USF&G Corporation
Management's Discussion and Analysis of Financial Condition
and Results of Operations
This section provides management's assessment of financial results and material
changes in financial position for USF&G Corporation and its two primary
subsidiaries, United States Fidelity and Guaranty Company ("USF&G Company") and
Fidelity and Guaranty Life Insurance Company ("F&G Life"), (collectively,
"USF&G" or "the Corporation") and discusses the results of operations for the
year ended December 31, 1994. The analysis focuses on the performance of
USF&G's business segments and its investment portfolio. Amounts have not been
restated for the mergers with Discover Re Managers, Inc. ("Discover Re"), and
Victoria Financial Corporation ("Victoria"). The mergers are accounted for as
poolings-of-interests; therefore, the consolidated financial statements and
notes thereto have been restated. A reconciliation of the previously separate
enterprises to the restated financial statements is included as Note 1.11 to
the consolidated financial statements. Separate discussions regarding Discover
Re and Victoria are included at Section 2a and Section 2b of this Analysis,
respectively. (Note: A glossary of certain terms used in this discussion can be
found at the end of this section. The terms are italicized the first time they
appear in the text.)
Index
1. Consolidated Results 12
2. Property/Casualty Insurance Operations 13
2a. Discover Re 21
2b. Victoria 22
3. Life Insurance Operations 22
4. Parent and Noninsurance Operations 24
5. Investments 24
6. Financial Condition 29
7. Liquidity 30
8. Regulation 31
9. Income Taxes 33
10. Glossary of Terms 35
1. Consolidated Results
1.1. Summary of net income
The table below shows the major components of net income.
(in millions) 1994 1993 1992
Income (loss) from continuing
operations before realized gains,
facilities exit costs, income taxes
and cumulative effect of adopting
new accounting standards $ 129 $ 3 $(113)
Net realized gains on investments 5 6 148
Facilities exit costs (183) - -
Loss from discontinued operations - - (7)
Income tax benefit 281 28 -
Income (loss) from cumulative effect of
adopting new accounting standards:
Income taxes - 90 -
Postretirement benefits - (52) -
Net income $ 232 $ 165 $ 28
The table below shows the components by major business segment of income (loss)
from continuing operations before realized gains, facilities exit costs, income
taxes and cumulative effect of adopting new accounting standards.
(in millions) 1994 1993 1992
Property/casualty insurance $194 $182 $ (3)
Life insurance 14 (6) (4)
Parent and noninsurance (79) (83) (106)
Income (loss) from continuing
operations before realized gains,
facilities exit costs, income taxes
and cumulative effect of adopting
new accounting standards $129 $ 93 $(113)
Property/casualty insurance segment income (loss) from continuing operations
before realized gains, facilities exit costs, income taxes and cumulative
effect of adopting new accounting standards increased $12 million from 1993 to
1994 due to improved underwriting results. The life insurance segment's
$20 million improvement from 1993 to 1994 was due to the combined effects of
higher product sales and improved spreads on annuity products. The major
factors influencing the improvement in the parent and noninsurance segment for
1994 are the improved results from noninsurance subsidiaries and reduced
interest expense partially offset by a loss on long-term subleases.
Other items affecting net income include a $183 million charge related to the
planned consolidation of the Corporation's Baltimore headquarters facilities
(refer to Section 1.2 of this Analysis). Also included in net income is a $281
million income tax benefit primarily related to the recognition of deferred
tax assets (refer to Section 9 of this Analysis).
The $137 million improvement in net income from 1992 to 1993 was driven by a
$200 million improvement in property/casualty underwriting results. The 1992
net income included $51 million in restructuring charges related to branch
office consolidation which has been completed.
1.2. Facilities exit costs
As a result of USF&G's restructuring activities in the early 1990s and ongoing
efforts to improve the overall cost effectiveness of the Corporation, USF&G's
available headquarters office space significantly exceeds it needs,
particularly at the 40-story office building ("the Tower") in downtown
Baltimore. USF&G sold the Tower in 1984 and subsequently leased it back. Since
1991, the total headquarters staff has decreased by approximately 28 percent,
including a 48 percent decrease in the number of employees who are located at
the Tower. During 1994, USF&G developed and committed to a plan to consolidate
its Baltimore headquarters facilities. The plan encompasses relocating all
USF&G personnel currently residing at the Tower to the Mount Washington
facilities in Baltimore which USF&G owns. Implementation of the plan began in
January 1995. The relocation of Tower personnel will begin in mid-1995 and is
expected to be completed by the end of 1996. The lease on the Tower, which
expires in September 2009, will not be terminated. Approximately 30 percent of
the Tower is currently sublet and USF&G intends to sublet the remaining space
as it is vacated.
The facilities exit costs of $183 million recorded in the fourth quarter of
1994 represent the present value of the rent and other operating expenses
incurred under the Tower lease from the time USF&G vacates the Tower through
the expiration of the lease in 2009. Approximately $28 million of unamortized
deferred gain arising from the 1984 sale-leaseback was also recognized upon
adoption of the facilities exit plan. Potential future sublease income was not
considered in calculating the facilities exit costs. To the extent that
additional or extended subleases are signed in the future, the present value of
income to be received over the term of such a sublease will be recognized in
the period the sublease is signed.
2. Property/Casualty Insurance Operations
Property/casualty insurance operations, the principal business segment,
accounted for 84 percent of USF&G's revenues in 1994, compared with 85 percent
and 88 percent in 1993 and 1992, respectively, and 67 percent of its assets at
December 31, 1994 and 1993, compared with 63 percent at December 31, 1992.
Financial results for this segment are as follows:
(in millions) 1994 1993 1992
Premiums earned* $ 2,283 $ 2,327 $ 2,533
Losses and loss expenses (1,691) (1,758) (2,088)
Underwriting expenses (792) (796) (872)
Net underwriting losses (200) (227) (427)
Net investment income 423 433 475
Restructuring charges - - (46)
Other revenues and (expenses), net (29) (24) (5)
Income (loss) from continuing
operations before realized gains,
facilities exit costs, income taxes
and cumulative effect of adopting
new accounting standards $ 194 $ 182 $ (3)
*See Glossary of Terms
Improved underwriting results were the primary reason for the increase in
property/casualty income in 1994 when compared with 1993 and 1992 (refer to
Section 2.2 of this Analysis). The decrease in net investment income is
attributable to an investment base which declined in order to meet cash flow
needs (refer to Section 5.1 of this Analysis). The 1993 fluctuation in other
revenues and expenses primarily reflects the decision to eliminate certain
policyholders' dividends in 1992 and the reversal in that year of previously
accrued but unpaid dividends. Restructuring charges relating to branch office
consolidations also affected results in 1992.
2.1. Premiums earned
Premiums earned totaled $2.3 billion in 1994 and 1993, compared with $2.5
billion in 1992. The table below shows the major components of premiums earned
and premiums written.
1994 1993 1992
Premiums Premiums Premiums
(in millions) Earned Written Earned Written Earned Written
Branch Office
Voluntary Production:
Direct $1,919 $1,968 $1,949 $1,929 $2,272 $2,128
Ceded reinsurance (150) (162) (124) (124) (85) (85)
Net branch office
voluntary 1,769 1,806 1,825 1,805 2,187 2,043
Voluntary pools and
associations 41 37 45 46 41 44
Involuntary pools and
associations 83 70 152 133 163 147
Other premium
adjustments (5) (16) - 42 (15) (57)
Total primary 1,888 1,897 2,022 2,026 2,376 2,177
Assumed Reinsurance:
Finite risk 172 180 169 249 74 171
Traditional risk 223 235 136 154 83 72
Total assumed 395 415 305 403 157 243
Total $2,283 $2,312 $2,327 $2,429 $2,533 $2,420
Direct voluntary premiums written increased two percent in 1994 in response to
management's strategies to grow business in targeted market segments. These
growth strategies follow planned actions to exit unprofitable markets and
product lines in 1993 which had reduced premium production by nine percent in
that year. The increase in ceded reinsurance is primarily the result of risk
management as part of USF&G's strategy to enter the excess property market in
commercial lines. Additionally, USF&G ceded $5 million of catastrophe
reinsurance premiums under an assessment by the Florida Hurricane Catastrophe
Fund which was established in response to 1992's Hurricane Andrew. Premiums
from involuntary pools and associations decreased 47 percent in 1994, after a
10 percent decrease in 1993, as USF&G continued to reduce exposure in these
unprofitable markets. Other premium adjustments relate primarily to changes in
earned but not reported premiums and unbilled installment premiums.
Traditional risk assumed reinsurance premiums increased substantially in
1994 as USF&G expanded into international reinsurance markets, while the demand
for finite risk reinsurance has decreased as a result of the new accounting
requirements of Statement of Financial Accounting Standards ("SFAS") No. 113
and Emerging Issues Task Force ("EITF") 93-6 which were issued in 1993.
The table below shows net premiums earned and the statutory loss ratios by
lines of property/casualty insurance including results from voluntary and
involuntary pools and associations. The table illustrates the changes in
premium mix from 1992 to 1994. Management's focus on reducing exposure to less
profitable lines of insurance has been a key factor in the improved
underwriting results. The most dramatic examples are the workers' compensation
line and assumed reinsurance. Workers' compensation has a cumulative three-year
statutory loss ratio of 143.8 and represented 13 percent of total
property/casualty premiums earned in 1992 but only 5 percent in 1994. Assumed
reinsurance premiums increased from 6 percent of total premiums earned in
1992 to 17 percent in 1994, with a cumulative three-year statutory loss ratio
of 69.9 as of December 31, 1994.
In 1995, management will continue to develop strategies to achieve a more
profitable mix of business by further penetrating target markets, implementing
new products and services, and enhancing underwriting and customer service
structures through improved technology and performance.
1994 1993 1992
Premiums Statutory Premiums Statutory Premiums Statutory
Earned % Loss Ratio Earned % Loss Ratio Earned % Loss Ratio
(dollars in millions)
Commercial Lines:
Auto $ 380 17% 58.8 $ 399 17% 54.8 $ 442 18% 64.5
General
liability 357 16 89.4 351 15 80.5 388 15 99.2
Property 326 14 71.8 321 14 60.4 332 13 69.5
Workers'
compensation 126 5 121.0 152 7 210.8 318 13 121.0
Total commercial
lines 1,189 52 78.1 1,223 53 83.0 1,480 59 86.9
Fidelity/Surety:
Fidelity 17 1 29.6 18 1 55.7 19 1 24.6
Surety 107 5 37.8 100 4 49.2 92 3 33.5
Total fidelity/
surety 124 6 36.7 118 5 50.2 111 4 32.0
Personal Lines:
Auto 410 18 66.5 504 22 70.3 551 22 73.6
Homeowners 126 5 107.3 149 6 73.3 184 7 102.2
Other personal 39 2 49.1 28 1 65.6 50 2 67.9
Total personal
lines 575 25 74.2 681 29 70.7 785 31 80.0
Assumed Reinsurance:
Finite risk 172 7 71.9 169 7 70.1 74 3 78.9
Traditional risk 223 10 64.8 136 6 62.1 83 3 72.8
Total assumed
reinsurance 395 17 67.9 305 13 67.3 157 6 76.9
Total $2,283 100% 73.1 $2,327 100% 75.4 $2,533 100% 82.0
2.2. Underwriting results
Underwriting results represent premiums earned less incurred losses, loss
expenses and underwriting expenses. It is not unusual for property/casualty
insurance companies to have underwriting losses that are offset by investment
income.
Underwriting gains (losses) by major business category are as follows:
(in millions) 1994 1993 1992
Commercial $(186) $(223) $(343)
Fidelity/surety 6 (8) 6
Personal (60) (28) (110)
Total primary (240) (259) (447)
Assumed reinsurance 40 32 20
Net underwriting losses $(200) $(227) $(427)
Voluntary $(179) $(176) $(390)
Involuntary (21) (51) (37)
Net underwriting losses $(200) $(227) $(427)
Consolidated property/casualty underwriting ratios, calculated based on
generally accepted accounting principles ("GAAP") and statutory accounting
practices, are as follows:
1994 1993 1992
GAAP Underwriting Ratios:
Loss ratio 74.0 75.6 82.4
Expense ratio* 34.7 34.2 34.4
Combined ratio 108.7 109.8 116.8
Statutory Underwriting Ratios:
Loss ratio 73.1 75.4 82.0
Expense ratio 35.0 33.7 34.9
Combined ratio 108.1 109.1 116.9
*See Glossary of Terms
Statutory underwriting ratios exclude the effects of policyholder dividends
which, if included, would increase the ratios by 0.3 each year.
Underwriting results improved $27 million from 1993 to 1994 and $200 million
from 1992 to 1993. The improvements generally resulted from management's
actions to improve product/market mix, apply stricter underwriting standards,
and improve claims practices, as well as from lower incurred catastrophe losses
in 1994 and 1993 when compared to 1992 (refer to Section 2.4 of this Analysis).
The rate of improvement in 1994 was not as dramatic as that seen in 1993 since
net catastrophe losses were relatively consistent from 1993 to 1994 after
decreasing $72 million from 1992 to 1993. Additionally, significant weather
related losses not designated as catastrophe losses had an adverse effect on
1994 results, particularly in personal lines. The statutory loss ratio has
improved 8.9 points overall since 1992, and 6.7 points in that same period when
catastrophe losses are excluded. The overall improvement of $16 million in
involuntary underwriting results since 1992 reflects management's actions to
reduce exposure to involuntary business in states with substantial involuntary
market burdens. The major impact of these actions was felt in 1992 when
involuntary underwriting results improved more than $100 million when compared
to previous years. While management will remain focused on controlling
involuntary underwriting losses, the degree of improvement is expected to be
less than that realized in previous years. The increase in involuntary
underwriting losses in 1993 over 1992 was primarily due to an assessment of
loss reserves from involuntary workers' compensation insurance pools.
Improved premium mix and reduced costs have been the main reason for the
improved underwriting results since 1990, despite continuing competitive
pressures. Management intends to monitor the premium mix and costs and
implement other strategies with the goal of continuing the improvement in
underwriting results, although such improvements cannot be assured. These
strategies include the introduction of specialty products, continued
penetration of targeted industries and market segments, further development of
underwriting expertise, reduced catastrophe exposure and investments in
technological advancements. Management will also continue to focus on
improving product pricing, although intense competitive pressures in the
property/casualty insurance industry, especially in the pricing of commercial
lines products, is expected to continue to restrict underwriting results.
Commercial Lines
Commercial lines products include property, auto, inland marine, workers'
compensation, and general and umbrella liability coverage for businesses. The
commercial lines business has two distinct market segments-middle market and
small business. USF&G has further defined the middle market into three
strategic business units in an effort to better service customers and improve
profitability: service businesses, contractors, and manufacturers.
The following table shows the components of underwriting results for commercial
lines:
(in millions) 1994 1993 1992
Premiums Written:
Branch office voluntary direct $ 1,210 $ 1,165 $ 1,303
Other, net of ceded reinsurance (11) 82 52
Total premiums written $ 1,199 $ 1,247 $ 1,355
Premiums earned $ 1,189 $ 1,223 $ 1,480
Losses (929) (1,014) (1,299)
Expenses (446) (432) (524)
Net underwriting losses $ (186) $ (223) $ (343)
Voluntary $ (181) $ (187) $ (316)
Involuntary (5) (36) (27)
Net underwriting losses $ (186) $ (223) $ (343)
GAAP and statutory underwriting ratios are as follows:
1994 1993 1992
GAAP Underwriting Ratios:
Loss ratio 78.1 83.0 87.8
Expense ratio 37.5 35.3 35.4
Combined ratio 115.6 118.3 123.2
Statutory Underwriting Ratios:
Loss ratio 78.1 83.0 86.9
Expense ratio 36.2 34.4 36.3
Combined ratio 114.3 117.4 123.2
Commercial lines branch office voluntary direct premiums written increased 4
percent in 1994, compared with decreases of 11 percent and 20 percent in 1993
and 1992, respectively. The increase is primarily the result of new business
growth in targeted market segments. Although net premiums written in the
commercial lines business have declined, the largest components of the decline
have been the reduced participation in voluntary pools and the decrease in
involuntary premium, both of which have benefited net underwriting results. The
involuntary business losses were $31 million less in 1994 than in 1993,
after increasing $9 million from 1992 to 1993. The improved involuntary results
arose primarily from management actions to reduce workers' compensation
premiums which led to reduced participation in the involuntary workers'
compensation pools.
Underwriting results in the commercial lines category improved $37 million over
1993 and $120 million from 1992 to 1993. This improvement is primarily the
result of the change in the mix of business and the application of stricter
underwriting standards, as well as lower catastrophe losses in 1994 and 1993.
In commercial lines, the mix of the least profitable line of business, workers'
compensation, with a 1994 statutory loss ratio of 121.0, has decreased from 21
percent of commercial lines premiums earned in 1992 to 11 percent in 1994,
while the mix of the two most profitable lines of business, auto and core
property, has increased. Commercial auto, with a statutory loss ratio of 58.8
in 1994, increased from 30 percent of commercial lines premiums earned in 1992
to 32 percent in 1994. USF&G's core commercial property business consists of
fire/allied and inland marine products, which had a statutory loss ratio of
62.1 in 1994. Premiums from these product lines increased from 15 percent of
commercial lines premiums earned in 1992 to 19 percent in 1994.
The statutory loss ratio for commercial lines improved 4.9 points in 1994 from
1993 and 8.8 points in 1994 from 1992. Management believes the improved loss
ratio trend is evidence of the positive effects of the strategies implemented
to improve underwriting results. Also contributing to the improvement over
1992 is the reduction in catastrophe losses (refer to Section 2.4 of this
Analysis). Losses incurred from Hurricane Andrew represented approximately 1.6
points of the 1992 commercial lines statutory loss ratio.
In January 1995, USF&G entered into a definitive agreement to purchase all of
the outstanding equity of Discover Re Managers, Inc. The transaction closed in
the second quarter of 1995. See Section 2a of this Analysis.
Fidelity/Surety
The fidelity/surety segment provides contract and non-contract surety bonds to
construction companies, commercial businesses and individuals; financial
institution bonds to banks, stockbrokers and credit unions; and fidelity bonds
to commercial businesses and governmental entities.
The following table shows the components of underwriting results for
fidelity/surety:
(in millions) 1994 1993 1992
Premiums Written:
Branch office voluntary direct $169 $148 $137
Other, net of ceded reinsurance (35) (27) (28)
Total premiums written $134 $121 $109
Premiums earned $124 $118 $111
Losses (46) (59) (36)
Expenses (72) (67) (69)
Net underwriting gains (losses) $ 6 $ (8) $ 6
Voluntary $ 6 $ (8) $ 6
Involuntary - - -
Net underwriting gains (losses) $ 6 $ (8) $ 6
GAAP and statutory underwriting ratios are as follows:
1994 1993 1992
GAAP Underwriting Ratios:
Loss ratio 36.7 50.2 32.3
Expense ratio 57.9 56.6 62.6
Combined ratio 94.6 106.8 94.9
Statutory Underwriting Ratios:
Loss ratio 36.7 50.2 32.0
Expense ratio 54.2 56.0 64.0
Combined ratio 90.9 106.2 96.0
Fidelity/surety experienced an improvement in underwriting results in 1994 due
to increased premiums and decreased losses. The regionalization of USF&G's
surety business in 1993 led to further penetration of existing contract surety
markets in 1994, while new products and further expansion into financial
institutions markets resulted in premium growth in the fidelity lines. Losses
decreased in 1994 after a $23 million increase in 1993 which was primarily a
result of unfavorable loss developments on a limited number of prior years'
claims.
Personal Lines
Personal lines products include auto, homeowners, watercraft and personal
excess insurance for individuals and families.
The following table shows the components of underwriting results for personal
lines:
(in millions) 1994 1993 1992
Premiums Written:
Branch office voluntary direct $ 589 $ 616 $ 688
Other, net of ceded reinsurance (25) 42 38
Total premiums written $ 564 $ 658 $ 726
Premiums earned $ 575 $ 681 $ 785
Losses (427) (481) (635)
Expenses (208) (228) (260)
Net underwriting losses $ (60) $ (28) $(110)
Voluntary $ (44) $ (13) $(100)
Involuntary (16) (15) (10)
Net underwriting losses $ (60) $ (28) $(110)
GAAP and statutory underwriting ratios are as follows:
1994 1993 1992
GAAP Underwriting Ratios:
Loss ratio 74.2 70.6 80.9
Expense ratio 36.3 33.5 33.1
Combined ratio 110.5 104.1 114.0
Statutory Underwriting Ratios:
Loss ratio 74.2 70.7 80.0
Expense ratio 36.8 33.7 33.2
Combined ratio 111.0 104.4 113.2
Branch office voluntary premium has declined only 4 percent in 1994, after
declining 10 percent in 1993. In 1994, the net premium decrease resulted from
management's plans to improve the agency force and exit certain involuntary
markets, and from increased ceded reinsurance. The net premium decreases in
1993 were a result of planned management actions to exit certain unprofitable
markets and to reduce writings in high risk catastrophe areas.
The increased underwriting loss in 1994 is primarily due to increased losses
from the homeowners line of business which was adversely affected in 1994 by
significantly higher than normal first quarter weather related losses not
designated as catastrophe losses. Winter storms and the Northridge earthquake
in the first quarter of 1994 produced most of the $32 million in catastrophe
losses for the personal lines business, primarily in homeowners. Exclusive of
these catastrophe losses, the homeowners statutory loss ratio was 84.2 in 1994,
compared with 107.3 when catastrophe losses are included. Although the personal
lines statutory loss ratio increased 3.5 points in 1994, almost half of that
increase is the result of catastrophe losses. The personal lines statutory loss
ratio improved 9.3 points from 1992 to 1993 (a 3.5 point improvement excluding
Hurricane Andrew in 1992).
Management's strategies to reduce exposure in unprofitable markets and lines of
business, including reunderwriting the auto book of business, applying stricter
underwriting standards, reducing exposure in certain high risk catastrophe
areas and introducing new products, have improved the underwriting results and
statutory loss ratios of the auto and other personal lines of business since
1992. These strategies are currently being applied to the homeowners line, and
are anticipated to result in improvements in 1995 in selected target markets.
Underwriting losses from involuntary markets were relatively consistent from
1993 to 1994, and increased $5 million from 1992 to 1993. The increase in 1993
losses was due to unfavorable development on prior years' claims and costs
associated with third party administrators managing the assigned risk
involuntary business.
In December 1994, USF&G entered into a definitive agreement to purchase all of
the outstanding stock of Victoria Financial Corporation. The transaction
closed in the second quarter of 1995. See Section 2b of this Analysis.
Assumed Reinsurance
Reinsurance products are managed by F&G Re and marketed through national and
international reinsurance brokers. The reinsurance segment has historically
produced underwriting gains.
The following table shows the components of underwriting results for assumed
reinsurance lines:
(in millions) 1994 1993 1992
Premiums written $ 415 $ 403 $ 243
Premiums earned $ 395 $ 305 $ 157
Losses (290) (204) (118)
Expenses (65) (69) (19)
Net underwriting gains $ 40 $ 32 $ 20
Finite risk $ 12 $ 9 $ 14
Traditional risk 28 23 6
Net underwriting gains $ 40 $ 32 $ 20
GAAP and statutory underwriting ratios are as follows:
1994 1993 1992
GAAP Underwriting Ratios:
Loss ratio 73.2 66.7 75.0
Expense ratio 16.5 22.6 12.1
Combined ratio 89.7 89.3 87.1
Statutory Underwriting Ratios:
Loss ratio 67.9 67.3 76.9
Expense ratio 22.7 24.6 17.0
Combined ratio 90.6 91.9 93.9
Underwriting results in this category continue to be favorably affected by
increased premiums due to the strong demand for reinsurance. Recent large
catastrophe losses, such as Hurricane Andrew in 1992 and the Northridge
earthquake in 1994, have increased the demand for traditional risk reinsurance
in both the international and domestic property catastrophe markets.
Net premiums written in the international market for traditional risk assumed
reinsurance increased to $120 million in 1994 from $49 million in 1993. This
growth in international writings accounts for over 87 percent of the increase
in traditional risk premiums written. This increase is offset by the reduced
demand for finite risk assumed reinsurance as a result of the accounting
requirements of SFAS No. 113 and EITF 93-6 which were issued in 1993.
2.3. Losses incurred and loss reserves
Losses and loss expenses incurred totaled $1.7 billion in 1994, compared with
$1.8 billion and $2.1 billion in 1993 and 1992, respectively. The reduction is
due primarily to lower premium volume and actions taken to better manage claims
and claim costs and reduce exposures in undesirable markets. The reduction from
1992 to 1993 is also due to lower catastrophe losses. Reserves for unpaid
losses and loss expenses totaled $6.1 billion at December 31, 1994, a decrease
of $229 million from December 31, 1993. The impact of adopting SFAS No. 113
increased reserves by $1.2 billion at December 31, 1993 when compared with
December 31, 1992. This new accounting standard eliminated the previous
practice of reporting assets and liabilities net of the effect of reinsurance.
Excluding the effects of SFAS No. 113, reserves in 1993 declined $264 million
from 1992.
Selected claims information for the property/casualty segment is as follows:
(dollars in millions) 1994 1993 1992
At December 31:
Net reserves $5,084 $5,276 $5,540
Number of outstanding claims 81,024 91,285 103,952
For the year ended December 31:
Losses paid $1,883 $2,022 $2,252
Number of new claims 342,292 352,194 395,697
Although reserve levels have been reduced, the 8 percent decrease in net
reserves since 1992 is significantly less than the decreases in earned
premiums, losses paid and claim activity over the same period. Earned premiums
decreased $250 million, or 10 percent, since 1992, while losses paid decreased
16 percent over the same period. The number of outstanding claims at December
31, 1994 declined by 22 percent compared with December 31, 1992, and the number
of new claims reported (excluding catastrophe claims) declined 13 percent from
1992 to 1994.
USF&G categorizes environmental, asbestos and other long-term exposures where
multiple claims relate to a similar cause of loss (excluding catastrophes) as
"common circumstance claims." Reserves for losses that have been reported and
certain legal expenses are established on the "case basis." Common
circumstance claims which have emerged, while substantial, are a relatively
small portion of total claim payments and reserves. Case reserves for these
claims are approximately three percent of the total reserves for unpaid losses
and loss expenses at December 31, 1994 and 1993.
The most significant common circumstance claim exposures include negligent
construction, environmental, and asbestos claims. Case reserves for these
exposures represent 82 percent of total common circumstance case reserves at
December 31, 1994. Other common circumstance claim categories stem from a
variety of situations such as lead paint, toxic fumes, breast implants, sexual
molestation and other disparate causes, provisions for which are included in
the total common circumstance case reserves.
The following tables set forth selected information for each of the three
primary categories of common circumstance claims, net of ceded reinsurance.
Negligent
(in millions) Construction Environmental Asbestos
Total reserves at
December 31, 1991 $ 48 $184 $106
Losses incurred 25 30 33
Claims paid (3) (27) (13)
Total reserves at
December 31, 1992 70 187 126
Losses incurred 14 99 22
Claims paid (10) (37) (23)
Total reserves at
December 31, 1993 74 249 125
Losses incurred (6) 106 5
Claims paid (13) (26) (5)
Total reserves at
December 31, 1994 $ 55 $329 $125
Total Reserves at December 31
(in millions) 1994 1993 1992
Negligent Construction:
Case reserves $ 18 $ 14 $ 14
Bulk reserves 37 60 56
Total $ 55 $ 74 $ 70
Environmental:
Case reserves $ 65 $ 61 $ 43
Bulk reserves 264 188 144
Total $329 $249 $187
Asbestos:
Case reserves $ 25 $ 45 $ 46
Bulk reserves 100 80 80
Total $125 $125 $126
The increase in environmental incurred losses is primarily due to an increased
allocation of bulk reserves from other lines of business based on enhancements
in the actuarial database with respect to such claims. This reallocation did
not effect management's assessment of the overall adequacy of the reserve
position. Management believes that USF&G's reserve position is adequate
relative to its exposure to environmental and asbestos matters, and compares
favorably to other large property/casualty insurers. USF&G's customer base
generally does not include large manufacturing companies, which tend to incur
most of the known environmental and asbestos exposures. Many of USF&G's
environmental claims relate to small industrial or transportation accidents
which individually are unlikely to involve material exposures. In addition,
USF&G has traditionally been a primary coverage carrier, having written
relatively little high-level excess coverage; therefore, liability exposures
are generally restricted to primary coverage limits. USF&G's net paid losses
and loss expenses for environmental and asbestos claims have averaged
approximately $35 million per year over the last five years, or less than two
percent of the estimated industry level as of December 31, 1994, while USF&G's
related reserves at the end of 1994 are three percent of the estimated industry
total. In a study published in 1994, A.M. Best Company, Inc., an insurance
industry rating agency, measured the environmental and asbestos reserves held
by property/casualty insurers in terms of the number of years the reserves
could fund the average rate of payments, described as the "survival ratio."
USF&G's survival ratio of approximately 13 years for environmental and asbestos
losses is almost double A.M. Best's estimated 1994 industry average.
In 1994, approximately 28 percent of paid environmental claims related to
matters under which a USF&G insured was a potentially responsible party ("PRP")
under the Comprehensive Environmental Response, Compensation and Liability Act,
commonly referred to as "Superfund", but many of these PRPs were only
peripherally involved. In 1993, 35 percent of the environmental claims paid
related to Superfund.
The level of loss reserves for both current and prior years' claims is
continually monitored and adjusted for changing economic, social, judicial and
legislative conditions, as well as for changes in historical trends as
information regarding such conditions and actual claims develops. Management
believes that loss reserves are adequate, but establishing appropriate
reserves, particularly with respect to environmental, asbestos and other long-
term exposure claims, is highly judgmental and an inherently uncertain process.
It is possible that, as conditions change and claims experience develops,
additional reserves may be required in the future. There can be no assurance
that such adjustments will not have a material adverse effect on USF&G's
results of operations or financial condition.
2.4. Catastrophe losses
Gross catastrophe losses totaled $73 million in 1994, compared with $81 million
in 1993 and $292 million in 1992. These losses, net of losses ceded to
reinsurers, were $67 million in 1994, $68 million in 1993 and $140 million in
1992. Catastrophe losses, net of reinsurance, represented three percent of
premiums earned for the years ended December 31, 1994 and 1993, compared with
six percent for 1992. Net catastrophe losses in 1994 included $23 million from
the Northridge earthquake in February, as well as approximately $26 million
from winter storms in the first quarter of the year, while 1993's net
catastrophe losses included $27 million from the East Coast blizzard in March
1993. The 1992 losses, the highest in USF&G's history, were primarily from
Hurricane Andrew in Florida and hailstorms and tornadoes in Kansas and
Oklahoma.
2.5. Ceded reinsurance
USF&G reinsures portions of its policy risks with other insurance companies or
underwriters. Reinsurance allows USF&G to obtain indemnification against
losses associated with insurance contracts it has written by entering into a
reinsurance contract with another insurance enterprise (the reinsurer). USF&G
pays (cedes) an amount to the reinsurer which in turn agrees to reimburse USF&G
for a specified portion of any claims paid under the reinsured contracts.
Reinsurance gives USF&G the ability to write certain individually large risks
or groups of risks, and helps to control its exposure to losses by ceding a
portion of such large risks. USF&G's ceding reinsurance agreements are
generally structured on a treaty basis whereby all risks meeting a certain
criteria are automatically reinsured. Shrinking capacity in the reinsurance
market and the high catastrophe losses in recent years have increased prices
and reduced the availability of catastrophe reinsurance. Property catastrophe
reinsurance costs were $34 million in 1994 (including a $5 million assessment
from the Florida Hurricane Catastrophe Fund), compared with $30 million and $26
million in 1993 and 1992, respectively. The current catastrophe structure shows
improvement from prior years by increasing USF&G's total reinsurance protection
from $205 million in 1993 to $215 million in 1994, and by providing greater
protection in all treaty layers through increased reinsurance placement.
USF&G's property catastrophe loss retention level at December 31, 1994 is $75
million, which in the event of a second loss, is lowered to $50 million. Loss
retention levels for 1993 and 1992 were $50 million and $23 million,
respectively, and did not include any "second event" protection.
2.6. Capacity
A key measure of both strength and growth capacity for property/casualty
insurers is the ratio of premiums written to statutory policyholders' surplus.
At the end of 1994 and 1993, USF&G's premium-to-surplus ratio was 1.4:1,
compared with 1.5:1 at the end of 1992. The industry average is approximately
1.3:1. Insurance regulators generally accept a ceiling for this ratio of 3.0:1;
therefore, at its current ratio, USF&G has the capacity to grow by writing new
business.
2a. Discover Re
On April 13, 1995, USF&G consummated its merger with Discover Re. In the
transaction, which is accounted for as a pooling-of-interests, USF&G exchanged
5.4 million shares of common stock, worth approximately $78.5 million, for all
of the outstanding equity of Discover Re. Discover Re provides insurance,
reinsurance and related services to the alternative risk transfer ("ART")
market, primarily in the municipalities, transportation, education and retail
sectors. Through the ART market, a company can self-insure the predictable,
frequency portion of its own losses. The insurance premiums which were
previously paid to traditional insurance companies in order to transfer risk
are instead used to self-insure those relatively predictable losses and to
purchase insurance for the less frequent, high severity losses that could have
a major financial impact on a company. Although ART mechanisms reduce the
amount of premium to the traditional market, they do not reduce the need for
comprehensive risk management services, including policy and claims management
and processing, underwriting, actuarial, investment and other administrative
management. Also, in some cases, ART clients still require third party
insurance policies. The ART market represents approximately 30 percent of the
commercial insurance market. This merger facilitates USF&G's access to the ART
market and, management believes, provides increased growth potential by
augmenting certain of the existing core commercial lines insurance operations.
The following table shows the components of underwriting results for Discover
Re:
(in millions) 1994 1993 1992
Premiums written $ 27 $ 20 $ 12
Premiums earned $ 22 $ 16 $ 8
Losses (17) (13) (6)
Expenses (5) (4) (2)
Net underwriting losses $ - $ (1) $ -
GAAP and statutory underwriting ratios are as follows:
1994 1993 1992
GAAP Underwriting Ratios:
Loss ratio 76.2 76.2 80.0
Expense ratio 23.8 26.7 30.3
Combined ratio 100.0 102.9 110.3
Statutory Underwriting Ratios:
Loss ratio 76.2 76.2 80.0
Expense ratio 22.6 23.9 28.4
Combined ratio 98.8 100.1 108.4
2b. Victoria
On May 22, 1995, USF&G consummated its merger with Victoria. In the
transaction, which is accounted for as a pooling-of-interests, USF&G exchanged
3.8 million shares of common stock, worth approximately $59.1 million, for all
of the outstanding equity of Victoria. Victoria is an insurance holding company
which specializes in nonstandard personal lines auto coverage. Nonstandard
automobile insurance companies provide automobile insurance to individuals who
are unable to obtain preferred or standard insurance coverage due to their
inability to meet certain standard underwriting criteria, based on factors such
as age, type of automobile, residence location and driving record. Management
believes that this merger will allow USF&G to enhance premium retention and
grow the personal lines business through an expanded product portfolio.
The following table shows the components of underwriting results
for Victoria:
(in millions) 1994 1993 1992
Premiums written $ 50 $ 53 $ 43
Premiums earned $ 51 $ 49 $ 38
Losses (36) (34) (26)
Expenses (17) (16) (13)
Net underwriting losses $ (2) $ (1) $ (1)
GAAP and statutory underwriting ratios are as follows:
1994 1993 1992
GAAP Underwriting Ratios:
Loss ratio 69.1 70.1 69.1
Expense ratio 31.2 28.5 30.1
Combined ratio 100.3 98.6 99.2
Statutory Underwriting Ratios:
Loss ratio 69.1 70.1 69.1
Expense ratio 32.2 28.2 30.3
Combined ratio 101.3 98.3 99.4
3. Life Insurance Operations
Life insurance operations (F&G Life) represent 15 percent of USF&G's total
revenues in 1994, compared with 14 percent and 13 percent in 1993 and 1992,
respectively. F&G Life also represents 33 percent of the assets at December 31,
1994, compared with 34 percent and 37 percent at December 31, 1993 and 1992,
respectively.
Financial results for F&G Life are as follows:
Years Ended December 31
(in millions) 1994 1993 1992
Premiums $ 152 $ 129 $ 104
Net investment income 317 321 349
Policy benefits (388) (395) (377)
Underwriting and operating expenses (67) (61) (77)
Restructuring charges - - (3)
Income (loss) from continuing operations
before realized gains, facilities exit
costs, income taxes and cumulative effect
of adopting new accounting standards $ 14 $ (6) $ (4)
Income for the year ended December 31, 1994 improved when compared with 1993
and 1992 as a result of continued positive sales trends and improved profit
margins, partially offset by higher sales related expenses. The increase in
sales is attributed to the new product initiatives and refocused distribution
channels (refer to Section 3.2 of this Analysis). Profit margins improved
during the year as current and projected spreads between investment income and
interest credited to policyholders improved compared with 1993 levels. This
resulted from lower rates being credited to annuities where the guaranteed rate
period has expired and improved spread management on new and renewal business.
The higher profit margins are also attributable to the favorable retention of
the single premium deferred annuity ("SPDA") block, originally sold in 1988
through 1990 by investment brokers (refer to Section 3.3 of this Analysis). The
declining trend in net investment income is primarily due to SPDA surrenders
which are reducing the level of invested assets. This trend is likely to
continue in 1995. This trend was partially offset in 1994 by the recognition
of $8 million from the sale of a timber investment.
3.1. Products
F&G Life issues annuity and life insurance products. F&G Life's principal
products are structured settlements, deferred annuities (including tax
sheltered annuities), immediate annuities and life insurance products.
Structured settlements are immediate annuities principally sold to the
property/casualty company in settlement of insurance claims.
Deferred annuity products accumulate cash values to which interest is credited.
In 1994, deferred annuities were credited with interest rates that ranged
between 4.0 and 9.5 percent, depending upon the year of issue and interest
guarantee duration. The majority of deferred annuities in force were issued
with initial interest guarantees from one to six years, with most of these
written between 1988 and 1990 with a six year interest guarantee. The deferred
annuities also include provisions for charges if the annuitant chooses to
surrender the policy (see Section 3.3 of this Analysis). After the interest
guarantee expires, the interest crediting rates can be adjusted annually on a
policy's anniversary date.
Deferred annuity products are sold through independent agents, insurance
brokers and national wholesale distributors. F&G Life's tax sheltered annuity
products ("TSAs") are deferred annuities that provide retirement income. TSAs
are sold through a national wholesale distribution network primarily to
teachers.
Other annuities sold by F&G Life primarily consist of single premium immediate
annuities ("SPIAs"). SPIAs provide a fixed stream of payments over a fixed
period of time or over an individual's lifetime.
F&G Life markets universal life ("UL") and term life insurance products,
primarily through independent agents. UL insurance provides a death benefit for
the life of the insured and accumulates cash values to which interest is
credited. Term life insurance provides a fixed death benefit if the insured
dies during the contractual period.
3.2. Sales
The following table shows life insurance and annuity sales (premiums and
deposits) by distribution system and product type:
(in millions) 1994 1993 1992
Distribution System:
Direct-structured settlements $ 88 $ 66 $ 37
Property/casualty brokerage 48 49 67
National brokerage 46 14 -
National wholesaler 71 39 -
Other 33 37 51
Total $286 $205 $155
Product Type:
Structured settlement annuities $ 88 $ 66 $ 37
Single premium deferred annuities 82 44 33
Tax sheltered annuities 63 35 -
Other annuities 41 54 74
Life insurance 12 6 11
Total $286 $205 $155
Sales in 1994, led by structured settlement annuities, single premium deferred
annuities, and tax sheltered annuities, have increased 40 percent over 1993
sales and 85 percent over 1992 sales. In its effort to continue the improvement
in sales and profitability, F&G Life intends to continue to concentrate on the
expansion of its existing distribution channels while also developing other
marketing networks. F&G Life is also continuing the development of selected
products, and modifying current product offerings to meet customer needs.
Despite F&G Life's attention to expanding its distribution channels and to
product development, demand for its products is affected by fluctuating
interest rates and the relative attractiveness of alternative investment,
annuity or insurance products, as well as its credit ratings. As a result,
there is no assurance that the improved sales trend will continue at the same
level. Total life insurance in force was $11.8 billion at December 31, 1994,
compared with $12.1 billion and $12.4 billion at December 31, 1993 and 1992,
respectively.
3.3. Policy surrenders
Deferred annuities and universal life products are subject to surrender. Nearly
all of F&G Life's surrenderable annuity policies allow a refund of the cash
value balance less a surrender charge. The surrender charge varies by product.
Single premium deferred annuities, which represent 67 percent of surrenderable
business, have surrender charges that decline from six percent in the first
policy year to zero percent in the seventh and later policy years. Newer
products that have been issued during 1994 have surrender charges that
decline from nine percent in the first policy year to zero percent in the tenth
and later policy years. Such built-in surrender charges provide protection
against premature policy surrender.
Policy surrenders totaled $576 million for the year ended December 31, 1994.
This compares with $211 million and $192 million for 1993 and 1992,
respectively. Surrender activity has increased as a result of expiring
surrender charges, primarily on the investment broker block of SPDA, as
policyholders seek other investment alternatives.
During 1994, management had in place a policy conservation program that
provided policyholders with a competitive renewal option within F&G Life once
their surrender charge period had expired. Through December 31, 1994,
policyholders representing approximately 27 percent of the expiring block
elected this option. An additional 23 percent of the expiring block was
retained under the terms of the original contract, free of surrender charges
and at short-term interest rates which are adjusted annually.
The total account value of F&G Life's deferred annuities is $2.3 billion, 15
percent of which is surrenderable at current account value (i.e., without
surrender charges). The surrender charge period on an additional $1.3 billion
of F&G Life's single premium deferred annuity products expires through the end
of 1997, of which $515 million expires during 1995. The experience thus far
for $693 million of SPDAs where the surrender charge period expired in the
fourth quarter of 1993 through the fourth quarter of 1994 indicates that on
average, 50 percent of the expiring block may surrender; however, in the
future, a larger percentage may surrender should interest rates continue their
upward trend. While this will put pressure on F&G Life's ability to increase
assets, given the relatively high interest rates credited when these annuities
were issued, overall profit margins would continue to improve as they surrender
or rollover to new products with lower rates. Management believes that F&G
Life, with liquid assets equal to 124 percent of the surrender value of
surrenderable business at December 31, 1994, continues to maintain a high
degree of liquidity and has the ability to meet surrender obligations for the
foreseeable future.
3.4. Deferred policy acquisition costs ("DPAC")
Costs to acquire and issue annuities and life insurance policies are generally
deferred and amortized in future periods in relationship to expected gross
profits. The recoverability of these amounts is regularly reviewed by
management through monitoring of surrender experience, projected investment
spreads and other criteria.
Policy acquisition costs unfavorably affected results as $4 million, $8 million
and $10 million of normally deferrable costs were expensed in 1994, 1993 and
1992, respectively, because surrender experience and sales levels did not
support the continued deferral of such costs.
During the year ended December 31, 1994, $26 million of current year expense
has been deferred compared with $12 million and $11 million for the years ended
December 31, 1993 and 1992, respectively. The increase in the deferral is due
to the higher level of sales and improved future spread income during 1994
compared with 1993 and 1992. Amortization of the beginning DPAC balance was
$21 million, $10 million and $25 million for the years ended 1994, 1993 and
1992, respectively. The rate of amortization in future periods would be
accelerated if surrender activity increases and/or product margins permanently
narrow.
4. Parent and Noninsurance Operations
Parent company interest and other unallocated expenses and net losses from
noninsurance operations were as follows:
Years Ended December 31
(in millions) 1994 1993 1992
Parent Company Expenses:
Interest expense $ (34) $ (37) $ (35)
Unallocated expense, net (48) (35) (34)
Noninsurance Operations:
Management consulting 1 (2) (4)
Oil and gas - - (18)
Other noninsurance investments 2 (9) (13)
Restructuring charges - - (2)
Income (loss) from continuing operations
before realized gains, facilities exit
costs, income taxes and cumulative effect
of adopting new accounting standards $ (79) $ (83) $(106)
The results for the parent company and noninsurance operations improved
slightly when compared to 1993. This improvement was primarily a result of
recognizing $6 million of dividend income from an investment in an asset
management company, as well as improvements in management consulting operations
and certain real estate investments. Unallocated expenses increased over 1993
due primarily to a $9 million non-recurring loss on long-term subleases.
Interest expense was slightly lower in 1994 than 1993; however, interest
expense is expected to increase in 1995 due to higher short-term interest rates
(refer to Section 6 of this Analysis). The $18 million loss in 1992 related to
an oil and gas subsidiary which was merged with another oil and gas company
converting USF&G's interest into an equity investment of the successor company.
5. Investments
USF&G's investment mix continues to reflect a concentration in high quality
fixed-income securities. Long-term fixed maturities comprised 83 percent of
total investments at December 31, 1994, compared with 84 percent and 81 percent
at December 31, 1993 and 1992, respectively. Total investments have decreased
due to unrealized losses in the available for sale portfolio, as well as the
use of proceeds from sales and repayments of fixed maturities to meet cash flow
needs, primarily from SPDA surrenders. The following table shows the
distribution of USF&G's investment portfolio.
At December 31
(dollars in millions) 1994 1993 1992
Total investments $10,421 $11,377 $11,346
Fixed Maturities:
Held to maturity 45% 41% 64%
Available for sale 38 43 17
Total fixed maturities 83 84 81
Common and preferred stocks 1 1 1
Short-term investments 4 3 5
Mortgage loans and real estate 10 9 9
Other invested assets 2 3 4
Total 100% 100% 100%
5.1. Net investment income
The following table shows the components of net investment income.
Years Ended December 31
(dollars in millions) 1994 1993 1992
Net Investment Income From:
Fixed maturities $669 $721 $739
Equity securities 7 9 12
Options - - 37
Short-term investments 13 9 27
Mortgage loans and real estate 58 41 50
Other, less expenses (4) (31) (48)
Total $743 $749 $817
Average Yields:
Total investments 6.9% 6.7% 7.3%
Fixed maturities 7.4% 7.7% 8.6%
Investment income for the period ended December 31, 1994 decreased $6 million
or one percent, and $74 million or nine percent when compared to the same
periods of 1993 and 1992, respectively. The decrease in investment income from
fixed maturities is primarily due to an investment base which declined in order
to meet SPDA surrenders and other cash flow needs. In addition, given the
relatively low long-term interest rate environment, proceeds from sales,
maturities or repayments of fixed maturities during 1993 and 1994 were
reinvested in fixed maturities with lower yields. Overall, investment income in
fixed maturities decreased by seven percent and ten percent when compared to
1993 and 1992, respectively. Although interest rates have increased in 1994,
new purchases of fixed maturities totaling $693 million were not significant
enough to affect the average yield.
The increase in net investment income from short-term investments since 1993
primarily reflects the higher short-term interest rate environment. Real estate
and mortgage loan investment income has increased as a result of the sale of
timberland investments, prepayment of a mortgage loan, and a new loan program
whereby USF&G is investing a greater percentage of capital in commercial
mortgage loans versus equity real estate. Other income less expenses improved
primarily due to USF&G's share of earnings from an equity interest in
Renaissance Reinsurance Ltd. ("Renaissance Re"), an offshore reinsurance
company. USF&G recorded $17 million of net investment income from Renaissance
Re during 1994 and $5 million during 1993. Future income from the investment
in Renaissance Re is subject to volatility and exposure to catastrophe losses
and other risks inherent in the property/casualty reinsurance industry. Reduced
interest expense accrued on ceded premiums held by USF&G accounts for the
remainder of the improvement in other net investment income.
5.2. Net realized gains on investments
The components of net realized gains include the following:
Years Ended December 31
(in millions) 1994 1993 1992
Net Gains From Sales:
Fixed maturities $ 3 $ 79 $179
Equities and options - 5 44
Real estate and other 12 6 16
Total net gains 15 90 239
Impairments:
Fixed maturities (1) (10) (20)
Equities - (8) -
Real estate and other (9) (66) (71)
Total impairments (10) (84) (91)
Net realized gains $ 5 $ 6 $148
Realized gains from real estate and other investments for 1994 resulted from
the sale of timberland investments and USF&G's portion of realized gains from
investments in limited partnerships. The $79 million in realized gains on fixed
maturities in 1993 is primarily due to USF&G's repositioning a portion of its
fixed maturity investments to more effectively match the duration of its life
insurance liabilities. The $179 million in realized gains in 1992 is the result
of investment sales to offset declines in capital and statutory surplus caused
by catastrophe losses in 1992. In 1992, USF&G realized $52 million of gains on
equities and reallocated the proceeds to relatively less volatile fixed
maturities.
To reflect the impairments in the value of certain investments, USF&G made
provisions for impairment of $10 million in 1994 compared with $84 million in
1993 and $91 million in 1992. Real estate impairments in 1994 primarily
related to specific properties whose recent appraisal values reflected other
than temporary impairments. Real estate impairments were taken in 1993 to
write down to net realizable value properties that were sold or expected to be
sold in the near term. Real estate impairments in 1992 reflect both changes in
circumstances related to specific properties and general real estate market
deterioration. The impairment of fixed maturities relates to specific
investments whose impairment is considered other than temporary. The 1993
impairments on equities related to specific equity holdings which were sold
shortly thereafter.
5.3. Unrealized gains (losses)
The components of the changes in unrealized gains (losses) were as follows:
Years Ended December 31
(in millions) 1994 1993 1992
Fixed maturities available for sale $(401) $222 $ -
Deferred policy acquisition
costs adjustment 63 (30) -
Equity securities 3 23 (39)
Options, foreign currency and other 1 4 21
Total $(334) $219 $(18)
USF&G adopted SFAS No. 115, "Accounting for Certain Investments in Debt and
Equity Securities," in the fourth quarter of 1993. SFAS 115 requires that the
portion of fixed maturity investments classified as "available for sale" be
recorded at market value with the unrealized gains/losses reported as a
component of shareholders' equity. Prior to the adoption of SFAS No. 115,
fixed maturities available for sale were recorded at lower of cost or market
with no effect on shareholders' equity. Unrealized gains on fixed maturities
at December 31, 1993 reflects the low interest rate environment of 1993.
However, rising interest rates during 1994 resulted in a decrease in the
unrealized gain on fixed maturities available for sale from $222 million at
December 31, 1993 to an unrealized loss of $179 million at December 31, 1994.
This was partially offset by a related change in the DPAC adjustment from the
prior year's unrealized loss of $30 million to an unrealized gain of $33
million at December 31, 1994. This adjustment is made to reflect assumptions
about the effect of potential asset sales of fixed maturities available for
sale on future DPAC amortization.
5.4. Fixed maturity investments
The tables below detail the composition of the fixed maturity portfolio.
At December 31
1994
Net
Amortized Market Unrealized
(in millions) Cost Value (Loss)
Fixed Maturities:
Held to maturity $4,650 $4,275 $(375)
Available for sale 4,160 3,981 (179)
Total $8,810 $8,256 $(554)
At December 31
1993
Net
Amortized Market Unrealized
(in millions) Cost Value Gain
Fixed Maturities:
Held to maturity $4,661 $4,796 $135
Available for sale 4,681 4,903 222
Total $9,342 $9,699 $357
At December 31
1992
Net
Amortized Market Unrealized
(in millions) Cost Value Gain
Fixed Maturities:
Held to maturity $7,218 $7,290 $72
Available for sale 1,987 2,029 42
Total $9,205 $9,319 $114
At December 31
(dollars in millions) 1994 % 1993 % 1992 %
Corporate investment-grade bonds $5,017 57 $4,866 52 $3,103 34
Mortgage-backed securities 1,915 22 2,403 26 3,824 42
Asset-backed securities 931 10 1,149 12 995 11
U.S. Government bonds 277 3 308 3 554 6
High-yield bonds* 616 7 562 6 522 5
Tax-exempt bonds 47 1 48 1 71 1
Other 7 - 6 - 136 1
Total fixed maturities at
amortized cost 8,810 100 9,342 100 9,205 100
Total market value of
fixed maturities 8,256 9,699 9,319
Net unrealized gains (losses) $ (554) $ 357 $ 114
Percent market-to-amortized cost 94 104 101
*See Glossary of Terms
Increasing interest rates, which resulted in declining bond prices, were
responsible for the 10 percent decrease in the fixed maturity portfolio's
overall market-to-amortized cost ratio from December 31, 1993. Interest rates
rose an average 270 basis points during 1994.
Investments in mortgage-backed securities declined 20 percent and 50 percent
when compared with holdings at December 31, 1993 and 1992, respectively, due
primarily to prepayments of the underlying mortgages. While subject to
prepayment risk, credit risk related to USF&G's mortgage-backed securities
portfolio at December 31, 1994 is believed to be minimal since 99 percent of
such securities have AAA ratings or are collateralized by obligations of the
U.S. Government or its agencies. Asset-backed securities declined 19 percent
and six percent when compared with holdings at December 31, 1993 and 1992,
respectively, as a result of sales and maturities. The net proceeds from sales,
maturities and prepayments in 1994 were generally reinvested into corporate
investment-grade bonds.
Investment-grade bonds, including debt obligations of the U.S. Government and
its agencies, comprised 93 percent of the portfolio at December 31, 1994,
compared with 94 percent and 93 percent at December 31, 1993 and 1992,
respectively. The table below shows the credit quality of the long-term fixed
maturity portfolio as of December 31, 1994.
Percent Market-
Amortized Market to-Amortized
(dollars in millions) Cost Percent Value Cost
U.S. Government and
U.S. Government
Agencies $2,075 23% $1,952 94%
AAA 1,368 16 1,324 97
AA 1,317 15 1,191 90
A 2,395 27 2,244 94
BBB 1,039 12 973 94
Below BBB 616 7 572 93
Total $8,810 100% $8,256 94%
USF&G's holdings in high-yield bonds comprised seven percent of the total fixed
maturity portfolio at December 31, 1994, compared with six percent at both
December 31, 1993 and 1992. Of the total high-yield bond portfolio, 72 percent
is held by the life insurance segment, representing 10 percent of its total
investments. The table below illustrates the credit quality of USF&G's high-
yield bond portfolio at December 31, 1994.
Percent Market-
Amortized Market to-Amortized
(dollars in millions) Cost Percent Value Cost
BB $366 60% $337 92%
B 248 40 233 94
CCC and lower 2 - 2 100
Total $616 100% $572 93%
The information on credit quality in the preceding two tables is based upon the
higher of the rating assigned to each issue by either Standard & Poor's or
Moody's. Where neither Standard & Poor's nor Moody's has assigned a rating to a
particular fixed maturity issue, classification is based on 1) ratings
available from other recognized rating services; 2) ratings assigned by the
NAIC; or 3) an internal assessment of the characteristics of the individual
security, if no other rating is available.
At December 31, 1994, USF&G's five largest investments in high-yield bonds
totaled $88 million in amortized cost and had a market value of $72 million.
None of these investments individually exceeded $30 million. USF&G's largest
single high-yield bond exposure represented five percent of the high-yield
portfolio and 0.3 percent of the total fixed maturity portfolio.
5.5. Real estate
The table below shows the components of USF&G's real estate portfolio.
At December 31
(in millions) 1994 1993 1992
Mortgage loans $ 349 $ 302 $ 186
Equity real estate 760 793 926
Reserves (98) (108) (108)
Total $1,011 $ 987 $1,004
The increase in mortgage loans reflects USF&G's strategy of maintaining a
generally consistent level of real estate assets while changing the mix to more
traditional mortgage loans and less equity real estate investments. This
strategy is designed to reduce risk and increase yields in the real estate
portfolio.
USF&G's real estate investment strategy emphasizes diversification by
geographic region, property type and stage of development. The diversification
of USF&G's mortgage loan and real estate portfolio is as follows:
At December 31
1994 1993 1992
Geographic Region:
Pacific/Mountain 34% 33% 33%
Midwest 20 18 19
Mid-Atlantic 17 19 17
Southeast 16 22 22
Southwest 8 5 6
Northeast 5 3 3
Type of Property:
Office 37% 37% 33%
Land 26 27 28
Apartments 24 19 16
Retail/other 7 6 10
Industrial 6 9 11
Timberland/agriculture - 2 2
Development Stage:
Operating property 75% 73% 72%
Land development 15 16 17
Land packaging 10 11 11
Real estate investments are generally appraised at least once every three
years. Appraisals are obtained more frequently under certain circumstances such
as when there have been significant changes in property performance or market
conditions. All of these appraisals are performed by professionally certified
appraisers.
At December 31, 1994, USF&G's five largest real estate investments had a book
value of $325 million. The largest single investment was a land development
project located in San Diego, California with a book value of $93 million, or
nine percent of the total real estate portfolio.
Mortgage loans and real estate investments not performing in accordance with
contractual terms, or performing significantly below expectation, are
categorized as nonperforming. Nonperforming real estate investments at
December 31, 1994 declined 16 percent and 40 percent when compared with
December 31, 1993 and 1992, respectively. This decline in nonperforming real
estate was a result of the combination of the sale of a nonperforming real
estate property, write-downs on other specific properties, and
reclassifications.
The book value of the components of nonperforming real estate are as follows:
At December 31
(dollars in millions) 1994 1993 1992
Restructured loans and investments* $ - $ 4 $ 4
Real estate held as in-substance
foreclosure* - 14 15
Real estate acquired through foreclosure
or deed-in-lieu of foreclosure* 117 121 190
Land investments* 56 57 71
Nonperforming equity investments* 35 53 66
Total nonperforming real estate $ 208 $ 249 $ 346
Real estate reserves $ (98) $(108) $(108)
Reserves/nonperforming real estate 47% 43% 31%
*See Glossary of Terms
Valuation allowances are established for impairments of mortgage loans and
equity real estate values based on periodic evaluations of the operating
performance of the properties and their exposure to declines in value. The
allowance totaled $98 million, or nine percent of the entire real estate
portfolio, at December 31, 1994, compared with $108 million, or 10 percent of
the total real estate portfolio, at both December 31, 1993 and 1992. The
decrease in the reserves on real estate investments is a result of applying the
reserve to specific properties where permanent impairment has occurred. In
light of USF&G's current plans with respect to the portfolio, management
believes the allowance at December 31, 1994 continues to adequately reflect
the current condition of the portfolio. Should deterioration occur in the
general real estate market or with respect to individual properties in the
future, additional reserves may be required. Although USF&G anticipates that
any sales of real estate will be in an orderly fashion as and when market
conditions permit, if USF&G was required to dispose of a significant portion of
its real estate in the near term, it is likely that it would recover amounts
substantially less than the related carrying values. Prospectively, efforts
will continue to reduce risk and increase yields in the real estate portfolio
by selling equity real estate when it is advantageous to do so and reinvesting
the proceeds in medium-term mortgage loans.
6. Financial Condition
6.1. Assets
USF&G's assets totaled $13.8 billion at December 31, 1994, compared with $14.3
billion and $13.1 billion at the end of 1993 and 1992, respectively. The $561
million reduction in 1994 is primarily due to a $401 million reduction in the
market value of the fixed maturity investments classified as available for
sale. In addition, proceeds from the sale of investments were used to meet
cash flow needs.
6.2. Debt
USF&G's corporate debt totaled $586 million at December 31, 1994, compared with
$574 million at December 31, 1993 and 1992. The increase in corporate debt is
mainly attributable to foreign currency translation adjustments of $13 million
from non-U.S. dollar denominated debt. As a result of entering into forward
contracts, there was no effect on net income from the translation of non-U.S.
dollar denominated debt.
Proceeds from two debt offerings in 1994 were used to retire other portions of
USF&G Corporation's debt. During the first quarter of 1994, proceeds of $126
million from the issuance of Zero Coupon Convertible Notes were used to redeem
higher interest bearing medium and long-term notes. USF&G also issued $150
million 8 3/8% Senior Notes due 2001 in the second quarter of 1994, the
proceeds from which were used to repay a portion of the short-term bank credit
facility (see Section 7 of this Analysis).
USF&G's real estate and other debt totaled $30 million at December 31, 1994,
compared with $44 million and $42 million at December 31, 1993 and 1992,
respectively. Real estate debt increased as a result of the restructuring of a
real estate partnership where USF&G became a controlling general partner.
Shortly thereafter, USF&G defeased all but $9 million of such debt. Real estate
debt was reduced by $11 million as a result of a deed-in-lieu of foreclosure,
whereby property in which USF&G has a partnership interest was conveyed back to
the lender, and further reduced by the early payoff of a $11 million real
estate loan.
6.3. Shareholders' equity
USF&G's shareholders' equity totaled $1.4 billion at December 31, 1994, $1.5
billion at December 31, 1993 and $1.3 billion at December 31, 1992. The
decrease was primarily the result of the $401 million decline in unrealized
gains on fixed maturity investments available for sale reduced by a $63 million
change in the related life insurance segment's DPAC adjustment. Net income of
$232 million less common and preferred dividends of $64 million partially
offset the reduction in equity.
6.4. Regulatory risk-based capital
The National Association of Insurance Commissioners ("NAIC") has adopted model
regulations which establish minimum capitalization requirements based on a
"risk-based capital" formula. These regulations, which were first effective for
property/casualty companies for the year ended December 31, 1994 and for life
insurance companies for the year ended December 31, 1993, establish four levels
at which corrective action must be taken. These levels are: (1) the "company
action level," at which the company must submit a comprehensive financial plan
with specific proposals to address certain financial problems; (2) the
"regulatory action level," at which the appropriate regulatory authorities will
perform a financial analysis and order certain corrective actions; (3) the
"authorized control level," at which the regulatory authorities may place the
company under regulatory control; and (4) the "mandatory control level," at
which the regulatory authorities must place the company under regulatory
control.
Application of these levels depends upon the insurer's "adjusted risk-based
capital" as a percentage of the "minimum risk-based capital." Risk-based
capital is calculated after adjusting capital for certain asset, credit,
market, underwriting, off balance sheet and other risks inherent in the assets,
liabilities and business of the insurer. Various levels of corrective actions
are required if the adjusted risk-based capital is less than 200% of the
authorized control level risk-based capital.
USF&G Company had adjusted risk-based capital of $1.62 billion as of December
31, 1994, which represented 382% of the authorized control level risk-based
capital. F&G Life had adjusted risk-based capital of $427 million and $441
million as of December 31, 1994 and 1993, respectively, which represented 422%
and 396% of the authorized control level risk-based capital as of those dates.
Accordingly, as of the dates indicated, both USF&G Company and F&G Life had
adjusted risk-based capital above the levels which would require corrective
action.
6.5. Capital strategy
In January 1994, USF&G filed a shelf registration statement with the Securities
and Exchange Commission. As of the time this registration statement went into
effect, USF&G had available $647 million of unissued debt, preferred stock,
common stock and warrants to purchase debt and stock. This registration
statement was reduced by $126 million after the issuance of the Zero Coupon
Convertible Notes and by $149 million after the issuance of the 8 3/8% Senior
Notes. Subject to capital market conditions, USF&G plans to refinance up to
$300 million of debt over the next several years.
During 1994, USF&G called for redemption 2.4 million shares of its Series C
Preferred Stock. The remaining shares were called for redemption effective
February 24, 1995. As a result of these calls, over 93 percent of the Series C
Preferred Stock converted into 14.7 million shares of common stock in
accordance with the terms of the Series C Preferred Stock. Pursuant to
arrangements the Corporation previously entered into with an unaffiliated
financial institution, USF&G sold 716,600 shares of common stock to this
institution to fund a portion of the cash redemptions resulting from these
calls.
In December 1994, USF&G entered into a definitive agreement to purchase all of
the outstanding stock of Victoria Financial Corporation for approximately 4.1
million shares or $55.3 million of USF&G's common stock, depending on the
average market price of USF&G common stock over a specified period preceding
the closing of the transaction. Victoria is an insurance holding company which
specializes in nonstandard auto coverage. Additionally, in January 1995, USF&G
entered into a definitive agreement to purchase all of the outstanding equity
of Discover Re Managers, Inc., for approximately 5.4 million shares or $78.5
million of USF&G's common stock. Discover Re provides insurance, reinsurance
and related services to the alternative risk transfer market. Both
transactions are expected to close in the second quarter of 1995.
As further explained in Section 7.2 of this Analysis, USF&G negotiated a $400
million credit facility in 1994 to replace the $700 million facility that was
due to expire in March 1995.
7. Liquidity
Liquidity is a measure of an entity's ability to secure enough cash to meet its
contractual obligations and operating needs. USF&G requires cash primarily to
pay policyholders' claims and benefits, debt and dividend obligations, and
operating expenses. USF&G's sources of cash include cash flow from operations,
credit facilities, marketable securities and sales of other assets. Management
believes that internal and external sources of cash will continue to exceed
USF&G's short-term and long-term needs.
7.1. Cash flow
USF&G had cash flow from operating activities of $115 million for the year
ended December 31, 1994 and $87 million and $97 million for the years ended
December 31, 1993 and 1992, respectively. The growth of cash flows from
operating activities for 1994 as compared to 1993 is due primarily to large
repayments made to reinsurers in 1993 because of new accounting pronouncements
that initiated the termination of several reinsurance contracts. In addition,
deposits and withdrawals of universal life and investment contracts, which for
GAAP reporting purposes are considered financing activities, had a net cash
outflow of $418 million in 1994 as compared to $196 million and $125 million
for 1993 and 1992, respectively.
7.2. Credit facilities
At December 31, 1994, USF&G maintained a $400 million committed credit facility
with a group of foreign and domestic banks. This represents the renegotiation
of a prior credit facility of $700 million at December 31, 1993. Management
elected to reduce the size of the facility due to the reduction in borrowings
against it and the Corporation's reestablished access to capital markets.
Borrowings outstanding under the credit facility totaled $215 million at
December 31, 1994 and $375 million at both December 31, 1993 and 1992. The
credit agreement contains restrictive covenants pertaining to indebtedness,
tangible net worth, liens and other matters. USF&G was in compliance with these
covenants at December 31, 1994, 1993 and 1992.
In addition, at December 31, 1994, USF&G maintained a $100 million foreign
currency credit facility and a $100 million letter of credit facility. There
were no borrowings on the foreign currency credit facility or the letter of
credit facility at December 31, 1994.
7.3. Marketable securities
USF&G's fixed-income, equity security and short-term investment portfolios are
liquid and represent substantial sources of cash. The market value of its
fixed-income securities was $8.3 billion at December 31, 1994 which represents
94 percent of its amortized cost. At December 31, 1994, equity securities,
which are reported at market value on the balance sheet, totaled $70 million.
Short-term investments totaled $421 million.
7.4. Liquidity restrictions
There are certain restrictions on payments of dividends by insurance
subsidiaries that may limit USF&G's ability to receive funds from its
subsidiaries. The Maryland Insurance Code requires the Maryland Insurance
Commissioner's prior approval for any dividend payments during a 12 month
period from a Maryland insurance subsidiary, such as USF&G Company, to its
holding company which exceeds 10 percent of policyholders' surplus as of the
prior calendar year end. In addition, notice of any other dividend must be
given to the Maryland Insurance Commissioner prior to payment, and the
Commissioner has the right to prevent payment of such dividend if it is
determined that such payment could impair the insurer's surplus or financial
condition. Dividends of approximately $157 million are currently available for
payment to USF&G Corporation from USF&G Company during 1995 without prior
regulatory approval. Dividends paid to USF&G Corporation from USF&G Company
totaled $125 million in 1994, 1993 and 1992. USF&G's insurance subsidiaries'
admitted assets for statutory purposes included a total of approximately $244
million in receivables from the parent and affiliated companies.
7.5. Technology upgrades
USF&G has initiated a plan to upgrade its information technology and convert
its mainframe based systems to a client server based system. During 1995, USF&G
plans to invest over $20 million in this project. Total expenditures over the
next three years on this project are estimated to be approximately $50 million.
USF&G's plan is to recover this investment through future cost savings and
competitive advantages.
8. Regulation
USF&G's insurance subsidiaries are subject to extensive regulatory oversight in
the jurisdictions where they do business. This regulatory structure, which
generally operates through state insurance departments, involves the licensing
of insurance companies and agents, limitations on the nature and amount of
certain investments, restrictions on the amount of single insured risks,
approval of policy forms and rates, setting of capital requirements,
limitations on dividends, limitations on the ability to withdraw from certain
lines of business such as personal lines and workers' compensation, and other
matters. From time to time, the insurance regulatory framework has been the
subject of increased scrutiny. At any one time there may be numerous
initiatives within state legislatures or state insurance departments to alter
and, in many cases, increase state authority to regulate insurance companies
and their businesses. Proposals to adopt a federal regulatory framework have
also been discussed. It is not possible to predict the future impact of
increasing state or potential federal regulation on USF&G's operations.
Additional information regarding legal and regulatory contingencies may be
found in Note 13, "Legal Contingencies," to the consolidated financial
statements.
8.1. Proposition 103
In November 1988, voters in the State of California passed Proposition 103,
which required insurers doing business in California to rollback most
property/casualty premium prices in effect between November 1988 and November
1989 to November 1987 levels, less an additional 20 percent discount, unless an
insurer could establish that such rate levels threatened its solvency. In May
1989, the California Supreme Court ruled that an insurer does not have to face
insolvency in order to qualify for an exemption from the rollback requirements
and is entitled to a "fair and reasonable return."
The California Insurance Department's authority to establish regulations
setting forth a basis for determining what constitutes a "fair and reasonable
return" has been the subject of significant controversy. In August 1994, the
California Supreme Court issued its opinion in 20th Century Insurance Company
v. Garamendi, affirming the California Insurance Department's authority to
establish a broad industry-wide formula for implementing Proposition 103. The
20th Century Insurance Company subsequently settled the matter with the
California Insurance Department, and on February 22, 1995, the United States
Supreme Court denied the writ of certiorari filed by the other litigants in the
proceedings. It is not clear how the current regulations adopted by the
California Insurance Department will apply to USF&G, and there are many issues
which remain unsettled. The range of liability to USF&G could be from less than
$10 million up to approximately $31 million, including interest. The ultimate
outcome of this issue is not expected to have a material adverse effect on
USF&G's results of operations or financial position since any such liability is
not expected to materially exceed amounts already reserved.
8.2. Maine "Fresh Start" litigation
In 1987, the State of Maine adopted workers' compensation reform legislation
which was intended to rectify historic rate inadequacies and encourage
insurance companies to reenter the Maine voluntary workers' compensation
market. This legislation, which was popularly known as "Fresh Start," required
the Maine Superintendent of Insurance to annually determine whether the
premiums collected for policies written in the involuntary market and related
investment income were adequate on a policy-year basis. The Superintendent was
required to assess a surcharge on policies written in later policy years if it
was determined that rates were inadequate. Assessments were to be borne by
workers' compensation policyholders, except that for policy years beginning in
1989 the Superintendent could require insurance carriers to absorb up to 50
percent of any deficits if the Superintendent found that insurance carriers
failed to make good faith efforts to expand the voluntary market and depopulate
the residual market. Insurance carriers which served as servicing carriers for
the involuntary market would be obligated to pay 90 percent of the insurance
industry's share. The Maine Fresh Start statute requires the Superintendent to
annually estimate each year's deficit for seven years before making a final
determination with respect to that year.
In March 1993, the Superintendent affirmed a prior Decision and Order (known as
the "1992 Fresh Start Order") in which he found, among other things, that there
were deficits for the 1988, 1989 and 1990 policy years, and that insurance
carriers had not made a good faith effort to expand the voluntary market and
consequently were required to bear 50 percent of any deficits relating to the
1989 and 1990 policy years. The Superintendent further found that a portion of
these deficits were attributable to servicing carrier inefficiencies and poor
investment practices and ordered that these costs be absorbed by insurance
carriers. Also, in May 1993, the Superintendent found that insurance carriers
would be liable for 50 percent of any deficits relating to the 1991 policy year
(the "1993 Fresh Start Order"), but indicated that he would make no further
determinations regarding the portions of any deficits attributable to alleged
servicing carrier inefficiencies and poor investment practices until his
authority to make such determinations was clarified in the various suits
involving prior Fresh Start orders.
USF&G was a servicing carrier for the Maine residual market in 1988 through
1991. USF&G withdrew from the Maine voluntary market and as a servicing carrier
effective December 31, 1991. USF&G joined in an appeal of the 1992 Fresh Start
Order which was filed April 5, 1993 in the Maine Superior Court. In addition to
The Hartford Accident and Indemnity Company and USF&G, the National Council of
Compensation Insurance ("NCCI") and several other insurance companies which
were servicing carriers during this time frame have instituted similar appeals.
Similar appeals of the Superintendent's 1993 Fresh Start Order have been filed
by USF&G, the NCCI and several other servicing carriers in the same court. The
appeals of the 1993 Fresh Start Order will be heard on a consolidated basis.
On October 17, 1994, the Superior Court of Maine upheld the Superintendent's
finding in the 1992 Fresh Start Order that the insurance carriers failed to
exercise their good faith best efforts to expand the voluntary market and
consequently were required to bear 50 percent of the deficit relating to the
1989 and 1990 policy years. The Superior Court also held that the
Superintendent improperly held that $40 million of the deficit should be
attributed to the carriers due to servicing carrier inefficiencies and poor
investment practices. USF&G and the other parties challenging the
Superintendent's order have appealed to the Maine Law Court, the highest court
in Maine, the Superior Court's ruling on the carriers' lack of good faith, and
the Superintendent may likewise appeal the Superior Court ruling that it was
improper to shift $40 million of the deficit to carriers due to alleged
inefficiencies and poor investment practices.
Estimates of the potential deficits vary widely and are continuously revised as
loss and claims data matures. If the Superintendent were to prevail on all
issues, then the range of ultimate liability for USF&G, based on the most
recent estimates provided by the Superintendent and the NCCI, respectively,
could range from approximately $12 million to approximately $21 million.
8.3. Involuntary market plans
Most states require insurers to provide coverage for less desirable risks
through participation in mandatory programs. USF&G's participation in assigned
risk pools and similar plans, mandated now or in the future, creates and is
expected to create downward pressure on earnings.
8.4. Withdrawal from business lines
Some states have adopted legislation or regulations restricting or otherwise
limiting an insurer's ability to withdraw from certain lines of business. Such
restrictions are most often found in personal lines and workers' compensation
insurance. They include prohibitions on mid-term cancellations and limiting
reasons based upon which an insurer may non-renew policies, requirements for
amendments to underwriting standards, rates and policy forms to be approved by
state regulators, specifications of a maximum percentage of a book of business
which may be non-renewed within the state within any 12 month period, and
prohibitions on exiting a single line of business within a state (thus
requiring an insurer to either continue an unprofitable line or give up all
lines of business and withdraw from a state entirely). Such restrictions limit
USF&G's ability to manage its exposure to unprofitable lines and adversely
affects earnings to the extent USF&G is required to continue writing
unprofitable business.
8.5. Guaranty funds
Insurance guaranty fund laws have been adopted in most states to protect
policyholders in case of an insurer's insolvency. Insurers doing business in
those states can be assessed for certain obligations of insolvent companies
to policyholders and claimants. These assessments, under certain circumstances
can be credited against future premium taxes. Net of such tax credits, USF&G
incurred $9 million of guaranty fund expense in 1994 and $15 million and $13
million in 1993 and 1992, respectively.
Financial difficulties of certain insurance companies over the past several
years are expected to result in additional assessments that could have a
negative impact on future earnings. State laws limit the amount of annual
assessments which are based on percentages (generally two percent) of
assessable annual premiums in the year of insolvency. The ultimate amount of
these assessments cannot be reasonably estimated, but are not expected to have
a material adverse effect on USF&G's financial position.
8.6. NAIC proposals
The National Association of Insurance Commissioners ("NAIC") has proposed
several model laws and regulations which are in varying stages of discussion.
The NAIC has adopted model regulations which establish minimum capitalization
requirements based on a "risk-based capital" formula (refer to Section 6.4 of
this Analysis). The NAIC has also proposed a Model Investment Law and
amendments to the Model Holding Company System Regulatory Act. These model acts
address investments which are permissible for property/casualty and life
insurers to hold, and investments in subsidiaries and affiliates, respectively.
Adoption of these model laws is targeted for 1995. It is not expected that the
final adoption of these regulations by the NAIC will result in any material
adverse effect on USF&G's liquidity or financial position.
8.7. National health care
President Clinton and Congress have considered various proposals to enact a
comprehensive national health care system. Enactment of certain of these
proposals would result in the coordination of the medical payment system for
workers' compensation and the medical payments component of automobile
insurance within a reformed national health care system or a merger of workers'
compensation and automobile medical coverage into a reformed health care
system. Although some form of national health care may be enacted, it is
unclear whether or to what extent such legislation will address workers'
compensation or personal automobile insurance. No reliable prediction can be
made at this time as to the ultimate outcome of the legislative deliberations
regarding national health care reform or the effect such legislation may have
on USF&G.
8.8. Superfund
The Comprehensive Environmental Response, Compensation and Liability Act
("CERCLA"), more commonly known as "Superfund," is scheduled to be reauthorized
in 1995. Insurance companies, other businesses, environmental groups and
municipalities are advocating a variety of reform proposals to revise the
cleanup and liability provisions of CERCLA. No reliable prediction can be made
as to the ultimate outcome of the legislative deliberations regarding the
reauthorization of CERCLA or the effect such revisions may have on USF&G.
8.9. Insurance regulatory information system
The NAIC's Insurance Regulatory Information System ("IRIS") ratios are intended
to assist state insurance departments in their review of the financial
condition of insurance companies operating within their respective states. IRIS
specifies eleven industry ratios and establishes a "usual range" for each
ratio. Significant departure from a number of ratios may lead to inquiries
from state insurance regulators. As of December 31, 1994, USF&G was within the
"usual range" for all IRIS ratios.
8.10. Taxation of deferred annuities
From time to time, various proposals have been considered by Congress, the
Office of Management and Budget and the Department of the Treasury to include
within current taxable income all or a portion of the interest payments which
accrue on certain deferred annuity products, including some deferred annuity
products sold by F&G Life. Currently, such interest is not taxed until the time
of distribution. All such proposals have focused exclusively on deferred
annuities and have not included annuities issued in connection with structured
settlements of claims or on tax sheltered annuities. No reliable prediction can
be made at this time as to the outcome of any such proposals or the effect such
proposals may have on F&G Life.
8.11. Federal antitrust legislation
Congress has considered various proposals to revise the McCarran-Ferguson Act
of 1945. This act has historically provided the insurance industry with broad
antitrust exemptions. Various proposals have been made which would repeal many
of those exemptions, although "safe harbors" may be preserved for data
collection, loss development, common policy forms, residual market pooling
arrangements and other areas essential to the property/casualty insurance
industry. No reliable prediction can be made at this time as to the outcome of
any of these proposals or the effect they may have on USF&G.
9. Income Taxes
Effective January 1, 1993, USF&G changed its method of accounting for income
taxes as required by SFAS No. 109, "Accounting for Income Taxes." This
standard requires recognition of future tax benefits attributable to net
operating loss carry-forwards ("NOLs") and to deductible temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. A valuation allowance is
required if it is more likely than not that some or all of the deferred tax
asset may not be realized. The valuation allowance is established based on an
evaluation of positive and negative evidence as to the likelihood of realizing
some or all of the deferred tax assets.
At December 31, 1993, USF&G had recorded a $119 million net deferred tax asset,
as it was the opinion of management it was more likely than not that there
would be sufficient future taxable income to result in the realization of this
benefit. The primary negative evidence that existed at December 31, 1993 was
the cumulative pretax net losses for the years 1991 through 1993. The primary
positive evidence at that time was forecasted taxable income sufficient to
recover a portion of the tax benefit within three to five years and a tax
planning strategy to generate future taxable income to utilize such NOLs, if
necessary.
At December 31, 1994, the net deferred tax asset increased to $416 million,
primarily based on the increasing weight of positive evidence which resulted in
a $203 million net decrease in the valuation allowance. Management reviews the
valuation allowance on a quarterly basis. Throughout 1994, the weight of
evidence became increasingly more positive as the core earnings trend improved
each quarter. As 1994 progressed, the negative evidence of cumulative losses
which were caused by 1991 results became increasingly less of a factor. By the
end of 1994, cumulative pretax net income was positive from 1992 through 1994.
Given the substantially reduced degree of negative evidence and management's
increased confidence in the sustainability of the improved earnings of the core
insurance segments and, therefore, its enhanced ability to forecast future
taxable income, it became appropriate to reduce the valuation allowance
beginning in the second quarter of 1994. The largest adjustment to the
valuation allowance occurred in the fourth quarter of 1994 as the Corporation
continued to achieve its forecasted results. This coincided with the
elimination of the negative evidence of three-year cumulative net losses and
with the completion of the Corporation's budgeting and mid-range forecasting
process, allowing for more reliable projections of future taxable income.
USF&G has NOLs of $750 million which expire as follows: $147 million in 2005
and $603 million in 2006. The NOLs available for future utilization were
generated primarily by the noninsurance businesses of USF&G and nonrecurring
charges related to the business restructuring program. A majority of these
noninsurance businesses that caused a significant drain on prior earnings have
been sold, divested or liquidated by USF&G.
Future levels of net income and taxable income from the core insurance
operations are dependent on several factors, including general economic and
specific insurance industry conditions, competitive pressures, catastrophe
losses, adverse involuntary loss experience, etc. Because of these risk
factors, as well as other factors beyond the control of management, no
assurance can be given that sufficient taxable income will be generated to
utilize the NOLs or otherwise realize the deferred tax assets. However,
management has considered these factors in reaching its conclusion that it is
more likely than not that there will be sufficient future taxable income to
result in the realization of the recorded $416 million deferred tax asset. This
realization is dependent, in whole or in part, on USF&G's ability to generate
future taxable income from ordinary and recurring operations. Based on USF&G's
evaluations, approximately $1.2 billion of future taxable income would need to
be generated to realize the $416 million deferred tax asset. If 1994 pretax
net income before realized gains and facilities exit costs of $129 million is
assumed to be an average taxable income for future years, then USF&G will be
able to realize enough income within nine years to fully recognize the net
deferred tax asset. This is well within the tax carry-forward period. Further,
management's three to five year forecast, which reflects management's
expectations as to earnings growth, indicates sufficient future taxable income
to, more likely than not, realize the recorded asset.
USF&G's tax returns have not been reviewed by the Internal Revenue Service
("IRS") since 1989 and the availability of the NOLs could be challenged by the
IRS upon review of returns through 1993. Management believes, however, that IRS
challenges that would limit the recoverability of $416 million in tax benefits
are unlikely, and adjustments to the tax liability, if any, for years through
1994 will not have a material adverse effect on USF&G's financial position.
10. Glossary of Terms
Account value: Deferred annuity cash value available to policyholders before
the assessment of surrender charges.
Catastrophe losses: Property/casualty insurance claim losses resulting from a
sudden calamitous event, such as a severe storm, are categorized as
"catastrophes" when they meet certain severity and other criteria determined by
a national organization.
Expense ratio: The ratio of underwriting expenses to net premiums written, if
determined in accordance with statutory accounting practices ("SAP"), or the
ratio of underwriting expenses (adjusted by deferred policy acquisition costs)
to earned premiums, if determined in accordance with GAAP.
High-yield bonds: Fixed maturity investments with a credit rating below the
equivalent of Standard & Poor's "BBB." In addition, nonrated fixed maturities
that, in the judgment of USF&G, have credit characteristics similar to those of
a fixed maturity rated below BBB are considered high-yield bonds.
Involuntary pools and associations: Property/casualty insurance companies are
required by state laws to participate in a number of assigned risk pools,
automobile reinsurance facilities, and similar mandatory plans ("involuntary
market plans"). These plans generally require coverage of less desirable risks,
principally for workers' compensation and automobile liability, that do not
meet the companies' normal underwriting standards. As mandated by legislative
authorities, insurers generally participate in such plans based upon their
shares of the total writings of certain classes of insurance.
Liquid assets to surrender value: Liquid assets (publicly traded bonds,
stocks, cash and short-term investments) divided by surrenderable policy
liabilities, net of surrender charges. A measure of an insurance company's
ability to meet liquidity needs in case of annuity surrenders.
Loss ratio: The ratio of incurred losses and loss expenses to earned premiums,
determined in accordance with SAP or GAAP, as applicable. The difference
between SAP and GAAP relates to deposit accounting for GAAP related to certain
financial reinsurance assumed.
Nonperforming real estate: Mortgage loans and real estate investments that are
not performing in accordance with their contractual terms or that are
performing at an economic level significantly below expectations. Included in
the table of nonperforming real estate are the following terms:
Deed-in-lieu of foreclosure: Real estate to which title has been obtained
in satisfaction of a mortgage loan receivable in order to prevent
foreclosure proceedings.
In-substance foreclosure: Collateral for a mortgage loan is in-substance
foreclosed when the borrower has little or no equity in the collateral, does
not have the ability to repay the loan, and has effectively abandoned
control of the collateral to USF&G.
Land investments: Land investments that are held for future development
where, based on current market conditions, returns are projected to be
significantly below original expectations.
Nonperforming equity investments: Equity investments with cash and GAAP
return on book value less than five percent, but excluding land investments.
Restructured loans and investments: Loans and investments whose terms have
been restructured as to interest rates, participation, and/or maturity date
such that returns are projected to be significantly below original
expectations.
Policyholders' surplus: The net assets of an insurer as reported to regulatory
agencies based on accounting practices prescribed or permitted by the National
Association of Insurance Commissioners and the state of domicile.
Premiums earned: The portion of premiums written applicable to the expired
period of policies.
Premiums written: Premiums retained by an insurer, after the assumption and
cession of reinsurance.
Underwriting results: Property/casualty pretax operating results excluding
investment results, policyholders' dividends, and noninsurance activities;
generally, premiums earned less losses and loss expenses incurred and
"underwriting" expenses incurred.