UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 8-K
CURRENT REPORT
Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
Date of Report (Date of
earliest event reported): Commission File Number
February 26, 1998 1-8233
USF&G CORPORATION
(Exact name of registrant as specified in its charter)
Maryland 52-1220567
State or other jurisdiction of (IRS Employer Identification No.)
incorporation)
6225 Centennial Way, Baltimore, Maryland 21209
(Address of principal executive offices) (Zip Code)
410-205-3000
(Registrant's telephone number, including area code)
USF&G CORPORATION
FORM 8-K
Item 5. Other Events.
The attached audited financial statements for the year ended
December 31, 1997, and related Management's Discussion and Analysis
of Financial Condition and Results of Operations, and other related
financial information are incorporated herein by reference.
USF&G CORPORATION
Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this Current Report on Form 8-K to be signed on its
behalf by the undersigned hereunto duly authorized.
USF&G Corporation
By: /s/ DAN L. HALE
--------------------------------
Dan L. Hale
Executive Vice President,
Chief Financial Officer
(Principal Financial Officer and
Principal Accounting Officer)
February 26, 1998
Information Filed Under Item 5
I. Selected Financial Data
II. Financial Statements
III. Notes to Consolidated Financial Statements
IV. Management's Discussion and Analysis of Financial Condition
and Results of Operations
V. Index to Exhibits
I. SELECTED FINANCIAL DATA
USF&G CORPORATION Five-Year Summary of Selected Financial Data
(dollars in millions except per share data) 1997 1996 1995 1994 1993
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Consolidated Results
Premiums earned $ 2,682 $ 2,731 $ 2,666 $ 2,508 $ 2,521
Net investment income 691 705 733 749 753
Total revenues 3,404 3,498 3,459 3,310 3,323
Income from continuing operations
before cumulative effect of
adopting new accounting standards 194 261 209 237 130
Net income 194 261 209 237 168
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Per Share Results
Income from continuing operations
before cumulative effect of
adopting new accounting standards $ 1.72 $ 2.05 $ 1.63 $ 2.00 $ .90
Net income 1.72 2.05 1.63 2.00 1.32
Book value 17.84 15.48 14.68 9.96 11.33
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Financial Position
Assets $15,819 $14,407 $14,651 $13,980 $14,481
Investments 10,944 10,076 11,107 10,561 11,474
Total debt 521 482 607 628 627
Capital securities 296 100 -- -- --
Shareholders' equity 2,077 1,969 1,984 1,441 1,556
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Common Stock
Market high $ 25 1/2 $ 21 3/4 $ 19 1/2 $ 16 1/8 $ 19 5/8
Market low 17 5/8 14 1/4 13 3/8 11 11/16 11 1/8
Market close 22 1/16 20 7/8 16 7/8 13 5/8 14 3/4
Cash dividends declared .26 .20 .20 .20 .20
Common shares outstanding 116,402,199 114,240,489 119,606,095 104,810,794 91,418,372
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II. FINANCIAL STATEMENTS
USF&G CORPORATION Consolidated Statement of Operations
Years Ended December 31
(dollars in millions except per share data) 1997 1996 1995
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Revenues
Premiums earned $2,682 $2,731 $2,666
Net investment income 691 705 733
Other 16 18 53
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Revenues before net realized gains 3,389 3,454 3,452
Net realized gains on investments 15 44 7
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Total revenues 3,404 3,498 3,459
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Expenses
Losses, loss expenses and policy benefits 2,071 2,181 2,178
Underwriting, acquisition and operating expenses 1,002 1,044 1,048
Interest expense 34 39 44
Reorganization severance 5 17 --
Facilities exit costs/(sublease income) -- (42) (6)
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Total expenses 3,112 3,239 3,264
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Income from operations before income taxes 292 259 195
Provision for income taxes 84 (2) (14)
Distributions on USF&G-obligated mandatorily redeemable preferred capital
securities of subsidiary trusts holding solely junior subordinated
deferrable interest debentures of USF&G, net of tax 14 -- --
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Net income $ 194 $ 261 $ 209
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Preferred stock dividend requirements 2 20 28
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Net income available to common stock $ 192 $ 241 $ 181
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Basic earnings per share $ 1.72 $ 2.05 $ 1.63
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Diluted earnings per share 1.63 1.95 1.53
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Weighted-average common shares outstanding (in 000s):
Basic 111,688 117,674 111,474
Diluted 120,109 127,734 130,064
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See Notes to Consolidated Financial Statements.
USF&G CORPORATION Consolidated Statement of Financial Position
At December 31
(dollars in millions except per share data) 1997 1996
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Assets
Investments:
Fixed maturities available for sale, at market (cost, 1997, $8,183; 1996, $8,066) $ 8,495 $ 8,164
Common and preferred stocks, at market (cost, 1997, $51; 1996, $16) 49 16
Short-term investments 571 535
Mortgage loans 641 406
Real estate 336 554
Other invested assets 852 401
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Total investments 10,944 10,076
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Cash 90 73
Accounts, notes and other receivables 878 763
Reinsurance receivables 1,646 1,576
Servicing carrier receivables 710 661
Deferred policy acquisition costs 468 456
Other assets 1,083 802
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Total assets $15,819 $14,407
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Liabilities
Unpaid losses, loss expenses and policy benefits $10,017 $ 9,584
Unearned premiums 1,148 1,113
Corporate debt 516 477
Real estate and other debt 5 5
Other liabilities 1,760 1,159
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Total liabilities 13,446 12,338
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USF&G-obligated mandatorily redeemable preferred capital securities of subsidiary
trusts holding solely junior subordinated deferrable interest debentures of USF&G 296 100
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Shareholders' Equity
Preferred stock, par value $50.00 (12,000,000 shares authorized;
shares issued, 1996, 3,999,910) __ 200
Common stock, par value $2.50 (240,000,000 shares authorized; shares
issued, 1997, 116,402,199; 1996, 114,240,489) 291 286
Paid-in capital 1,126 1,091
Net unrealized gains on investments and foreign currency 167 62
Retained earnings 493 330
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Total shareholders' equity 2,077 1,969
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Total liabilities, capital securities and shareholders' equity $15,819 $14,407
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See Notes to Consolidated Financial Statements.
USF&G CORPORATION Consolidated Statement of Cash Flows
Years Ended December 31
(in millions) 1997 1996 1995
---------------------------------------------
Operating Activities
Direct premiums collected $ 2,166 $ 2,183 $ 2,078
Net investment income collected 699 707 743
Direct losses, loss expenses and policy benefits paid (1,681) (1,751) (1,725)
Net reinsurance activity (159) (13) 69
Underwriting and operating expenses paid (844) (769) (760)
Interest paid (30) (37) (37)
Income taxes paid (7) (5) (5)
Other items, net 1 15 36
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Net cash provided from operating activities 145 330 399
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Investing Activities
Net (purchases), sales and maturities of short-term investments (30) (249) 148
Sales of fixed maturities held to maturity -- -- 21
Maturities/repayments of fixed maturities held to maturity -- -- 110
Purchases of fixed maturities available for sale (2,022) (1,189) (1,123)
Sales of fixed maturities available for sale 1,293 588 489
Maturities/repayments of fixed maturities available for sale 743 702 443
Purchases of other investments (414) (228) (302)
Sales, maturities and repayments of other investments 430 412 332
Purchase of subsidiaries (67) (57) --
Purchases of property and equipment (86) (59) (32)
Sales of property and equipment 3 14 2
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Net cash (used in) provided from investing activities (150) (66) 88
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Financing Activities
Deposits for universal life and investment contracts 460 438 310
Withdrawals of universal life and investment contracts (209) (535) (659)
Purchase of structured settlement annuity coinsurance contract (104) -- --
Net repayments of short-term borrowings 2 -- (227)
Long-term borrowings -- -- 228
Repayments of long-term borrowings -- (125) (42)
Issuances of capital securities 198 98 --
Issuances of common stock 21 11 6
Repurchases of common stock (101) (150) --
Redemptions of preferred stock (200) (2) --
Cash dividends paid to shareholders (33) (45) (53)
Cash distributions paid to holders of capital securities (12) -- --
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Net cash provided from (used in) financing activities 22 (310) (437)
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Increase (decrease) in cash 17 (46) 50
Cash at beginning of year 73 119 69
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Cash at end of year $ 90 $ 73 $ 119
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Noncash Transactions
Coinsurance transactions:
Transfer of investments and other assets in
exchange for reinsurance receivables $ 40 $ 964 $ --
---------------------------------------------
See supplemental cash flow information at Note 1.15.
See Notes to Consolidated Financial Statements.
USF&G CORPORATION Consolidated Statement of Shareholders' Equity
Years Ended December 31
(in millions except per share data) 1997 1996 1995
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Preferred Stock
Balance at beginning of year $ 200 $ 213 $ 331
Par value of Series B shares converted to common shares -- (12) (51)
Par value of Series C shares converted to common shares -- -- (66)
Par value of shares redeemed (200) (1) (1)
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Balance at end of year -- 200 213
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Common Stock
Balance at beginning of year 286 299 262
Par value of shares issued for conversion of Series B shares -- 5 21
Par value of shares issued for conversion of Series C shares -- -- 14
Par value of shares issued in Titan acquisition 13 -- --
Par value of other shares issued 4 3 2
Par value of shares repurchased (12) (21) --
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Balance at end of year 291 286 299
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Paid-In Capital
Balance at beginning of year 1,091 1,188 1,104
Excess of proceeds over par value of Series B shares converted -- 7 29
Excess of proceeds over par value of Series C shares converted -- -- 50
Excess of proceeds over par value of shares issued in Titan acquisition 99 -- --
Excess of proceeds over par value of other shares issued 17 8 5
Excess of cost over par value of shares repurchased (90) (129) --
Accrued stock-based compensation 4 15 --
Tax benefit from exercise of stock options 5 2 --
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Balance at end of year 1,126 1,091 1,188
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Net Unrealized Gains (Losses) on Investments and Foreign Currency
Balance at beginning of year 62 271 (147)
Change in unrealized gains (losses) 105 (209) 418
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Balance at end of year 167 62 271
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Minimum Pension Liability
Balance at beginning of year -- (100) (63)
Change in unfunded accumulated benefits -- 100 (37)
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Balance at end of year -- -- (100)
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Retained Earnings (Deficit)
Balance at beginning of year 330 113 (46)
Net income 194 261 209
Common stock dividends declared (per share, 1997, $.26; 1996 and 1995, $.20) (29) (24) (22)
Preferred stock dividend declared (per share, 1997, Series A, $1.03;
1996, Series A, $4.10, Series B $7.69; 1995, Series A $4.10,
Series B, $10.25) (2) (20) (28)
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Balance at end of year 493 330 113
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Total shareholders' equity $2,077 $1,969 $1,984
--------------------------------------------
See Notes to Consolidated Financial Statements.
III. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
USF&G CORPORATION Notes to Consolidated Financial Statements
Note 1 Summary of Significant Accounting Policies
1.1. Basis of presentation
The consolidated financial statements are prepared in accordance with generally
accepted accounting principles ("GAAP"). These statements include the accounts
of USF&G Corporation and its subsidiaries (collectively, "USF&G" or "the
Corporation"). Certain of the subsidiaries are consolidated on a one-month lag,
the effect of which is not material. Certain prior year amounts have been
reclassified to conform to the 1997 presentation.
The preparation of the consolidated financial statements in conformity with GAAP
requires management to make estimates and assumptions that affect the amounts
reported in the consolidated financial statements and accompanying notes. Actual
results could differ from these estimates.
USF&G is primarily engaged in the business of insurance. Property/casualty
insurance, which accounted for 88 percent of revenues before net realized gains
in 1997, is written primarily by United States Fidelity and Guaranty Company
("USF&G Company") and is sold primarily through independent agents and brokers
supported by USF&G Company's underwriting, marketing, administrative and claim
services offices located throughout the United States. Life insurance and
annuities, which accounted for 12 percent of revenues before net realized gains
in 1997, are written by Fidelity and Guaranty Life Insurance Company and its
subsidiary (collectively, "F&G Life"), and are sold throughout the United States
through independent agents, managing general agents and specialty insurance
brokerage firms. Noninsurance operations are composed primarily of the parent
company and asset management services. Additional information on the
Corporation's business segments is included in Note 16, "Information on Business
Segments".
1.2. Subsequent event
On January 19, 1998, The St. Paul Companies, Inc. ("St. Paul"), a Minnesota
corporation, and USF&G announced the signing of a definitive merger agreement
pursuant to which a wholly-owned subsidiary of St. Paul will be merged into
USF&G. The combined company will operate under the St. Paul name and be based in
St. Paul, Minnesota. The transaction is expected to be accounted for as a
pooling of interests and is intended to qualify as a tax-free reorganization. If
the merger is completed, the combined company would become the eighth-largest
property/casualty company in the United States, based on 1996 net written
premiums. Completion of the transaction is subject to, among other things,
approvals by the shareholders of USF&G and St. Paul, in addition to certain
regulatory approvals, and is expected to occur in mid-1998.
Under the terms of the merger agreement, each issued and outstanding share of
USF&G common stock will be converted into a number of shares of St. Paul common
stock determined according to a specified exchange ratio. That exchange ratio
will be based on the average of the average of the high and low market prices of
St. Paul's common stock during a 20-day trading period ending on the third
trading day prior to the date USF&G's shareholders vote on the approval of the
merger (the "St. Paul Average Price"). If the St. Paul Average Price is greater
than $78, USF&G shareholders will receive 0.2821 of a share of St. Paul common
stock for each USF&G share; if the St. Paul Average Price is less than $74 per
share, USF&G shareholders will receive 0.2973 of a share of St. Paul common
stock for each USF&G share; and if the St. Paul Average Price is between $74 and
$78 per share, USF&G shareholders will receive a fraction of a St. Paul share
equal to $22 divided by the St. Paul Average Price.
In connection with the merger, St. Paul and USF&G entered into a Stock Option
Agreement dated as of January 19, 1998. Pursuant to this agreement, USF&G
granted St. Paul an option, exercisable only in certain circumstances, to
purchase shares of USF&G common stock in an amount equal to 19.9 percent of the
shares of USF&G common stock outstanding at the time of exercise.
1.3. New accounting pronouncements
In February 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings per
Share" ("EPS"), which simplifies the standards for computing EPS. SFAS No. 128
replaces primary EPS with basic EPS, which excludes common stock equivalents,
and requires disclosure of EPS on the face of the income statement for all
entities, such as USF&G, with complex capital structures. USF&G adopted SFAS No.
128 effective December 31, 1997. In accordance with SFAS No. 128, all prior
periods presented have been restated to conform to the 1997 presentation.
In June 1996, the FASB issued SFAS No. 125, "Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities", which
provides new accounting and reporting standards for transfers and servicing of
receivables and other financial assets and extinguishments of liabilities. As
issued, the standard was effective for transactions occurring after December 31,
1996, and was to be applied prospectively. SFAS No. 127, "Deferral of the
Effective Date of Certain Provisions of FASB Statement No. 125", was issued in
December 1996, and deferred for one year both the criteria for determination of
a sale versus a secured borrowing for certain transactions, and new accounting
standards for assets transferred as collateral. Once adopted for transactions
occurring after December 31, 1997, SFAS No. 125 will impact USF&G's accounting
for participation in securities lending programs as well as for assets pledged
as collateral; however, this impact will primarily be limited to
reclassifications on the Consolidated Statement of Financial Position.
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income",
which establishes standards for the reporting and display of comprehensive
income and its components in a full set of general-purpose financial statements.
SFAS No. 130 is effective for fiscal years beginning after December 15, 1997 and
requires that an enterprise: (a) classify items of other comprehensive income by
their nature in a financial statement, and (b) display the accumulated balance
of other comprehensive income separately from retained earnings and additional
paid-in capital in the equity section of a statement of financial position. Once
adopted, USF&G anticipates that the major impact of SFAS No. 130 will be the
required reporting of unrealized gains or losses on available for sale
securities in comprehensive income.
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information". The Statement establishes standards for the
way that public business enterprises report information about operating segments
in annual financial statements and requires that selected information about
operating segments be included in interim financial reports issued to
shareholders. It also establishes standards for related disclosures about
products and services, geographic areas and major customers. The definition of
operating segments in this standard is based on the way that management
organizes and manages the segments within an enterprise. SFAS No. 131 is
effective for fiscal years beginning after December 15, 1997, and will require
USF&G to revise and expand its business segment disclosures.
In December 1997, the American Institute of Certified Public Accountants issued
Statement of Position ("SOP") No. 97-3, "Accounting by Insurance and Other
Enterprises for Insurance-Related Assessments". The SOP provides guidance for
determining when an entity should recognize a liability for guaranty fund and
other insurance-related assessments and on the measurement of the liability.
Additionally, it provides guidance on when an asset should be recognized for a
portion or all of the liability or paid assessment that can be recovered through
premium tax offsets of policy surcharges. The SOP is effective for fiscal years
beginning after December 15, 1998. The cumulative effect of adopting SOP No.
97-3 may be material; however, no reasonable estimation can be made at this
time.
1.4. Permitted statutory accounting practices
USF&G has both domestic and foreign subsidiaries. Reporting practices for
insurance subsidiaries prescribed or permitted by domestic or foreign regulatory
authorities (statutory accounting practices) differ from GAAP. Statutory amounts
for USF&G's insurance operations follow.
(in millions) 1997 1996 1995
------------------------
Statutory Net Income for the
Years Ended December 31:
Property/casualty insurance* $ 210 $ 167 $--
Subsidiaries and affiliates** 24 8 --
Life insurance 21 27 15
----------------------
Statutory Surplus at December 31:
Property/casualty insurance* $1,455 $1,374
Subsidiaries and affiliates** 236 243
Life insurance 195 213
----------------
*Includes USF&G Company and all subsidiaries required to be included in its
combined statutory statements.
**Includes those property/casualty subsidiaries
and affiliates not included in USF&G Company's combined statutory
statements.
USF&G's primary insurance subsidiaries, USF&G Company and F&G Life, are
domiciled in the State of Maryland and prepare their statutory financial
statements in accordance with statutory accounting practices prescribed or
permitted by the Maryland Insurance Administration. Prescribed statutory
accounting practices include state laws, regulations and general administrative
rules issued by the State of Maryland as well as a variety of publications and
manuals of the National Association of Insurance Commissioners ("NAIC").
Permitted statutory accounting practices encompass all accounting practices not
so prescribed, but allowed by the state of domicile.
The NAIC is currently in the process of developing a codification of statutory
accounting principles. The project, if finalized and implemented, could cause
changes to the calculation of statutory net income and statutory surplus. The
impact of any changes cannot be reasonably estimated at this time.
Property/Casualty Insurance: USF&G Company has received written approval from
the Maryland Insurance Administration to extend the required disposal period for
certain real property acquired as security for loans or other obligations. Under
the current Maryland Insurance Code, these assets are required to be disposed of
within five years from the date of acquisition. The Maryland Insurance
Administration extended this time period for certain properties. At December 31,
1997 and 1996, permitted transactions increased statutory surplus by $20 million
over what it would have been had prescribed accounting practices been followed
without the variances permitted by the regulatory authorities.
Life Insurance: In 1997, F&G Life received permission from the Maryland
Insurance Administration to release $39 million of capital gains related to a
coinsurance contract from the Interest Maintenance Reserve ("IMR"). In
conjunction with this release from the IMR, F&G Life established a $10 million
voluntary investment reserve funded from policyholders' surplus. The voluntary
investment reserve cannot be reduced until 1999 and requires Maryland Insurance
Administration permission to do so. As of December 31, 1997 and 1996, this
permitted practice had the effect of increasing statutory surplus by $23 million
and $38 million, respectively, over what it would have been had prescribed
accounting practices been followed without the variances permitted by the
regulatory authorities.
Since Maryland does not specifically prescribe by law or regulation reserves for
universal life ("UL") policies or group annuities, F&G Life follows reserving
practices which are permitted by the State of Maryland. For older generation
universal life policies, F&G Life holds the full account value as a reserve. For
newer generation UL policies, reserves are held based on a calculation according
to the NAIC UL Model Regulation, which has been adopted by many states. Many of
the group annuities sold by F&G Life are used to fund qualified pension and/or
profit sharing plans. For these annuities, the funds are not allocated to
individual participants, and the full account value is held as the reserve. For
group annuities where the funds and/or benefits are allocated to the individual
certificate holder, reserves are calculated according to laws prescribed for
individual annuities.
1.5. Investments
Fixed Maturities: USF&G classifies all of its fixed maturities as "available for
sale". These securities are held for an indefinite period of time and may be
sold in response to changes in interest rates and the yield curve, prepayment
risk, liquidity needs, or other factors. Fixed maturities classified as
"available for sale" are carried at market value, with unrealized gains and
losses recorded as a separate component of shareholders' equity. Unrealized
gains or losses on fixed maturities available for sale are offset by an
adjustment to life insurance deferred policy acquisition costs ("DPAC") which is
made on a pro forma basis as if the unrealized gains or losses on those assets
which match certain life insurance liabilities were realized. Specific
write-downs in the carrying value of fixed maturities are recognized in income
when an impairment is deemed other than temporary.
Common and Preferred Stocks: Investments in common and preferred stocks where
USF&G has significant influence over the investees' operating and financial
policies are accounted for using the equity method and included in other
invested assets. Other investments in common and preferred stocks are carried at
market value with the resulting unrealized gains or losses reported directly in
shareholders' equity.
Securities Lending: USF&G participates in a securities lending program whereby
certain securities from its portfolio are loaned to other institutions for short
periods of time. A fee is paid to USF&G by the borrower. Collateral that exceeds
the market value of the loaned securities is maintained by the lending agent and
reported in USF&G's other invested assets with an offsetting liability reported
in other liabilities. Invested assets and other liabilities include $515 million
and $128 million at December 31, 1997 and 1996, respectively, related to
securities lending collateral.
USF&G's policy is to require collateral equal to 102 percent of the market value
of the loaned securities. The securities are marked to market on a daily basis
to maintain the value of the collateral. The cash collateral is held by lending
agents and reinvested in certain approved types of securities. USF&G has an
indemnification agreement with the lending agents in the event a borrower
becomes insolvent or fails to return securities.
Mortgage Loans and Real Estate: Mortgage loans are carried at unpaid principal
balances. Real estate investments are reported at cost adjusted for equity
participation. Real estate acquired through foreclosure or deed-in-lieu of
foreclosure is initially recorded at estimated market value. Valuation
allowances are recognized for mortgage loans with deteriorations in collateral
performance which are deemed other than temporary, based on quarterly
evaluations. Impairments in the value of real estate investments are recorded as
direct reductions in the carrying value of those investments and are recognized
in income when indicators of impairment are present and the undiscounted cash
flows estimated to be generated by those assets are less than the assets'
carrying amount.
Interest and Dividend Income: Interest on fixed maturity investments is recorded
as income when earned and is adjusted for any amortization of purchase premium
or discount. Dividends on equity securities are recorded as income on
ex-dividend dates.
Realized Gains and Losses: Realized gains and losses on the sale of investments
are determined based on specific cost. Realized losses are also recorded when an
investment's net realizable value is below cost and the decline is deemed other
than temporary.
1.6. Recognition of premium revenues
Property/Casualty Insurance: Property/casualty insurance premiums are earned
principally on a pro rata basis over the lives of the policies and include
accruals for ultimate premium revenue anticipated under auditable and
retrospectively rated policies. Unearned premiums represent the portion of
premiums written applicable to the unexpired terms of policies in force.
Unearned premiums also include estimated and unbilled premium adjustments.
Life Insurance: Premiums on life insurance policies with fixed and guaranteed
premiums and benefits, and premiums on annuities with significant life
contingencies are recognized when due. Premiums received on UL policies and
annuity contracts are not recorded as revenues; instead, they are recognized as
deposits. Policy charges and surrender penalties are recorded as revenues.
1.7. Unpaid losses, loss expenses and policy benefits
Property/Casualty Insurance: The liability for unpaid property/casualty
insurance losses and loss expenses is based on an evaluation of reported losses
and on estimates of incurred but unreported losses. The reserve liabilities are
determined using adjusters' individual case estimates and statistical
projections. The liability was reported net of estimated salvage and subrogation
recoverables of $78 million and $99 million at December 31, 1997 and 1996,
respectively. Adjustments to the liability based on subsequent developments or
other changes in the estimate are reflected in results of operations in the
period in which such adjustments become known.
Certain liabilities for unpaid losses and loss expenses related to workers'
compensation and assumed reinsurance coverage are discounted to present value.
The carrying amount of such liabilities, net of reinsurance and net of discounts
of $401 million was $1.3 billion and $1.4 billion at December 31, 1997 and 1996,
respectively. Interest rates of up to four percent are used to discount these
liabilities.
Life Insurance: Ordinary life insurance reserves are computed under the net
level premium method using assumptions for future investment yields, mortality
and withdrawal rates. These assumptions reflect F&G Life's experience, modified
to reflect anticipated trends, and provide for possible adverse deviation.
Reserve interest rate assumptions are graded and range from 2.5 percent to 6.0
percent.
Universal life and deferred annuity reserves are computed on the retrospective
deposit method, which produces reserves equal to the cash value of the
contracts. Such reserves are not reduced for charges that would be deducted from
the cash value of policies surrendered. Reserves on immediate annuities with
guaranteed payments are computed on the prospective deposit method, which
produces reserves equal to the present value of future benefit payments.
1.8. Deferred policy acquisition costs
Acquisition costs, consisting of commissions, brokerage and other expenses
incurred at policy issuance, are generally deferred. Amortization of DPAC
totaled $687 million, $707 million and $714 million for the years ended December
31, 1997, 1996 and 1995, respectively, and was included in underwriting,
acquisition and operating expenses in the Consolidated Statement of Operations.
Property/Casualty Insurance: Anticipated losses, loss expenses, remaining costs
of servicing the policies and anticipated investment income are considered in
determining the recoverability of deferred property/ casualty insurance
acquisition costs. Such deferrals are amortized over the period that related
premiums are earned.
Life Insurance: Anticipated policy benefits, remaining costs of servicing the
policies and anticipated investment income are considered in determining the
recoverability of DPAC for interest-sensitive life and annuity products. Life
insurance acquisition costs are amortized based on assumptions consistent with
those used for computing policy benefit reserves. DPAC on ordinary life business
are amortized over their assumed premium paying periods. Universal life and
investment annuity acquisition costs are amortized in proportion to the present
value of their estimated gross profits over the products' assumed durations,
which are regularly evaluated and adjusted as appropriate.
1.9. Foreign currency translation
The functional currency for USF&G's foreign operations is typically the
applicable local currency. For those subsidiaries in highly inflationary
economies, however, the functional currency is the reporting currency (the U.S.
dollar).
Local currency balance sheet accounts are translated to U.S. dollars using
exchange rates in effect at the balance sheet date, and revenue and expense
accounts maintained in the local currency are translated using the average
exchange rates prevailing during the year. The unrealized gains or losses, net
of applicable deferred income taxes, resulting from translation are included in
shareholders' equity.
In highly inflationary economies (e.g., Mexico), monetary assets and liabilities
are remeasured into U.S. dollars using exchange rates in effect at the balance
sheet date, whereas nonmonetary balances are remeasured using historical
exchange rates. Revenue and expense accounts are remeasured using the average
exchange rates prevailing during the year for monetary transactions and
historical exchange rates for nonmonetary transactions. Realized gains or losses
resulting from remeasurement are included in net income.
USF&G's exposure to fluctuating currency exchange rates may be reduced or
effectively eliminated by certain financial instruments.
1.10. Goodwill
Goodwill, which represents the excess of cost over the fair value of net assets
acquired, is amortized on a straight-line basis over periods not exceeding 40
years. USF&G regularly evaluates the recoverability of goodwill to determine if
there has been any permanent impairment. The assessment is performed based on
the estimated future cash flows compared with the carrying value of the asset.
If impairment were indicated, a writedown to fair value (normally measured by
discounting estimated cash flows) would be taken.
1.11. Earnings per share
Basic earnings per share are computed by dividing income available to common
shareholders by the weighted-average common shares outstanding during the
period. Common stock equivalents are excluded from the calculation. Diluted
earnings per share assume the conversion of all securities whose contingent
issuance would have a dilutive effect on earnings.
The following table sets forth the computations of basic and diluted earnings
per share.
(dollars in millions except per
share data, shares in thousands) 1997 1996 1995
---------------------------
Numerator:
Net income $194 $261 $209
Preferred Stock Dividends:
Series A (2) (16) (16)
Series B -- (4) (12)
---------------------------
Total preferred stock dividends (2) (20) (28)
---------------------------
Numerator for basic EPS (income
available to common shareholders) 192 241 181
---------------------------
Effect of Dilutive Securities:
Series B preferred stock dividends -- 4 12
Zero coupon convertible notes 3 5 6
---------------------------
3 9 18
---------------------------
Numerator for diluted EPS
(income available to common
shareholders after assumed
conversions) $195 $250 $199
---------------------------
Denominator:
Denominator of basic EPS
(weighted-average shares) 111,688 117,674 111,474
Effect of dilutive securities:
Stock options 2,954 1,846 1,432
Contingent stock (variable
award plan) 285 279 --
Convertible preferred stock -- 2,151 9,931
Zero coupon convertible notes 5,182 5,784 7,227
---------------------------
Dilutive potential common shares 8,421 10,060 18,590
---------------------------
Denominator for diluted EPS
(adjusted weighted-average
shares and assumed conversions) 120,109 127,734 130,064
---------------------------
Basic earnings per share $1.72 $2.05 $1.63
Diluted earnings per share 1.63 1.95 1.53
---------------------------
Stock options to purchase a total of 10 million shares of USF&G's common stock
were outstanding at December 31, 1997. Of this total, 2.3 million options with
exercise prices ranging from $22.19 to $30.82 per share were not included in the
computation of diluted earnings per share in 1997 because the exercise prices of
these options exceeded the average market price of the common shares and,
therefore, would be antidilutive. The weighted-average exercise price for these
outstanding options was $22.92 per share.
Additionally, based upon certain cumulative multi-year income targets, a maximum
of 1.3 million shares of common stock could be issued under USF&G's Long-Term
Incentive Program ("LTIP"). In 1997, approximately 740,000 of these potentially
issuable shares of common stock were not included in the calculation of diluted
earnings per share because the applicable multi-year income targets were not
currently being achieved.
1.12. Reorganization severance
Severance costs covering approximately 280 and 700 employees in 1997 and 1996,
respectively, totaled $5 million and $17 million, respectively. During 1997,
USF&G's field structure was reorganized to accommodate the transfer of certain
policy and claim processing activities from the branch offices to three new
Centers for Agency Services and the Claim Reception Center. In 1998, the field
will be further consolidated and support functions will be centralized in
response to worsening market conditions.
1.13. Facilities exit costs/sublease income
During 1994, USF&G committed to a plan to consolidate its home office operations
in Baltimore, Maryland at its Mount Washington facility. The facilities exit
costs recorded in 1994 represented the present value of the rent and other
operating expenses to be incurred under the lease on the Corporation's principal
office building (the "Tower") from the time USF&G vacated the Tower through the
expiration of the lease in September 2009, but did not consider any potential
future sublease income, as such income was neither probable nor reasonably
estimable at that time. To the extent that additional or extended subleases are
subsequently negotiated, the present value of income to be received over the
term of those subleases is recognizable in the period such income becomes
probable and reasonably estimable. Sublease income of $54 million and $6 million
was recognized under the facilities exit plan in 1996 and 1995, respectively, as
a result of USF&G's negotiation of subleases with new and existing tenants. A
credit of $12 million was also recognized in 1996 related to reduced property
tax assessments on the Tower. During 1997, 1996 and 1995, the reserve for
facilities exit costs was increased by $12 million, $13 million and $16 million,
respectively, due to the amortization of the present value discount, and was
reduced by $20 million, $12 million and $10 million, respectively, of rent and
other operating expenses which were paid in 1997, 1996 and 1995 but were
recognized in the 1994 charge.
Additionally, USF&G recognized approximately $24 million of facilities exit
costs in 1996, representing the present value of the rent and other operating
expenses estimated to be incurred over the life of certain leases as a result of
the downsizing or closure of numerous branch offices. The reserve was reduced in
1997 by $6 million of rent and other operating expenses which were paid in 1997
but were recognized in the 1996 charge.
1.14. Business combinations
On December 22, 1997, USF&G acquired TITAN Holdings, Inc. ("Titan"), a
property/casualty insurance company located in San Antonio, Texas, for $259
million including assumed debt. Titan specializes in the non-standard automobile
and government entities insurance markets. The transaction was accounted for as
a purchase and resulted in goodwill of approximately $151 million. The
consideration paid included 5.1 million shares of the Corporation's common
stock, valued at approximately $112 million. As of December 31, 1997, $47
million in cash payments were made to reduce debt and cover certain other
acquisition-related expenses. The remaining consideration of $97 million,
consisting of cash payments to Titan's shareholders, was subsequently paid in
February 1998. The results of Titan's operations for the period from December 22
through December 31, 1997 have not been included in USF&G's Consolidated
Statement of Operations for 1997 as they were not material.
On December 17, 1996, USF&G acquired Afianzadora Insurgentes, S.A. de C.V.
("Afianzadora"), a surety bond company in Mexico, for $65 million in cash. This
acquisition, which was accounted for as a purchase, resulted in goodwill of $18
million. The results of Afianzadora's operations for the period from December 17
through December 31, 1996 were not included in USF&G's Consolidated Statement of
Operations for 1996 as they were not material.
1.15. Supplemental cash flow information
The Consolidated Statement of Cash Flows is presented using the "direct method",
which reports major classes of cash receipts and cash payments. A reconciliation
of net income to net cash provided from operating activities is as follows:
(in millions) 1997 1996 1995
-----------------------
Net income $ 194 $ 261 $209
Adjustments to reconcile net
income to net cash provided from
operating activities:
Net realized gains on investments (15) (44) (7)
Reorganization severance 5 17 --
Facilities exit costs/(sublease income) -- (42) (6)
Change in accrued income taxes 77 (7) (20)
Distributions on capital securities 14 -- --
Depreciation expense 38 29 25
Change in insurance liabilities 58 66 294
Change in DPAC (18) 38 (36)
Change in receivables (145) (167) (99)
Change in other liabilities 76 61 79
Change in other assets (123) 122 (31)
Change in other items, net (16) (4) (9)
-----------------------
Net cash provided from operating activities $ 145 $ 330 $399
-----------------------
Cash provided from operating activities does not include a $104 million portion
of a coinsurance contract purchased to cede certain structured settlement
annuity obligations (refer to Note 12, "Reinsurance"). This transaction is
considered financing in nature as it transfers a fixed payment obligation to the
coinsurer.
Note 2 Investments
2.1. Components of net investment income
(in millions) 1997 1996 1995
------------------------
Fixed maturities $593 $630 $664
Common and preferred stocks 1 3 4
Short-term investments 32 20 23
Mortgage loans and real estate 69 48 46
Other investment income, net of
interest expense on funds held 11 19 13
------------------------
Total investment income 706 720 750
Investment expenses (15) (15) (17)
------------------------
Net investment income $691 $705 $733
------------------------
2.2. Net realized gains on investments
(in millions) 1997 1996 1995
------------------------
Net Gains (Losses) on Sales:
Fixed maturities $ 3 $(12) $ 6
Common and preferred stocks -- 79 4
Mortgage loans and real estate 34 17 2
Other 14 18 18
------------------------
Net gains on sales 51 102 30
Impairments (36) (58) (23)
------------------------
Net realized gains on investments $ 15 $ 44 $ 7
------------------------
2.3. Unrealized gains (losses)
At December 31
(in millions) 1997 1996
----------------
Unrealized Gains:
Fixed maturities available for sale $319 $161
Common and preferred stocks 3 2
Foreign currency and other 20 20
----------------
Gross unrealized gains 342 183
----------------
Unrealized Losses:
Fixed maturities available for sale (7) (63)
Common and preferred stocks (5) (2)
Foreign currency and other (6) (4)
----------------
Gross unrealized losses (18) (69)
DPAC and policy benefits adjustment (67) (19)
Deferred taxes on net unrealized gains (90) (33)
----------------
Net unrealized gains $167 $ 62
----------------
2.4. Change in net unrealized gains (losses)
(in millions) 1997 1996 1995
------------------------
Fixed maturities available for sale $214 $(242) $ 524
DPAC and policy benefits adjustment (48) 54 (106)
Common and preferred stocks (2) 2 4
Foreign currency and other (2) 10 (4)
------------------------
Total change in unrealized
gains (losses) before taxes 162 (176) 418
Deferred taxes on net unrealized gains (57) (33) --
------------------------
Net change in unrealized
gains (losses) $105 $(209) $ 418
------------------------
2.5. Estimated market values of fixed maturity investments
There were no fixed maturities classified as "held to maturity" at December 31,
1997 and 1996. The cost and market value of fixed maturities available for sale
were as follows:
At December 31, 1997
Gross
Unrealized Market
(in millions) Cost Gains Losses Value
---------------------------------
U.S. Government bonds $ 497 $ 12 $(1) $ 508
Mortgage-backed securities 1,392 29 -- 1,421
Asset-backed securities 664 14 -- 678
Corporate bonds 4,249 199 (3) 4,445
State and political subdivision bonds 1,209 53 (1) 1,261
Foreign government bonds 172 12 (2) 182
---------------------------------
Total $8,183 $319 $(7) $8,495
---------------------------------
At December 31, 1996
Gross
Unrealized Market
(in millions) Cost Gains Losses Value
---------------------------------
U.S. Government bonds $ 334 $ 7 $ (3) $ 338
Mortgage-backed securities 1,464 22 (3) 1,483
Asset-backed securities 731 11 (1) 741
Corporate bonds 4,882 107 (51) 4,938
State and political subdivision bonds 425 6 (1) 430
Foreign government bonds 230 8 (4) 234
---------------------------------
Total $8,066 $161 $(63) $8,164
---------------------------------
2.6. Stated due dates of fixed maturities
The following table shows the stated due dates of fixed maturities available for
sale at December 31, 1997.
Market
(in millions) Cost Value
------------------
In 1998 $ 239 $ 240
1999 through 2002 2,090 2,141
2003 through 2007 1,613 1,683
After 2007 2,185 2,332
------------------
Subtotal 6,127 6,396
Mortgage/asset-backed securities 2,056 2,099
securities
------------------
Fixed maturities available
for sale $8,183 $8,495
------------------
Actual maturities may differ from stated due dates as borrowers may have the
right to call or prepay obligations.
Information regarding sales, repayments and maturities of fixed maturities
available for sale during 1997 is set forth in the following table.
Gross Gross
(in millions) Cost Proceeds Gains Losses
-------------------------------
Proceeds from sales $1,295 $1,293 $28 $(30)
Proceeds from 738 743 5 --
maturities/repayments
-------------------------------
Total proceeds $2,033 $2,036 $33 $(30)
-------------------------------
Proceeds from sales of fixed maturities classified as available for sale in 1996
totaled $588 million with gross gains of $14 million and gross losses of $28
million. In 1995, such sales totaled $489 million with gross gains of $16
million and gross losses of $13 million.
Proceeds from sales of fixed maturities held to maturity were $21 million (with
no gross gains and gross losses of $3 million) in 1995. These sales involved
five different issuers and were based on evidence of significant deterioration
of the issuers' creditworthiness, as determined from developments related
specifically to the issuers. USF&G performed a detailed analysis of the issuers'
operating trends, cash flows and ability to meet debt service.
From January 1, 1995 through December 3, 1995, reclassifications from held to
maturity to available for sale totaled $31 million of amortized cost. These
reclassifications were based on evidence of significant deterioration of the
issuers' creditworthiness. Gross unrealized losses on these securities totaled
$9 million at the time of the reclassifications. On December 4, 1995, all
remaining securities classified as held to maturity were reclassified to
available for sale as permitted by supplemental guidance to SFAS No. 115 issued
by the FASB in November 1995. This reclassification was made to allow maximum
flexibility in the management of the investment portfolio without being
restricted by accounting interpretations. The securities had a total amortized
cost of $4.5 billion, with gross unrealized gains of $117 million, at the time
of the reclassification.
2.7. Nonincome-producing investments
Fixed maturities at December 31, 1997 and 1996, for which no income was recorded
during those years, totaled $1 million. In addition, nonincome-producing real
estate totaled $20 million and $28 million at December 31, 1997 and 1996,
respectively.
Note 3 Insurance Liabilities
3.1. Property/casualty insurance reserves - unpaid losses and loss expenses
Activity in unpaid losses and loss expenses for the property/casualty segment is
summarized as follows:
(in millions) 1997 1996 1995
------------------------
Total reserve at beginning of year, gross $6,032 $6,097 $6,158
Less reinsurance recoverables 987 984 1,016
------------------------
Net balance at January 1 5,045 5,113 5,142
------------------------
Incurred Related To:
Current year 1,933 2,030 1,856
Prior years (139) (162) (54)
------------------------
Total incurred 1,794 1,868 1,802
------------------------
Paid Related To:
Current year 726 764 635
Prior years 1,225 1,190 1,196
------------------------
Total paid 1,951 1,954 1,831
------------------------
Net balance at December 31 4,888 5,027 5,113
Plus reserves acquired* 140 18 --
Plus reinsurance recoverables 1,172 987 984
------------------------
Total reserve at end of year, gross $6,200 $6,032 $6,097
------------------------
*Reserves acquired relate to the purchases of Titan in 1997 and Afianzadora in
1996.
Losses and loss expenses recorded in the current period financial statements are
affected by changes in estimates of insured events occurring in prior periods.
Loss and loss expense reserves are established based on actuarial evaluation of
required reserves by accident year. Each accident year is independently
evaluated. Typically, the reserve requirements are greatest in the most recent
accident year, where there is the higher degree of uncertainty.
Losses incurred in 1997, 1996 and 1995 included $116 million, $110 million and
$77 million, respectively, of favorable development related to prior years'
experience in the assumed reinsurance business. Given the inherent uncertainty
in reserving for assumed reinsurance losses, current accident year reserves are
established on a conservative basis. Based on actuarial analysis in 1997 and
1996, the favorable development in assumed reinsurance from prior accident years
was substantially offset by the establishment of current accident year reserves.
The workers' compensation line was the key contributor of the remaining
favorable development of $23 million in 1997 and $52 million in 1996. These
favorable trends in older accident years are attributable to reform efforts by
various states in the early 1990s to contain workers' compensation loss costs,
the results of which are emerging in recent calendar years. In addition,
favorable development in 1996 included recognition of the effect on reserve
estimation models of the increased use of structured settlement annuities to
close workers' compensation claims. Prior years' loss reserve decreases in
workers' compensation were substantially offset by reserve increases in
liability lines for the current accident years.
Reserves for asbestos-related illnesses and environmental claims cannot be
estimated with traditional loss reserving techniques. Liabilities are
established for known claims (including the cost of litigation) when sufficient
information has been developed to indicate the involvement of a specific
insurance policy and management can reasonably estimate its liability. In
addition, liabilities have been established to cover additional exposures on
both known and unasserted claims. Estimates of the liabilities are reviewed and
updated continually. Developed case law and adequate claim history do not exist
for such claims, especially because significant uncertainty exists about the
outcome of coverage litigation and whether past claim experience will be
representative of future loss experience.
3.2. Life benefit reserves
The table below shows F&G Life's benefit reserves by policy type.
At December 31
(in millions) 1997 1996
-----------------
Single Premium Annuities:
Deferred $1,374 $1,314
Immediate 1,048 1,001
Other annuities 367 610
Universal/term/group life 1,027 627
-----------------
Gross balance 3,816 3,552
Reinsurance receivable 786 782
-----------------
Total reserves, net $3,030 $2,770
-----------------
Note 4 Debt
4.1. Debt outstanding
At December 31
(in millions) 1997 1996
----------------
Corporate:
Short-term and Current Maturities of
Long-term:
Credit facility $ 35 $--
7% Senior Notes due 1998 145 --
Long-term:
Zero Coupon Convertible
Notes due 2009 107 102
8 3/8% Senior Notes due 2001 149 150
7% Senior Notes due 1998 -- 145
7 1/2% Senior Notes due 2005 80 80
----------------
Total corporate debt 516 477
Real estate and other debt 5 5
----------------
Total debt outstanding $521 $482
----------------
4.2. Short-term debt
For general corporate purposes, USF&G maintained two committed, standby credit
facilities with a group of foreign and domestic banks totaling $450 million at
December 31, 1997. The facility in place for $200 million will expire in
December 1998 and the remaining facility will expire in 2002. These facilities
replaced the $250 million committed, standby credit facility and the $150
million multi-currency credit facility in place at December 31, 1996, and permit
either borrowing of funds or letter of credit issuances. USF&G pays facility
fees on the total amount of the commitments based on its long-term debt credit
ratings. Borrowings at December 31, 1997 totaled $35 million. There were no
borrowings against the committed, standby credit facility or the multi-currency
credit facility at December 31, 1996.
Interest rates on borrowed funds are based on current market rates. At December
31, 1997 and 1996, the annual weighted-average interest rate under the
facilities was 5.96% and 5.76%, respectively. USF&G was in compliance with the
covenants contained in these agreements at December 31, 1997 and 1996. The most
restrictive covenants require USF&G to maintain a tangible net worth of at least
$1.3 billion plus 50 percent of the net income earned during the commitment
period and an indebtedness-to-capital ratio below 55 percent.
4.3. Debt extinguishments
From April through August 1996, USF&G repurchased approximately $39 million of
outstanding Zero Coupon Convertible Notes through the use of excess corporate
cash and borrowings from the credit facility. The balance of the credit facility
was repaid in December 1996 with excess corporate cash and proceeds from the
issuance of capital securities (refer to Note 6).
In 1996, real estate and other debt was reduced by $11 million as a result of a
deed-in-lieu of foreclosure whereby property with an outstanding $7 million note
was conveyed back to the lender and a $4 million loan was repaid.
4.4. Shelf registration
USF&G Corporation has available $142 million of unissued debt, preferred stock,
common stock and warrants under a 1994 shelf registration.
4.5. Redeemable debt
The Zero Coupon Convertible Notes are redeemable beginning in 1999 for an amount
equal to the original issue price plus amortized original issue discount.
4.6. Maturities of long-term debt
Real
Estate
(in millions) Corporate and
Other
-------------------------
1998 $145 $--
1999 -- --
2000 -- --
2001 149 --
2002 -- --
-------------------------
Note 5 Leases
USF&G occupies office facilities under lease agreements that expire at various
dates through 2009. In addition, data processing, office and transportation
equipment is leased under agreements that expire at various dates through 2002.
Most leases contain renewal options that may provide for rent increases based on
prevailing market conditions. Some leases also may contain purchase options
based on fair market value or contractual values, if greater. Capital leases are
immaterial in amount. Rent expense for the years ended December 31, 1997, 1996
and 1995 was $25 million, $40 million and $44 million, respectively.
The following table shows the future minimum payments to be made under
noncancelable leases at December 31, 1997.
Home Other
Office Office Equip-
(in millions) Building Space ment Total
-----------------------------------
1998 $ 16 $22 $15 $ 53
1999 19 19 7 45
2000 25 15 5 45
2001 26 9 14 49
2002 25 5 -- 30
After 2002 174 1 -- 175
-----------------------------------
Total $285 $71 $41 $397
-----------------------------------
USF&G is also the lessor under various subleases on its office facilities. The
minimum rentals to be received in the future under noncancelable subleases is
$96 million at December 31, 1997.
USF&G's principal office lease involves the Tower which the Corporation sold in
1984 and subsequently leased back. As of January 1997, USF&G has vacated the
Tower (refer to Note 1.13); however, USF&G is obligated to continue to make
rental payments under the lease, which provides for rent increases every five
years through its expiration in September 2009.
Note 6 Capital Securities of Subsidiary Trusts
Series A: On December 24, 1996, USF&G Capital I ("Capital I"), a business trust
wholly owned by USF&G, issued $100 million (100,000 shares) of 8.5% Capital
Securities, Series A ("Series A Securities"). Payments on the Series A
Securities are guaranteed by USF&G on a subordinated basis, but only to the
extent Capital I has funds available to make such payments. This guarantee,
considered together with the terms of debentures issued by USF&G (described
below) and an agreement for USF&G to pay other expenses and liabilities of
Capital I, constitutes a full and unconditional subordinated guarantee by USF&G
of Capital I's obligations under the Series A Securities.
Capital I used the proceeds from the Series A Securities issuance to purchase
$100 million principal amount of 8.5% Junior Subordinated Debentures issued by
USF&G ("Series A Debentures"). The Series A Debentures rank junior and
subordinate in right of payment to certain other indebtedness of USF&G, and
mature on December 15, 2045.
Interest payments on the Series A Debentures are
deferrable, at USF&G's option, at any time for up to five years at a time, and
provided there has not been an event of default. In the event USF&G elects to
defer interest payments on the Series A Debentures, payments of distributions on
the Series A Securities will likewise be deferred. Interest and distributions
continue to accrue during any payment deferral period.
The Series A Debentures
are redeemable under certain circumstances related to tax events at a price of
$1,000 per debenture plus any accrued and unpaid interest and a "make whole"
payment. Proceeds from any redemptions of the Series A Debentures will be used
to redeem a like amount of the Series A Securities. Additionally, USF&G has the
right, under certain circumstances related to tax events, to shorten the
maturity of the Series A Debentures to a date no earlier than June 24, 2016, in
which case the stated maturity of the Series A Securities will likewise be
affected.
Series B: On January 10, 1997, USF&G Capital II ("Capital II"), a second
business trust wholly owned by USF&G, issued $100 million (100,000 shares) of
8.47% Capital Securities, Series B ("Series B Securities"). Payments on the
Series B Securities are guaranteed on the same basis as the guarantee of the
Series A Securities.
Capital II used the proceeds from the Series B Securities issuance to purchase
$100 million principal amount of 8.47% Deferrable Interest Junior Subordinated
Debentures, Series B ("Series B Debentures") issued by USF&G, which mature on
January 10, 2027. The Series B Debentures also rank junior and subordinate to
certain other indebtedness of USF&G, but rank equal with the Series A
Debentures. The Series B Debentures and Series B Securities have interest/
distribution deferral terms similar to those of the Series A Debentures and
Series A Securities, described above. The Series B Debentures are redeemable at
USF&G's option at any time beginning in January 2007 at scheduled redemption
prices ranging from $1,042 to $1,000 per debenture, plus any accrued and unpaid
interest.
The Series B Debentures are also redeemable prior to January 2007 under certain
circumstances related to tax and other special events. Proceeds from any
redemptions of the Series B Debentures will be used to redeem a like amount of
the Series B Securities. Additionally, USF&G has the right, under certain
circumstances related to tax events, to shorten the maturity of the Series B
Debentures to a date no earlier than July 10, 2016, in which case the stated
maturity of the Series B Securities will likewise be affected.
Series C: On July 8, 1997, USF&G Capital III ("Capital III"), a third business
trust wholly owned by USF&G, issued $100 million (100,000 shares) of 8.312%
Capital Securities, Series C ("Series C Securities"). Payments on the Series C
Securities are guaranteed on the same basis as the guarantee of the Series A and
Series B Securities.
Capital III used the proceeds from the Series C Securities issuance to purchase
$100 million principal amount of 8.312% Junior Subordinated Debentures issued by
USF&G ("Series C Debentures"). The Series C Debentures rank junior and
subordinate in right of payment to certain other indebtedness of USF&G, but rank
equal with the Series A and Series B Securities. The Series C Debentures and
Series C Securities have interest/distribution deferral terms similar to those
of the Series A and Series B Debentures and Series A and Series B Securities,
described above.
The Series C Debentures mature on July 1, 2046, and are redeemable under certain
circumstances related to tax events at a price of $1,000 per debenture plus any
accrued and unpaid interest and a "make whole" payment. Proceeds from any
redemptions of the Series C Debentures will be used to redeem a like amount of
the Series C Securities. Additionally, USF&G has the right, under certain
circumstances related to tax events, to shorten the maturity of the Series C
Debentures to a date no earlier than April 8, 2012, in which case the stated
maturity of the Series C Securities will likewise be affected.
The Series A , Series B and Series C Debentures and related interest expense and
income, as well as USF&G's interest in Capital I, Capital II and Capital III,
are eliminated in consolidation. The Series A, Series B and Series C Securities
are shown in the Consolidated Statement of Financial Position under the caption,
"USF&G-obligated mandatorily redeemable preferred capital securities of
subsidiary trusts holding solely junior subordinated deferrable interest
debentures of USF&G". Distributions on the Series A, Series B and Series C
Securities are shown, net of tax, in the Consolidated Statement of Operations
under the caption "Distributions on USF&G-obligated mandatorily redeemable
preferred capital securities of subsidiary trusts holding solely junior
subordinated deferrable interest debentures of USF&G, net of tax".
The sole assets of Capital I, Capital II and Capital III are the Series A,
Series B and Series C Debentures, respectively. Neither Capital I, Capital II
nor Capital III have operations independent of the aforementioned relationships
with USF&G and the holders of their respective capital securities. In the event
USF&G exercises its right to defer interest payments on the Series A, Series B
or Series C Debentures, it will be prohibited from making payments with respect
to any capital debt or securities which rank equal or junior in right of payment
to the Series A, Series B and Series C Debentures, including cash dividends on
its common or preferred stock. In no case may the deferral of payments described
above extend beyond the stated maturity dates of the respective securities.
Note 7 Shareholders' Equity
7.1. Classes of stock
USF&G is authorized to issue 12 million shares of $50 par value preferred stock
and 240 million shares of $2.50 par value common stock.
7.2. Preferred stock
USF&G had no preferred stock outstanding at December 31, 1997. At December 31,
1996 and 1995, there were 4 million shares of $4.10 Series A Convertible
Exchangeable Preferred Stock ("Series A Preferred Stock") issued and
outstanding. During the first half of 1997, USF&G called for redemption all of
the remaining outstanding shares of its Series A Preferred Stock. Holders of
10,227 shares of the Series A Preferred Stock converted their shares into 12,308
shares of common stock. USF&G redeemed all of the remaining outstanding shares
of its Series A Preferred Stock for $200 million cash.
USF&G had 277,550 shares and 1.3 million shares of $10.25 Series B Cumulative
Convertible Preferred Stock ("Series B Preferred Stock") issued and outstanding
at December 31, 1996 and 1995, respectively. During 1996 and 1995, USF&G called
for redemption 233,550 shares and 832,650 shares, respectively, of its Series B
Preferred Stock. These shares were converted into 1.9 million shares and 6.9
million shares, respectively, of common stock in accordance with the terms of
the Series B Preferred Stock. Holders of an additional 20,000 shares and 189,800
shares of Series B Preferred Stock voluntarily converted their shares into
166,320 shares and 1.6 million shares, respectively, of common stock during 1996
and 1995. The holder of another 24,000 shares of Series B Preferred Stock
voluntarily redeemed those shares for cash during 1996.
7.3. Changes in common stock shares
1997 1996 1995
--------------------------------------
Outstanding, January 1 114,240,489 119,606,095 104,810,794
Shares repurchased (4,706,430) (8,400,700) --
Shares issued 6,868,140 3,035,094 14,795,301
--------------------------------------
Outstanding, December 31 116,402,199 114,240,489 119,606,095
--------------------------------------
In December 1997, USF&G issued approximately 5.1 million shares of common stock
in consideration for its acquisition of Titan. In conjunction with a stock
repurchase program instituted in 1996, USF&G repurchased 4.7 million and 8.4
million shares of its common stock during 1997 and 1996, respectively. USF&G
also issued 2.1 million shares of common stock during 1996 for the conversion of
the Series B Preferred Stock. During 1995, USF&G issued 8.5 million shares of
common stock for the conversion of the Series B Preferred Stock, and 5.5 million
shares of common stock for the conversion of the $5.00 Series C Cumulative
Convertible Preferred Stock.
7.4. Shareholder rights plan
USF&G has a shareholder rights plan ("the plan") to deter coercive or unfair
takeover tactics and to prevent a potential purchaser from gaining control of
USF&G without offering a fair price to all of the Corporation's shareholders.
The plan, which otherwise would have expired in 1997, was extended until 2007
and amended in several respects in February 1997. Under the plan, as amended,
each outstanding share of USF&G's common stock has one preferred share purchase
right (a "right") expiring in 2007. Each right entitles the registered holder to
purchase 1/100 of a share of a new class of junior preferred stock for $105. The
rights cannot be exercised unless certain events occur that might lead to a
concentration in ownership of common shares or unless certain other events
relating to a change in control take place. At that time, each right may be
converted into rights to acquire common stock having a value of twice the $105
exercise price. In certain circumstances, the plan also provides that the rights
can be exchanged for USF&G's common stock without payment of the purchase price.
Rights held by holders of 15 percent or more of USF&G's common stock, or their
associates, may be null and void. Under certain conditions, the rights also
become convertible into the rights to acquire shares of common stock of an
acquiror having a value of twice the exercise price. USF&G will generally be
entitled to redeem the rights, at $.01 per right, any time before the tenth day
(subject to further deferral) after a 15 percent position is acquired. In
January 1998, the plan was amended to provide that the rights would not become
exercisable as a result of the transactions contemplated with St. Paul under the
merger agreement or the related stock option agreement.
7.5. Dividend restrictions
There are certain restrictions on payments of dividends by insurance
subsidiaries that may limit USF&G Corporation's ability to receive funds from
its subsidiaries. Under the Maryland Insurance Code, Maryland insurance
subsidiaries, such as USF&G Company and F&G Life, must provide the Maryland
Insurance Commissioner (the "Commissioner") with not less than thirty days'
prior written notice before payment of an "extraordinary dividend" to its
holding company. (Refer to Section 4.3, "Dividend Restrictions", of Management's
Discussion and Analysis of Financial Condition and Results of Operations.) In
addition, ten days' prior 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.
Cash dividends of $136 million, $134 million and $83 million were paid during
1997, 1996 and 1995, respectively, to USF&G Corporation by USF&G Company. Such
dividends were not subject to the requirements for extraordinary dividends. In
addition, effective June 1, 1995, and with the Commissioner's consent, USF&G
Company declared an extraordinary dividend payable to USF&G Corporation valued
at $323 million, which consisted of all of the issued and outstanding capital
stock of F&G Life. Prior to payment of such dividend, F&G Life was a
wholly-owned subsidiary of USF&G Company. As a result of such dividend payment,
F&G Life is now a direct, wholly-owned subsidiary of USF&G Corporation.
Dividends of up to $146 million will be available for payment from USF&G Company
to USF&G Corporation during 1998 without being deemed extraordinary.
Cash dividends of $40 million, $139 million and $31 million were paid during
1997, 1996 and 1995, respectively, to USF&G Corporation by F&G Life. In
addition, effective December 17, 1997 and December 29, 1995 and with the
Commissioner's consent, F&G Life declared extraordinary dividends payable to
USF&G Corporation consisting of investments in various real estate properties,
totaling $25 million and $28 million, respectively. Consequently, all of the
1997 and 1996 dividends were deemed extraordinary, and were paid with the
Commissioner's consent. Further, any dividends which F&G Life would propose to
pay in 1998 would be deemed extraordinary dividends and subject to the
thirty-day notice period.
Note 8 Financial Instruments and Derivatives
Fair value information is based on quoted market prices where available. In
cases where quoted market prices are not available, fair values are based on
internal estimates using present value or other valuation techniques. Those
techniques are significantly affected by the assumptions used, such as
applicable discount rate and estimated future cash flows. Therefore, the derived
fair value estimates cannot be substantiated by comparison to independent
markets and, in many cases, could not be realized in immediate settlement of the
instrument. Fair value disclosure requirements exclude certain financial
instruments and all nonfinancial instruments. The fair value of many
insurance-related liabilities do not require disclosure. However, in its
strategy of asset/liability matching, USF&G takes into consideration the future
cash requirements of its insurance-related liabilities. Had a presentation of
these liabilities been made, due to their long-term nature, the fair value of
insurance-related liabilities would have been significantly less than their
carrying value.
8.1. Financial instruments
Cash and Short-Term Investments: The carrying amounts reported in the
Consolidated Statement of Financial Position for these instruments approximate
their fair values.
Fixed Maturity Investments: Fair values for publicly-traded fixed maturity
investments are based on quoted market prices. For privately-placed fixed
maturities, estimated fair values are derived by discounting expected future
cash flows using a current market rate applicable to the yield, credit quality
and maturity of the investment. At December 31, 1997, the amortized costs and
market values of fixed maturity investments were as follows:
Amortized Market
(in millions) Cost Value
------------------------
Publicly traded $7,696 $8,015
Private placements 487 480
------------------------
Total fixed maturity investments $8,183 $8,495
------------------------
All fixed maturities are classified as available for sale and are reported in
the Consolidated Statement of Financial Position at market value.
Common and Preferred Stocks: The carrying values of common and preferred stocks
as reported in the Consolidated Statement of Financial Position are based on
quoted market prices and reflect their fair values.
Mortgage Loans and Policy Loans: The fair values for mortgage loans and policy
loans are estimated based on discounted cash flow analyses, using interest rates
currently being offered for loans with similar credit risk. Loans with similar
characteristics are aggregated for purposes of the calculations. At December 31,
1997, the carrying amounts and fair values of investments in mortgage loans and
policy loans were as follows:
Carrying Fair
(in millions) Amount Value
------------------------
Mortgage loans $641 $658
Policy loans 82 86
------------------------
Other Assets and Other Liabilities: Other invested assets considered financial
instruments include equity interests in minority ownership investments,
interests in limited partnerships and related notes receivable. It is not
practicable to estimate their fair value due to the closely-held nature of these
investments.
Other assets and liabilities considered financial instruments include agents'
balances receivable, prepaid and accrued expenses and other receivables
generally of a short-term nature. It is assumed the carrying value of these
financial instruments approximates their fair value.
Short- and Long-Term Debt: The carrying amount of USF&G's short-term borrowings
approximates its fair value. The fair value of long-term debt is based on market
quotes or estimated discounted cash flow analyses, based on USF&G's current
incremental borrowing rates for similar types of borrowing arrangements. The
carrying amounts and estimated fair value of debt instruments at December 31,
1997 were as follows:
Carrying Fair
(in millions) Amount Value
------------------------
Corporate $516 $545
Real estate and other 5 5
------------------------
Total debt $521 $550
------------------------
Investment Contracts: Fair values for F&G Life's single premium deferred
annuities, other deferred annuities, single premium immediate annuities and
supplementary contracts are primarily derived by estimating the cost to
extinguish its liabilities under an assumption reinsurance transaction. The
estimated statutory profits the assuming company would realize from the
transaction are discounted at a typical internal rate of return objective. If
such a transaction were to occur, GAAP would require the unamortized balance of
deferred policy acquisition costs associated with these liabilities to be
immediately expensed. The amount of the related unamortized DPAC was
approximately $136 million at December 31, 1997. The fair values of the
remaining liabilities under investment contracts are estimated using discounted
cash flow calculations, based on interest rates currently being offered for like
contracts with similar maturities.
The carrying amounts and estimated fair values of F&G Life's liabilities for
investment contracts at December 31, 1997 were as follows:
Carrying Fair
(in millions) Amount Value
------------------------
Single premium deferred annuities $ 699 $ 654
Other deferred annuities 709 637
Single premium immediate annuities
and supplementary contracts 85 81
Group annuities 65 63
------------------------
Total $1,558 $1,435
------------------------
Off-Balance Sheet Financial Instruments: The fair values of USF&G's financial
guarantees written totaled $2 million at December 31, 1997, and were estimated
using discounted cash flow analyses based on USF&G's current incremental
borrowing rate for similar types of borrowing arrangements. The fair value of
foreign exchange options, which are derived from quoted market prices, were less
than $1 million at December 31, 1997. The estimates of the fair value of USF&G's
interest rate swaps were obtained from the counterparties to the agreement or
were derived by discounting the expected future cash flows, and totaled $4
million at December 31, 1997.
8.2. Derivatives
USF&G uses derivative instruments, including options and swaps, to manage
foreign exchange and interest rate risk, reduce borrowing costs and minimize the
impact of rate fluctuations on the settlement of debt and other financial
instruments. USF&G limits its use of derivative instruments.
Foreign exchange options are used to manage exposure to the effects of foreign
currency exchange rate fluctuations on foreign-denominated transactions.
Cash-settled equity swaps on USF&G common stock are used to manage exposure to
stock price fluctuations on stock-based incentive compensation expense. Interest
rate swaps are used to manage the exposure to fluctuating rates and the
relationship of fixed/floating interest rates on corporate debt. Individually,
and in the aggregate, the impact of these transactions on the financial position
and results of operations is not material. At December 31, 1997, the
Corporation's mark-to-market position on these derivative instruments was a
gross gain of $4 million and a gross loss of less than $1 million.
In addition, exchange-traded and over-the-counter catastrophe options and swaps,
linked to an index of losses related to natural disasters, are an additional
insurance-related source of income. USF&G limits and monitors its maximum
exposure to loss. Individually, and in the aggregate, the impact of these
transactions on the financial position and results of operations is not
material. At December 31, 1997, the maximum exposure to loss was less than $3
million and gross unrealized gains and gross unrealized losses were
approximately $1 million.
USF&G is subject to the risk that the counterparties will fail to perform.
However, these risks are mitigated by the credit quality of the counterparties
and the gains and losses of the underlying instruments. USF&G seeks to manage
the credit risk by establishing minimum credit ratings for counterparties to the
transactions.
Note 9 Stock-Based Compensation
Stock options have been granted to full-time officers and key employees under
four incentive plans: Stock Option Plan of 1987, Stock Option Plan of 1990,
Stock Incentive Plan of 1991, and Stock Incentive Plan of 1997 (collectively,
the "Management Plans"). In addition, the 1994 Stock Plan for Employees of USF&G
(the "Broad-Based Plan") grants eligible employees, other than officers and key
employees participating in other stock incentive plans, options to purchase
shares.
The Corporation applies Accounting Principles Board Opinion ("APB") No. 25 and
related interpretations in accounting for its employee stock options. Under APB
No. 25, no compensation expense is recognized since the exercise price of the
options is equal to the market price of the underlying stock on the date of the
grant.
In addition, under the Corporation's Long-Term Incentive Program, USF&G awards
shares of common stock to full-time officers based on three-year performance
goals established by the Board of Directors. Compensation expense, determined
under APB No. 25 as the number of shares to be issued at a given performance
level times the current market price of the stock, is accrued over the
three-year performance cycle. Net income for 1997 and 1996 included $6 million
and $13 million, respectively, of compensation expense for LTIP awards.
Under the Management Plans and Broad-Based Plan, the Corporation may grant
options to participating employees to purchase up to 16 million and 5 million
shares of common stock, respectively. At December 31, 1997, 7 million and 1
million options were available for future grant under the Management Plans and
Broad-Based Plan, respectively. Under all plans, the exercise price of each
option equals the market price of USF&G's stock on the date of grant, and an
option's maximum term is ten years. Options vest ratably over three years under
the Management Plans, and vest after two years under the Broad-Based Plan.
Had compensation expense for these plans been determined based on the fair value
of awards at the grant date, as prescribed by SFAS No. 123, net income and
earnings per share would have been as follows:
1997 1996 1995
--------------------
Pro forma net income (in millions) $ 182 $ 254 $ 205
Pro forma basic earnings per share 1.61 1.99 1.59
Pro forma diluted earnings per share 1.52 1.89 1.49
--------------------
Note: The effects of applying SFAS No. 123 shown here are not likely to be
representative of the effects in future years due to the exclusion of awards
granted in prior years but vesting (and therefore expensed) in 1995, 1996 and
1997.
The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model. The weighted-average assumptions used for
grants in each year were as follows:
1997 1996 1995
-------------------------------
Expected volatility 21.1% 25.0% 25.4%
Dividend yield 1.13% 1.24% 1.53%
Management Plans:
Risk-free interest rates 6.52% 6.36% 7.25%
interest rates
Expected lives 5 years 7 years 7 years
Broad-Based Plan:
Risk-free interest rates 6.35% 5.98% 7.07%
Expected lives 3 years 4 years 4 years
-------------------------------
The Black-Scholes method is one of many models used to calculate the fair value
of an option. Because the models are sensitive to changes in the different
assumptions used, the effect on fair value estimates can be significant.
Accordingly, the derived fair value of options cannot be substantiated by
comparison to independent markets. The fair value also cannot be realized in
immediate settlement.
A summary of the status of USF&G's stock option plans as of December 31, 1997,
1996 and 1995, and changes during the years ended on those dates are presented
in the table below. The 1997 activity includes options granted pursuant to the
merger agreement with Titan, in which the Corporation assumed 899,731
exercisable outstanding options, based on the exchange ratio applicable to the
acquisition.
Weighted-Average
Exercise
Shares Price
-----------------------------
Outstanding at January 1, 1997 9,101,408 $13.95
Granted 2,404,142 22.52
Granted in conjunction with acquistion 899,731 12.14
Exercised (1,533,314) 13.20
Surrendered or canceled (873,341) 18.23
-----------------------------
Outstanding at December 31, 1997 9,998,626 $15.58
-----------------------------
Options exercisable at December 31, 1997 5,146,295 $13.24
-----------------------------
Weighted-average fair value of options
granted during 1997 $ 5.66
-----------------------------
Weighted-Average
Exercise
Shares Price
-----------------------------
Outstanding at January 1, 1996 7,290,207 $12.97
Granted 3,363,988 14.63
Exercised (910,396) 11.45
Surrendered or canceled (642,391) 15.30
-----------------------------
Outstanding at December 31, 1996 9,101,408 $13.95
-----------------------------
Options exercisable at December 31, 1996 3,714,777 $13.39
-----------------------------
Weighted-average fair value of options
granted during 1996 $ 4.55
-----------------------------
Weighted-Average
Exercise
Shares Price
-----------------------------
Outstanding at January 1, 1995 5,908,451 $12.86
Granted 2,714,806 13.72
Exercised (733,603) 7.33
Surrendered or canceled (599,447) 16.86
-----------------------------
Outstanding at December 31, 1995 7,290,207 $12.97
-----------------------------
Options exercisable at December 31, 1995 2,707,398 $12.82
-----------------------------
Weighted-average fair value of options
granted during 1995 $ 4.63
-----------------------------
The following table summarizes information about stock options outstanding at
December 31, 1997:
Range of Options Outstanding Options Exercisable
Exercise Remaining Average Average
Price Number Life* Price** Number Price**
--------------------------------------------------------
$6.25-10 1,129,256 3.6 $ 9.19 1,129,256 $ 9.19
11-15 6,236,325 7.2 13.97 3,708,650 13.74
16-20 378,312 6.4 16.78 176,940 16.94
21-28 2,129,005 9.2 22.53 5,721 22.50
29-30.82 125,728 1.7 29.48 125,728 29.48
--------------------------------------------------------
$6.25-30.82 9,998,626 7.1 $15.30 5,146,295 $13.24
--------------------------------------------------------
*Represents the weighted-average remaining contractual life of options in
years.
**Represents the weighted-average exercise price of options.
Under the terms of the merger agreement with St. Paul, all options outstanding
as of the effective date of the merger and that were granted prior to January
19, 1998, will become fully vested and exercisable upon consummation of the
merger.
Note 10 Retirement Benefits
10.1. Retirement plans
USF&G has noncontributory retirement plans covering most regular full-time
employees of the Corporation and its affiliates. An employee's pension benefit
is based on salary, years of service and Social Security benefits. USF&G makes
contributions to the retirement plans based on amounts required to be funded
under provisions of the Employee Retirement Income Security Act of 1974, as
amended. The plans' funded status and amounts recognized in the consolidated
financial statements were as follows:
At December 31
(dollars in millions) 1997 1996
-------------------
Actuarial Present Value of:
Accumulated benefit obligation $410 $370
Vested benefits 392 355
-------------------
Plan assets at fair value $439 $379
Projected benefit obligation 427 385
-------------------
Funded status 12 (6)
Unrecognized net loss 91 105
Unrecognized prior service cost
(benefit) (12) (15)
Adjustment for minimum pension
liability -- --
-------------------
Net prepaid pension cost $ 91 $ 84
-------------------
Actuarial Assumptions:
Weighted-average discount rate 7.00% 7.50%
Average rate of increase in future
compensation levels 5.00 5.00
-------------------
As a result of the lower interest rate environment, USF&G decreased the discount
rate assumption as of December 31, 1997, which increased the accumulated benefit
obligation. The expected long-term rate of return on assets was 8.5% for 1997,
1996 and 1995.
The assets held by the plan consist primarily of fixed-income and equity
securities. USF&G classifies prepaid pension cost with other assets in the
Consolidated Statement of Financial Position.
The components of net pension expense were as follows:
(in millions) 1997 1996 1995
------------------------
Service cost $ 7 $ 8 $ 5
Interest cost 29 28 27
Actual return on plan assets (71) (20) (63)
Net amortization (deferral) 43 (4) 43
------------------------
Net periodic pension expense $ 8 $ 12 $ 12
------------------------
10.2. Postretirement benefits
USF&G sponsors a defined-dollar postretirement health care (medical and dental)
plan and noncontributory life insurance plan covering most regular full-time
employees of the Corporation and its affiliates. USF&G's contributions and costs
are determined based on the annual salary and the type of coverage elected by
covered employees. USF&G's contributions to the plan are a percentage of plan
costs based on age and service of employees at retirement. Additionally, the
plan costs are capped at projected 1998 cost levels, and retiree contributions
are increased for the total medical costs over the projected levels.
USF&G accrues the cost of health care, life insurance and other retiree benefits
when the employees' services are rendered, and funds the health care and life
insurance benefit costs principally on a pay-as-you-go basis.The plans' combined
funded status and amounts recognized in the consolidated financial statements
were as follows:
At December 31
(in millions) 1997 1996
----------------
Accumulated Postretirement Benefit
Obligation:
Retirees $43 $43
Fully-eligible active plan participants 1 1
Other active plan participants 8 7
----------------
52 51
Plan assets at fair value -- --
----------------
Unfunded obligation 52 51
Unrecognized net (loss) gain (1) 2
----------------
Accrued postretirement benefit costs $51 $53
----------------
USF&G classifies accrued postretirement benefit costs with other liabilities in
the Consolidated Statement of Financial Position.
Net periodic postretirement benefit costs consisted of $1 million of service
cost and $4 million of interest cost for each of the years ended December 31,
1997, 1996 and 1995.
The weighted-average annual assumed rate of increase in per capita cost of
covered benefits (i.e., medical trend rate) for the plans is 7.25 percent for
1998 and 1997, and is assumed to decrease to 5.25 percent in 2003 for
participants age 65 or younger, and 7.00 percent for 1998 and 1997, decreasing
to 5.25 percent for participants over age 65, and remain at that level
thereafter. Increasing the assumed medical trend rate by one percentage point in
each year would increase the accumulated postretirement benefit obligation by
approximately $4 million and the aggregate of the service and interest cost
components of net periodic postretirement benefit cost for the year by less than
$1 million. The weighted-average discount rate used in determining the
accumulated postretirement benefit obligation was 7.00 percent and 7.50 percent
at December 31, 1997 and 1996, respectively.
Note 11 Income Taxes
USF&G Corporation and its subsidiaries file a consolidated federal income tax
return. Deferred tax liabilities or assets are recognized for the estimated
future tax effects attributable to net operating loss carryforwards ("NOLs") and
to temporary differences between the tax basis and GAAP basis of an asset or a
liability. A valuation allowance is required if, based on the weight of
available evidence, it is more likely than not that some or all of the deferred
tax asset will not be realized.
At December 31, 1997, the net deferred tax asset of $317 million recorded by
USF&G was supported by a combination of forecasted taxable income and a tax
strategy that USF&G would implement to prevent NOLs from expiring. Based on the
weight of positive and negative evidence, USF&G believes that it is more likely
than not that it will be able to realize all of its deferred tax assets.
Accordingly, no valuation allowance was provided at December 31, 1997.
11.1. Significant components of deferred tax assets and liabilities
At December 31
(in millions) 1997 1996
----------------
Deferred Tax Liabilities:
DPAC $145 $146
Net unrealized gains 90 33
Prepaid pension cost 32 29
Real estate 24 15
Other invested assets 5 4
Other 38 37
----------------
Total deferred tax liabilities 334 264
----------------
Deferred Tax Assets:
Facilities exit costs 48 51
Unpaid losses and loss expenses 220 228
Future policy benefits 66 59
Unearned premiums 52 54
Foreign reinsurance 48 47
Postretirement benefits 18 19
Other 15 40
NOLs 184 202
----------------
Total deferred tax assets 651 700
Valuation allowance for deferred tax assets -- --
----------------
Deferred tax assets, net of
valuation allowance 651 700
----------------
Net deferred tax assets $317 $436
----------------
The components of the changes in the valuation allowance were recorded through
shareholders' equity and operations, as follows:
(in millions) 1997 1996 1995
---------------------
Changes Recognized in Shareholders'Equity:
Changes related to net unrealized
(gains) losses $-- $ 95 $(147)
Change related to minimum pension liability -- (35) 13
---------------------
Total changes recognized in
shareholders' equity -- 60 (134)
---------------------
Changes Recognized in Statement of Operations:
Reduction for increased likelihood
of realization -- (96) (81)
Other adjustments -- -- 2
---------------------
Total changes recognized in
statement of operations -- (96) (79)
---------------------
Total change in valuation allowance $-- $(36) $(213)
---------------------
11.2. Income tax expense (benefit)
The components of the total income tax expense (benefit) were recorded through
shareholders' equity and operations, as follows:
(in millions) 1997 1996 1995
----------------------
Recorded in Shareholders' Equity:
Benefit from deduction of employee
stock options exercised $ (5) $(2) $ --
Deferred expense for change in
unrealized gain on investments 57 33 --
---------------------
Net expense recorded in
shareholders' equity 52 31 --
---------------------
Recorded in Statement of Operations:
Expense on net income 84 (2) (14)
Benefit from distributions on
capital securities (7) -- --
---------------------
Total expense (benefit) recorded
in statement of operations 77 (2) (14)
---------------------
Total income tax expense (benefit)
recorded $129 $29 $(14)
---------------------
11.3. Components of provision for income taxes (benefit)
(in millions) 1997 1996 1995
----------------------
Current tax $ 28 $ 8 $ 61
NOL utilization (18) (5) (56)
----------------------
Current tax, net of NOL utilization 10 3 5
Deferred tax (benefit) 67 91 62
Tax benefit of capital securities 7 -- --
Adjustment of the beginning of the
year valuation allowance -- (96) (81)
----------------------
Provision for income taxes
(benefit) $ 84 $ (2) $(14)
----------------------
Income taxes paid $ 7 $ 5 $ 5
----------------------
11.4. Reconciliation of taxes at federal rates to provision for income taxes
(benefit)
(in millions) 1997 1996 1995
----------------------
Tax at federal rates $102 $ 91 $ 68
Tax Effect (Benefit):
Adjustment of the beginning of the
year valuation allowance -- (96) (81)
Tax-exempt interest income (14) (2) (2)
Other (4) 5 1
----------------------
Provision for income taxes (benefit) $ 84 $ (2) $(14)
----------------------
11.5. Net operating loss carryforwards
At December 31, 1997, USF&G had NOLs
remaining for tax return purposes expiring in 2006. The amount and timing of
recognizing the benefit of these NOLs depends on future taxable income and
limitations imposed by tax laws. The approximate amounts of USF&G's NOLs on a
regular tax basis and an alternative minimum tax ("AMT") basis at December 31,
1997 were as follows:
(in millions) Tax Return NOLs
-----------------
Regular tax basis $525
AMT basis 393
-----------------
Note 12 Reinsurance
USF&G reinsures portions of its policy risks with other insurance companies or
underwriters, and assumes policy risks from other insurance companies and
through participation in pools and associations. Reinsurance gives USF&G the
ability to write larger risks and control its exposure to losses from
catastrophes or other events that cause unfavorable underwriting results.
USF&G's ceding reinsurance agreements are generally structured on a treaty basis
whereby all risks meeting certain criteria are automatically reinsured. Amounts
recoverable from reinsurers are estimated in a manner consistent with the claim
liability associated with the reinsured policy. Reinsurance contracts do not
relieve USF&G from its obligation to policyholders. Failure of reinsurers to
honor their obligations could result in losses to USF&G. USF&G evaluates the
financial condition of its reinsurers and monitors concentrations of credit
risks arising from similar economic characteristics of the reinsurers to
minimize its exposure to significant losses from reinsurer insolvencies.
At December 31, 1997 and 1996, property/casualty reinsurance receivables totaled
$860 million and $794 million, respectively. Of these amounts, approximately $89
million and $95 million, respectively, were associated with the Workers'
Compensation Reinsurance Bureau ("WCRB"), a single voluntary reinsurance
association of primary workers' compensation insurers formed for the purpose of
providing excess of loss reinsurance to its members. USF&G is a member of this
pool. Each member is required to hold collateral, for the benefit of all member
companies, in the form of investment-grade securities equaling 115 percent of
the member's share of outstanding receivables of the WCRB. This collateral
requirement mitigates the risk of the WCRB becoming insolvent. Risk of loss is
minimal for the remainder of receivables due to similar pool arrangements with
collateral requirements, other contracts where funds are withheld, or letters of
credit maintained. Credit risk is also diversified among numerous reinsurers.
Additionally, USF&G has been active in the involuntary market as a servicing
carrier whereby USF&G processes business for a pool but takes no direct
underwriting risk because it is directly reimbursed for the cost of processing
policies and settling any related claims. Servicing carrier receivables of $710
million and $661 million associated with this business are separately disclosed
in the Consolidated Statement of Financial Position at December 31, 1997 and
1996, respectively.
In August 1996, F&G Life entered into a coinsurance contract with an
unaffiliated life insurance company to cede a significant portion of F&G Life's
block of single premium deferred annuities (the "broker SPDA block"). As part of
the transaction, F&G Life transferred $932 million of investments and other
assets to the coinsurer, and recorded a reinsurance receivable of $964 million.
In December 1997, F&G Life entered into another coinsurance agreement with an
unaffiliated life reinsurance company whereby F&G Life transferred approximately
$144 million of investments and other assets to the reinsurer and recorded a
reinsurance receivable of $131 million. These transactions had no material
effect on USF&G's 1997 or 1996 net income. As of December 31, 1997, the addition
of receivables under the 1997 contract, offset by surrender activity under the
1996 contract, reduced the reserves for the transferred annuity blocks and the
related reinsurance receivable balances to $765 million. At December 31, 1997
and 1996, F&G Life's reinsurance receivables totaled $786 million and $782
million, respectively.
The effect of reinsurance on USF&G's premiums and losses was as follows:
1997
Premiums Losses Unpaid Unearned
(in millions) Written Earned Incurred Losses Premiums
--------------------------------------------
Property/Casualty:
Direct $2,391 $2,386 $1,699 $4,703 $1,057
Assumed 539 573 355 1,451 91
--------------------------------------------
Gross 2,930 2,959 2,054 6,154 1,148
Ceded (478) (414) (260) (1,125) (184)
--------------------------------------------
Net 2,452 2,545 1,794 5,029 964
Life N/A 137 277 3,816 N/A
--------------------------------------------
Total $2,452 $2,682 $2,071 $8,845 $ 964
--------------------------------------------
1996
Premiums Losses Unpaid Unearned
(in millions) Written Earned Incurred Losses Premiums
--------------------------------------------
Property/Casualty:
Direct $2,401 $2,346 $1,721 $4,614 $ 991
Assumed 621 609 372 1,418 122
--------------------------------------------
Gross 3,022 2,955 2,093 6,032 1,113
Ceded (383) (369) (225) (987) (120)
--------------------------------------------
Net 2,639 2,586 1,868 5,045 993
Life N/A 145 313 3,552 N/A
--------------------------------------------
Total $2,639 $2,731 $2,181 $8,597 $ 993
--------------------------------------------
1995
Premiums Losses Unpaid Unearned
(in millions) Written Earned Incurred Losses Premiums
--------------------------------------------
Property/Casualty:
Direct $2,318 $2,253 $1,607 $4,675 $ 945
Assumed 634 637 436 1,422 110
--------------------------------------------
Gross 2,952 2,890 2,043 6,097 1,055
Ceded (389) (398) (241) (984) (136)
--------------------------------------------
Net 2,563 2,492 1,802 5,113 919
Life N/A 174 376 3,719 N/A
--------------------------------------------
Total $2,563 $2,666 $2,178 $8,832 $ 919
--------------------------------------------
Included in assumed unpaid losses in the preceding tables are $18 million and
$34 million related to loss portfolio transfer agreements at December 31, 1997
and 1996, respectively. USF&G has not entered into any such agreements to cede
its unpaid losses.
Note 13 Financial Guarantees
As of December 31, 1997, USF&G was contingently liable for par value amounts
totaling approximately $89 million on financial guarantee exposures ceded
through reinsurance agreements with a monoline insurance company in which USF&G
formerly had a minority ownership interest. In addition, USF&G has other
financial guarantee obligations where the par value guaranteed totaled $3
million at December 31, 1997, maturing at various dates through 2005. USF&G has
also committed, in connection with the sale of certain real estate mortgages, to
assumption of the first $15 million in losses, if any, that would arise as a
result of default on multi-family mortgages securitized as mortgage-backed
securities.
Note 14 Legal Contingencies
USF&G's insurance subsidiaries are routinely engaged in litigation in the normal
course of their businesses, including defending claims for punitive damages. As
insurers, they defend third-party claims brought against their insureds, as well
as defend themselves against first-party and coverage claims. Additionally,
contingencies may arise from insurance regulatory matters and regulatory
litigation matters (refer to Note 14.3).
In the opinion of management, such contingencies and the contingencies described
below are not expected to have a material adverse effect on USF&G's consolidated
financial position, although it is possible that the results of operations in a
particular quarter or annual period would be materially affected by an
unfavorable outcome.
14.1. Workers' compensation litigation
A series of class actions have been filed against the National Council on
Compensation Insurance ("NCCI"), the insurance companies which served as
servicing carriers in various states, and the National Workers' Compensation
Reinsurance Pool ("NWCRP"). The complaints generally allege that the defendants
conspired to fix servicing carrier fees at unreasonably high and noncompetitive
levels thereby allegedly causing inflated deficits in the voluntary market,
excessive expansion of the residual market and excessive contraction of the
voluntary market. The plaintiffs generally seek unspecified compensatory and
punitive damages and, in some cases, civil penalties, treble damages under state
antitrust laws, and temporary and permanent injunctive relief. Plaintiffs'
counsel in these cases have, from time to time, indicated that similar cases may
be filed in other states. USF&G believes that it has meritorious defenses to
each of the class actions and has determined to defend the actions vigorously. A
determination of the outcome of these cases cannot be made at this time. Each of
the currently pending cases is described below.
North Carolina: On November 24, 1993, N.C. Steel, Inc., and six other North
Carolina employers filed a class action captioned N.C. Steel, Inc., et al., v.
National Council on Compensation Insurance, et al., in the General Court of
Justice, Superior Court Division, Wake County, North Carolina against the NCCI,
North Carolina Rate Bureau, USF&G and eleven other insurance companies that
served as servicing carriers for the North Carolina involuntary workers'
compensation market. On January 20, 1994, the plaintiffs filed an amended
complaint seeking to certify a class of all employers who purchased workers'
compensation insurance in the State of North Carolina after November 24, 1989.
On February 14, 1995, the trial court granted the defendants' motion to dismiss
the complaint. The plaintiffs appealed, and on July 16, 1996, the North Carolina
Court of Appeals affirmed the dismissal of the plaintiffs' first claim for
relief, which is premised on alleged excessive rates, but reversed the trial
court's decision to dismiss the plaintiffs' second claim for relief, which is
premised on employers allegedly being improperly shifted from the voluntary
market to the assigned risk market as a result of stricter underwriting caused
by high residual market burdens. The parties are awaiting the decision of the
North Carolina Supreme Court following a hearing of both issues on March 18,
1997.
South Carolina: On August 22, 1994, the Attorney General of the State of South
Carolina filed a suit captioned State of South Carolina, County of Greenville,
et al., v. National Council on Compensation Insurance, et al., in the County of
Greenville, South Carolina against the NCCI, the NWCRP, USF&G and seven other
insurance companies that served as servicing carriers for the South Carolina
involuntary workers' compensation market. The Attorney General alleges that the
conspiracy occurred for an unspecified period of time prior to January 1994.
Discovery is underway in the case and a trial is scheduled for November 1998.
Kansas: On October 3, 1996, a Kansas employer filed a class action captioned
Amundson & Associates Art Studies, Ltd., et al., v. National Council on
Compensation Insurance, et al., in the District Court of Wyandotte County,
Kansas against the NCCI and the insurance companies that acted as servicing
carriers for the Kansas involuntary workers' compensation market. The defendants
removed the case to the United States District Court for the District of Kansas,
but on September 17, 1997, the federal District Court granted the plaintiff's
motion to remand the case to the state court. The defendants have filed a motion
to dismiss the case, and a hearing on that motion is scheduled for March 2,
1998. No trial date has yet been set.
Tennessee: On December 31, 1996, four Tennessee employers filed a class action
captioned Jo Ann Forman, Inc., et al., v. National Council on Compensation
Insurance, et al., in the Chancery Court of Marion County, Tennessee against the
NCCI, NWCRP and the insurance companies that acted as servicing carriers for the
Tennessee involuntary workers' compensation market. The defendants have filed a
motion to dismiss the case and are awaiting the decision of the trial court
following a hearing on July 14, 1997. No discovery has yet occurred.
Missouri: On February 20, 1997, six Missouri employers filed a class action
captioned Atlas Reserve Temporaries, Inc., et al., v. Vanliner Insurance Co., et
al., in the Circuit Court of Cole County, Missouri against the NCCI, USF&G and
other insurance companies that acted as servicing carriers for the Missouri
involuntary workers' compensation market. On August 26, 1997, the trial court
denied the defendants' motion to dismiss the case, and the defendants appealed
that decision. On September 26, 1997, the Missouri Court of Appeals denied the
defendants' appeal. The defendants have moved for a change in venue. No
discovery has yet occurred.
14.2. Shareholder lawsuits
On January 23 and February 2, 1998, two shareholders of USF&G filed separate
suits against the Corporation captioned Sam Dickstein v. USF&G Corporation, et
al., and Ethel Theodore v. USF&G Corporation, et al., in the Circuit Court for
Baltimore City, Maryland. In these actions, the Corporation and some or all of
its directors were named as defendants, along with St. Paul. The suits generally
allege that the proposed merger agreement between USF&G and St. Paul is
wrongful, unfair and harmful to USF&G's public shareholders and that USF&G's
directors failed to: (1) undertake an adequate evaluation of USF&G's worth; (2)
take adequate steps to enhance USF&G's value; (3) effectively expose USF&G to
the marketplace; and (4) act independently to protect the interests of USF&G's
shareholders. St. Paul is accused of aiding and abetting the alleged breaches of
duty. The suits seek to have a plaintiff class certified of all shareholders of
USF&G (excluding the individual defendants) and seek to enjoin the proposed
merger and/or obtain monetary damages for the alleged conduct. USF&G believes
the allegations in the suits are without merit, and is determined to defend the
actions vigorously. A determination of the outcome of these cases cannot be made
at this time.
14.3. Regulation
USF&G's insurance subsidiaries are subject to extensive regulatory oversight in
the jurisdictions where they do business. 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. It is not possible to predict the
future impact of increasing regulation on USF&G's operations. (Additional
information regarding regulatory matters may be found in Section 9,
"Regulation", of Management's Discussion and Analysis of Financial Condition and
Results of Operations.)
Note 15 Interim Financial Data (Unaudited)
(in millions except Quarter
per share data) First Second Third Fourth*
------------------------------------
Revenues 1997 $845 $872 $828 $859
1996 867 858 871 902
1995 818 856 885 900
------------------------------------
Net income 1997 $45 $47 $48 $54
1996 57 67 35 102
1995 49 46 49 65
------------------------------------
Basic EPS** 1997 $.38 $.43 $.43 $.48
1996 $.43 $.52 $.26 $.84
1995 .39 .35 .37 .52
------------------------------------
Diluted EPS** 1997 $.36 $.40 $.40 $.46
1996 .42 .50 .25 .79
1995 .36 .33 .36 .48
------------------------------------
*The fourth quarter 1996 and 1995 results reflect tax benefits of $3 million and
$15 million, respectively (refer to Note 11). The fourth quarter 1996 results
also reflect $(30) million in facilities exit costs/(sublease income) as
discussed in Note 1.13.
**The sum of quarterly income per share amounts may not equal the full year's
amount due to stock issuances, repurchases and redemptions during presented
periods.
Note 16 Information on Business Segments
USF&G's principal business segments are property/casualty insurance and life
insurance.
16.1. Assets
The assets of the insurance operations are primarily investments. Foreign
assets, consisting primarily of the assets of Afianzadora (refer to Note 1.14),
are not material. Assets of the business segments were as follows:
At December 31
(in millions) 1997 1996
-------------------
Property/casualty insurance $11,204 $10,099
Life insurance 4,478 4,204
Noninsurance operations and
eliminations 137 104
-------------------
Consolidated total $15,819 $14,407
-------------------
16.2 Operations
USF&G's insurance business is geographically diversified throughout North
America. Reinsurance and noninsurance operations are located in the United
States, Europe and various foreign countries. Foreign operations, in total, are
not material. Summarized financial information for the business segments is as
follows:
Income (Loss) from Operations
Revenues Before Income Taxes**
(in millions) 1997 1996 1995 1997 1996 1995
----------------------------------------------------------------------
Property/Casualty Insurance
Underwriting Results:
Commercial Insurance Group $ 936 $ 954 $ 876 $ (89) $ (82) $ (97)
Family and Business Insurance Group 932 989 982 (71) (147) (119)
Discover Re 29 22 25 4 2 1
F&G Re 459 480 490 30 52 43
Surety Group 189 141 119 27 8 16
-----------------------------------------------------------------------
Property/casualty underwriting results 2,545 2,586 2,492 (99) (167) (156)
Net investment income* 443 441 438 443 441 438
Net realized gains on investments* 12 63 14 12 63 14
Other 9 10 12 (27) (106) (42)
-----------------------------------------------------------------------
Total property/casualty insurance 3,009 3,100 2,956 329 231 254
-----------------------------------------------------------------------
Life Insurance:
Premium income 137 145 174
Net investment income 253 269 306
Net realized gains (losses) on investments 14 (57) 1
Other -- -- 1
-----------------------------------------------------------------------
Total life insurance 404 357 482 78 (8) 28
-----------------------------------------------------------------------
Noninsurance operations and eliminations (9) 41 21 (115) 36 (87)
-----------------------------------------------------------------------
Consolidated total $3,404 $3,498 $3,459 $ 292 $ 259 $ 195
-----------------------------------------------------------------------
*Net investment income and net realized gains (losses) on investments are not
allocated to property/casualty business units.
**Income (loss) from operations before income taxes for 1996 included facilities
exit (costs)/income by segment as follows:
Property/casualty, $(28) million; and Noninsurance operations, $70 million.
IV. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
USF&G CORPORATION Management's Discussion and Analysis of Financial Condition
and Results of Operations
This discussion provides management's assessment of financial results and
material changes in financial position for USF&G Corporation (consolidated,
"USF&G" or "the Corporation"), its two primary business segments - property/
casualty insurance and life insurance - and its investment portfolio. Property/
casualty insurance is written primarily by United States Fidelity and Guaranty
Company ("USF&G Company"); life insurance and annuities are written primarily by
Fidelity and Guaranty Life Insurance Company ("F&G Life"). Certain prior-year
amounts have been reclassified to conform to the 1997 presentation.
In connection with, and because it desires to take advantage of, the "safe
harbor" provisions of the Private Securities Litigation Reform Act of 1995,
USF&G cautions readers regarding certain forward-looking statements in the
following discussion and in any other statement made by, or on the behalf of,
USF&G, whether or not in future filings with the Securities and Exchange
Commission. Forward-looking statements are statements not based on historical
information and which relate to future operations, strategies, financial results
or other developments. Forward-looking statements are necessarily based upon
estimates and assumptions that are inherently subject to significant business,
economic and competitive uncertainties and contingencies, many of which are
beyond USF&G's control and many of which, with respect to future business
decisions, are subject to change, especially in light of the proposed merger
discussed in Section 1.5 of this Analysis. These uncertainties and contingencies
can affect actual results and could cause actual results to differ materially
from those expressed in any forward-looking statements made by, or on behalf of,
USF&G. USF&G disclaims any obligation to update forward-looking information.
As used in Sections 1 and 3 of this Analysis, "operating income" is defined as
net income, excluding realized gains and losses on investments, reorganization
severance, facilities exit (costs)/sublease income, income taxes and
distributions on capital securities of subsidiary trusts. Operating income is
presented in a manner which is not intended to conform with generally accepted
accounting principles ("GAAP"). Management believes this presentation provides
a meaningful understanding of the core drivers of an insurance company's
operations. Operating income combines premiums earned, net investment income and
other income and offsets these amounts by losses, loss expenses and policy
benefits, underwriting, acquisition and operating expenses and interest expense.
However, net realized gains on investments, reorganization severance, facilities
exit (costs)/sublease income, income taxes and distributions on capital
securities are significant components of net income and should be considered in
assessing USF&G's overall financial performance. This operating income caption
may not be comparable to other similarly titled measures of the Corporation or
other companies and should not be construed as an alternative to income from
continuing operations or cash flows from operating, investing or financing
activities as determined in accordance with GAAP. A glossary of certain other
terms used in this discussion can be found in Section 10; the terms are
italicized the first time they appear in the text.
1. Consolidated Results
1.1. Summary of net income
The table below shows the major components of net income.
(in millions) 1997 1996 1995
------------------------
Property/casualty insurance operations $ 322 $213 $240
Life insurance operations 64 49 27
Parent and noninsurance operations (104) (72) (85)
------------------------
Operating income 282 190 182
Net realized gains on investments 15 44 7
Reorganization severance (5) (17) --
Facilities exit (costs)/sublease income -- 42 6
Income tax benefit, net -- 2 14
Provision for income taxes (84) -- --
Distributions on capital securities,
net of tax (14) -- --
------------------------
Net income $ 194 $261 $209
------------------------
Property/casualty insurance segment results increased $109 million in 1997 when
compared with 1996 due primarily to decreased catastrophe losses in 1997 and
changes in the allocation of corporate non-underwriting expenses. From 1995 to
1996, the property/casualty segment's results decreased $27 million primarily as
a result of increased catastrophe losses. Life insurance segment results
improved in 1997 and 1996 due primarily to the combined effects of increased
annuity sales and improved investment spreads on annuity and universal life
products and lower expenses. (Refer to Section 3 of this Analysis.)
The results for the parent company and noninsurance operations for 1997 showed
an increase in operating loss of $32 million when compared with 1996. This
increase was primarily attributable to changes in the allocation of corporate
non-underwriting expenses. At the end of 1996, the Corporation reevaluated its
method of allocating non-underwriting expenses from the parent company to the
business segments. Prior to 1997, corporate non-underwriting expenses were
allocated to the property/casualty business units based primarily on written
premiums. In 1997, these expenses were no longer allocated as it was determined
that there is insufficient correlation between these expenses and the premiums
generated. Management believes the latter approach provides a more meaningful
understanding of each business unit's performance. This change increased parent
and noninsurance operating loss and increased property/casualty operating income
by $48 million in 1997, but had no effect on consolidated results.
From 1995 to 1996, the parent company and noninsurance operations showed a
decrease in loss from operations of $13 million primarily due to reduced parent
company expenses as a result of the Corporation consolidating its headquarters
facilities (refer to Section 1.2 of this Analysis), and reduced interest expense
due to the refinancing and repayments of certain corporate debt during 1996.
Net realized gains on investments in 1997 resulted primarily from sales and
impairments of various real estate investments. In 1996, net realized gains on
investments consisted primarily of a $78 million gain on the sale of USF&G's
ownership interest in Chancellor Capital Management, Inc., and $40 million of
impairment losses on certain real estate investments (refer to Section 5.3 of
this Analysis).
The reorganization severance in 1996 resulted from the realignment of the field
workforce under the reorganized business units (refer to Section 2 of this
Analysis). The 1996 reserve was exhausted in 1997 upon completion of the
reorganization plan. The 1997 charge for reorganization severance resulted from
centralization of support functions and further consolidation of the field in
response to worsening market conditions.
1.2. Facilities exit costs/sublease income
During 1994, USF&G developed and committed to a plan to consolidate its
Baltimore headquarters facilities. The plan encompassed relocating all USF&G
personnel residing at a downtown office building (the "Tower") to the
Corporation's Mount Washington facilities in Baltimore. USF&G is obligated under
the lease on the Tower through September 2009.
Implementation of the plan began in January 1995. The relocation of the Tower
personnel began in mid-1996 and was completed in January 1997. Since 1995,
$27 million of improvements have been made to the Mount Washington facilities,
including reconfigured office spaces and an additional parking garage. The plan
was completed by the end of 1997.
Facilities exit costs recorded in 1994 represented the present value of the rent
and other operating expenses then estimated to be incurred under the Tower lease
from the time USF&G vacated the Tower through the expiration of the lease in
2009. These costs did not consider any potential future sublease income, as such
income was neither probable nor reasonably estimable at that time.
To the extent that additional or extended subleases are subsequently negotiated,
the present value of income to be received over the term of those subleases is
recognizable in the period such income becomes probable and reasonably
estimable. Net income for 1996 and 1995 included $54 million and $6 million,
respectively, of sublease income recognized as a result of USF&G's negotiation
of subleases with new and existing tenants. Net income for 1996 also included a
credit of $12 million related to reduced property tax assessments on the Tower
which resulted from a settlement reached with the State of Maryland and the City
of Baltimore in June 1996.
Additionally, USF&G devised and implemented a plan in 1996 to reorganize its
branch system. This reorganization included the downsizing or closure of several
offices. For those offices where USF&G continues to be responsible for the
leases, the present value of the rent and other operating expenses estimated to
be incurred over the life of the leases and related to unoccupied space,
approximately $24 million, was recognized as facilities exit costs in 1996.
1.3. Income taxes
In 1997, USF&G began to record income tax expense through its Consolidated
Statement of Operations, as it had fully recognized all of its deferred tax
assets as of December 31, 1996. The financial statement recognition of tax
expense or benefit is not necessarily an appropriate indicator of income taxes
to be paid, however, as the Corporation has income tax net operating loss
carryforwards ("NOLs") of $525 million available for regular tax purposes and
$393 million for alternative minimum tax purposes remaining at the end of 1997.
These carryforwards will be used to reduce income taxes payable in future years.
The realization of deferred tax assets is dependent, in whole or in part, upon
the Corporation's ability to generate sufficient taxable income in future years.
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, such as competitive pressures,
catastrophe losses, adverse 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 realize the deferred
tax assets. Management has considered various risk 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 $317 million net
deferred tax asset. Based primarily upon the positive evidence associated with
the recent trend of improved operating results, USF&G has also determined that a
valuation allowance is not necessary at December 31, 1997.
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 1996. Management believes, however, that IRS
challenges that would limit the recoverability of the net deferred tax asset are
unlikely, and adjustments to the tax liability, if any, for years through 1997
will not have a material adverse effect on USF&G's financial position.
1.4. Capital securities of subsidiary trusts
In December 1996, January 1997 and July 1997, three business trusts wholly owned
by USF&G issued a total of $300 million of USF&G-obligated mandatorily
redeemable preferred capital securities. Distributions on these securities, net
of tax, totaled $14 million in 1997. Proceeds from the first two issuances of
the preferred capital securities were used to redeem the $4.10 Series A
Convertible Exchangeable Preferred Stock ("Series A Preferred Stock"), resulting
in annual after-tax savings of over $5 million compared with the dividends on
the Series A Preferred Stock. Proceeds from the third issuance of preferred
capital securities were used to repay intercompany loans and balances
outstanding against the standby credit facilities.
1.5. Subsequent event
On January 19, 1998, The St. Paul Companies, Inc. ("St. Paul"), a Minnesota
corporation, and USF&G announced the signing of a definitive merger agreement
pursuant to which a wholly-owned subsidiary of St. Paul will be merged into
USF&G. Completion of the transaction is subject to, among other things,
approvals by the shareholders of USF&G and St. Paul, in addition to certain
regulatory approvals, and is expected to occur in mid-1998.
If the merger is completed, the combined company will become the eighth-largest
property/casualty company in the United States, based on 1996 net written
premiums. The combined company will operate under the St. Paul name and be based
in St. Paul, Minnesota.
While USF&G will continue to conduct business as a stand-alone company until
such time as the merger is completed, there are risks that the pendancy of the
merger will adversely affect USF&G's operations. Agency alliances, premium
retention, productivity, product development and staff turnover may deteriorate
despite management's efforts to maintain existing relationships. USF&G's 1998
results of operations could also be materially affected by merger-related costs,
such as agency commission override programs, staff retention bonuses and
transaction expenses. In addition, the merger agreement places certain
limitations on USF&G's ability to execute certain capital and operational
transactions without St. Paul's consent.
2. Strategic Overview
USF&G's operations are organized into a portfolio of businesses: the Commercial
Insurance Group ("CIG"), the Family and Business Insurance Group ("FBIG"), the
Specialty Businesses, and Life Insurance. This organization recognizes the
groups' distinctly different strategies of growth and profitability. As
individual businesses, each is able to develop its own distinct products,
distribution channels, technology systems and field structures, and each is
currently in its own stage of development, with a common focus on long-term
strategic positioning.
2.1. CIG
CIG's strategy is to become a product-driven business, characterized by a
relatively higher risk/higher return book of business, requiring specialized
underwriting and risk management capabilities. Upon its base of commodity-like
standard middle market commercial business, CIG is expanding its Excess &
Surplus lines, and developing specialized product capabilities to penetrate
higher-margin market segments.
CIG reorganized its field structures in 1996, shifting from a shared,
broad-based field structure to one serving exclusively CIG target markets,
producers and customers. In addition to its general underwriting offices, CIG
operates separate business resource platforms individually dedicated to specific
specialized businesses. CIG's products are distributed through multiple
channels, including retail, wholesale and surplus lines brokers and agents.
Enabled by these operational initiatives, CIG is steadily shifting its mix of
business from standard commercial products toward its Excess & Surplus lines and
"specialty segments" (such as Commercial Real Estate, Financial Institutions,
Government Entities and Technology), which management believes have profitable
growth opportunities, though they require more specialized underwriting and
entail greater risk. At the same time, CIG continues to institute various profit
improvement initiatives in its core business areas, as well as to exit markets
or restructure products where the profitability outlook is less favorable. This
strategy prompted the decision to exit CIG's Commercial Trucking segment of
business, commencing in the third quarter of 1997. Deteriorating market
conditions and the difficulty in executing the desired underwriting strategy led
management to decide to withdraw from this book of business, rather than to
continue in an underperforming segment.
In December 1997, USF&G acquired TITAN Holdings, Inc. ("Titan"), a
property/casualty company in San Antonio, Texas. Titan wrote $63 million of
direct premium in the government entities market during 1997. This acquisition
is expected to more than double CIG's business in that specialty segment in
1998.
Overall, CIG's ability to achieve premium growth, while at the same time
maintaining desirable underwriting results, is expected to be difficult in the
near future, given the intense price competition in the commercial lines
markets.
2.2. FBIG
FBIG is principally a distribution-driven business consisting of small
commercial, personal and non-standard auto lines. This group is generally
characterized by a relatively lower risk/lower return book of business, and,
with the exception of its exposure to natural catastrophes, can generate a
stable and consistent source of earnings. FBIG's products are commodity-like, in
that pricing, cost competitiveness and efficient processing are critical in
gaining and retaining customers, as well as in achieving favorable underwriting
results.
FBIG's non-standard auto business will grow in 1998 as a result of the Titan
acquisition. Titan's non-standard auto direct premiums written totaled $146
million in 1997. Titan also provides FBIG's non-standard auto business with
direct-marketing capability.
2.3. Specialty Businesses
USF&G's Specialty Businesses are relatively higher risk/higher return
businesses, relying on market expertise and superior product/service value to
succeed.
Discover Re
USF&G provides insurance, reinsurance and related services to the alternative
risk transfer market through Discover Re Managers, Inc. ("Discover Re"), a
wholly-owned subsidiary of USF&G Company. Discover Re provides products for
self-insured companies and pools, as well as ceding to and reinsuring captive
insurers. Because less premium is retained on captive business, net written
premium may not rise as much as gross program premiums; however, the captive
business is expected to generate significant fee income.
F&G Re
Assumed reinsurance business, which has traditionally been very profitable for
USF&G, is managed by F&G Re, Inc. ("F&G Re"), a wholly-owned subsidiary of USF&G
Company. Assumed reinsurance contracts are generally written through domestic
and international reinsurance brokers, and cover a broad array of risks. F&G Re
expanded its international presence in 1997 with the opening of an F&G Re
representative office in Hong Kong, the acquisition of an 80 percent ownership
interest in Ashley Palmer Limited, a Lloyd's of London managing agency, and
investment in several Lloyd's of London underwriting syndicates. F&G Re's
strategy is to manage its growth opportunistically, and only write business that
meets its risk and profitability standards. In response to the intense pricing
and market share competition in the assumed reinsurance business, this strategy
has resulted in significant decreases in premium levels. This trend is expected
to continue in 1998. The traditional reinsurance market is also beginning to see
growing competition from the capital markets in the form of securitized
insurance risks, which could affect F&G Re's competitive position.
Surety Group
The Surety Group provides contract and noncontract surety bonds to construction
companies, commercial businesses and individuals. Over the last few years, the
Surety Group has shifted its mix of business toward small and large contractor
segments, which have historically been USF&G's most profitable surety segments,
and generally produce stable underwriting profits.
In 1997, the Surety Group solidified its international presence through the
successful integration of its 1996 acquisition, Afianzadora Insurgentes, S.A. de
C.V. ("Afianzadora"), the largest surety bond company in Mexico. In 1998, the
Surety Group will continue to explore the expansion of its international
business. The Surety Group will also focus on growing its domestic market share,
particularly in the western United States through its San Francisco office.
2.4. Life Insurance
Life insurance products are written through F&G Life, a wholly-owned subsidiary
of USF&G Corporation. F&G Life's principal products are deferred annuities
(including tax sheltered annuities), structured settlement annuities, and
immediate annuities. In addition to annuities, F&G Life's sales strategy is
beginning to concentrate more heavily on traditional life insurance products, as
these products typically realize a higher margin.
In 1996, F&G Life completed the outsourcing of its policy administration and
information services functions. The outsourcing of these functions provides
significant operating benefits, including improved customer service and reduced
per-policy operating costs.
Also in 1996, F&G Life entered into a coinsurance contract (the "1996
Coinsurance Contract") with an unaffiliated life insurance company to cede all
of the remaining block of single premium deferred annuities ("SPDAs") that were
originally sold through stock brokerage firms (the "broker SPDA block"). In
1997, another coinsurance contract was entered into with an unaffiliated life
reinsurance company (the "1997 Coinsurance Contract"), whereby F&G Life ceded a
portion of its structured settlement annuities written prior to 1994 to the
coinsurer. These transactions removed from F&G Life's direct obligations
underperforming blocks of business that had significant exposure to changes in
current interest rates. The broker SPDA block was also subject to high surrender
rates. F&G Life's profitability and cash flows have improved as a result.
2.5. Claim
In September 1996, USF&G opened a national Claim Reception Center (the "CRC")
in Tampa. The CRC provides toll-free, 24-hour claim reporting service to
customers and agents throughout the United States. The CRC processes
approximately 80 percent of the total number of property/casualty claims
submitted. Advanced telecommunications systems in place at the CRC facilitate
rapid response time and enhanced data management, while the CRC's database
of preferred contractors allows for quick and reliable claims service. The
combination of these state-of-the-art systems in one center not only improves
customer service, but should also reduce per-claim loss adjustment expenses.
Further expansion of the CRC and its claim-processing capacity is planned in
1998.
3. Results of Operations
3.1. Property/casualty insurance
Property/casualty insurance operations, consisting of CIG, FBIG and Specialty
Businesses, accounted for 88 percent of USF&G's consolidated revenues before net
realized gains in 1997 and 1996, compared with 85 percent in 1995, as well as
71 percent and 70 percent of its consolidated assets at December 31, 1997 and
1996, respectively.
Financial highlights for the consolidated property/casualty insurance operations
were as follows:
(in millions) 1997 1996 1995
-----------------------
Premiums written $2,452 $2,639 $2,563
Premiums earned* 2,545 2,586 2,492
Net underwriting losses (99) (167) (156)
Operating income 322 213 240
-----------------------
*See Glossary of Terms.
Property/casualty insurance segment underwriting results and operating income
improved in 1997 when compared with 1996 due primarily to decreased catastrophe
losses in 1997. Operating income also benefited from changes in the allocation
of corporate non-underwriting expenses (refer to Section 1.1 of this Analysis).
A significant measurement of a property/casualty company's underwriting
performance is its combined ratio, which is the sum of its loss ratio and
expense ratio. Consolidated property/ casualty ratios, calculated based on
statutory accounting practices and GAAP, were as follows:
1997 1996 1995
------------------------
GAAP Underwriting Ratios:
Loss ratio 70.5% 72.3% 72.3%
Expense ratio 33.4 34.2 34.0
Combined ratio 103.9 106.5 106.3
GAAP combined ratio, excluding
catastrophe losses 102.9% 102.3% 103.8%
Statutory combined ratio 103.3% 105.6% 105.8%
------------------------
Overall, the combined ratios have improved more than 2 points since 1995. In
addition to lower catastrophe losses and management actions to mitigate exposure
to such losses, the improvement is a result of management's initiatives to
improve the product/market mix, apply strict underwriting standards, and reduce
underwriting and loss adjustment expenses.
Gross catastrophe losses totaled $28 million in 1997, compared with $114 million
in 1996 and $71 million in 1995. These losses, net of losses ceded to
reinsurers, were $26 million in 1997, $108 million in 1996 and $63 million in
1995. The majority of the catastrophe losses in 1997 were incurred from various
windstorms, hailstorms, tornadoes and floods. Catastrophes in 1996 were the
second-highest level of catastrophe losses ever experienced by USF&G and
included severe winter storms and floods in the first quarter, and Hurricane
Fran and a freak windstorm in Arizona in the third quarter. The 1995 catastrophe
losses were primarily due to several hurricanes, as well as various hailstorms,
tornadoes and floods, and the April 1995 bombing of the federal building in
Oklahoma City.
The following table shows the major components of property/casualty premiums
written and premiums earned.
1997 1996 1995
Premiums Premiums Premiums
(in millions) Written Earned Written Earned Written Earned
-----------------------------------------------
Gross voluntary $2,189 $2,209 $2,194 $2,164 $2,138 $2,055
Ceded reinsurance (260) (211) (127) (135) (154) (154)
-----------------------------------------------
Net voluntary 1,929 1,998 2,067 2,029 1,984 1,901
Pools and associations 56 57 42 55 51 75
Discover Re 45 29 27 22 27 25
F&G Re 414 459 499 480 512 490
Other premium adjustments 8 2 4 -- (11) 1
-----------------------------------------------
Total property/casualty
segment $2,452 $2,545 $2,639 $2,586 $2,563 $2,492
-----------------------------------------------
Gross voluntary premiums represent business generated directly by CIG, FBIG and
Surety. Gross voluntary premiums written in 1997 were generally flat when
compared with 1996 due primarily to intense pricing competition in the property/
casualty industry, as well as the effects of commission rate actions in FBIG's
personal lines and the exit from CIG's Trucking segment. The three percent
growth in gross voluntary premiums written in 1996 when compared with 1995 was
largely the result of management's strategies to grow business in targeted
market segments. The increase in ceded premiums in 1997 related primarily to a
new quota share reinsurance treaty entered into during the year (refer to
Section 4.2 of this Analysis).
CIG
The following table shows underwriting results for CIG:
(in millions) 1997 1996 1995
-------------------------
Gross voluntary premiums written $989 $1,013 $975
Net premiums written 923 962 921
Underwriting loss (89) (82) (97)
GAAP Underwriting Ratios:
Loss ratio 76.3% 74.3% 75.6%
Expense ratio 33.2 34.3 35.5
Combined ratio 109.5 108.6 111.1
-------------------------
CIG gross voluntary premiums written decreased two percent in 1997 when compared
with 1996. Decreases in the standard middle market segments, due to competitive
market conditions, and CIG's decision to withdraw from Trucking and other
underperforming lines of business, were substantially offset by premium growth
in the Excess & Surplus lines and CIG's Specialty Segments. The Excess & Surplus
lines and Specialty Segments, which together represent 38 percent of CIG's 1997
gross premiums, grew 23 percent in 1997 when compared with 1996. The four
percent increase in gross voluntary premiums written in 1996 when compared with
1995 was largely due to growth in Excess & Surplus lines and Specialty Segments
as a result of management's initiatives to grow these higher-margin businesses
and to shift away from standard commercial business.
This mix shift is expected to continue in 1998.
Underwriting results for CIG deteriorated $7 million in 1997 when compared with
1996, with a 2-point increase in the loss ratio over that period. Continued
improvements in the expense ratio, which resulted primarily from management's
efforts in the past two years to reduce and control costs, were offset in 1997
by a deterioration in market pricing, primarily in liability-intensive lines,
and generally poor underwriting performance in Trucking. The Trucking segment
had $85 million of gross voluntary premiums written and approximately $42
million of underwriting losses in 1997. In 1998, management expects to continue
its cost-control initiatives and increase its specialty business mix in order
to improve profitability. However, 1998 profitability will be pressured by the
intensely competitive pricing environment and a commission override program
implemented in February 1998 to incent agents to retain business with USF&G
during the pendancy of the merger and the subsequent transition with St. Paul.
FBIG
The following table shows underwriting results for FBIG:
(in millions) 1997 1996 1995
-------------------------
Gross voluntary premiums written $958 $1,007 $997
Net premiums written 860 991 974
Underwriting loss (71) (147) (119)
GAAP Underwriting Ratios:
Loss ratio 75.0% 79.0% 74.5%
Expense ratio 32.6 35.9 37.6
Combined ratio 107.6 114.9 112.1
-------------------------
FBIG gross voluntary premiums written decreased $49 million when compared with
1996 primarily due to intense competition in the personal lines and small
commercial markets, as well as management's actions to lower the commission
rates on most personal lines and some small commercial business, effective April
1, 1997. Net written premiums were further reduced by the ceding of $109 million
of premium under a new personal lines quota share reinsurance treaty (refer to
Section 4.2 of this Analysis). In 1998, small business premiums are expected to
grow as management continues to emphasize this business, while non-standard auto
premiums are expected to grow significantly as a result of the Titan
acquisition.
FBIG's loss ratio improved 4.0 points in 1997 when compared with 1996 due
primarily to decreased catastrophe losses. Excluding catastrophe losses, FBIG's
underwriting results improved $18 million in 1997 and 1996, driven primarily by
reduced expenses. The expense ratio improved 3.3 points in 1997 when compared
with 1996 due primarily to the lower commission rates, as well as to continued
expense management, which contributed to the 1.7 point decrease in the expense
ratio in 1996. The benefits of expense management are expected to continue in
1998 as FBIG continues to realize the operating efficiencies resulting from the
centralized underwriting and policy processing in its Centers for Agency
Services, which were established in 1996. However, 1998 profitability will be
pressured by the intensely competitive pricing environment for small commercial
business and a commission override program implemented in February 1998 to
incent agents to retain business with USF&G during the pendancy of the merger
and the subsequent transition with St. Paul.
Specialty Businesses
Discover Re
The following table shows underwriting results for Discover Re:
(in millions) 1997 1996 1995
-------------------------
Gross program premiums $162 $129 $77
Net premiums written 45 27 27
Service fees 14 12 7
Underwriting gain 4 2 1
GAAP Underwriting Ratios:
Loss ratio 70.2% 77.2% 79.7%
Expense ratio 14.1 12.4 16.9
Combined ratio 84.3 89.6 96.6
-------------------------
Growth in Discover Re's captive business was the primary driver of increases in
gross program premiums in 1997 when compared with 1996. Management is increasing
its focus on captive business which, despite typically resulting in
proportionally less retained premium, is expected to generate significant fee
income compared with traditional alternative risk transfer products. In
addition, changes to Discover Re's reinsurance program contributed to the
increase in net written premium.
F&G Re
The following table shows underwriting results for reinsurance assumed
through F&G Re:
(in millions) 1997 1996 1995
-------------------------
Net Premiums Written:
Traditional risk $254 $326 $297
Finite risk* 160 173 215
-------------------------
Total premiums written $414 $499 $512
-------------------------
Underwriting gain $ 30 $ 52 $ 43
-------------------------
GAAP Underwriting Ratios:
Loss ratio 64.0% 63.9% 70.2%
Expense ratio 29.4 25.4 21.0
Combined ratio 93.4 89.3 91.2
-------------------------
*See Glossary of Terms.
The reinsurance industry suffers from severe pricing competition in both
international and domestic markets. F&G Re's strategy to respond to pricing
pressures by sacrificing premium volume when necessary to maintain its
underwriting standards led to the 17 percent decline in net written premiums in
1997 when compared with 1996, and resulted in the relatively flat level of
premiums in 1996 when compared with 1995. These pricing and premium volume
issues led to declines in underwriting profitability in 1997 when compared with
1996. The increase in the expense ratio in 1997 when compared with 1996 is
primarily due to product mix changes and the premium volume decrease in relation
to fixed costs. The improvement in underwriting results in 1996 when compared
with 1995 was primarily due to favorable loss experience and a mix shift toward
typically higher-margin traditional risk reinsurance. With the current market
conditions, F&G Re expects to experience a decline in assumed reinsurance
premiums in 1998, which could adversely affect underwriting results.
Surety
The following table shows underwriting results for the Surety Group:
(in millions) 1997 1996 1995
-------------------------
Gross voluntary premiums written $242 $174 $166
Net premiums written 210 160 129
Underwriting gain 27 8 16
GAAP Underwriting Ratios:
Loss ratio 35.5% 39.1% 36.5%
Expense ratio 50.3 54.9 49.8
Combined ratio 85.8 94.0 86.3
-------------------------
Surety gross voluntary premiums written increased 39 percent in 1997 when
compared with 1996, primarily due to growth in international surety business,
which consists largely of the new business from Afianzadora. Afianzadora
represented 24 percent of total Surety gross premiums written in 1997. The
increase in premiums written in 1996 over 1995 was due primarily to increased
penetration in the domestic contract surety business.
Afianzadora's underwriting results were included for the first time in 1997
after it was acquired in December 1996, and contributed $9 million of Surety's
underwriting gain. Premium growth and generally improved loss experience in
domestic contract surety also contributed to the improved 1997 underwriting
results. The comparison of underwriting results between 1996 and 1995 was
adversely impacted by unusually large contract surety losses in the first half
of 1996.
3.2. Life insurance
Life insurance operations (F&G Life) represented 12 percent of USF&G's
consolidated revenues before net realized gains in 1997 and 1996, compared with
14 percent in 1995. F&G Life also represented 28 percent of consolidated assets
at December 31, 1997, compared with 29 percent at December 31, 1996.
Financial highlights for F&G Life were as follows:
(in millions) 1997 1996 1995
----------------------
Sales $446 $427 $348
Premiums earned 137 145 174
Net investment income 253 269 306
Operating income 64 49 27
----------------------
F&G Life's premiums earned continued to decline in 1997, when compared with 1996
and 1995, primarily due to a reduction in sales of life contingent structured
settlement annuities. Structured settlement annuities with life contingencies
are recognized as premiums earned under GAAP. Non-life contingent contracts are
recorded directly in the balance sheet on a deposit accounting basis, pursuant
to Statement of Financial Accounting Standards ("SFAS") No. 97, "Accounting and
Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for
Realized Gains and Losses from the Sale of Investments". Structured settlement
annuities are sold primarily to the property/casualty segment to settle
insurance claims. The decline in sales of these annuities for 1997 and 1996
resulted from a higher-than-average level of structured settlement annuities
which the property/casualty segment purchased in prior years as part of its
efforts to settle older property/casualty claims. Structured settlement
annuities sales are expected to grow in 1998 as F&G Life expands these products
to external customers.
The declining trend in net investment income is primarily due to a lower asset
base created by the transfer of approximately $918 million of F&G Life's fixed
maturities under the 1996 Coinsurance Contract. Despite the decrease in premiums
earned and net investment income, operating income for 1997 and 1996 increased
when compared with 1996 and 1995, respectively, primarily due to improved
investment spread management on annuity and universal life products and strong
expense controls. Results for 1995 included $4 million of transition-related
costs, including employee separation costs, as a result of F&G Life's agreement
to outsource its information services and policy administration.
Sales
The following table shows life insurance and annuity sales (premiums and
deposits) by distribution system and product type.
(in millions) 1997 1996 1995
------------------------
Distribution System:
Brokerage $268 $255 $125
National wholesaler 91 79 91
Direct structured settlements 74 79 108
Other 13 14 24
------------------------
Total $446 $427 $348
------------------------
Product Type:
Single premium deferred annuities $248 $231 $112
Tax sheltered annuities 84 78 84
Structured settlement annuities 74 79 108
Other annuities 23 27 30
Life insurance 17 12 14
------------------------
Total $446 $427 $348
------------------------
The increasing growth trend in sales is primarily due to management's continued
concentration on the expansion of its new and existing products and distribution
channels. Despite this marketing emphasis, demand for its products is affected
by fluctuating interest rates and the relative attractiveness of alternative
investment, annuity or insurance products, as well as credit ratings. As a
result, there is no assurance that the improved sales trend will continue. Total
life insurance in force was $10.7 billion at December 31, 1997 and 1996.
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.
F&G Life's current product offerings have surrender charges that decline from
nine percent in the first policy year to zero percent by the tenth policy year.
Such built-in surrender charges discourage surrender in the early years of a
policy.
Policy surrenders totaled $171 million in 1997, compared with $471 million and
$587 million in 1996 and 1995, respectively. Surrender activity decreased
significantly due to the coinsurance of the broker SPDA block. At the time of
the 1996 Coinsurance Contract, the broker SPDA block had a current account value
of approximately $964 million. As of December 31, 1997, surrender activity under
the 1996 Coinsurance Contract had reduced the broker SPDA block benefit reserves
and the related reinsurance receivable to $634 million.
F&G Life's profitability is expected to continue to grow in 1998 as the mix of
sales continues to shift toward the higher-margin traditional life insurance
products, and as management continues to focus on improving investment spreads
and expense controls. However, the current low interest rate environment may
make F&G Life's annuity products less attractive in the marketplace than
alternative investment products, which could have an adverse effect on
profitability.
4. Reserves and Surplus
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 or new products for which the Corporation has less historical
information and experience, 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 financial condition or results of operations.
4.1. Mass torts
USF&G categorizes long-term exposures where multiple claims relate to
a similar cause of loss (excluding catastrophes) as "mass torts". Mass tort
exposures include construction defect, environmental and asbestos claims.
Reserves for losses that have been reported and certain legal expenses are
established on the "case basis". Bulk reserves are established, in addition to
the case reserves, to reflect incurred but not reported losses and also provide
for future development of case basis loss reserves. Total case and bulk reserves
for these mass torts, net of ceded reinsurance, comprised approximately eight
percent of the total net property/casualty reserves for unpaid losses and loss
expenses at December 31, 1997 and ten percent at December 31, 1996.
The following tables set forth selected information for each of the major
categories of mass torts, net of ceded reinsurance.
Construction
(in millions) Defect Environmental Asbestos
-----------------------------------------
Net reserves at December 31, 1994 $ 55 $329 $125
Losses incurred 2 10 16
Claims paid (17) (27) (5)
-----------------------------------------
Net reserves at December 31, 1995 40 312 136
Losses incurred 12 20 7
Claims paid (12) (24) (8)
-----------------------------------------
Net reserves at December 31, 1996 40 308 135
Losses incurred 13 26 (4)
Claims paid (16) (30) (5)
-----------------------------------------
Net reserves at December 31, 1997 $ 37 $304 $126
-----------------------------------------
Net Reserves at
December 31
(in millions) 1997 1996
------------------------
Construction Defect:
Case reserves $ 18 $ 20
Bulk reserves 19 20
------------------------
Total $ 37 $ 40
------------------------
Environmental:
Case reserves $ 72 $ 60
Bulk reserves 232 248
------------------------
Total $304 $308
------------------------
Asbestos:
Case reserves $ 34 $ 38
Bulk reserves 92 97
------------------------
Total $126 $135
------------------------
In 1997 and 1996, both case and bulk reserve levels for environmental and
asbestos have remained relatively flat. This stability is reflective of
management's belief that USF&G's reserve position is adequate relative to its
exposure to environmental and asbestos matters. 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.
In 1997, approximately 50 percent of environmental claims paid 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 1996 and 1995, respectively, 32 percent and 22 percent
of the environmental claims paid related to Superfund. The increase from 1996 to
1997 related to an initiative by the Claim department to aggressively settle
large and/or older environmental claims in order to contain loss adjustment
expenses. At December 31, 1997, 36 percent of USF&G's environmental case
reserves outstanding related to PRPs. (Refer to Section 9.4 of this Analysis.)
4.2. 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) premium 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.
In the second quarter of 1997, USF&G Company realigned its catastrophe
reinsurance to reflect its strategic initiatives in FBIG and CIG. USF&G Company
secured a 60 percent quota share treaty, covering losses and excluding loss
expenses, for its personal lines residential property business (homeowners and
dwelling/fire policies) which allows USF&G Company to limit its exposure to
historically volatile underwriting losses in these lines. To further protect
against catastrophe losses on the remainder of the FBIG residential property
business, USF&G Company obtained an aggregate excess of loss treaty providing
$15 million of coverage in excess of a $20 million annual aggregate deductible.
In addition, effective July 1, 1997, USF&G Company expanded its property
catastrophe reinsurance coverage by reducing its retention from $75 million to
$50 million and increasing its reinsurance coverage limit from $175 million to
$250 million, providing protection against catastrophe losses in lines not
covered by the personal lines quota share treaty.
The property catastrophe treaty provides the following coverage layers:
(in millions)
Losses and Loss Expenses Incurred Reinsurance
Above To and Including Coverage
- ------------------------------------------------------
$ 50 $ 75 50%
75 250 90
250 300 50
- ------------------------------------------------------
A Surety treaty provides the following coverage layers at December 31, 1997:
(in millions)
Losses and Loss Expenses Incurred Reinsurance
Above To and Including Coverage
- ------------------------------------------------------
$ 5 $ 30 100%
30 70 95
- ------------------------------------------------------
Additionally, a property per risk treaty is in place which, after a $5 million
annual aggregate deductible, provides coverage of $97 million in excess of USF&G
Company's $3 million retention limit for CIG and FBIG's small commercial
business.
The 1996 and 1997 Coinsurance Contracts represent significant reinsurance
relationships for F&G Life, as discussed in Sections 2.4 and 3.2 of this
Analysis.
4.3. Dividend restrictions
There are certain restrictions on payments of dividends by insurance
subsidiaries that may limit USF&G Corporation's ability to receive funds from
its subsidiaries. Under the Maryland Insurance Code, Maryland insurance
subsidiaries, such as USF&G Company and F&G Life, must provide the Maryland
Insurance Commissioner (the "Commissioner") with not less than thirty days'
prior written notice before payment of an "extraordinary dividend" to its
holding company. "Extraordinary dividends" are dividends which, together with
any dividends paid during the immediately preceding twelve-month period, would
be in excess of ten percent of the subsidiary's statutory policyholders' surplus
as of the prior calendar year end. Extraordinary dividends may not be paid until
either such thirty-day period has expired and the Commissioner has not
disapproved the payment or the Commissioner has approved the payment within such
period. In addition, ten days' prior notice of any other dividend must be given
to the 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.
During 1997, F&G Life, with the Commissioner's consent, paid extraordinary
dividends to USF&G Corporation. Because any dividends paid during the
immediately preceding twelve-month period are considered when determining
whether future dividends constitute extraordinary dividends, any dividends which
F&G Life would propose to pay in 1998 would be deemed extraordinary dividends
and subject to the thirty-day notice period described above. Dividends of up to
$146 million will be available for payment from USF&G Company to USF&G
Corporation during 1998 without being deemed extraordinary. The application of
the thirty-day notice requirement to any dividends of its subsidiaries is not
expected to materially affect the liquidity of USF&G Corporation. Additional
information regarding dividends paid to USF&G Corporation by its insurance
subsidiaries may be found in Note 7.5, "Dividend restrictions", to the
consolidated financial statements.
4.4. Capacity
A traditional measure of growth capacity for property/casualty insurers is the
ratio of premiums written to statutory policyholders' surplus. At the end of
1997, USF&G Company's premium-to-surplus ratio was 1.5:1, compared with 1.8:1
and 1.7:1 at the end of 1996 and 1995, respectively. 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.
4.5. Risk-based capital
The National Association of Insurance Commissioners ("NAIC") has adopted model
regulations which establish minimum capitalization requirements using a
"risk-based capital" formula. These regulations define four levels at which
corrective action must be taken: (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 credit, market, underwriting,
off-balance sheet and other risks inherent in certain assets, liabilities and
business of the insurer. Various levels of corrective actions are required if
the adjusted risk-based capital is less than 200 percent of the authorized
control level risk-based capital.
USF&G Company had adjusted risk-based capital of $1.3 billion at December 31,
1997 and 1996, which represented 304 percent and 286 percent, respectively, of
the authorized control level risk-based capital. F&G Life had adjusted
risk-based capital of $261 million and $294 million at December 31, 1997 and
1996, respectively, which represented 421 percent and 467 percent, respectively,
of the authorized control level risk-based capital at those dates. Accordingly,
as of the dates indicated, both USF&G Company and F&G Life had adjusted
risk-based capital significantly above the levels which would require corrective
action.
5. Investments
USF&G maintains an investment mix concentrated in high-quality fixed-income
securities. The acquisition of Titan in December 1997 added $256 million to
total investments. Also contributing to the increase in total investments was a
$214 million increase in unrealized gains on fixed maturities. Increased
activity under USF&G's securities lending program resulted in a $387 million
increase in other invested assets. The following table shows the distribution of
USF&G's investment portfolio.
At December 31
(dollars in millions) 1997 1996
------------------
Total investments $10,944 $10,076
------------------
Fixed maturities available for sale 78% 81%
Common and preferred stocks -- --
Short-term investments 5 5
Mortgage loans and real estate 9 10
Other invested assets 8 4
------------------
Total 100% 100%
------------------
5.1. Investment strategy
USF&G's primary objective is to maintain a high-quality investment portfolio
structured to maximize returns consistent with the financial goals of each
business segment while operating within approved policy guidelines and
maintaining sufficient liquidity to fund cash disbursements. Investment policies
and strategies are approved by senior management and reviewed by the Board of
Directors. Sophisticated proprietary financial modeling systems are employed in
the management of the assets. Investment activities are managed based on the
individual requirements of the property/casualty and life insurance segments and
the characteristics of each segment's underlying liabilities.
The following table shows the distribution of the investment portfolio for the
property/casualty insurance segment.
At December 31
(dollars in millions) 1997 1996
--------------------
Total investments $7,495 $6,860
--------------------
Taxable fixed maturities 60% 76%
Tax-exempt fixed maturities 15 5
Common and preferred stocks 1 --
Short-term investments 6 7
Mortgage loans 5 4
Real estate 3 3
Other invested assets 10 5
--------------------
Total 100% 100%
--------------------
The property/casualty investment strategy encompasses factors such as risk,
duration, return and regulatory requirements. The real estate strategy has been
and continues to be to reduce equity real estate holdings and reinvest in
commercial mortgage loans. The fixed maturity strategy previously emphasized
holdings of investment-grade corporate bonds with maturities that best matched
the property/casualty segment's liability structure. As this segment's income
tax position has changed as a result of profitability and the depletion of its
NOLs, the focus has turned toward investing available cash flows into a higher
proportion of tax-exempt securities in order to maximize after-tax investment
income.
The following table shows the distribution of the investment portfolio for the
life insurance segment.
At December 31
(dollars in millions) 1997 1996
--------------------
Total investments $3,415 $3,174
--------------------
Taxable fixed maturities 84% 83%
Common and preferred -- --
stocks
Short-term investments 3 5
Policy loans 2 2
Mortgage loans 8 5
Real estate 3 5
Other invested assets -- --
--------------------
Total 100% 100%
--------------------
The life insurance investment strategy also encompasses factors such as risk,
duration, return and regulatory requirements, and the real estate strategy is
consistent with that of the property/casualty segment. The focus going forward
will be to maintain a close duration match by product line through explicitly
investing new premium cash flows to match new liabilities. The portfolio mix
will remain relatively stable with a continued emphasis on noncallable corporate
bonds and limited exposure to high-yield bonds and mortgage-backed securities.
5.2. Net investment income
The following table shows the components of net investment income.
(dollars in millions) 1997 1996 1995
-------------------------
Net investment income from:
Taxable fixed maturities $550 $626 $658
Tax-exempt fixed maturities 43 4 6
Common and preferred stocks 1 3 4
Short-term investments 32 20 23
Mortgage loans and real estate 69 48 46
Other investment income, net of
interest expense on funds held 11 19 13
-------------------------
Total investment income 706 720 750
Investment expenses (15) (15) (17)
-------------------------
Net investment income $691 $705 $733
-------------------------
Average annualized yields:
Total investments 7.0% 6.9% 6.9%
Fixed maturities 7.3% 7.3% 7.4%
-------------------------
Investment income declined in 1997 and 1996 primarily due to the decrease in
average invested assets which resulted from the transfer of fixed maturities
related to the 1996 Coinsurance Contract (refer to Section 2.4 of this
Analysis). The property/ casualty segment mix shift to tax-exempts is evident by
the related increase in tax-exempt net investment income. Although yields on
tax-exempt securities are lower than those on taxable securities, the
significant tax savings from these investments will result in higher after-tax
investment income than would be possible with a portfolio consisting primarily
of higher-yielding taxable bonds. The increase in interest income from
short-term investments is a result of higher average investment balances and the
inclusion in 1997 of $9 million of short-term investment income earned by
Afianzadora. Investment income on mortgage loans and real estate for 1997
reflected the strategy of reducing equity real estate holdings and reinvesting
in commercial mortgage loans collateralized by income-producing real estate.
Other investment income in 1997, 1996 and 1995 included $17 million, $19 million
and $26 million, respectively, of income related to USF&G's share of earnings
from an equity interest in RenaissanceRe Holdings, Ltd. ("RenaissanceRe"), a
property reinsurance company in Bermuda. Future income from the investment in
RenaissanceRe is subject to volatility and exposure to catastrophe losses and
other risks inherent in the property/ casualty reinsurance industry. Also netted
against other investment income was interest credited to funds held on
reinsurance contracts of $21 million, $20 million and $31 million in 1997, 1996
and 1995, respectively.
5.3. Net realized gains on investments
(in millions) 1997 1996 1995
------------------------
Net Gains (Losses) on Sales:
Fixed maturities $ 3 $(12) $ 6
Common and preferred stocks -- 79 4
Mortgage loans and real estate 34 17 2
Other 14 18 18
------------------------
Net gains on sales 51 102 30
Impairments (36) (58) (23)
------------------------
Net realized gains
on investments $ 15 $ 44 $ 7
------------------------
Realized gains on sales of mortgage loans and real estate primarily relate to
sales of equity real estate. In 1997, these sales consisted of twelve operating
properties and five nonincome-producing land investments. Realized gains on
common and preferred stocks in 1996 were largely the result of a $78 million
gain on the sale of USF&G's ownership interest in Chancellor Capital Management,
Inc. Other realized gains in 1997, 1996 and 1995 related primarily to USF&G's
share of gains from its equity in certain venture capital-type limited
partnerships.
Impairment adjustments in 1997 and 1996 related primarily to equity real estate.
During 1997, the business strategy for a land development project was revised to
accelerate the period of time over which the assets will be disposed.
Additionally, management changed its intent regarding an investment in a retail
center, such that the asset was deemed held for sale and written down to market
value. As a result, a $21 million impairment in the carrying values of these
investments was recorded to state these assets at fair value. Similar
impairments of $40 million were made in 1996 in the carrying values of other
equity real estate investments. In each year, impairment adjustments were also
taken on certain fixed maturities and other assets. These impairments relate to
specific assets and are realized when the decline in fair value is deemed other
than temporary, or when the fair value is significantly less than book value and
it is probable that the asset will be sold before any recovery in value can
occur.
5.4. Unrealized gains (losses)
The components of the changes in unrealized gains (losses) were as follows:
(in millions) 1997 1996 1995
------------------------
Fixed maturities available for sale $214 $(242) $ 524
Deferred policy acquisition costs and
policy benefits adjustment (48) 54 (106)
Common and preferred stocks (2) 2 4
Foreign currency and other (2) 10 (4)
------------------------
Total change in unrealized
gains (losses) before taxes 162 (176) 418
Deferred tax on net unrealized gains (57) (33) --
------------------------
Net change in unrealized
gains (losses) $105 $(209) $ 418
------------------------
Fluctuations in the unrealized gains and losses on fixed maturities are
primarily a result of fluctuating interest rates. Yields on U.S. Treasuries with
2- to 30-year maturities decreased an average of 49 basis points in 1997,
increased an average of 78 basis points during 1996, and fell an average of 235
basis points in 1995. As a result, the net unrealized gain on fixed maturities
available for sale at December 31, 1997 was $312 million, compared with net
unrealized gains of $98 million and $340 million at December 31, 1996 and
December 31, 1995, respectively. Also affecting the 1995 change in unrealized
gains on fixed maturities was the 1995 reclassification of the entire "held to
maturity" fixed maturity portfolio to "available for sale". Unrealized gains and
losses on fixed maturities are offset by related changes in the deferred policy
acquisition costs ("DPAC") and policy benefits adjustment, which represents the
amount by which the life insurance segment's DPAC would be adjusted if the
unrealized gains on the related assets were realized. The DPAC and policy
benefits adjustment was a loss of $67 million at December 31, 1997, compared
with losses of $19 million and $73 million at December 31, 1996 and 1995,
respectively. The tax effect on net unrealized gains was $90 million and $33
million, at December 31, 1997 and 1996, respectively. The tax effect on net
unrealized gains (losses) at December 31, 1995 was offset by the deferred tax
asset valuation allowance, pursuant to SFAS No. 109. This valuation allowance
was eliminated in 1996 (refer to Section 1.3 of this Analysis).
5.5. Fixed maturity investments
The following table details the composition of the fixed maturity portfolio.
(in millions) 1997 Percent 1996 Percent
-----------------------------------
Corporate and other
investment-grade bonds $3,927 48% $4,673 58%
Mortgage-backed securities 1,392 17 1,464 18
Asset-backed securities 664 8 731 9
U.S. Government bonds 497 6 334 4
High-yield bonds 599 7 548 7
Tax-exempt bonds 1,104 14 316 4
-----------------------------------
Total fixed maturities at
amortized cost 8,183 100% 8,066 100%
Total market value of fixed maturities 8,495 8,164
-----------------------------------
Net unrealized gains $ 312 $ 98
-----------------------------------
Percent market-to-amortized cost 104% 101%
-----------------------------------
Decreasing interest rates, which result in higher bond prices, were responsible
for the improvement in the overall market-to-amortized cost ratio between years.
While subject to prepayment risk, credit risk related to USF&G's mortgage-backed
securities portfolio at December 31, 1997 is believed to be minimal since 99
percent of such securities had AAA ratings or were collateralized by obligations
of the U.S. Government or its agencies. The net proceeds from sales, maturities
and repayments in 1997 were predominately reinvested in tax-exempt bonds. In
1996, proceeds were reinvested in both corporate investment-grade and tax-exempt
bonds. Investment-grade bonds, including debt obligations of the U.S. Government
and its agencies, comprised 93 percent of the portfolio at December 31, 1997 and
1996. The following table shows the credit quality of the long-term fixed
maturity portfolio at December 31, 1997.
Percent
Market-to-
Amortized Market Amortized
(in millions) Cost Percent Value Cost
--------------------------------------
U.S. Government and
U.S. Government $1,872 23% $1,913 102%
Agencies
AAA 1,548 19 1,607 104
AA 1,136 14 1,186 104
A 1,894 23 1,968 104
BBB 1,134 14 1,189 105
BB 246 3 259 105
B 352 4 372 106
CCC and lower 1 -- 1 100
--------------------------------------
Total $8,183 100% $8,495 104%
--------------------------------------
Information on credit quality 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.
High-yield investments generally involve a greater degree of risk than
investment-grade securities. Expected returns should, however, compensate for
the added risk. USF&G attempts to minimize the risks associated with high-yield
investments by limiting the exposure to any one issuer and by closely monitoring
the creditworthiness of such issuers. At December 31, 1997, USF&G's five largest
investments in high-yield bonds totaled $65 million in amortized cost and had a
market value of $66 million. USF&G's largest single high-yield bond exposure
represented five percent of the high-yield portfolio and less than one percent
of the total fixed maturity portfolio.
5.6. Real estate
The table below shows the components of USF&G's real estate portfolio.
At December 31
(in millions) 1997 1996
----------------
Mortgage loans $641 $406
Equity real estate 336 554
----------------
Total $977 $960
----------------
The increase in the real estate portfolio in 1997 was due to new mortgage loan
originations, offset in part by equity real estate sales and mortgage loan
prepayments. In addition, $17 million of mortgage loans were added as a result
of the Titan acquisition. Mortgage loan originations in 1997 and 1996 consisted
of fixed-rate loans collateralized by apartment and office properties. The
equity real estate sales in 1997 included twelve operating properties and five
nonincome-producing land investments. The operating property sales included a
$148 million portfolio sale of eight office properties. These sales were
consistent with USF&G's continued strategy 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.
USF&G's real estate investment strategy emphasizes diversification by geographic
region and property type. The diversification of USF&G's mortgage loan and real
estate portfolio was as follows:
At December 31
1997 1996
-----------------
Geographic Region:
Pacific/Mountain 27% 31%
Mid-Atlantic 16 23
Midwest 16 17
Southeast 16 16
Northeast 13 5
Southwest 12 8
-----------------
Type of Property:
Apartments 41% 24%
Office 30 46
Land 15 17
Retail/other 7 8
Industrial 7 5
-----------------
The shift in office properties and apartments is the result of the $148 million
office portfolio sale and the funding of several loans collateralized by
apartments.
At December 31, 1997, USF&G's five largest real estate investments had a
carrying value of $282 million. The largest single investment was a land
development project located in San Diego, with a carrying value of $93 million,
or nine percent of the total real estate portfolio.
Mortgage loans and real estate are evaluated on a quarterly basis as part of
management's asset quality review process. This process ensures that the
financial and operating aspects of a property's performance are closely
monitored, analyzed and acted upon if appropriate. 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 were required to dispose of a significant portion of
its real estate in the near term, it is possible that it would recover amounts
less than the related carrying values.
6. Financial Condition
6.1. Assets
USF&G's assets totaled $15.8 billion at December 31, 1997, compared with
$14.4 billion at the end of 1996. This increase is primarily due to the addition
of $577 million of assets related to Titan, including $157 million of goodwill
included in other assets, and an increase in the market value of fixed maturity
investments classified as available for sale (refer to Section 5.4 of this
Analysis). Additionally, there was a $387 million increase in funds held as
collateral under USF&G's securities lending program, which are recorded as an
increase to both other invested assets and other liabilities, respectively, in
the Consolidated Statement of Financial Position.
6.2. Debt
USF&G's corporate debt totaled $516 million at December 31, 1997, compared with
$477 million at December 31, 1996. The increase in corporate debt is mainly
attributable to $35 million outstanding on USF&G's committed, standby credit
facility at December 31, 1997. These funds were used to refinance outstanding
receivables related to an insurance premium finance company acquired in the
Titan acquisition. During 1996, $114 million was drawn against a credit facility
to fund the repayment of the 5 1/2% Swiss Franc Bonds which matured in January
1996, and to repurchase approximately $39 million in outstanding Zero Coupon
Convertible Notes. That balance was paid down during 1996 with excess corporate
cash and proceeds from the issuance of capital securities (refer to Section 6.3
of this Analysis).
6.3. Shareholders' equity
USF&G's shareholders' equity totaled $2.1 billion and $2.0 billion at December
31, 1997 and 1996, respectively. The increase was primarily due to the addition
of $194 million of net income in 1997 and the $105 million increase in net
unrealized gains on investments and foreign currency, and was partially offset
by the redemption of $200 million, or the entire outstanding balance, of USF&G's
Series A Preferred Stock.
During 1997, USF&G redeemed substantially all of the remaining outstanding
shares of its Series A Preferred Stock for $200 million cash, using the proceeds
from the first two issuances of the capital securities (refer to Section 1.4 of
this Analysis). During 1996, USF&G issued 2.1 million shares of common stock as
a result of the redemption of all of its outstanding $10.25 Series B Cumulative
Convertible Preferred Stock ("Series B Preferred Stock). Since 1994, USF&G has
issued a total of 26 million shares of common stock related to the conversion of
the Series B Preferred Stock and the $5.00 Series C Cumulative Convertible
Preferred Stock ("Series C Preferred Stock"). These redemptions and conversions
have resulted in annual savings of over $32 million (net of after-tax
distributions on capital securities and expected dividends on shares of common
stock issued on conversion), compared with the dividends on the Series A, Series
B and Series C Preferred Stock.
In December 1996, $100 million of capital securities were issued in a private
placement transaction. In January and July 1997, a total of $200 million of
capital securities were issued in public offerings, bringing total capital
securities, net of issuance costs, to $296 million outstanding at December 31,
1997. The proceeds from the first two issuances were used to redeem all of the
outstanding shares of Series A Preferred Stock. Proceeds from the third issuance
were used to repay intercompany loans and balances outstanding against the
committed, standby credit facilities. During 1996, USF&G announced a plan to
repurchase up to 13.3 million shares of the Corporation's common stock and
common stock equivalents. As of December 31, 1996, 8.6 million shares had been
repurchased. The program was completed during the first half of 1997 with the
purchase of an additional 4.7 million shares. As a result of the pendancy of the
merger with St. Paul, USF&G has suspended repurchases of its common stock.
No minimum pension liability was recorded in 1997 or 1996. The need to record a
minimum pension liability and changes in unrealized gains and losses are
significantly affected by interest rate movements, which are beyond the control
of management. Consequently, no assurance can be given that the minimum pension
liability will not be reestablished in the near future, or that unrealized
losses on investments available for sale will not result in significant
reductions of shareholders' equity.
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 operating needs.
7.1. Cash flow
USF&G had cash flow from operating activities of $145 million, $330 million and
$399 million for the years ended December 31, 1997, 1996 and 1995, respectively.
The decline in operating cash flows in 1997 was due primarily to an increase in
cash outflows for net reinsurance activity, which was largely the result of an
$82 million decrease in net cash flows from F&G Re due to declines in premiums
assumed (refer to Section 3.1 of this Analysis) and a $49 million net cash
outflow related to the personal lines quota share treaty (refer to Section 4.2
of this Analysis). The decline of cash flows from operating activities for 1996
compared with 1995 was due primarily to the unusually high level of catastrophe
losses paid in 1996 (refer to Section 3.1 of this Analysis) and the decline in
net investment income collected (refer to Section 5.2 of this Analysis). The
1996 decrease in cash flows from net reinsurance activity relates to ceding of
Discover Re's increased captive business, but is offset by an increase in the
related direct premiums collected.
In addition, deposits and withdrawals of universal life and investment
contracts, such as annuities, which for GAAP reporting purposes are considered
financing activities, had net cash inflows of $251 million in 1997 compared with
net cash outflows of $97 million in 1996 and $349 million in 1995. These net
cash outflows related primarily to SPDA surrender activity and decreased as a
result of the 1996 Coinsurance Contract. Cash flows are expected to continue to
benefit in the future from the 1996 Coinsurance Contract, which significantly
reduced F&G Life's exposure to cash outflows for surrender activity.
7.2. Credit facilities
For general corporate purposes, USF&G maintained two committed, standby credit
facilities with a group of foreign and domestic banks totaling $450 million at
December 31, 1997. A facility in place for $200 million will expire in December
1998 and the remaining facility will expire in 2002. These facilities permit
either borrowing of funds or letter of credit issuances. Borrowings at December
31, 1997 totaled $35 million. The credit agreements contain restrictive
covenants pertaining to indebtedness, tangible net worth, liens and other
matters. USF&G was in compliance with the covenants contained in these
agreements at December 31,1997. USF&G expects to refinance approximately
$145 million of 7% Senior Notes due in May 1998.
8. Contingencies
8.1. Legal contingencies
USF&G's insurance subsidiaries are routinely engaged in litigation in the normal
course of their businesses, including defending claims for punitive damages. As
insurers, they defend third-party claims brought against their insureds, as well
as defend themselves against first-party and coverage claims. In addition to
such litigation, USF&G Corporation and its subsidiaries are subject to other
litigation and claims in the ordinary course of their businesses. Additional
information on certain other litigation contingencies may be found in Note 14,
"Legal Contingencies", to the consolidated financial statements.
In the opinion of management, such contingencies are not expected to have a
material effect on USF&G's consolidated financial position, although it is
possible that the results of operations in a particular quarter or annual period
would be materially affected by an unfavorable outcome.
8.2. Year 2000
The "Year 2000 Issue" is the result of computer programs that were designed with
the inability to accept, process or display dates in the next century. Computer
programs and various types of electronic equipment that have date-sensitive
software may recognize a date using "00" as the year 1900 rather than the year
2000. If not corrected, this could result in system or electronic equipment
failures or miscalculations causing disruptions of operations, including, among
other things, a temporary inability to process transactions or engage in normal
business activities with insureds, agents, suppliers or other business partners.
The Year 2000 Issue is significant for many businesses, especially insurers and
others in the financial sector. For USF&G, there are three principal aspects to
the Year 2000 Issue: readying its own computer systems for the Year 2000;
coordinating with agents and other third parties with whom the Corporation
interacts as to their Year 2000 readiness; and the risk of claims from insureds
resulting from the effects of the Year 2000 Issue.
The Corporation has adopted a comprehensive program to address each of these
aspects of the Year 2000 Issue. It expects to spend more than $15 million during
1998 and 1999 to modify its own systems. These costs relate to the core
processing systems and are expected to be the majority of the total Year 2000
costs; however, there will likely be additional costs related to non-core
systems, equipment, processes or other business aspects that are as yet
undetermined. The modifications are expected to be completed in the first
quarter of 1999. USF&G is also formally communicating with many of the
significant third parties with whom it interacts, with a view toward encouraging
them to implement Year 2000 changes that will be compatible with USF&G's
systems. Finally, the Corporation is reviewing its underwriting guidelines,
policy forms and product pricing to minimize the risk it faces as an insurer;
however, the extent of such underwriting risk, if any, is uncertain, and is a
function of the specific policy coverage provided, the nature of the potential
damage and the steps taken by insured parties to mitigate their exposure.
Although there can be no assurances, it is not currently expected that the Year
2000 Issue will have a material adverse effect on the Corporation's business,
operations or financial condition, although this will be dependent on, among
other things, USF&G's ability to successfully execute its plans to mitigate the
risks which might otherwise apply. Despite USF&G's efforts in this direction,
there can be no guarantee that the systems of other companies, on which USF&G's
systems rely and with which they interface, will be converted timely, or that a
failure to convert by another company, or a conversion that is incompatible with
USF&G's systems, would not have a material adverse effect on USF&G.
9. 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 and deposit 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. State insurance departments routinely conduct financial and market
conduct examinations and assess fines for violations of the myriad state
regulations affecting the conduct of the insurance business. 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. It is not
possible to predict the future impact of increasing regulation on USF&G's
operations.
9.1. 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. Underwriting losses from
involuntary market plans totaled $8 million in 1997, compared with $4 million
and $13 million in 1996 and 1995, respectively.
9.2. 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 nonrenew 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 nonrenewed within the state within any twelve-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 may limit
USF&G's ability to manage its exposure to unprofitable lines and can adversely
affect earnings to the extent USF&G is required to continue writing unprofitable
business.
9.3. 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 $2 million of guaranty fund expense in 1997 and 1996, and $5 million in
1995.
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.
9.4. Superfund
Superfund is scheduled to be reauthorized in 1998. Insurance companies, other
businesses, environmental groups and municipalities are advocating a variety of
reform proposals to revise the cleanup and liability provisions of Superfund. No
reliable prediction can be made as to the ultimate outcome of the legislative
deliberations regarding the reauthorization of Superfund or the effect such
revisions may have on USF&G.
9.5. 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, 1997, USF&G was within or favorably
exceeded the "usual range" for all of the IRIS ratios.
9.6. Taxation of annuities and life insurance products From time to time,
various proposals have been considered by Congress, the Office of Management and
Budget and the Department of the Treasury to change the current federal income
tax treatment of deferred annuities and life insurance products. Under some of
these proposals, an individual policyholder's taxable income would include all
or a portion of the interest accrued on such products, including some of the
products sold by F&G Life. Currently, such interest is not taxed until the time
of distribution. Other proposals have focused on the policyholder's tax basis in
certain deferred annuities and life insurance products, and on other aspects of
federal income tax treatment of annuities and life insurance. 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.
9.7. Glass-Steagall reform
Congress and the Administration are considering various proposals to restructure
the U.S. financial services industry through repeal or modification of the
Glass-Steagall Act and the Bank Holding Company Act. The proposals would, to
varying degrees, allow banks to affiliate with other financial services
providers, including insurance companies. It is unclear to what extent any final
legislation would address bank insurance authority, and no reliable prediction
can be made at this time as to the ultimate outcome of the legislative
deliberations regarding restructuring of the financial services industry or the
effect such legislation may have on USF&G.
10. Glossary of Terms
Account value: Deferred annuity cash value available to policyholders before the
assessment of surrender charges.
Alternative risk transfer ("ART"): A form of insurance through which a company
self-insures, or reinsures through a captive insurer, the predictable frequency
portion of its own losses and purchases insurance for the less frequent, high
severity losses that could have a major financial impact on the company.
Bulk reserves: Loss and loss expense reserves derived from statistical
projections of "incurred but not reported" losses, i.e., estimated ultimate
incurred losses less case reserves.
Captive insurer: A closely-held insurance company owned by one or more
organizations whose purpose is to insure some or all of the risks of
shareholders or affiliated organizations.
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.
Deferred annuity: A life insurance product purchased with either a lump-sum or
flexible premium, which accumulates interest over a fixed period or over an
individual's lifetime, with payments deferred to a designated future time.
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.
Finite risk reinsurance: Reinsurance arrangements providing coverage at lower
margins than traditional risk reinsurance in return for a lower probability of
loss to the reinsurer.
Gross program premiums: Total ART policy premiums written by a USF&G affiliate
or a nonaffiliate captive insurer.
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.
Immediate annuity: A life insurance product which provides a fixed stream of
payments over a fixed period of time or over an individual's lifetime, with
payments beginning at the inception of the contract.
Investment spreads: The difference between the interest rates earned on invested
assets and the interest rates credited to policyholders.
Loss ratio: The ratio of incurred losses and loss expenses to earned premiums,
in accordance with either SAP or GAAP.
Non-standard auto: Automobile insurance for 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.
Policyholders' surplus: The net assets of an insurer as reported to regulatory
agencies based on accounting practices prescribed or permitted by the NAIC and
the state of domicile.
Premiums earned: The portion of premiums written applicable to the expired
period of policies.
Premiums written: The amount of premium charged to insureds for insurance
coverage.
Reinsurance: For a consideration, an assuming insurer agrees to indemnify a
ceding insurer against all or part of the loss the latter may sustain under the
policy or policies it has issued. The legal rights of the insured are not
affected by the transaction, and the ceding insurer remains liable to the
insured for payment of policy benefits.
Structured settlement annuity: An immediate annuity sold to the property/
casualty company or third parties to fund the settlement of insurance claims.
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. It is not unusual for property/casualty
companies to have underwriting losses that are offset by investment income.
Universal life: A life insurance product which provides a death benefit for the
life of the insured and accumulates cash values to which interest is credited.
IV. INDEX TO EXHIBITS
EXHIBIT 23 CONSENT OF INDEPENDENT AUDITORS
USF&G CORPORATION Exhibit 23 - Consent of Independent Auditors
We consent to the incorporation by reference in the Registration Statement
Number 33-20449, 33-9405, 33-33271, 33-21132, 33-51859, 33-65471 and 333-13685
on Form S-3, and Number 2-72026, 2-61626, 2-98232, 33-16111, 33-38113, 33-35095,
33-43132, 33-45664, 33-45665, 33-61965, 33-55667, 33-55669, 33-55671, 33-59535,
33-64839, 333-04359, 333-42489, 333-42491, and 333-42493 on Form S-8, of USF&G
Corporation, of our report dated February 20, 1998, with respect to the
consolidated financial statements included in this Current Report (Form 8-K)
dated February 26, 1998, of USF&G Corporation.
Baltimore, Maryland
February 26, 1998
USF&G CORPORATION Report of Independent Auditors
Board of Directors
USF&G Corporation
We have audited the accompanying consolidated statement of financial position of
USF&G Corporation as of December 31, 1997 and 1996, and the related consolidated
statements of operations, cash flows and shareholders' equity for each of the
three years in the period ended December 31, 1997. These financial statements
are the responsibility of the Corporation's management. Our responsibility is to
express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of USF&G Corporation
at December 31, 1997 and 1996, and the consolidated results of its operations
and its cash flows for each of the three years in the period ended December 31,
1997, in conformity with generally accepted accounting principles.
/s/ ERNST & YOUNG LLP
Baltimore, Maryland
February 20, 1998