UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

þ		Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the Quarter Ended March 31, 2006.

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

Commission file number    001-13790

HCC Insurance Holdings, Inc.

(Exact name of registrant as specified in its charter)

Delaware		76-0336636
(State or other jurisdiction of            incorporation or organization)		(IRS Employer                     Identification No.)
13403 Northwest Freeway, Houston, Texas		77040-6094
(Address of principal executive offices)		(Zip Code)
(713) 690-7300
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.

Yes þ No o

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

Large accelerated filer þ       Accelerated filer o       Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o       No þ

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

On April 30, 2006, there were approximately 111.2 million shares of common stock, $1.00 par value issued and outstanding.

 

 

	•		the ability or willingness of reinsurers to pay balances due us;
	•		the occurrence of terrorist activities;
	•		our ability to maintain our competitive position;
	•		changes in our assigned financial strength ratings;
	•		our ability to raise capital in the future;
	•		attraction and retention of qualified employees;
	•		fluctuations in the fixed income securities market, which may reduce the value of our investment assets;
	•		our ability to successfully expand our business through the acquisition of insurance-related companies;
	•		our ability to receive dividends from our insurance company subsidiaries in needed amounts;
	•		fluctuations in foreign exchange rates; and
	•		failures of our information technology systems, which could adversely affect our business.

These events or factors could cause our results or performance to differ materially from those we express in our forward-looking statements. Although we believe that the assumptions underlying our forward-looking statements are reasonable, any of these assumptions, and, therefore, also the forward-looking statements based on these assumptions, could themselves prove to be inaccurate. In light of the significant uncertainties inherent in the forward-looking statements 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 at the date made and we will not update these forward-looking statements unless the securities laws require us to do so. In light of these risks, uncertainties and assumptions, any forward-looking events discussed in this report may not occur.

HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

(unaudited, in thousands, except per share data)

		March 31,				December 31,
		2006				2005
ASSETS
Investments:
Fixed income securities, at fair value (amortized cost: 2006 - $2,573,727; 2005 - $2,277,139)		$	2,541,316			$	2,268,624
Short-term investments, at cost, which approximates fair value			592,831				839,581
Other investments, at fair value (cost: 2006 - $216,020; 2005 - $144,897)			230,187				149,223
Total investments			3,364,334				3,257,428
Cash			51,111				73,935
Restricted cash and cash investments			182,568				170,978
Premium, claims and other receivables			855,880				884,654
Reinsurance recoverables			1,349,351				1,360,483
Ceded unearned premium			239,530				239,416
Ceded life and annuity benefits			73,213				73,415
Deferred policy acquisition costs			161,329				156,253
Goodwill			531,286				532,947
Other assets			297,716				276,557
Total assets		$	7,106,318			$	7,026,066
LIABILITIES
Loss and loss adjustment expense payable		$	2,837,495			$	2,813,720
Life and annuity policy benefits			73,213				73,415
Reinsurance balances payable			149,897				176,954
Unearned premium			825,375				807,109
Deferred ceding commissions			66,900				65,702
Premium and claims payable			735,131				753,859
Notes payable			309,426				309,543
Accounts payable and accrued liabilities			350,578				332,068
Total liabilities			5,348,015				5,332,370
SHAREHOLDERS’ EQUITY
Common stock, $1.00 par value; 250.0 million shares authorized (shares issued and outstanding: 2006 – 111,173; 2005 – 110,803)			111,173				110,803
Additional paid-in capital			757,850				747,568
Retained earnings			887,226				817,013
Accumulated other comprehensive income			2,054				18,312
Total shareholders’ equity			1,758,303				1,693,696
Total liabilities and shareholders’ equity		$	7,106,318			$	7,026,066

See Notes to Condensed Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Statements of Earnings

(unaudited, in thousands, except per share data)

		Three months ended March 31,
		2006				2005
REVENUE
Net earned premium		$	380,571			$	320,117
Fee and commission income			31,468				33,076
Net investment income			36,581				22,341
Net realized investment loss			(1,298	)			(3	)
Other operating income			18,750				4,147
Total revenue			466,072				379,678
EXPENSE
Loss and loss adjustment expense, net			220,567				186,063
Policy acquisition costs, net			78,215				59,357
Other operating expense			46,803				45,949
Interest expense			2,154				1,808
Total expense			347,739				293,177
Earnings before income tax expense			118,333				86,501
Income tax expense			39,782				29,183
Net earnings		$	78,551			$	57,318
Basic earnings per share data:
Net earnings per share		$	0.71			$	0.56
Weighted average shares outstanding			111,014				103,241
Diluted earnings per share data:
Net earnings per share		$	0.67			$	0.54
Weighted average shares outstanding			116,896				105,734
Cash dividends declared, per share		$	0.075			$	0.057

See Notes to Condensed Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Statement of Changes in Shareholders’ Equity

Three months ended March 31, 2006

(unaudited, in thousands, except per share data)

														Accumulated
						Additional								other				Total
		Common				paid-in				Retained				comprehensive				shareholders’
		stock				capital				earnings				income				equity
Balance at December 31, 2005		$	110,803			$	747,568			$	817,013			$	18,312			$	1,693,696
Net earnings			—				—				78,551				—				78,551
Other comprehensive loss			—				—				—				(16,258	)			(16,258	)
Comprehensive income																			62,293
Issuance of 370 shares for exercise of options, including tax benefit of $1,904			370				7,422				—				—				7,792
Stock-based compensation			—				2,860				—				—				2,860
Cash dividends declared, $0.075 per share			—				—				(8,338	)			—				(8,338	)
Balance at March 31, 2006		$	111,173			$	757,850			$	887,226			$	2,054			$	1,758,303

See Notes to Condensed Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(unaudited, in thousands)

		Three months ended March 31,
		2006				2005
Cash flows from operating activities:
Net earnings		$	78,551			$	57,318
Adjustments to reconcile net earnings to net cash provided by operating activities:
Change in premium, claims and other receivables			44,362				(133,768	)
Change in reinsurance recoverables			11,132				(824	)
Change in ceded unearned premium			(114	)			52,300
Change in loss and loss adjustment expense payable			23,775				49,939
Change in reinsurance balances payable			(27,057	)			(29,842	)
Change in unearned premium			18,266				(16,842	)
Change in premium and claims payable, net of restricted cash			(30,318	)			99,875
Change in trading portfolio			(47,994	)			(41,328	)
Depreciation and amortization expense			3,825				3,710
Other, net			3,509				(6,629	)
Cash provided by operating activities			77,937				33,909
Cash flows from investing activities:
Sales of fixed income securities			65,654				55,681
Maturity or call of fixed income securities			59,226				32,250
Cost of securities acquired			(471,614	)			(277,000	)
Change in short-term investments			246,750				145,025
Sale of strategic investment			17,363				—
Earnout payment for purchase of subsidiary			(24,000	)			—
Other, net			(2,047	)			(1,118	)
Cash used by investing activities			(108,668	)			(45,162	)
Cash flows from financing activities:
Issuance of notes payable			11,000				—
Payments on notes payable			(11,107	)			(93	)
Sale of common stock			7,792				21,087
Dividends paid			(8,310	)			(5,783	)
Other			8,532				(3,814	)
Cash provided by financing activities			7,907				11,397
Net increase (decrease) in cash			(22,824	)			144
Cash at beginning of period			73,935				69,933
Cash at end of period		$	51,111			$	70,077

See Notes to Condensed Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands, except per share data)

(1)		GENERAL INFORMATION
		HCC Insurance Holdings, Inc. and its subsidiaries (collectively, we, us or our) include domestic and foreign property and casualty and life insurance companies, underwriting agencies and reinsurance brokers. We provide specialized property and casualty, surety, and group life, accident and health insurance coverages and related agency and reinsurance brokerage services to commercial customers and individuals. We market our products both directly to customers and through a network of independent brokers, producers and agents. Our lines of business include diversified financial products (which includes directors’ and officers’ liability, professional indemnity, employment practices liability and surety); group life, accident and health; aviation; London market account (which includes energy, marine, property, and accident and health); and other specialty lines of insurance. We operate primarily in the United States, the United Kingdom, Spain, Bermuda and Ireland, although some of our operations have a broader international scope.
		Basis of Presentation
		Our unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (generally accepted accounting principles) and include the accounts of HCC Insurance Holdings, Inc. and its subsidiaries. We have made all adjustments that, in our opinion, are necessary for a fair presentation of results of the interim periods, and all such adjustments are of a normal recurring nature. All significant intercompany balances and transactions have been eliminated in consolidation. The condensed consolidated financial statements should be read in conjunction with our annual audited consolidated financial statements and related notes. The condensed consolidated balance sheet at December 31, 2005 was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles.
		Management must make estimates and assumptions that affect amounts reported in our financial statements and in disclosures of contingent assets and liabilities. Ultimate results could differ from those estimates. We have reclassified certain amounts in our 2005 condensed consolidated financial statements to conform to the 2006 presentation. The reclassifications included the elimination of certain intercompany premium receivable and premium payable balances and reclassification of the corresponding lines in our 2005 condensed statement of cash flows. None of our reclassifications had an effect on our consolidated net earnings, shareholders’ equity or cash flows.
		During 2005, we completed several acquisitions. The results of operations of the acquired entities are included in our condensed consolidated financial statements beginning on the effective date of each acquisition. Thus, our condensed consolidated statements of earnings and cash flows for the three months ended March 31, 2005 do not contain any operations of the entities acquired in 2005 prior to their acquisition date.
		Income Tax
		For the three months ended March 31, 2006 and 2005, the income tax provision was calculated based on an estimated effective tax rate for each fiscal year. Our effective tax rate differs from the United States Federal statutory rate primarily due to tax-exempt municipal bond interest and state income taxes.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands, except per share data)

(2)		STOCK OPTIONS
		Our stock option plans, the 2004 Flexible Incentive Plan and 2001 Flexible Incentive Plan, are administered by the Compensation Committee of the Board of Directors. Options granted under these plans may be used to purchase one share of our common stock. All options are granted at fixed exercise prices at the market price of our common stock on the grant date and no options have been repriced. Options vest over a period of up to seven years, which is the requisite service period, and expire four to ten years after grant date.
		Statement of Financial Accounting Standards (SFAS) No. 123(R), Share-Based Payment, requires companies to charge the fair value of stock-based compensation to earnings. Effective January 1, 2006, we adopted SFAS 123(R) using the modified prospective method. Compensation expense will be recognized in 2006 and thereafter based on our unvested stock options granted before January 1, 2006 and all options granted after that date. The 2005 and prior period financial statements were not restated. We will use the Black-Scholes single option pricing model to determine the fair value of an option on its grant date and will expense that value on a straight-line basis over the option’s vesting period. We made no modifications to our stock option plans in conjunction with our adoption of SFAS 123(R). In 2005, we accounted for stock options granted to employees in accordance with Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and no stock-based compensation expense was recorded.
		In the first quarter of 2006, we expensed $2.3 million ($1.7 million after tax or $0.01 per diluted share) of stock-based compensation, after the effect of the deferral and amortization of related policy acquisition costs. At March 31, 2006, there was approximately $33.6 million of total unrecognized compensation expense related to unvested options that is expected to be recognized over a weighted-average period of three years. In 2006, we expect to recognize $10.4 million of expense, including the amortization of deferred policy acquisition costs, related to stock-based compensation for options currently outstanding.
		The table below shows the weighted-average fair value of options granted and the related weighted-average assumptions used in the Black-Scholes model. The risk-free interest rate is based on the U.S. Treasury rate that most closely approximates each option’s expected term. We based our expected volatility on the historical volatility of our stock over a period matching each option’s expected term. Our dividend yield is based on an average of our historical dividend payments divided by the stock price. We used historical exercise patterns by grant type to estimate the expected option life.

		Three months ended March 31,
		2006				2005
Fair value of options granted		$	6.65			$	7.09
Risk free interest rate			4.5	%			3.8	%
Expected volatility			22	%			32	%
Expected dividend yield			1.0	%			1.0	%
Expected option life		3.5 years				4.9 years

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands, except per share data)

The following table details our stock option activity during the three months ended March 31, 2006.

						Weighted-				Weighted-
						average				average				Aggregate
		Number				exercise				contractual				intrinsic
		of shares				price				life				value
Outstanding, beginning of year			8,219			$	20.71
Granted at market value			463				31.64
Exercised			(373	)			15.87
Forfeited and expired			(106	)			20.58
Outstanding, end of period			8,203				21.55			4.3 years				$	108,701
Exercisable, end of period			1,660				17.36			3.0 years					28,953

		The aggregate intrinsic value (the amount by which the fair value of the underlying stock exceeds the exercise price) of options exercised during the first quarter of 2006 and 2005 was $6.0 million and $13.8 million, respectively. At March 31, 2006, 12.1 million shares of our common stock were authorized and reserved for the exercise of options, of which 8.2 million shares were reserved for options previously granted and 3.9 million shares were reserved for future issuance.
		Exercise of options during the first quarter of 2006 and 2005 resulted in cash receipts of $5.9 million and $21.1 million, respectively. We generally recognize a tax benefit when our employees exercise options. SFAS 123(R) requires that we report the tax benefit related to the excess of the tax deductible amount over the recognized compensation expense as financing cash flow, rather than as operating cash flow under APB 25. We recorded a $1.9 million benefit as financing cash flow in the first quarter of 2006 and $4.9 million as operating cash flow in the first quarter of 2005.
		Prior to adoption of SFAS 123(R), we were required to disclose the effect on net earnings and earnings per share if we had used the fair value method of SFAS No. 123, Accounting for Stock-Based Compensation, to value stock options. The effect on our consolidated financial results in the first quarter of 2005 if we had valued our options using the fair value method under SFAS 123 and the assumptions listed above for the three months ended March 31, 2005 is as follows:

Reported net earnings		$	57,318
Stock-based compensation using fair value method, net of income taxes			(1,277	)
Pro forma net earnings		$	56,041
Reported basic earnings per share		$	0.56
Fair value stock-based compensation			(0.02	)
Pro forma basic earnings per share		$	0.54
Reported diluted earnings per share		$	0.54
Fair value stock-based compensation			(0.01	)
Pro forma diluted earnings per share		$	0.53

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands, except per share data)

(3)		REINSURANCE
		In the normal course of business, our insurance companies cede a portion of their premium to domestic and foreign reinsurers through treaty and facultative reinsurance agreements. Although ceding for reinsurance purposes does not discharge the primary insurer from liability to its policyholder, our insurance companies participate in such agreements in order to limit their loss exposure, protect them against catastrophic loss and diversify their business. The following table presents the effect of such reinsurance transactions on our premium and loss and loss adjustment expense.

										Loss and loss
		Written				Earned				adjustment
		premium				premium				expense
Three months ended March 31, 2006
Primary business		$	410,191			$	422,510			$	227,250
Reinsurance assumed			95,867				70,880				45,791
Reinsurance ceded			(113,007	)			(112,819	)			(52,474	)
Net amounts		$	393,051			$	380,571			$	220,567
Three months ended March 31, 2005
Primary business		$	398,281			$	412,095			$	221,534
Reinsurance assumed			76,838				72,580				48,506
Reinsurance ceded			(117,767	)			(164,558	)			(83,977	)
Net amounts		$	357,352			$	320,117			$	186,063

		Ceding commissions netted with policy acquisition costs in the condensed consolidated statements of earnings were $10.0 million in 2006 and $30.7 million in 2005.
		The table below shows the components of reinsurance recoverables in our condensed consolidated balance sheets.

		March 31,				December 31,
		2006				2005
Reinsurance recoverable on paid losses		$	102,200			$	93,837
Reinsurance recoverable on outstanding losses			730,451				634,725
Reinsurance recoverable on incurred but not reported losses			527,012				644,062
Reserve for uncollectible reinsurance			(10,312	)			(12,141	)
Total reinsurance recoverables		$	1,349,351			$	1,360,483

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands, except per share data)

		Our reserve for uncollectible reinsurance covers potential collectibility issues, including disputed amounts and associated expenses. While we believe the reserve is adequate based on information currently available, conditions may change or additional information might be obtained which may require us to change the reserve in the future. 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.
		We limit the liquidity exposure related to our reinsurance recoverables by holding funds, letters of credit or other security, such that net balances due are significantly less than the gross balances shown in our condensed consolidated balance sheets. Additionally, our U.S. domiciled insurance companies require their reinsurers not authorized by the respective states of domicile of our insurance companies to collateralize their reinsurance obligations due to us. The table below shows the amounts of letters of credit and cash deposits held by us as collateral, plus other credits available for potential offset.

		March 31,				December 31,
		2006				2005
Payables to reinsurers		$	293,480			$	291,826
Letters of credit			348,292				350,135
Cash deposits			58,025				64,150
Total credits		$	699,797			$	706,111

The tables below present the calculation of net reserves, net unearned premium and net deferred policy acquisition costs.

		March 31,				December 31,
		2006				2005
Loss and loss adjustment expense payable		$	2,837,495			$	2,813,720
Reinsurance recoverable on outstanding losses			(730,451	)			(634,725	)
Reinsurance recoverable on incurred but not reported losses			(527,012	)			(644,062	)
Net reserves		$	1,580,032			$	1,534,933
Unearned premium		$	825,375			$	807,109
Ceded unearned premium			(239,530	)			(239,416	)
Net unearned premium		$	585,845			$	567,693
Deferred policy acquisition costs		$	161,329			$	156,253
Deferred ceding commissions			(66,900	)			(65,702	)
Net deferred policy acquisition costs		$	94,429			$	90,551

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands, except per share data)

(4)		EARNINGS PER SHARE
		The following table details the numerator and denominator used in the earnings per share calculations.

		Three months ended March 31,
		2006				2005
Net earnings		$	78,551			$	57,318
Weighted average common shares outstanding			111,014				103,241
Dilutive effect of outstanding options (determined using the treasury stock method)			1,528				1,589
Dilutive effect of convertible debt (determined using the treasury stock method)			4,354				904
Weighted average common shares and potential common shares outstanding			116,896				105,734
Anti-dilutive stock options not included in treasury stock method computation			2,563				26

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands, except per share data)

(5)		SEGMENT AND GEOGRAPHIC INFORMATION
		The performance of each segment is evaluated by our management based on net earnings. Net earnings is calculated after tax and after all corporate expense allocations, 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, 2005, we consolidated our largest underwriting agency (agency segment) into HCC Life Insurance Company (insurance company segment).

		Insurance								Other
		Company				Agency				Operations				Corporate				Total
Three months ended March 31, 2006
Revenue:
Domestic		$	343,487			$	14,769			$	19,781			$	1,177			$	379,214
Foreign			76,849				10,009				—				—				86,858
Inter-segment			6				17,958				—				—				17,964
Total segment revenue		$	420,342			$	42,736			$	19,781			$	1,177				484,036
Inter-segment eliminations																			(17,964	)
Consolidated total revenue																		$	466,072
Net earnings (loss):
Domestic		$	49,018			$	4,825			$	12,989			$	(1,937	)		$	64,895
Foreign			9,801				3,569				—				—				13,370
Total segment net earnings (loss)		$	58,819			$	8,394			$	12,989			$	(1,937	)			78,265
Inter-segment eliminations																			286
Consolidated net earnings																		$	78,551
Other items:
Net investment income		$	32,007			$	2,296			$	1,635			$	643			$	36,581
Depreciation and amortization			1,138				2,013				127				547				3,825
Interest expense (benefit)			375				2,846				114				(1,181	)			2,154
Capital expenditures			461				815				438				1,366				3,080
Income tax expense (benefit)			27,430				6,383				6,141				(470	)			39,484
Inter-segment eliminations																			298
Consolidated income tax expense																		$	39,782

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands, except per share data)

		Insurance								Other
		Company				Agency				Operations				Corporate				Total
Three months ended March 31, 2005
Revenue:
Domestic		$	284,643			$	12,762			$	1,906			$	579			$	299,890
Foreign			68,837				10,951				—				—				79,788
Inter-segment			96				21,529				—				—				21,625
Total segment revenue		$	353,576			$	45,242			$	1,906			$	579				401,303
Inter-segment eliminations																			(21,625	)
Consolidated total revenue																		$	379,678
Net earnings (loss):
Domestic		$	36,817			$	7,044			$	1,091			$	(3,391	)		$	41,561
Foreign			11,647				1,973				—				—				13,620
Total segment net earnings (loss)		$	48,464			$	9,017			$	1,091			$	(3,391	)			55,181
Inter-segment eliminations																			2,137
Consolidated net earnings																		$	57,318
Other items:
Net investment income		$	20,076			$	1,356			$	539			$	370			$	22,341
Depreciation and amortization			1,207				1,925				126				452				3,710
Interest expense (benefit)			61				2,030				189				(472	)			1,808
Capital expenditures			598				590				—				402				1,590
Income tax expense			21,161				6,010				224				477				27,872
Inter-segment eliminations																			1,311
Consolidated income tax expense																		$	29,183

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands, except per share data)

The following tables present selected revenue items by line of business.

		Three months ended March 31,
		2006				2005
Diversified financial products		$	169,112			$	106,851
Group life, accident and health			127,761				128,945
Aviation			33,197				33,817
London market account			21,928				26,711
Other specialty lines			28,640				21,225
Discontinued lines			(67	)			2,568
Net earned premium		$	380,571			$	320,117
Property and casualty		$	25,206			$	27,519
Accident and health			6,262				5,557
Fee and commission income		$	31,468			$	33,076

(6)		SUPPLEMENTAL INFORMATION
		Supplemental cash flow information was as follows.

		Three months ended March 31,
		2006				2005
Cash received from commutations		$	—			$	32,635
Income taxes paid			16,038				13,886
Interest paid			2,935				2,106
Comprehensive income			62,293				39,705

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(unaudited, tables in thousands, except per share data)

(7)		COMMITMENTS AND CONTINGENCIES
		Litigation
		We are party to lawsuits, arbitrations and other proceedings that arise in the normal course of our business. Many of such lawsuits, arbitrations and other proceedings involve claims under policies that we underwrite as an insurer or reinsurer, the liabilities for which, we believe, have been adequately included in our loss reserves. Also, from time to time, we are a party to lawsuits, arbitrations and other proceedings that relate to disputes over contractual relationships with third parties, or that involve alleged errors and omissions on the part of our subsidiaries. We have provided accruals for these items to the extent we deem the losses probable and reasonably estimable.
		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 appointment of the liquidator. The disputed payments, totaling $10.3 million, were made by the now insolvent reinsurer in connection with a commutation agreement. Our understanding is that such litigation is similar to other actions brought by the liquidator. We continue to vigorously contest the action.
		In April 2006, we were named as a defendant in a complaint related to insurance marketing and producer compensation practices. The lawsuit was filed in Federal District Court in Georgia by a number of corporate plaintiffs against approximately 100 insurance entity defendants. The complaint alleges violations of Federal antitrust law, the Racketeer Influenced and Corrupt Organizations Act and various state anti-fraud laws. The lawsuit seeks unspecified damages. We intend to vigorously contest the action.
		Although the ultimate outcome of the matters mentioned above cannot be determined at this time, based on present information, the availability of insurance coverage and advice received from our outside legal counsel, we believe the resolution of these matters will not have a material adverse effect on our consolidated financial position, results of operations or cash flows.
		Indemnifications
		In conjunction with the sales of business assets and subsidiaries, we have provided indemnifications to the buyers. Certain indemnifications cover typical representations and warranties related to our responsibilities to perform under the sales contracts. We cannot quantify the maximum potential exposure covered by all of our indemnifications because the indemnifications cover a variety of matters, operations and scenarios. Certain of these indemnifications have no time limit. For those with a time limit, the longest such indemnification expires on December 31, 2009.
		We accrue a loss related to our indemnifications when a valid claim is made by a buyer and we believe we have potential exposure. We currently have several claims under indemnifications that cover certain net losses incurred in periods prior to our sale of certain subsidiaries. As of March 31, 2006, we have recorded a liability of $19.9 million and have provided $8.1 million of letters of credit to cover our obligations or anticipated payments under these indemnifications.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

We are a specialty insurance group with offices in the United States, the United Kingdom, Spain, Bermuda and Ireland transacting business in more than 50 countries. Our group consists of insurance companies, underwriting agencies and reinsurance brokers. Our shares are traded on the New York Stock Exchange and had a market capitalization of $3.9 billion at March 31, 2006. We earned $78.6 million or $0.67 per diluted share in the first quarter of 2006 compared to $57.3 million or $0.54 in 2005, despite the dilution from a $150.0 million common stock offering in November 2005. Shareholders’ equity increased by 25% from a year ago to $1.8 billion at March 31, 2006, principally from a combination of net earnings and the 2005 equity offering.

We underwrite a variety of specialty lines of business identified as diversified financial products; group life, accident and health; aviation; London market account; and other specialty lines of business. Products in each line are marketed by our insurance companies and agencies, either through a network of independent agents and brokers, or directly to customers. With the exception of our public company directors’ and officers’ liability business, certain international aviation risks and our London market business, the majority of our business is generally lower limit, smaller premium business that is less susceptible to price competition, severity of loss or catastrophe risk. Our major insurance companies are rated “AA (Very Strong)” by Standard & Poor’s Corporation and “A+ (Superior)” by A.M. Best Company, Inc.

We generate our revenue from four primary sources: 1) risk-bearing earned premium produced by our insurance company operations, 2) non-risk-bearing fee and commission income received by our underwriting agency and intermediary operations, 3) ceding commissions in excess of policy acquisition costs earned by our insurance company operations and 4) investment income earned by all of our operations. We produced $466.1 million of revenue in the first quarter of 2006, an increase of 23% over the first quarter of 2005. The increase was due to higher net earned premium from increased retentions in our diversified financial products line of business, organic growth in certain lines of business and from acquisitions, increased investment income from a 32% growth in total investments and an increase in interest rates, and an increase in other operating income.

During the past several years, we substantially increased our shareholders’ equity by retaining most of our earnings and issuing additional shares of common stock. With this additional equity, we increased the underwriting capacity of our insurance companies and made strategic acquisitions, adding new lines of business or expanding those with favorable underwriting characteristics.

Our 2005 acquisitions are listed below. Net earnings and cash flows from each acquired entity are included in our operations beginning on the effective date of each transaction.

Company		Segment		Effective date acquired
United States Surety Company		Insurance company		March 1, 2005
HCC International Insurance Company		Insurance company		July 1, 2005
Perico Life Insurance Company		Insurance company		November 30, 2005
Perico Ltd.		Agency		December 1, 2005
Illium Insurance Group		Agency		December 31, 2005

The following section discusses our key operating results. Amounts in the following tables are in thousands, except for earnings per share, percentages, ratios and number of employees. Comparisons refer to first quarter 2006 compared to first quarter 2005.

Results of Operations

Net earnings increased 37% to $78.6 million ($0.67 per diluted share) in 2006 from $57.3 million ($0.54 per diluted share) in 2005. Growth in underwriting profits, net investment income and other operating income contributed to the increase in 2006 earnings.

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

		Three months ended March 31,
		2006				2005
Net earned premium			81.7	%			84.3	%
Fee and commission income			6.8				8.7
Net investment income			7.8				5.9
Net realized investment loss			(0.3	)			—
Other operating income			4.0				1.1
Total revenue			100.0				100.0
Loss and loss adjustment expense, net			47.3				49.0
Policy acquisition costs, net			16.8				15.6
Other operating expense			10.0				12.1
Interest expense			0.5				0.5
Earnings before income tax expense			25.4				22.8
Income tax expense			8.5				7.7
Net earnings			16.9	%			15.1	%

Total revenue increased 23% to $466.1 million in 2006, driven by significant growth in net earned premium, investment income and other operating income, which more than offset the expected decrease in fee and commission income. We expect total revenue to continue to grow throughout 2006.

Gross written premium, net written premium and net earned premium are detailed below. Premium increased from organic growth in certain lines of business and from acquisitions. Increased retentions, particularly in our diversified financial products line of business, contributed to the growth in net written and earned premiums. See the Insurance Company Segment section below for further discussion of the relationship and changes in premium revenue.

		Three months ended March 31,
		2006				2005
Gross written premium		$	506,058			$	475,119
Net written premium			393,051				357,352
Net earned premium			380,571				320,117

Fee and commission income are shown in the table below. Fee and commission income decreased slightly due to our insurance company subsidiaries ceding less insurance, thereby reducing ceding commissions earned by them and reinsurance commissions earned by our reinsurance intermediaries.

		Three months ended March 31,
		2006				2005
Agency		$	23,061			$	22,469
Insurance companies			8,407				10,607
Fee and commission income		$	31,468			$	33,076

The sources of net investment income are detailed below.

		Three months ended March 31,
		2006				2005
Fixed income securities		$	24,305			$	17,506
Short-term investments			7,540				4,193
Other investments			6,412				1,767
Total investment income			38,257				23,466
Investment expense			(1,676	)			(1,125	)
Net investment income		$	36,581			$	22,341

Net investment income increased 64% in 2006. This increase was primarily due to higher investment assets, which increased to $3.4 billion at March 31, 2006 compared to $2.6 billion at March 31, 2005, increasing interest rates and a better than expected yield on alternative investments. The growth in investment assets resulted from: 1) higher net earnings, 2) higher retentions, 3) commutations of reinsurance recoverables in late 2005, 4) our public offering of common stock in 2005 and 5) the increase in net loss reserves particularly from our diversified financial products line of business, which generally has a longer time period between occurrence and payment of claims. We continue to invest our funds primarily in fixed income securities, slightly extending their duration to 5.0 years at March 31, 2006 from 4.8 years at March 31, 2005 and increasing the percentage of tax-exempt municipal bonds in our investment portfolio. We expect investment assets and investment income to continue to increase in 2006.

At March 31, 2006, our unrealized loss on fixed income securities was $32.4 million, compared to an unrealized loss of $8.5 million at December 31, 2005, due to increases in market interest rates. The change in the unrealized gain or loss, net of the related income tax effect, is recorded in other comprehensive income. This loss is unlikely to affect future net earnings as we often hold our fixed income securities to maturity when we receive the full principal amount.

Information about our portfolio of fixed income securities is as follows:

		Three months ended March 31,
		2006				2005
Average yield			4.12	%			3.92	%
Average tax equivalent yield			5.04	%			4.82	%
Weighted-average maturity		7.8 years				7.4 years
Weighted-average duration		5.0 years				4.8 years

The average yield on our short-term investments increased from 2.5% in 2005 to 4.2% in 2006.

Other operating income increased $14.6 million in 2006. The increase related primarily to a gain from the partial sale of a strategic investment and net gains from trading securities. Period to period comparisons of other operating income may vary substantially depending on market values of trading securities and other financial instruments and on income from strategic investments or dispositions of such investments. The following table details the source of our other operating income.

		Three months ended March 31,
		2006				2005
Strategic investments		$	12,205			$	1,073
Trading securities			4,686				(269	)
Financial instruments			823				2,289
Other			1,036				1,054
Other operating income		$	18,750			$	4,147

Loss and loss adjustment expense increased 19% and policy acquisition costs increased 32% in 2006 primarily due to the growth in net earned premium. See the Insurance Company Segment section below for further discussion of the changes in loss and loss adjustment expense and policy acquisition costs.

Other operating expense, which includes compensation expense, increased 2% in 2006. The increase primarily related to stock option expense under Statement of Financial Accounting Standards (SFAS) No. 123(R) and operating expenses of subsidiaries acquired in the second half of 2005, partially offset by lower legal and accounting expenses. We had 1,458 employees at March 31, 2006 compared to 1,262 a year earlier, with the increase due to acquisitions. See the Recent Accounting Changes section below for further discussion of our adoption of SFAS 123(R) in 2006.

Our effective income tax rate was 33.6% for 2006, compared to 33.7% for 2005.

At March 31, 2006, book value per share was $15.82, up from $15.29 at December 31, 2005. Total assets were $7.1 billion and shareholders’ equity was $1.8 billion, up from $7.0 billion and $1.7 billion, respectively, at December 31, 2005.

Segments

Insurance Company Segment

Net earnings of our insurance company segment increased 21% to $58.8 million in the first quarter of 2006 compared to $48.5 million in the first quarter of 2005. The growth in segment net earnings was driven by an increase in underwriting income, increased investment income and the operations of acquired subsidiaries. Even though there is some pricing competition in certain of our markets, our margins remain at an acceptable level of profitability due to our underwriting expertise and discipline. We expect net earnings from our insurance companies to continue to grow during 2006.

Premium

Gross written premium increased 7% to $506.1 million in 2006. Net written premium increased 10% to $393.1 million and net earned premium increased 19% to $380.6 million in 2006. These increases were primarily due to higher retention levels on non-catastrophe business, acquisitions and the mix of business due to increased premium in lines where we had greater retentions. The overall percentage of retained premium increased to 78% in 2006 from 75% in 2005. Net written and net earned premium are expected to continue to grow in 2006.

The following tables provide premium information by line of business.

		Gross				Net				NWP				Net
		written				written				as % of				earned
		premium				premium				GWP				premium
Three months ended March 31, 2006
Diversified financial products		$	197,246			$	161,645				82	%		$	169,112
Group life, accident and health			134,154				129,443				96				127,761
Aviation			56,234				35,425				63				33,197
London market account			74,507				38,723				52				21,928
Other specialty lines			43,889				27,900				64				28,640
Discontinued lines			28				(85	)		nm					(67	)
Totals		$	506,058			$	393,051				78	%		$	380,571
Three months ended March 31, 2005
Diversified financial products		$	199,072			$	145,997				73	%		$	106,851
Group life, accident and health			150,082				129,449				86				128,945
Aviation			49,102				32,126				65				33,817
London market account			43,196				28,912				67				26,711
Other specialty lines			35,519				21,074				59				21,225
Discontinued lines			(1,852	)			(206	)		nm					2,568
Totals		$	475,119			$	357,352				75	%		$	320,117

nm — Not meaningful comparison

The changes in premium volume and retention levels between years resulted principally from the following factors:

	•		Diversified financial products — Gross written premium was flat. Growth in our surety line of business from both organic growth and our 2005 acquisitions was offset by lower premium volume in our international directors’ and officers’ liability and professional indemnity books of business due to competitive pricing pressure, although profit margins on these lines remain at acceptable levels. The growth in net written and net earned premium was due to increased retentions resulting from a reduction in proportional reinsurance.
	•		Group life, accident and health — Gross written premium declined primarily because we non-renewed a book of business which was 100% reinsured. Profit margins remain at acceptable levels despite competition from the fully insured market.
	•		London market account — Gross written premium increased due to the substantial increase in rates in the energy sector as a result of the 2005 hurricane losses, more than offsetting a reduction in our property premium. Net written premium increased for the same reason and will be reflected in increases in our net earned premium later in 2006 and into 2007. In 2006, to increase our capacity and spread our risk in the energy sector, we entered into a new quota share reinsurance agreement, which resulted in a decrease in our retention although net written premium has still increased. Although the cost of our 2006 excess of loss reinsurance increased, our potential profitability is greater on the increased gross written premium. The reduction in property premium has reduced our aggregate exposure in Florida and the Gulf of Mexico.

	•		Other specialty lines — We experienced organic growth in our other specialty lines of business from increased writings in several products. The mix of products affected the retention percentages. Rates in this line have been relatively stable.

Losses and Loss Adjustment Expenses

Our net adverse development relating to prior year losses included in net incurred loss and loss adjustment expense was $2.6 million in 2006 and $1.6 million in 2005. Deficiencies and redundancies in reserves occur as a result of our continuing review and as losses are finally settled or claims exposures change. We have no material exposure to environmental or asbestos losses and believe we have provided for all material net incurred losses.

Our gross loss ratio was 55.3% in 2006 and 55.7% in 2005. The following table provides comparative net loss ratios by line of business, which were relatively consistent with the prior year ratios.

		Three months ended March 31,
		2006								2005
		Net				Net				Net				Net
		earned				loss				earned				loss
		premium				ratio				premium				ratio
Diversified financial products		$	169,112				50.8	%		$	106,851				49.1	%
Group life, accident and health			127,761				69.7				128,945				69.0
Aviation			33,197				54.3				33,817				51.6
London market account			21,928				48.1				26,711				44.6
Other specialty lines			28,640				58.7				21,225				59.7
Discontinued lines			(67	)		nm					2,568				102.1
Totals		$	380,571				58.0	%		$	320,117				58.1	%
Expense ratio							27.2								26.4
Combined ratio							85.2	%							84.5	%