

S-7

SCHEDULE 3

HCC INSURANCE HOLDINGS, INC.

SUPPLEMENTARY INSURANCE INFORMATION
(IN THOUSANDS)

COLUMN A COLUMN B COLUMN C COLUMN D COLUMN F COLUMN G COLUMN H
------------------------------ ----------- ----------------- -------- -------- ---------- -----------------
(1) (1) (2)
DECEMBER 31, FOR THE YEARS ENDED DECEMBER 31,
------------------------------------------ -----------------------------------------
DEFERRED FUTURE POLICY BENEFITS, CLAIMS,
POLICY BENEFITS, LOSSES, NET LOSSES AND
ACQUISITION CLAIMS AND UNEARNED PREMIUM INVESTMENT SETTLEMENT
SEGMENTS COSTS LOSS EXPENSES PREMIUMS REVENUE INCOME EXPENSES
------------------------------ ----------- ----------------- -------- -------- ---------- -----------------

2003
Insurance Company............. $18,814 $1,612,836 $592,311 $738,272 $42,345 $488,652
Underwriting Agency........... 2,991
Intermediary.................. 817
Other Operations.............. 224
Corporate..................... 970
Less discontinued
operations.................. (12)
------- ---------- -------- -------- ------- --------
Total....................... $18,814 $1,612,836 $592,311 $738,272 $47,335 $488,652
======= ========== ======== ======== ======= ========
2002
Insurance Company............. $18,883 $1,234,241 $331,050 $505,521 $33,587 $306,491
Underwriting Agency........... 2,954
Intermediary.................. 993
Other Operations.............. 41
Corporate..................... 194
Less discontinued
operations.................. (14)
------- ---------- -------- -------- ------- --------
Total....................... $18,883 $1,234,241 $331,050 $505,521 $37,755 $306,491
======= ========== ======== ======== ======= ========
2001
Insurance Company............. $15,390 $1,213,761 $179,530 $342,787 $30,766 $267,390
Underwriting Agency........... 5,202
Intermediary.................. 2,771
Other Operations.............. 85
Corporate..................... 814
Less discontinued
operations.................. (76)
------- ---------- -------- -------- ------- --------
Total....................... $15,390 $1,213,761 $179,530 $342,787 $39,562 $267,390
======= ========== ======== ======== ======= ========

COLUMN A COLUMN I COLUMN J COLUMN K
------------------------------ ----------------- --------- --------
(3)
FOR THE YEARS ENDED DECEMBER 31,
----------------------------------------

AMORTIZATION OF OTHER
DEFERRED POLICY OPERATING PREMIUM
SEGMENTS ACQUISITION COSTS EXPENSES WRITTEN
------------------------------ ----------------- --------- --------

2003
Insurance Company............. $138,212 $ 55,432 $865,502
Underwriting Agency........... 57,443
Intermediary.................. 31,034
Other Operations.............. 2,242
Corporate..................... 7,548
Less discontinued
operations.................. (12,786)
-------- -------- --------
Total....................... $138,212 $140,913 $865,502
======== ======== ========
2002
Insurance Company............. $ 99,521 $ 40,008 $545,911
Underwriting Agency........... 46,551
Intermediary.................. 26,857
Other Operations.............. 256
Corporate..................... (2,432)
Less discontinued
operations.................. (11,316)
-------- -------- --------
Total....................... $ 99,521 $ 99,924 $545,911
======== ======== ========
2001
Insurance Company............. $ 66,313 $ 53,250 $372,958
Underwriting Agency........... 37,577
Intermediary.................. 31,409
Other Operations.............. 5,995
Corporate..................... (1,539)
Less discontinued
operations.................. (12,886)
-------- -------- --------
Total....................... $ 66,313 $113,806 $372,958
======== ======== ========

---------------

(1) Columns C and D are shown ignoring the effects of reinsurance.

(2) Net investment income was allocated to the subsidiary, and therefore the
segment, on which the related investment asset was recorded.

(3) Other operating expenses is after all corporate expense allocations and
amortization of goodwill have been charged or credited to the individual
segments.

Note: Column E is omitted because we have no other policy claims and benefits
payable.

S-8

SCHEDULE 4

HCC INSURANCE HOLDINGS, INC.

REINSURANCE
(IN THOUSANDS)

COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F
------------------------------------- ------------- -------------- ------------ ---------- --------------
ASSUMED FROM PERCENT OF
CEDED TO OTHER OTHER AMOUNT
DIRECT AMOUNT COMPANIES COMPANIES NET AMOUNT ASSUMED TO NET
------------- -------------- ------------ ---------- --------------

For the year ended December 31, 2003:
Life insurance in force.............. $1,443,611 $481,870 $ -- $961,741 --%
========== ======== ======== ======== ==
Earned premium:
Property and liability insurance..... $ 651,893 $454,294 $205,165 $402,764 51%
Accident and health insurance........ 537,463 294,505 92,550 335,508 28
---------- -------- -------- --------
Total.............................. $1,189,356 $748,799 $297,715 $738,272 40%
========== ======== ======== ======== ==
For the year ended December 31, 2002:
Life insurance in force.............. $1,021,600 $529,874 $ -- $491,726 --%
========== ======== ======== ======== ==
Earned premium:
Property and liability insurance..... $ 293,614 $222,906 $133,736 $204,444 65%
Accident and health insurance........ 508,237 302,711 95,551 301,077 32%
---------- -------- -------- --------
Total.............................. $ 801,851 $525,617 $229,287 $505,521 45%
========== ======== ======== ======== ==
For the year ended December 31, 2001:
Life insurance in force.............. $ 597,886 $597,310 $ -- $ 576 --%
========== ======== ======== ======== ==
Earned premium:
Property and liability insurance..... $ 284,488 $229,791 $ 95,342 $150,039 64%
Accident and health insurance........ 505,405 435,549 122,892 192,748 64%
---------- -------- -------- --------
Total.............................. $ 789,893 $665,340 $218,234 $342,787 64%
========== ======== ======== ======== ==

S-9

SCHEDULE 5

HCC INSURANCE HOLDINGS, INC.

VALUATION AND QUALIFYING ACCOUNTS
(IN THOUSANDS)

2003 2002 2001
------- ------- -------

Reserve for uncollectible reinsurance:
Balance as of beginning of year........................... $ 7,142 $ 5,176 $ 4,057
Provision charged to expense.............................. 7,671 5,530 1,119
Amounts (written off) recovered........................... 178 (3,564) --
------- ------- -------
BALANCE AS OF END OF YEAR.............................. $14,991 $ 7,142 $ 5,176
======= ======= =======
Allowance for doubtful accounts:
Balance as of beginning of year........................... $ 2,279 $ 2,779 $ 3,325
Acquisitions of subsidiaries.............................. 13 455 453
Provision charged to expense.............................. 167 487 2,366
Amounts (written off) recovered........................... 90 (1,442) (3,365)
------- ------- -------
BALANCE AS OF END OF YEAR.............................. $ 2,549 $ 2,279 $ 2,779
======= ======= =======

S-10