NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. General
The interim financial statements in this report include
adjustments based on management's best estimates and
judgments, including estimates of future loss payments,
which are necessary to present a fair statement of the
results for the interim periods reported. These adjustments
are of a normal, recurring nature. These financial
statements are prepared on the basis of generally accepted
accounting principles and should be read in conjunction with
the financial statements and related notes in the 1993
Annual Report. Certain prior year amounts have been
reclassified to conform with the 1994 presentation.
2. Participation in Pools and Associations
Participation in pools and associations includes the
Company's equity in Engineering Insurance Group ("EIG").
In September of 1994, the Company announced an agreement to
purchase from General Reinsurance Corporation its 50 percent
interest in EIG for $20 million. A closing prior to
December 31, 1994 is anticipated. The Company's investment
in EIG will be consolidated at the time of acquisition.
6
</page>
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF CONSOLIDATED RESULTS OF OPERATIONS
AND FINANCIAL CONDITION
SEPTEMBER 30, 1994
RESULTS OF OPERATIONS
- - ---------------------
Overview
- - --------
Income after taxes and before accounting changes for the third
quarter of 1994 was $12.3 million or $0.60 per share compared to
a prior year third quarter loss of $22.6 million or $1.09 per
share. Income after taxes and before accounting changes for the
first nine months of 1994 and 1993 was $38.5 million or $1.88 per
share and $0.7 million or $0.03 per share, respectively. Third
quarter 1993 results included a $20.0 million restructuring
charge, reserve strengthening of $19.0 million and a $7.8 million
expense for losses related to the Midwest floods. Third quarter
1994 results included a pre-tax charge of $2.9 million for
California Proposition 103.
The improvements in results for the third quarter and first nine
months of 1994 compared to the corresponding periods in 1993
reflect continued improvement in both insurance and engineering
services operating gains, offset, in part, by a reduced level of
realized investment gains and net investment income.
In November 1988, California voters passed Proposition 103
requiring premium rollbacks on certain policies then in effect to
20 percent below the rates that were in effect in November 1987.
Upon challenge in the courts, the California Supreme Court, in
1989, held that insurers could not be deprived of a fair and
reasonable return and subsequently, in 1991, emergency
regulations were issued by the regulators which, among other
things, defined a "fair and reasonable rate of return". The
Company and a number of other insurers successfully challenged
the regulations in Los Angeles Superior Court and, in February
1993, the Court issued a decision enjoining the enforcement of
the emergency regulations. This decision was appealed to the
California Supreme Court, which, in August 1994, ruled in favor
of the California Insurance Department and upheld the
regulations. The Company continues to maintain its position that
the rollback formula is constitutionally defective and that a
fair rate of return cannot arbitrarily be capped at 10 percent;
however, based upon this most recent ruling, the Company
established a reserve in the third quarter of $2.9 million.
Total revenues declined 5.0 percent in the third quarter of 1994
to $151.5 million and 5.4 percent for the first nine months of
1994 to $454.7 million compared to prior year amounts. The
decline in the third quarter was primarily due to lower realized
gains while the decline in the first nine months of 1994
reflected lower insurance premiums and lower realized gains.
Total expenses were 29.2 percent lower in the third quarter of
1994, and 16.1 percent lower for the first nine months of 1994
compared to the same periods for 1993. The most significant
contributing factors were the decrease in claims and adjustment
expenses and the restructuring charge taken in 1993.
7
</page>
The effective tax rate for the third quarter of 1994 was 31.0
percent compared to 24.0 percent for the comparable prior year
period. The tax rate for the first nine months of 1994 was 28.0
percent compared to 75.0 percent for the first nine months of
1993. Tax rate fluctuations in the third quarter and first nine
months of 1994 compared to 1993 resulted from significant
improvement in insurance and engineering services operating
results. This changed the mix of pre-tax income between fully
taxable earnings and tax preferred investment income.
Business Developments
- - ---------------------
In September of 1994, the Company announced an agreement to
purchase, by year's end, the remaining 50 percent interest for
$20.0 million in Engineering Insurance Group (EIG) from General
Reinsurance Corporation. The results of the Company's
participation in EIG for the third quarter of 1994 compared with
the third quarter of 1993 were constant while results for the
first nine months of 1994 showed improvement over the comparable
prior period. This improvement was attributed primarily to
increased growth in this book of business.
On September 26, 1994, the Board of Directors approved an
increase in the quarterly dividend from $0.53 to $0.55 per share.
Recent Accounting Developments
- - ------------------------------
In October 1994, the Financial Accounting Standards Board (the
Board) issued Statement of Financial Accounting Standards No. 119
(SFAS 119) "Disclosure about Derivative Financial Instruments and
Fair Value of Financial Instruments". SFAS 119, which is
effective for the Company's calendar-year 1994 financial
statements, requires more complete disclosure about derivative
financial instruments such as forwards, futures, swap, and option
contracts. The Company has limited exposure to such instruments.
In October 1994, the Board also issued Statement of Financial
Accounting Standards No. 118 (SFAS 118) "Accounting by Creditors
for Impairment of a Loan-Income Recognition and Disclosures"
effective for fiscal years beginning after December 15, 1994.
Implementation of SFAS 118 is not expected to have an impact on
the Company's financial results.
In June 1993, the Board issued Statement of Financial Accounting
Standards No. 116 (SFAS 116) "Accounting for Contributions
Received and Contributions Made" effective for fiscal years
beginning after December 15, 1994. Implementation of SFAS 116 is
not expected to have an impact on the Company's financial results.
8
</page>
Insurance Operations
- - --------------------
Insurance operations include the insurance results of Hartford
Steam Boiler Inspection and Insurance Company and the Boiler
Inspection and Insurance Company of Canada. EIG's results will
be included in insurance operations after the acquisition
is completed.
The components of net earned insurance premiums were as follows
(in millions):
Quarter Ended Nine Months Ended
September 30 September 30
------------ ------------
1994 1993 1994 1993
---- ---- ---- ----
Gross Earned Premium $ 97.1 $ 95.4 $ 286.4 $ 285.6
Ceded Premium 11.3 9.1 31.0 23.6
------ ------ ------ ------
Insurance Premium $ 85.8 $ 86.3 $ 255.4 $ 262.0
====== ====== ====== ======
Insurance premiums in the third quarter of 1994 were flat
compared to the third quarter of 1993. Insurance premiums for
the first nine months of 1994 decreased 2.5 percent compared to
the first nine months of 1993. The decline in insurance premiums
resulted, in part, from the Company's major reunderwriting
program, which began in early 1993, to improve the insurance
business through better risk selection. The Company acknowledged
that it would likely experience lower volume in order to achieve
improved profitability. Volume reductions were offset partially
by price increases, changes in deductibles and risk selection.
Reductions in net insurance premiums for the third quarter and
first nine months of 1994 also reflect increases in reinsurance
costs due to higher facultative placements and renewed treaties.
Higher retention, which could affect future claim levels, allowed
for modest increases in the cost of existing treaties renewed.
The components of the combined ratio, excluding the charge for
Proposition 103 recognized in the third quarter of 1994 and the
1993 restructuring charge, were as follows:
Quarter Ended Nine Months Ended
September 30 September 30
------------- -------------
1994 1993 1994 1993
---- ---- ---- ----
Loss ratio 39.4% 80.0% 43.4% 61.3%
Expense ratio 51.9% 50.9% 50.2% 49.8%
---- ---- ---- ----
Combined ratio 91.3% 130.9% 93.6% 111.1%
==== ===== ==== =====
9
</page>
The improvement in loss ratios compared with the same periods in
1993 was primarily due to better underwriting results. Third
quarter 1993 results also included reserve strengthening for
adverse development of estimated 1992 year-end reserves and
losses related to the Midwest floods.
The expense ratio for the third quarter and first nine months of
1994 compared to comparable 1993 periods increased slightly due
to the impact of higher reinsurance costs on net premiums while
expenses were relatively consistent from period to period.
Engineering Services Operations
- - -------------------------------
Net engineering services revenues for the third quarter and first
nine months of 1994 decreased 3.0 percent and 1.2 percent,
respectively, compared to the same periods in 1993. Although
revenue decreased, profit margins improved substantially during
the third quarter and the first nine months of 1994 as the
Company continued to focus on higher margin business and reduce
expenses. Net engineering services profit margin increased to
8.5 percent from 5.7 percent in the third quarter of 1994 and to
7.7 percent from 4.3 percent during the first nine months of 1994
compared to the same periods in 1993.
Radian Corporation, the Company's environmental services
subsidiary, has continued to improve its results over the
previous year. The increase in Radian's operating margin for the
first nine months of 1994 compared to the same period in 1993
accounted for the majority of the change in engineering services.
Investment Operations
- - ---------------------
The Company's investment strategy continues to be to maximize
total return on the investment portfolio over the long-term --
through investment income and capital appreciation. Investment
income decreased 12.3 percent for the third quarter of 1994
compared to the third quarter of 1993 and 15.5 percent for the
first nine months of 1994 compared to the first nine months of
1993. Realized investment gains decreased 72.3 percent in the
third quarter of 1994 and 62.6 percent for the first nine
months of 1994 compared to the same periods in 1993. The
decrease in investment income resulted primarily from declines in
rates of return and a decrease in average invested assets. The
decrease in average invested assets resulted from cash used to
pay dividends, repurchase Company stock and purchase fixed
assets.
Since the second quarter of 1994 the Company experienced
improvement in net unrealized gains in its investment portfolio,
despite the fact that average invested assets decreased. The
improvement in net unrealized gains is representative of the
rebound the equity market experienced in the third quarter
following an overall market decline in the first half of 1994.
While this rebound contributed favorably to the Company's ability
to generate investment income and improve shareholders' equity,
to date, net unrealized gains have not yet been restored to
10
</page>
December 31, 1993 levels. As a defensive move to anticipated
increases in interest rates, the Company continues to shorten
the maturity of its fixed income portfolio and has reduced the
mix of its equity holdings in relation to total invested assets.
The Company's investment portfolio continues to consist of high
grade investments. Equity securities, including non-redeemable
preferreds, and fixed maturities, including redeemable
preferreds, are carried at fair value and are classified as
available for sale. The market value of the portfolio at
September 30, 1994 decreased to $448.1 million from $506.0
million at December 31, 1993. The $57.9 million decline was the
result of both the decrease in average invested assets and lower
unrealized investment gains.
FINANCIAL CONDITION
- - -------------------
Capital Resources
- - -----------------
Capital resources consist of shareholders' equity and debt
outstanding representing those funds deployed or available to be
deployed to support business operations.
Shareholders' equity of $303.8 million at September 30, 1994
decreased by $20.9 million since December 31, 1993, representing
a decrease in book value per share of $0.95 to $14.85 from
$15.80. The decrease in book value per share relates primarily
to the decrease in unrealized gains, net of tax, of $23.6 million
during the first nine months of 1994, and share repurchases.
Dividends paid by the Company are limited by state insurance
regulations. The current restriction is the greater of 10
percent of statutory surplus or prior year's net income as
reported to the regulatory agencies. Due to the Company's strong
financial position, regulatory approval was received for the
payment of dividends declared through September 30, 1994.
At September 30, 1994, the Company had significant short-term and
long-term borrowing capacity. The Company is currently
authorized to issue up to $75 million of commercial paper.
Commercial paper outstanding at September 30, 1994 and December
31, 1993 was $31.1 and $42.7 million, respectively.
During 1994, approximately $43.0 million of debt of EIG matured
and was repaid through reductions in EIG's investments. Other
than the anticipated acquisition of EIG, the Company currently
has no significant capital commitments planned for the remainder
of 1994 and beyond.
Liquidity
- - ---------
Liquidity refers to the Company's ability to generate sufficient
funds to meet the cash requirements of its business operations.
11
</page>
The Company receives a regular inflow of cash from maturing
investments, engineering and insurance operations and maintains a
highly liquid investment portfolio. The Company manages its cash
and short-term investment position to meet its operating expense
and claim payment needs.
Cash provided from operations for the first nine months of 1994
was $31.1 million compared to $59.0 million for the first nine
months of 1993. The decrease in cash provided from operations
was primarily related to claims settlement for losses incurred in
1993 and severance payments related to restructuring. These were
offset by stronger operating results and changes in reinsurance
recoverable and receivables.
Cash provided by operations and investment activities was used to
pay dividends, repay short-term borrowings, purchase fixed assets
and repurchase Company stock.
12
</page>