SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1999
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ______ to ______
Commission File Number 001-13135
HSB GROUP, INC.
(Exact name of registrant as specified in its charter)
Connecticut 06-1475343
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
P.O. Box 5024, One State Street
Hartford, Connecticut 06102-5024
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (860) 722-1866
Securities registered pursuant to Section 12(b) of the Act:
Name of each exchange
Title of each class on which registered
- ------------------- -------------------
Common stock, without par value New York Stock Exchange, Inc.
Rights to Purchase Depositary Receipts New York Stock Exchange, Inc.
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.
Yes....X.., No........
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K............
The aggregate market value of the voting stock held by non-affiliates of the
registrant as of February 15, 2000 was $699,824,639.
Number of shares of common stock outstanding as of February 15, 2000:
29,247,002.
Documents Incorporated by Reference:
Portions of the Proxy Statement dated March 16, 2000 for the Annual Meeting of
Shareholders to be held April 18, 2000 are incorporated by reference in Parts
III and IV herein.
PART I
Item 1. Business.
A. GENERAL DEVELOPMENT OF BUSINESS
HSB Group, Inc. (together with its subsidiaries referred to as the
"Company" or "HSB" hereinafter) was formed under the laws of the State of
Connecticut in 1997 to serve as the holding company for The Hartford Steam
Boiler Inspection and Insurance Company (HSBIIC) and its subsidiaries. The
Hartford Steam Boiler Inspection and Insurance Company was chartered as an
insurance company by the Connecticut legislature in 1866.
The Company's operations are divided into four reportable operating segments
- - Commercial insurance, Global Special Risk insurance, Engineering Services and
Investments. The most significant business of the Company is providing insurance
against losses from accidents to boilers, pressure vessels, and a wide variety
of mechanical and electrical machinery and equipment along with a high level of
inspection and engineering services aimed at loss prevention. Net earned
premiums for the Company's insurance segments in the aggregate were $381.9
million for 1999, which accounted for approximately 63 percent of the Company's
revenues. See Note 10 to the Consolidated Financial Statements located in Item 8
of Part II herein for information on the Company's net written and net earned
premiums over the last three years.
The Company conducts its business in Canada through its subsidiary, The
Boiler Inspection and Insurance Company of Canada. Insurance for risks located
in countries other than the United States and Canada is written by HSB
Engineering Insurance Limited (HSB EIL).
The following is a summary of recent developments in the business of the
Company.
The reinsurance agreements as discussed below effective January 1, 1998
between HSBIIC, Employers Reinsurance Corporation (ERC) and Industrial Risk
Insurers (IRI) were terminated with respect to loss or liabilities arising out
of occurrences taking place on or after January 1, 2000. As a result, HSBIIC
will no longer retain 85 percent of the equipment breakdown insurance and 15
percent of the property insurance of the combined insurance portfolio for risks
arising on or after January 1, 2000. The joint underwriting association that was
known as HSB Industrial Risk Insurers will, from January 1, 2000, be known as
Industrial Risk Insurers.
Concurrent with the termination of the reinsurance agreements, HSBIIC, ERC
and IRI replaced the operating agreement for IRI dated January 1, 1998. The new
agreement, effective January 1, 2000, calls for HSBIIC to retain 0.5 percent
membership share in IRI with the ability to increase its total share up to a
maximum of 10 percent, at no cost, at HSBIIC's option. In addition, the
agreement also establishes an arrangement for HSB to perform equipment breakdown
engineering and inspection services for clients of IRI and provides for a fixed
fronting fee in the event that IRI continues to use HSBIIC's licenses. See
"Participation in Industrial Risk Insurers" on page 13 for additional
information.
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On January 6, 1998, HSBIIC sold its 23.5 percent share in IRI to ERC, one
of the world's largest reinsurance companies, in accordance with a previously
announced purchase and sale agreement between ERC and IRI's twenty-three member
insurers. IRI is a voluntary, unincorporated joint underwriting association
which provides property insurance for the class of business known as "highly
protected risks" (HPR) -- larger manufacturing, processing, and industrial
businesses that have invested in protection against loss through the use of
sprinklers and other means. Contemporaneous with the close of the sale, IRI was
reconstituted with ERC (with a 99.5 percent share) and HSBIIC (with a .5 percent
share) as the sole members. Under the 1998 agreements, HSBIIC wrote the business
for the reconstituted IRI (which was renamed HSB Industrial Risk Insurers) using
its insurance licenses and provided certain other management and technical
services. In addition, through various reinsurance agreements with ERC and IRI,
HSBIIC transferred its manufacturing book of business to IRI and retained 85% of
the equipment breakdown insurance and 15% of the property insurance of the
HSBIIC/IRI combined portfolio.
On December 31, 1997, to support the Company's role with HSB IRI, a
business trust formed by HSB sold $300 million of 20-year, 7 percent Convertible
Capital Securities in a private placement to ERC, of which $250 million was
contributed by the Company to HSBIIC. The capital securities are convertible
into HSB common stock, at any time, subject to regulatory approval. See Note 13
to the Consolidated Financial Statements located in Item 8 of Part II herein for
more information on this transaction.
Effective July 1, 1998, HSBIIC completed an acquisition of the monoline
boiler and machinery business and the ASME inspection services, which certify
boiler and pressure vessel compliance with the codes and standards of the
American Society of Mechanical Engineers, of the Kemper Insurance Companies.
Kemper and HSBIIC also completed an agreement for HSBIIC to reinsure boiler and
machinery coverage included as part of Kemper's commercial package policies.
The Company also offers professional scientific and technical consulting
services for industry and government on a world-wide basis through HSBIIC's
Engineering Department and its engineering subsidiaries. In 1999, net
engineering services revenues were $119.6 million, which accounted for
approximately 19.7 percent of the Company's revenues.
On January 2, 1998, the Company exercised its option to put its 40 percent
share in Radian International LLC (Radian LLC) to The Dow Chemical Company for
approximately $129 million, net of expenses. Radian LLC was formed in January
1996 as a joint venture with Dow to provide environmental, engineering,
information technology, remediation and strategic chemical management services
to industries and governments world-wide. In connection with the formation of
the new company, the Company contributed substantially all of the assets of its
wholly-owned subsidiary, Radian Corporation to Radian LLC. The results of Radian
LLC were classified as discontinued operations following ratification in July
1997 by the Board of Directors of management's decision to exercise its put. The
Company's share of Radian LLC's losses incurred subsequent to such decision of
approximately $6.6 million after-tax was deferred until the closing of the sale
on January 2, 1998, at which time an estimated after-tax gain of
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$30.3 million, net of deferred losses, was realized. In 1996 and prior to July
1997, the Company's share of the joint venture's results were recorded as equity
in Radian.
Recently the Company has been focusing on identifying acquisition
candidates in the niche engineering management consulting service business,
primarily in process or energy related industries, in order to expand or
complement its engineering service capabilities. The Company does not currently
anticipate that any single acquisition within the next twelve months will be
material to the operations or financial position of the Company, however, this
does not rule out the possibility.
In July 1999, HSBIIC acquired Structural Integrity Associates, Inc.
(Structural) based in San Jose, California. Structural is an engineering
consulting and inspection services firm specializing in the analysis, control
and prevention of structural and equipment failures. Its services include
inspection and condition assessment and monitoring and remaining life analysis,
repair, remediation and total risk management of critical equipment and
structures. In April 1998, HSB acquired Solomon Associates, Inc. (SAI) based in
Dallas, Texas. SAI is an engineering management consulting firm that provides
comparative performance benchmarking consulting to the refining, petro-chemical
and power generation industries. During 1997, the Company completed the
acquisition of Haughton Engineering Services Limited of England. Haughton offers
a wide range of inspection services in the United Kingdom to help ensure
compliance with regulatory codes. During 1997, the Company also acquired a 51
percent interest in Integrated Process Technologies LLC (IPT). IPT measures and
manages facility costs and service performance on an outsource basis for large
businesses with geographically distributed locations.
The Company is a multi-national company operating primarily in North
American, European, and Asian markets. Currently, the Company's principal market
for its insurance and engineering services is the United States. However, the
Company does desire to become a stronger competitor in the international
machinery breakdown insurance and related engineering services markets as it
believes that there is significant opportunity for profitable growth overseas.
In 1999, the revenues and pre-tax income associated with operations outside of
the United States were approximately 13.2 percent and 9.5 percent, respectively.
Identifiable assets associated with operations outside of the United States are
approximately 19.5 percent of the consolidated amount. See Note 1 and Note 5 to
the Consolidated Financial Statements located in Item 8 of Part II herein for
more financial data based on geographic location and business segments.
B. PRODUCTS AND SERVICES
Insurance
Equipment breakdown insurance provides for the indemnification of the
policyholder for financial loss resulting from destruction or damage to an
insured boiler, pressure vessel, or other item of machinery or equipment caused
by an accident. This financial loss can include the cost
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to repair or replace the damaged equipment (property damage), and product
spoilage, lost profits and expenses to avert lost profits (business
interruption) stemming from an accident.
The Company distinguishes itself from other insurance suppliers by
providing a high level of loss prevention, failure analysis and other
engineering services with the insurance product. This heavy emphasis on loss
prevention historically has had the dual effect of increasing underwriting and
inspection expenses, while reducing loss and loss adjustment expenses.
An important ancillary benefit for the policyholder is that the inspection
performed by the Company's inspector on a boiler, pressure vessel, or other
piece of equipment, as part of the insurance process, is normally accepted by
state and other regulatory jurisdictions for their certification purposes.
Without a certificate of inspection by the insurance carrier or another
inspection agency, policyholders cannot legally operate many types of equipment.
The Company also writes all risk property insurance for risks with
significant machinery and equipment exposures, in addition to its more
traditional boiler and machinery products. The all risk line is marketed to
customers with equipment and machinery exposures, such as electric utilities,
where sophisticated engineering services are important to loss prevention and
control. These customers are offered technical services such as computerized
evaluations of fire protection systems in addition to fire inspections and
boiler and machinery inspections. The Company also writes all risk coverage
specifically tailored for data processing systems.
Engineering Services
HSBIIC's Engineering Services division provides quality assurance services,
inspections to code standards of the American Society of Mechanical Engineers
(ASME) and other organizations, ISO certification and registration services and,
using its proprietary technologies and databases, provides other specialized
consulting, condition monitoring, benchmarking and inspection services related
to the design and applications of boilers, pressure vessels, and many other
types of equipment for domestic and foreign equipment manufacturers and
operators. HSBIIC is the largest Authorized Inspection Agency for ASME codes in
the world. The Engineering Services division also offers training and
educational services related to these areas. In addition the Company has been
developing and expanding its services to respond to the growing trend to
outsource the management and maintenance of property, plant and equipment.
Aside from HSBIIC, the Company's engineering affiliates include HSB
Reliability Technologies Corp. (HSB RT), HSB Professional Loss Control, Inc.
(HSB PLC), Integrated Process Technologies LLC (IPT), Solomon Associates, Inc.
(SAI), Structural Integrity Associates, Inc. (Structural) and HSB Haughton
Engineering Services Limited (Haughton). HSB RT maintains an extensive database
on equipment maintenance and reliability and provides preventive maintenance
consulting services and programs to a wide range of businesses and industries.
Such services and programs are designed to increase production,
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reduce maintenance, energy and spare parts inventory costs, and extend equipment
life. HSB PLC is a fire protection consulting and engineering firm. Its services
include inspections, hazards analysis and risk assessment, engineering design,
code consulting, research and testing, and training. Structural, SAI, Haughton,
and Integrated Process Technologies, in which the Company holds a majority
interest, are described on page 4.
C. COMPETITION
Insurance
The Company is the largest writer of equipment breakdown insurance in North
America and is establishing a significant presence in the engineering insurance
market outside of North America. Based on net premiums written reported in the
1999 edition of Best's Aggregates and Averages, the Company has approximately a
39 percent market share and no other single company has more than a 10 percent
market share of the domestic equipment breakdown market. The Factory Mutual
Insurance Company has a market share of approximately 18 percent.
In general, the insurance market is influenced by the total insurance
capacity available based on policyholder surplus. Over the last few years,
global capacity to accept risk has grown as new insurers enter the property
casualty market and new financial products have been designed to securitize
catastrophe risks. In addition to available capacity, competition in the
equipment breakdown insurance market is based on price and service to the
insured. Service includes maintaining customer relationships, engineering and
loss prevention activities, and claims settlement. The Company prices its
product competitively in the marketplace, but primarily competes by offering a
high level of service, not by offering the lowest-priced product.
Competition in the equipment breakdown insurance market, as well as the
property/casualty market in general, has intensified in recent years as a result
of continuing restructuring and consolidation in the insurance industry.
However, because the Company primarily underwrites risks which require unique
engineering expertise and jurisdictionally mandated inspections, the Company
believes that its products and services will continue to be competitive.
Engineering Services
The Company provides a wide range of engineering, consulting and inspection
services as described on page 5. For most of these services it has numerous
competitors, some of whom are much larger and have greater financial resources
than the Company.
Competition in these areas is based on price and on the qualifications,
experience and availability of the individuals who perform the work. The
Company's force of inspectors, engineers, and technicians is spread throughout
the world. Ongoing training programs
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ensure that the Company's inspectors, engineers, and technicians are kept
up-to-date on the latest engineering and technical developments.
D. MARKETING
Insurance
The Company's various functional operations are aligned to focus on its two
principal customer groups, commercial risks and global special risks. The
Company believes that this organizational structure allows it to service its
customers more effectively and efficiently and at the same time to be a more
aggressive and flexible competitor.
Currently, the Company's principal market for its insurance business is the
United States. In 1999, 90 percent of its net written premiums related to risks
located in the United States. Of the direct premiums written in the United
States in 1999 (gross premiums less return premiums and cancellations, excluding
reinsurance assumed and before deducting reinsurance ceded), less than 10
percent was written in any one state. With the exception of California, Florida,
New York, Pennsylvania and Texas, no state accounted for more than 5 percent of
such premiums.
The Company has contracts with independent insurance agencies in all fifty
states, the District of Columbia, Puerto Rico and Canada. These agencies market
the Company's direct insurance to its small and medium commercial accounts.
Personal contact with these independent insurance agents is accomplished through
the Company's field sales force which operates out of various branch offices
across the country and in Canada. It is the Company's policy in appointing
agents to be selective, seeking to maintain and strengthen its existing
relationships and to develop relationships with new agents whom the Company
believes will become a continuing source of profitable business. The Company
periodically reviews its agency contracts and selectively reduces them in order
to retain only those agents who consistently produce certain minimum levels of
business for the Company.
Large, engineering-intensive U.S. and international accounts, most of which
comprise the Global Special Risk segment, are primarily marketed and serviced by
account teams comprised of underwriting, marketing, engineering and claims staff
who have specialized knowledge of particular customer industries. U.S. customers
are serviced primarily by HSBIIC. Canadian customers are serviced by The Boiler
Inspection and Insurance Company of Canada. Overseas customers are serviced by
HSB Engineering Insurance Limited, based in London, with additional offices in
Hong Kong, China, Malaysia, Australia, Miami, Spain, Korea and South Africa.
Additionally, the Company markets its insurance products through the
distribution channels of the companies which it reinsures. See discussion of
reinsurance assumed on page 11.
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Large account business is brokered through a small number of brokers as a
result of the significant consolidation of the international brokerage business
in the late 1990s. For 1999, approximately 26 percent of the Company's gross
written premium, which included HSB Industrial Risk Insurers, was produced by
J&H Marsh & McLennan and Sedgwick Group.
No other insured or broker accounts for more than 10 percent of the
consolidated total revenues of the Company.
Engineering Services
The Company's engineering services are marketed in a variety of ways.
Customized services related to loss prevention, failure analysis, and equipment
testing are generally sold in conjunction with the insurance contract but are
also available separately. Most other engineering services are marketed on a bid
or proposal basis. While such business is usually price sensitive, the exacting
standards and requirements set by industry and government for most of the
services offered by the Company tend to diminish that effect.
Engineering services are marketed and serviced primarily by personnel
located in the Company's various domestic and international offices.
While the primary market for engineering services continues to be the U.S.,
the Company has been focusing on expanding its international business, primarily
in Europe, the Pacific Rim and certain countries in South America as demand for
engineering services is expected to grow at a faster rate in these developing
regions than in the U.S.
No engineering services customer accounts for more than 10 percent of the
Company's consolidated total revenues.
E. REGULATION
Insurance
The Company's domestic insurance subsidiaries' operations are subject to
regulation throughout the United States. Various aspects of the insurance
operations are regulated, including the type and amount of business that can be
written, the price that can be charged for particular forms of coverage, policy
forms, trade and claim settlement practices, reserve requirements and agency
appointments. Regulations also extend to the form and content of financial
statements filed with such regulatory authorities, the type and concentration of
permitted investments for insurers, and the extent and nature of transactions
between members of a holding company system, including dividends involving
insurers. In general, such transactions must be on fair and reasonable terms,
and in some cases, prior regulatory approval is required. In addition, many
states require advance notification, and in the case of domiciliary insurers,
require prior approval of any acquisition of control (generally presumed to
exist in the case of a 10% or more ownership of voting securities) of an
8
insurance company. Such laws, while intended to protect policyholder interests,
may delay or prevent certain transactions effecting a change in control of an
insurer.
The nature and extent of regulations pertaining to the business the Company
writes outside of the U.S. varies considerably. Regulations cover various
financial and operational areas, including such matters as amount and type of
reserves, currency, policy language, repatriation of assets and compulsory
cessions of reinsurance.
In the United States, the National Association of Insurance Commissioners
(NAIC) has adopted risk-based capital (RBC) requirements applicable to property
and casualty insurers. The RBC formula establishes a required statutory surplus
level for an insurer based on the risks inherent in its overall operations which
are identified as underwriting risk, invested asset risk, credit risk and
off-balance sheet risk. The law provides for regulatory responses ranging from
requiring a plan of corrective action to placing the insurer under regulatory
control for insurers whose surplus is below the prescribed RBC target. HSBIIC's
adjusted capital significantly exceeded the authorized control level RBC for
1999.
NAIC Insurance Regulatory Information System (IRIS) ratios are part of the
solvency impairment early warning system of the NAIC. They consist of twelve
categories of financial data with defined acceptable ranges for each. Companies
with ratios outside of the acceptable ranges are selected for closer review by
regulators. HSBIIC's IRIS ratios were within acceptable ranges for 1999 with the
exception of the change in surplus ratio. This ratio exceeded the normal range
for surplus increases or decreases due to $152.7 million of dividends paid by
HSBIIC to HSB Group, Inc., net unrealized losses of $92.9 million primarily due
to a decrease in the carrying value of its insurance subsidiaries and a decline
in the value of the fixed income portfolio, and other statutory surplus
adjustments of $18.0 million, offset by $80.0 million of net income.
The Company's insurance subsidiaries' operations are subject to examination
by insurance regulators at regular intervals. The most recently concluded
insurance examination for HSBIIC was conducted for the years 1995 - 1998 by the
Connecticut Insurance Department, the HSBIIC's domestic regulator. No material
findings or adjustments were included in the final report of the examination.
Similar regulatory procedures govern the Company's other U.S. and foreign
insurance subsidiaries.
Insurance guaranty fund laws exist in all states which subject insurers to
assessments up to prescribed limits for certain obligations of insolvent
insurers to their policyholders and claimants. The Company is permitted to
recover a portion of these assessments through premium tax offsets and policy
surcharges.
See Note 6 to the Consolidated Financial Statements located in Item 8 of
Part II herein for additional information on statutory reporting.
As discussed earlier, the Company's insureds receive, in addition to the
insurance product, inspections which meet state, county or municipally mandated
requirements. In
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order for the Company's inspectors to perform these mandated inspections, they
must be commissioned. Commissioning is conducted by the National Board of Boiler
and Pressure Vessel Inspectors and the various state jurisdictional authorities.
The majority of the Company's inspectors are commissioned, and the Company
believes that it has an adequate number of commissioned inspectors to conduct
its business affairs.
Engineering Services
A portion of the Company's engineering services revenue comes from
certifying that boilers and pressure vessels are being constructed according to
standards adopted by the American Society of Mechanical Engineers (ASME). The
commission that authorizes inspectors to conduct insurance inspections also
authorizes them to perform ASME Code inspections. The Company performs other
certification and inspection services which are governed by established
standards, such as ISO 9000.
Other
The Company and members of its professional and technical staff are subject
to a variety of other state, local and foreign licensing and permit requirements
and other laws generally applicable to corporations and businesses.
F. INSURANCE OPERATIONS
Policies
Pricing for the Company's insurance policies is based upon the rates the
Company has developed for use with its various products. In many jurisdictions
in which the Company does business, such rates, as well as the policy forms
themselves, must be approved by the jurisdiction's insurance regulator. Rates
for the Company's products are developed based upon estimated claim costs,
expenses related to the acquisition and servicing of the business, engineering
expenses and a profit component.
Coverages for unique risks are judgment-rated, taking into account
deductibles, the condition of the insured's equipment, loss prevention and
maintenance programs of the insured, and other factors.
Policies are normally written for a term of one year. Most of the Company's
policies provide coverage for property damage and business interruption to
insured property (including buildings and structures under the Company's all
risk policy) resulting from covered perils. Property insured under the Company's
equipment breakdown policies includes such equipment as steam boilers, hot water
boilers, pressure vessels, refrigerating and air conditioning systems, motors,
generators, compressors, pumps, engines, fans, blowers, gear sets, turbines,
transformers, electrical switch gear, data processing and business equipment and
a wide variety of production and processing equipment.
10
The Company's policy with respect to the business it underwrites is to
generally manage its risks to probable maximum losses (PMLs) not in excess of
$50 million and maximum foreseeable losses (MFLs) not in excess of $100 million.
The Company's current reinsurance program generally limits the Company's
retention on any one loss to $1 million, with potentially higher per risk
retentions dependent on aggregate losses experienced by the Company during the
reinsurance period.
Reinsurance Assumed
The predominant practice in the insurance industry is to combine several
types of insurance coverages into one policy referred to as a package policy.
The Company has reinsurance agreements with approximately 200 multi-line
insurance companies to reach the small to mid-sized customers that purchase such
package policies. This business primarily focuses on small and mid-sized
commercial customers and it offers a significant opportunity for growth by the
Company because, based on Company estimates, equipment breakdown coverage is
only provided currently to less than 15 percent of the over 10 million insured
companies and institutions in the United States.
Under the reinsurance agreements, the Company's reinsured companies may
include equipment breakdown exposures in their multi-peril policies, and such
risks will be assumed by the Company under the terms of the agreements. These
plans generally provide that the Company will assume 100 percent of each boiler
and machinery risk, subject to the capacity specified in the agreement, and will
receive the entire equipment breakdown premium except for a ceding commission
which will be retained by the reinsured company for commissions to agents and
brokers, premium taxes and handling expenses.
Although the Company assumes the role of reinsurer, it continues to have
selling and underwriting responsibilities as well as involvement in inspecting
and claims adjusting. In effect, the Company becomes the equipment breakdown
insurance department of the reinsured company and provides equipment breakdown
underwriting (that is, the examination and evaluation of the risk based on its
engineering judgments), claims and engineering services as if it were part of
that organization. Traditionally, as part of the underwriting process, the
Company retains the right to decline or restrict coverage in the same manner as
it does for its own business. The Company also writes a simplified program
(referred to as ReSource) under which a reinsured company agrees to include
equipment breakdown insurance on a portfolio of accounts meeting specific
underwriting guidelines and occupancy parameters, which the Company agrees to
reinsure for equipment breakdown losses.
The insurance industry, in general, continues to undergo significant
restructuring and consolidation. A considerable amount of merger and acquisition
activity has occurred over the last several years and, with the advent of
financial services reform, more contraction is possible in the future. Depending
on the specific companies involved in these activities and other market factors,
the level of reinsured business the Company assumes in the future under the
arrangements described above could be impacted.
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The Company also assumes reinsurance, primarily on a facultative basis, for
certain large risks and several insurance pools.
The written premium generated through reinsurance assumed totaled $363.3
million in 1999, representing approximately 46.6 percent of the Company's gross
written premium.
Reinsurance Ceded
As a property carrier, the Company is subject to losses that may arise from
catastrophic events. The Company participates in various facultative, quota
share and excess of loss reinsurance agreements to limit its exposure,
particularly to catastrophic losses and high risk lines, and to provide
additional capacity to write business. The Company evaluates its exposures and
reinsurance needs annually to implement a program that corresponds with the
level of exposure it is willing to retain. Under the Company's current treaty
reinsurance program, its maximum retention on any one risk is generally limited
to $1 million, with potentially higher per risk retentions depending on
aggregate losses experienced by the Company during the reinsurance program
period. In addition, the Company uses facultative reinsurance on certain high
exposure risks and has catastrophe reinsurance for aggregate net losses greater
than $15 million.
The Company utilizes well-capitalized domestic and international
reinsurance companies and syndicates for its reinsurance program and monitors
their financial condition on an ongoing basis. For reinsurers that are not
accredited in their state of domicile, the Company typically requires collateral
for reinsurance recoverable from such carriers. In the unlikely event that the
Company's reinsurers are unable to meet their obligations, the Company would
continue to have primary liability to policyholders for losses incurred.
Uncollectible reinsurance recoverables have not had, and are not expected by
management to have in the future, a material adverse effect on the consolidated
results of operations or financial position of the Company. The Company is not
party to any contracts that do not comply with the risk transfer provisions of
SFAS 113 "Accounting and Reporting for Reinsurance of Short-Duration and
Long-Duration Contracts".
For additional information on reinsurance, see Notes 10 and 11 to the
Consolidated Financial Statements located in Item 8 of Part II herein.
Pools and Joint Underwriting Associations
With the exception of HSB Industrial Risk Insurers as described on page 2
and discussed below, the Company does not participate to any significant degree
in voluntary reinsurance pools of other insurance companies because the Company
generally chooses to insure only those risks which it has inspected or has the
right to inspect. From time to time, the Company is required to participate in
certain joint underwriting associations which provide insurance for particular
classes of insureds when insurance in the voluntary market is unavailable.
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Participation in Industrial Risk Insurers
Industrial Risk Insurers (IRI) is an unincorporated, voluntary joint
underwriting association that provides property insurance for the class of
business known as "highly protected risks" for larger manufacturing, processing
and industrial businesses which have invested in protection against loss through
the use of sprinklers and other means. As part of the arrangement with Employers
Reinsurance Corporation (ERC) effective January 1, 1998 (see "A. GENERAL
DEVELOPMENT OF BUSINESS") HSBIIC wrote the insurance in 1999 and 1998 for IRI
(which did business under the name HSB Industrial Risk Insurers) using its
insurance licenses and provided certain other services. In addition, through
various quota share reinsurance agreements with Employers Reinsurance
Corporation and HSB IRI, HSBIIC transferred its manufacturing book of business
to HSB IRI and retained 85 percent of the equipment breakdown insurance and 15
percent of the property insurance of the combined insurance portfolio.
In 1998 and 1999, HSBIIC's membership interest in HSB IRI was .5 percent.
In 1997 and 1996, HSBIIC's membership interest was 23.5 percent and 14 percent
respectively. In 1996 and prior the shares were .5 percent. As discussed above
(see "A. GENERAL DEVELOPMENT OF BUSINESS") the reinsurance agreements effective
January 1, 1998 between HSBIIC, ERC and IRI were terminated with respect to loss
or liabilities arising out of occurrences taking place on or after January 1,
2000. Net earned premium attributable to the agreements with ERC and HSB IRI,
prior to the placement of reinsurance by the Company for its own account, was 11
percent of the Company's total consolidated revenues for 1999 and 15 percent for
1998. Ceding commissions, which are netted out of expenses, were 16 percent of
consolidated revenues for 1999 and 11 percent for 1998.
Claims and Claim Adjustment
Essentially all claims under the Company's policies of insurance are
handled by the Company's own claims handlers. Management believes that the
Company's handlers are better able to make the connection between loss
prevention and loss control. The Company employs claims handlers in its various
offices throughout the country, Canada and the U.K. Claims handlers, in many
cases, are assigned to particular customer groups in order to apply specialized
industry knowledge to the adjustment of claims.
Claims and adjustment expense reserves comprise one of the largest
liabilities of the Company. Reserves are established to reflect estimates of
total losses and loss adjustment expenses that will ultimately be paid under
direct and assumed insurance contracts. Loss reserves include claims and
adjustment expenses on claims that have been reported but not settled and those
that have been incurred but not yet reported. Loss reserve estimates reflect
such variables as past loss experience and inflation. In addition, due to the
nature of much of the coverages, complex engineering judgments are involved.
Subjective judgments are an integral component of the loss reserving process,
due to the nature of the variables involved. Previously established loss
reserves are regularly adjusted as loss experience develops and new information
becomes available. Adjustments to previously established
13
reserves are reflected in the financial statements in the period in which the
estimates are changed.
The normal turnaround time in paying small claims is less than six months.
The vast majority of claims are settled within one year and very few remain
unsettled two years after the loss occurs. This pattern is somewhat skewed in
terms of claim dollars (as noted in the schedule on pages 17 - 18) as it is the
larger claims that often take longer to adjust. Compared to the
property/casualty industry as a whole, the Company has a very "short-tail"
settlement period. The Company's claims expenses are based on estimates of the
current costs of replacing productive capacity. The Company does not employ
discounting techniques in establishing liabilities for claims and claim
adjustment expenses.
For those relatively few claims involving litigation, the Company uses both
its in-house law department and outside counsel, depending on the issues, costs,
and staffing requirements.
The following table provides a reconciliation of the beginning and ending
reserves for net claims and claim adjustment expenses for the years ended
December 31, 1999, 1998 and 1997.
RECONCILIATION OF NET LIABILITY FOR
CLAIMS AND CLAIM ADJUSTMENT EXPENSES
1999 1998 1997
-------------------------------
(in millions)
Net liability for claims and
Adjustment expenses at January 1, $169.7 $190.8 $177.8
Plus:
Provision for claims and adjustment
expenses occurring in the current year 165.4 164.0 209.5
Increase (decrease) in estimated claims and
adjustment expenses arising in prior years 0.4 10.9 8.4
-------------------------------
Total incurred claims and adjustment expenses $165.8 $174.9 $217.9
-------------------------------
Less:
Payment for claims arising in:
Current year 80.0 84.2 82.3
Prior years 99.4 111.8 122.6
-------------------------------
Total payments $179.4 $196.0 $204.9
-------------------------------
Net liability for claims and adjustment
expenses at December 31, $156.1 $169.7 $190.8
===============================
The loss ratio improved 0.8 percentage points in 1999 from 1998. This
improvement was primarily attributable to increased use of reinsurance. The 1999
results were impacted by $10 million of domestic weather-related events and the
Taiwan earthquake as well as $10 million in losses related to medical equipment
insurance contracts. These insurance contracts represented less than 1 percent
of the Company's revenues. The loss ratio decreased 0.2 percentage points in
1998 as compared to 1997. Loss results in 1998 were
14
impacted by severe ice storms in Canada, as well as a few significant losses in
our other international businesses. Prior year loss development in 1999, 1998
and 1997 added 0.1, 2.8 and 1.7 percentage points to the respective loss ratio.
The components of claims and adjustment expenses, net of reinsurance are
displayed above.
The following table shows a reconciliation of the net liability to the
gross liability for claims and claim adjustment expenses based on reinsurance
recoverable on unpaid losses.
RECONCILIATION OF NET LIABILITY TO GROSS LIABILITY
FOR CLAIMS AND CLAIM ADJUSTMENT EXPENSES
1999 1998 1997
-----------------------------
(in millions)
Net liability for claims and
Adjustment expenses at December 31, $156.1 $169.7 $190.8
Reinsurance recoverable on unpaid claims
and adjustment expenses 626.2 388.5 85.9
-----------------------------
Gross liability for claims and
adjustment expenses at December 31, $782.3 $558.2 $276.7
=============================
15
RECONCILIATION OF GROSS LIABILITY FOR CLAIMS AND
CLAIM ADJUSTMENT EXPENSES
1999 1998 1997
------------------------------
(in millions)
Gross liability for claims and claim adjustment
expenses at January 1, $558.2 $276.7 $302.9
Plus:
Provision for claims and claim adjustment
expenses occurring in the current year 653.0 572.7 263.3
Increase (decrease) in estimated claims and
claim adjustment expenses arising in prior
years 31.7 46.9 (0.2)
------------------------------
Total incurred claims and claim adjustment
expenses $684.7 $619.6 $263.1
------------------------------
Less:
Payment for claims arising in:
Current year 164.9 141.0 90.6
Prior years 295.7 197.1 198.7
------------------------------
Total payments $460.6 $338.1 $289.3
------------------------------
Gross liability for claims and claim adjustment
expenses at December 31, $782.3 $558.2 $276.7
==============================
The claim and claim expense reserve runoff table on the following pages
shows the amounts of the net liability for 1989 through 1999 and the amounts of
the gross liability for 1993 through 1999. The ten-year development table for
gross liabilities is being constructed progressively, with 1993 as the base
year. Within the tables for net and gross liabilities, each column shows the
reserve established at each calendar year-end as well as cumulative totals for
claims payments and re-estimated liabilities for both that accident year and all
previous years that combined make up that year-end reserve. The redundancy
(deficiency) shown on a gross and net basis is a cumulative number for that year
and all previous years.
16
RECONCILIATION OF BEGINNING AND ENDING CLAIMS RESERVES
AND EXHIBIT OF REDUNDANCIES (DEFICIENCIES)
(in millions)
Net Reserves
YEAR ENDED 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
- ---------- ---- ---- ---- ---- ---- --- ---- ---- ---- ---- ----
Net Liability for
Unpaid Claims and
Claim Adjustment
Expenses $139.6 $115.7 $111.4 $132.8 $171.3 $161.3 $145.5 $177.8 $190.8 $169.7 $156.1
Cumulative Amount
Paid as of:
End of Year - - - - - - - - - - -
One Year Later 85.6 86.7 91.2 99.7 108.8 111.7 80.6 122.6 111.8 99.4 -
Two Years Later 104.2 109.7 115.5 134.0 152.1 126.9 99.8 146.3 144.8 - -
Three Years Later 110.3 120.6 127.0 154.4 153.4 134.5 112.1 160.4 - - -
Four Years Later 112.5 127.6 137.7 151.1 157.8 144.1 119.2 - - - -
Five Years Later 118.9 132.7 135.7 151.6 166.1 149.6 - - - - -
Six Years Later 123.0 131.4 135.7 160.0 166.5 - - - - - -
Seven Years Later 121.4 130.9 136.7 160.4 - - - - - - -
Eight Years Later 120.8 131.6 136.9 - - - - - - - -
Nine Years Later 121.5 131.8 - - - - - - - - -
Ten Years Later 121.7 - - - - - - - - - -
Net Liability
Reestimated as of:
End of Year 139.6 115.7 111.4 132.8 171.3 161.3 145.5 177.8 190.8 169.7 156.1
One Year Later 129.4 135.4 137.5 159.7 172.7 163.9 135.7 186.2 201.7 170.1 -
Two Years Later 127.4 138.0 139.7 166.6 173.9 157.3 128.8 187.5 188.8 - -
Three Years Later 127.8 136.9 141.1 165.2 170.6 154.2 131.2 179.6 - - -
Four Years Later 125.0 137.9 142.0 163.0 169.2 155.3 128.0 - - - -
Five Years Later 125.8 135.7 141.4 161.5 168.0 155.6 - - - - -
Six Years Later 125.5 136.0 141.3 163.4 168.5 - - - - - -
Seven Years Later 125.8 135.8 139.6 163.8 - - - - - - -
Eight Years Later 125.5 134.5 140.2 - - - - - - - -
Nine Years Later 124.2 134.8 - - - - - - - - -
Ten Years Later 124.5 - - - - - - - - - -
Cumulative Redundancy
(Deficiency) 15.1 (19.1) (28.8) (31.0) 2.8 5.7 17.5 (1.8) 2.0 (0.4) -
The net deficiencies in 1990, 1991 and 1992 were attributable to the
settlement of certain large losses for which the Company initially determined it
would not have liability, the settlement of some outstanding claims for more
than was originally anticipated, unusually late notice of loss provided by the
insured for several large losses, and reserves established for losses on which
the coverage was being contested. The 1995 net redundancy was attributable to
favorable claim development in the Company's foreign operations.
17
Gross Reserves
YEAR ENDED 1993 1994 1995 1996 1997 1998 1999
- ---------- ---- ---- ---- ---- ---- ---- ----
Gross Liability for
Unpaid Claims and Claim
Adjustment Expenses $214.4 $199.4 $190.9 $302.9 $276.7 $558.2 782.3
Cumulative Amount Paid as of:
End of Year - - - - - -
One Year Later 144.2 135.2 108.9 198.8 197.1 295.7
Two Years Later 189.9 164.1 158.0 284.2 242.3 -
Three Years Later 200.2 201.1 212.4 301.2 - -
Four Years Later 229.8 251.7 218.5 - - -
Five Years Later 277.0 256.2 - - - -
Six Years Later 277.6
Gross Liability Reestimated as of:
End of year 214.4 199.4 190.9 302.9 276.7 558.2 782.3
One Year Later 224.3 212.0 205.5 302.7 323.5 589.9
Two Years Later 227.0 228.3 194.6 339.8 309.4 -
Three Years Later 243.4 226.8 234.6 329.9 - -
Four Years Later 245.0 264.8 228.8 - - -
Five Years Later 281.4 263.1 - - - -
Six Years Later 281.8
Cumulative Redundancy
(Deficiency) (67.4) (63.6) (37.8) (26.9) (32.6) (31.7)
The adverse development primarily resulted from the decision rendered under
an arbitration proceeding for a claim occurring in 1992, adverse claims
experience in international operations primarily occurring in accident years
1997 and 1998, and the settlement of some large outstanding claims for more than
originally anticipated.
The growth in the gross liability for unpaid claims and claims adjustment
expenses from 1995 forward reflects the Company's changing participation in IRI
which was .5 percent through December 1, 1995, 14 percent effective December 1,
1995, 23.5 percent effective December 1, 1996 as well as the HSB IRI arrangement
effective January 1, 1998. See page 2 for details.
G. INVESTMENTS
Income from the Company's investment portfolio contributes significantly to
earnings. Each year there is a significant net inflow of cash from insurance,
engineering services and investment operations into the Company's investment
portfolio. In addition, cash flow is affected by the normal maturity of fixed
income investments, financing activities and the purchase and sale of equity
securities.
(in millions)
1999 1998 1997 1996 1995
-----------------------------------------------
Net Investment Income $ 64.1 $ 64.2 $ 36.8 $ 32.3 $ 28.9
Realized Investment Gains 40.6 25.4 14.1 12.1 2.8
-----------------------------------------------
Income from
Investment Operations $104.7 $ 89.6 $ 50.9 $ 44.4 $ 31.7
Net Unrealized Gains $ 4.7 $113.1 $ 95.3 $ 81.4 $ 65.4
Statutory Surplus (HSBIIC) $428.8 $612.6 $550.8 $292.4 $280.6
18
The Company's strategy continues to be to maximize total return on the
investment portfolio through investment income and capital appreciation.
Investment strategies for any given year are developed based on many factors
including operational results, tax implications, regulatory requirements,
interest rates, dividends to stockholders and market conditions. The
fluctuations in income from investment operations from 1995 through 1997 were
largely driven by the amount of realized gains generated in each of such years.
In 1995 the Company curtailed its realized gains in order to take advantage of a
strongly performing market and to build statutory surplus. In 1996 the Company
continued to build statutory surplus, however, high valuations towards the end
of the year caused the Company to realize gains. Realized investment gains
increased in 1997 over 1996 as the Company managed its portfolio to respond to
changing market conditions and tax planning opportunities, and as a result of
calls of fixed income and convertible securities. Realized investment gains in
1998 were significantly impacted by call premiums on fixed income instruments
and sales of certain convertible securities and common stocks in response to
market conditions. Realized investment gains increased $15.2 million in 1999 as
a result of repositioning the investment portfolio due to market fluctuations
and to keep the absolute amount of common equities from exceeding a certain
targeted percentage of the Company's GAAP capital. During 1999 bond yields
continued to move up, the impact of which has caused a reduction in the
Company's unrealized gains with respect to fixed income securities by
approximately $64.5 million.
Net investment income increased 11.8 percent in 1996 due to an increased
level of investable assets and to a lesser extent by dividend increases on the
Company's common stock investments. Net investment income for 1997 increased
13.9 percent compared to 1996. The increase is attributable to calls of high
yielding preferred stocks early in the year the proceeds of which were invested
in fully taxable securities, and more investable funds as the Company invested
the proceeds from its capital securities issued in the second half of 1997. In
1998 net investment income increased significantly due to the investment of the
capital securities proceeds and from the January 1998 sales of the Company's
interests in IRI and Radian International LLC. Net investment income for 1999
remained flat compared to 1998.
The significant increase in statutory surplus of HSBIIC for 1997 resulted
from a contribution to capital of $250 million of the $300 million in proceeds
received by the Company from the sale of its convertible capital securities to
Employers Reinsurance Corporation on December 31, 1997. The increase in surplus
for 1998 resulted from the January 1998 sales of HSBIIC's interests in IRI and
Radian International LLC. The decrease in surplus for 1999 primarily resulted
from $152.7 million of dividends paid by HSBIIC to HSB Group, Inc., net
unrealized losses of $92.9 million primarily due to a decrease in the carrying
value of its insurance subsidiaries and a decline in the value of the fixed
income portfolio, and other statutory surplus adjustments of $18.0 million,
offset by $80.0 million of net income.
In December 1996, HSBIIC entered into three "zero cost collar" contracts to
mitigate the effects of market risk on its U.S. common stock portfolio (which
for management
19
purposes included certain convertible preferreds). In the fourth quarter of
1997, HSBIIC settled all of its outstanding contracts resulting in realized
losses of $30.7 million for the year, all of which were offset by and
represented portfolio appreciation and returns that were realized. In 1997, the
Company's U.S. common stock portfolio experienced a total return of $57 million
(which included price appreciation of approximately $54 million) since December
31, 1996, and had a price movement correlation with the S&P 500 Index well in
excess of 80 percent.
The Company's investment portfolio consists of high-grade domestic and
foreign investments. Excluding short-term investments, HSB's investments are
primarily comprised of publicly traded, highly liquid securities. At December
31, 1999, the Company had approximately 52.9 percent of its invested assets in
fixed maturities as compared to 53.6 percent at year-end 1998. In the period
1991-1996 the Company gradually reduced its investments in common stocks as part
of its overall capital management strategy. At year-end 1999, the carrying value
of the equity securities portfolio represented 41.3 percent of invested assets
compared to 40.6 percent at year-end 1998.
The Company does not engage in cash-flow underwriting; it seeks to have
underwriting profit each year. None of the Company's claim reserves are
discounted as most claims settle, on average, within one year. Therefore, the
Company does not use duration measurements in managing its interest rate
exposure. Instead, the Company manages its portfolio on a segmented basis.
Approximately $300 million (cost basis) of the Company's invested assets
(comprised of perpetual and redeemable preferred stocks and corporate bonds) are
utilized to provide interest coverage and potential principal repayment over the
life of the convertible capital securities issued on December 31, 1997. The
remainder of the Company's invested assets, exclusive of cash and cash
equivalents, short-term securities and common stocks are invested to provide
income for the future. There are three portfolio areas with quite different
maturity/call characteristics. The portfolio of traditional bonds of
approximately $245 million has an average life of 22 years, with over 50 percent
of that portfolio callable in less than ten years. The sinking fund preferred
portfolio of $43 million, based on expected calls, has an estimated life of
three years. The $52 million adjustable rate preferred stock portfolio, based on
expected calls, has an estimated life of five years.
The Company believes the expected cash flows from the Company's operations,
maturities and calls are adequate to enable the Company to respond to the
previously discussed parameters that impact its investment strategy. See
"Investment Operations" in the Management's Discussion and Analysis of
Consolidated Financial Condition and Results of Operations located in Item 7 and
Note 7 to Consolidated Financial Statements in Item 8 of Part II herein for
additional information.
20
The following table summarizes the investment results of the Company's
investment portfolio:
Annualized Rate Investment
Net Invest- of Return (2) Gains (Losses) (3)
Cash and ment Income ------------------------------------------------
Invested Less Before After
Assets, Less Interest Income Income Change in
Borrowed Money Expense (1) Taxes Taxes Realized Unrealized
- ---------------------------------------------------------------------------------------------
(in millions) (in millions)
1999 $ 931.5 $61.8 6.4% 5.0% $40.6 $(108.4)
1998 1,048.7 63.4 6.6** 5.1** 25.4 17.8
1997 629.2* 35.5 6.1 5.1 14.1 13.9
* Does not include $300 million in proceeds from the sale of convertible capital
securities on December 31, 1997.
** For the calculation of Annualized Rate of Return "Cash and Invested Assets
Less Borrowed Money" includes the $300 million in proceeds in the beginning of
the year.
(1) Net investment income excludes realized investment gains and is reduced by
investment expenses, but is before the deduction for income taxes.
(2) The rates of return on investments shown above have been determined in
accordance with rules prescribed by the National Association of Insurance
Commissioners. These rates have been determined by the following formula:
2I
--
A + B - I
I is equal to net investment income, before taxes, earned on investment assets.
A+B is equal to the sum of the beginning and end of the year amounts shown under
"Cash and Invested Assets, Less Borrowed Money". The after tax rates of return
are computed in the same manner, but net investment income is reduced by income
taxes.
(3) Realized and unrealized investment gains (losses) are before income taxes.
H. EMPLOYEES
At year-end 1999, the Company, including its wholly-owned subsidiaries, had
2,471 full and part-time employees. Management believes that its relations with
its employees are satisfactory.
21
I. FORWARD-LOOKING STATEMENTS
For a summary of factors that may materially affect the Company's future
business, see "Forward-Looking Statements" in Management's Discussion and
Analysis of Consolidated Financial Condition and Results of Operations in Item
7.
Item 2. Properties.
The Hartford Steam Boiler Inspection and Insurance Company leases
approximately 221,516 square feet for its home office at One State Street,
Hartford, Connecticut under a long-term capital lease with One State Street
Limited Partnership. In addition to its home office facility, the Company leases
facilities for its branch offices and subsidiaries throughout the United States
and Canada, and in a small number of other foreign locations. The Company
considers the office facilities and other operating resources to be suitable and
adequate for its current and anticipated level of operations.
See Notes 8 and 9 to Consolidated Financial Statements located in Item 8 of
Part II herein for additional information.
Item 3. Legal Proceedings.
The Company is involved in various legal proceedings as defendant or
co-defendant that have arisen in the normal course of its business. In the
judgment of management, after consultation with counsel, it is improbable that
any liabilities which may arise from such litigation will have a material
adverse impact on the results of operations or the financial position of the
Company.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
Item 4(a). Executive Officers of the Registrant.
All executive officers are elected by the Board of Directors to hold office
until the next Annual Meeting of Shareholders. An officer may be removed at any
time by the Board of Directors. Gordon W. Kreh retired from his position as
President and Chief Executive Officer effective December 31, 1999.
Richard H. Booth, 52, Chairman since 3/00; President, Chief Executive Officer
and Director since 1/00; Director since 7/96; Executive Vice President of
Phoenix Home Life Mutual Insurance Company 10/94 - 12/99; director of Phoenix
Home Life Mutual Insurance Company 6/98 - 12/99.
22
Saul L. Basch, 53, Senior Vice President, Treasurer and Chief Financial Officer
since 10/95; Partner, Coopers & Lybrand L.L.P. 9/73 - 10/95, most recently as
Partner-in-Charge of Coopers & Lybrand's New York Insurance Industry Practice.
Michael L. Downs, 50, Senior Vice President since 2/94; Managing Director -
Engineering Insurance Co., Ltd. 1/91 - 2/94; Second Vice President 7/87 - 1/91;
Assistant Vice President 2/85 - 7/87; Assistant Secretary 4/80 - 2/85.
John J. Kelley, 54, Senior Vice President since 2/94; Corporate Secretary and
Special Assistant to the President 5/87 - 2/94; Assistant Vice President and
Special Assistant to the President 9/83 - 5/87; Assistant Vice President 9/79 -
9/83; Assistant Secretary 4/77 - 9/79.
William A. Kerr, 62, Senior Vice President - Engineering since 9/95; Vice
President and General Manager, Pratt & Whitney Turbo Power and Marine Division,
United Technologies Corporation 8/95 - 9/95; Vice President of Aftermarket
Operations, Pratt & Whitney 4/92 - 8/95.
Normand Mercier, 54, Senior Vice President - Commercial Risks - Operations since
9/98; Senior Vice President, HSBIIC since 4/98; President, The Boiler Inspection
and Insurance Company 1/90-4/98.
R. Kevin Price, 53, Senior Vice President and Corporate Secretary since 2/94;
Second Vice President 4/89 - 2/94; Assistant Vice President 1/84 - 4/89.
William Stockdale, 54, Senior Vice President since 9/95; Managing Director and
Chief Executive Officer of HSB Engineering Insurance Ltd., London, since 9/94.
Robert C. Walker, 56, Senior Vice President-Claims and General Counsel since
1/95; Senior Vice President - Claims 3/94 - 1/95.
PART II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters.
The Company's common stock is traded on the New York Stock Exchange under
the symbol HSB. As of February 15, 2000, the Company had 4,826 holders of
record.
Dividends paid by The Hartford Steam Boiler Inspection and Insurance
Company, HSB Group's principal subsidiary, are limited by state insurance
regulations. Approval from the Connecticut Insurance Commissioner is required
for dividend distributions within a twelve-month period which would exceed the
greater of (i) 10 percent of an insurer's statutory surplus or (ii) net income
calculated as of the December 31st last preceding. Regulatory approval was not
required for the payment of 1999 dividends. Approximately $80 million of
HSBIIC's statutory surplus is available for distribution to HSB Group, Inc. in
2000 without prior regulatory approval.
23
Quarterly dividends declared for the 1999 and 1998 fiscal years were as
follows:
First Second Third Fourth Year
------ ------ ----- ------ ----
1999 $.42 $.42 $.44 $.44 $1.72
1998 $.40 $.40 $.42 $.42 $1.64
Quarterly market prices for the Company's common stock were as follows for
the two most recent years:
First Second Third Fourth Year
------ ------ ----- ------ ----
1999 High $41.31 $41.88 $41.94 $38.38 $41.94
1999 Low $35.50 $35.50 $34.19 $31.88 $31.88
1998 High $44.92 $53.50 $57.63 $42.00 $57.63
1998 Low $36.45 $43.17 $40.38 $36.00 $36.00
24
Item 6. Selected Financial Data.
(in millions, except per share amounts)
1999 1998 1997 1996 1995
- --------------------------------------------------------------------------------------------------------------------------------
Summary of Consolidated Statements
of Operations
Revenues:
Gross earned premiums $ 823.8 $ 770.5 $ 609.3 $ 556.5 $455.0
Ceded premiums 441.9 374.4 118.1 107.9 65.9
------------------------------------------------------------------------------
Insurance premiums 381.9 396.1 491.2 448.6 389.1
Engineering services 119.6 93.5 61.3 55.8 49.9
Income from investment operations 104.7 89.6 50.9 44.4 31.7
------------------------------------------------------------------------------
Total revenues (1) $ 606.2 $ 579.2 $ 603.4 $ 548.8 $470.7
------------------------------------------------------------------------------
Income from continuing operations $ 72.8 $ 104.1 $ 66.3 $ 54.6 $ 52.7
Income from continuing operations
per common share - basic $ 2.51 $ 3.55 $ 2.21 $ 1.81 $ 1.72
Income from continuing operations
per common share - assuming dilution 2.50 3.35 2.20 1.81 1.72
Dividends declared per common share 1.72 1.64 1.56 1.52 1.49
- --------------------------------------------------------------------------------------------------------------------------------
Summary of Consolidated Statements
of Financial Position
Total assets $2,263.2 $2,138.6 $ 1,537.2 $1,112.3 $951.9
Long-term borrowings and
capital lease obligations 52.9 53.0 53.0 53.0 53.4
Convertible redeemable preferred stock -- -- -- 20.0 --
Company obligated mandatorily
Redeemable capital securities 409.0 408.9 408.9 -- --
Shareholders' equity:
Common 376.5 419.3 345.3 345.6 341.1
Per common share 12.95 14.53 11.75 11.50 11.21
Return on average equity 18.3% 35.2%(2) 19.1% 15.6% 19.5%
Stock price per share:
High $ 41.94 $ 57.63 $ 37.67 $ 34.83 $ 33.50
Low 31.88 36.00 29.58 28.58 26.50
Close 33.81 41.06 36.80 30.92 33.33
Common shares outstanding
at end of year (3) 29.1 28.9 29.4 30.0 30.5
- ---------------------------------------------------------------------------------------------------------------------------------
Insurance
Underwriting gain $ 21.3 $ 41.2 $ 39.8 $ 21.8 $ 34.2
Loss ratio 43.4% 44.2% 44.4% 45.6% 39.8%
Expense ratio 51.0% 45.4% 47.3% 49.1% 50.9%
-------------------------------------------------------------------------------
Combined ratio 94.4% 89.6% 91.7% 94.7% 90.7%
- ---------------------------------------------------------------------------------------------------------------------------------
Engineering Services
Operating gain $ 3.0 $ 7.3 $ 4.3 $ 7.3 $ 6.7
Engineering services margin 2.5% 7.8% 7.1% 13.2% 13.3%
Investments
Net investment income $ 64.1 $ 64.2 $ 36.8 $ 32.3 $ 28.9
Realized investment gains 40.6 25.4 14.1 12.1 2.8
-------------------------------------------------------------------------------
Income from investment operations $ 104.7 $ 89.6 $ 50.9 $ 44.4 $ 31.7
- ---------------------------------------------------------------------------------------------------------------------------------
(1) Excludes revenues from investments accounted for under the equity method.
(2) Includes gain on sale of IRI and Radian LLC.
(3) Reflects the repurchase of approximately 0.1, 1.2, 1.5, 0.4 and 0.2 million
shares in 1999, 1998, 1997, 1996 and 1995, respectively.
25
Item 7. Management's Discussion and Analysis of Consolidated Financial Condition
and Results of Operations
(dollar amounts in millions, except per share amounts)
Summary of Results of Operations
Consolidated Overview
For the years ended December 31, 1999 1998 1997
- ------------------------------------------------------------------------
Revenues:
Gross earned premiums $ 823.8 $ 770.5 $ 609.3
Ceded premiums 441.9 374.4 118.1
-------------------------------
Insurance premiums 381.9 396.1 491.2
Engineering services 119.6 93.5 61.3
Net investment income 64.1 64.2 36.8
Realized investment gains 40.6 25.4 14.1
-------------------------------
Total revenues $ 606.2 $ 579.2 $ 603.4
Income from continuing
operations (excluding the
gain on sale of IRI) $ 72.8 $ 80.3 $ 66.3
Gain on sale of IRI (after-tax) -- 23.8 --
-------------------------------
Income from continuing
operations 72.8 104.1 66.3
Discontinued operations -- 30.3 --
-------------------------------
Net income $ 72.8 $ 134.4 $ 66.3
-------------------------------
Earnings per share:
Income from continuing
operations (excluding
the gain on sale of IRI)
Assuming dilution $ 2.50 $ 2.67 $ 2.20
Income from continuing
operations:
Basic $ 2.51 $ 3.55 $ 2.21
Assuming dilution 2.50 3.35 2.20
Net income:
Basic $ 2.51 $ 4.59 $ 2.21
Assuming dilution 2.50 4.21 2.20
- ------------------------------------------------------------------------
The table above presents consolidated results of HSB Group, Inc. (HSB or the
Company).
Overview of Results of Operations
Income from continuing operations for 1999, excluding the 1998 gain on sale of
Industrial Risk Insurers (IRI) discussed below, decreased $7.5 million or 9.3
percent from 1998. The decline in after-tax earnings was primarily due to
reduced underwriting profits as well as a decline in the engineering services
operating gain. The impact of these items was partially offset by higher income
from investment operations, virtually all of which resulted from increased net
realized gains in 1999. Excluding the gain on sale of IRI, income from
continuing operations per common share on a diluted basis decreased 6.4 percent
in 1999 as compared to 1998.
26
In comparison to 1998, the major contributors to the reduction in pre-tax
earnings (exclusive of realized gains) were: increased information systems costs
(including Year 2000 remediation costs) of $8 million; reduced profits from HSB
Industrial Risk Insurers of $7 million; change in management and other expenses
related to consolidation and relocation of certain businesses of $5 million; and
$3 million of reduced margins in certain engineering businesses.
Net income for 1998 included after-tax gains on the sale of HSB's interest in
IRI of $23.8 million and Radian International LLC (Radian LLC) of $30.3 million.
The Radian LLC gain is net of after-tax operating losses of $6.6 million that
were deferred in 1997 when the decision was made to exercise HSB's option to put
the Company's interest to The Dow Chemical Company (Dow). As a result, HSB's
interest in Radian LLC was classified as a discontinued operation in 1997. The
Company's after-tax earnings, excluding the after-tax gains on sales of IRI and
Radian LLC, increased 21.1 percent in 1998 compared with 1997 due to increased
underwriting profits, improved engineering results and higher net realized
gains. Income from continuing operations, excluding the gain on sale of IRI, per
common share on a diluted basis increased 21.4 percent in 1998 from 1997.
Total revenues grew 4.7 percent in 1999 as compared to a decline of 4.0 percent
in 1998. The increase in 1999 was attributable to growth in engineering services
as well as strong realized investment gains offset by a reduction in net earned
premiums. Gross earned premiums grew 6.9 percent in 1999 and 26.5 percent in
1998. In 1999, much of this increase was attributable to the continued growth in
our commercial book of business as well as a full year's earnings related to the
1998 acquisition of the Kemper book noted in the Other Developments section of
this Management's Discussion and Analysis (MD&A).
Ceded premiums increased 18.0 and 217.0 percent in 1999 and 1998, respectively,
resulting from the HSB Industrial Risk Insurers arrangement and related
reinsurance with Employers Reinsurance Corporation (ERC), as well as the
increasing effect of the Company's reinsurance programs which utilized
significantly more quota share reinsurance on certain of our books of business.
The Company anticipates that quota share reinsurance will not have as
significant a role as 2000 progresses.
The combined ratio for the Company increased to 94.4 percent in 1999 from 89.6
percent in 1998. In 1997, the combined ratio was 91.7 percent. The 1999 ratio
was adversely impacted by the increase in the expense ratio from 45.4 percent in
1998 to 51.0 percent in 1999.
Engineering services revenue increased 27.9 percent in 1999 and 52.5 percent in
1998. The growth in both 1999 and 1998 was led by additional revenues from our
recent acquisitions. Operating margins decreased to 2.5 percent from 7.8 percent
in 1998. The investment of operating funds to develop new products and establish
start-up operations, and the consolidation of certain businesses coupled with
reduced volume and profits in certain of our traditional engineering businesses
caused margins to contract from 1998.
Income from investment operations increased 16.9 percent in 1999 primarily as a
result of increased realized investment gains from repositioning the investment
portfolio due to market fluctuations and to keep the absolute amount of common
equities from exceeding a certain targeted percentage of the Company's Generally
Accepted Accounting Principles (GAAP) capital. Net investment income grew 74.5
percent in 1998 from the investment of proceeds from the sales of IRI and Radian
LLC and the issuance of capital securities in the second half of 1997.
The effective tax rate on income from continuing operations before distributions
on capital securities for 1999 was 28.2 percent compared to 29.6 percent and
26.8 percent for 1998 and 1997, respectively. Tax rate fluctuations occur as the
levels of underwriting and engineering services results and realized gains
change the mix of pre-tax income between fully taxable earnings and tax
preferred earnings. Various tax credits (primarily foreign tax credits) also
impact the effective rate. The Company continues to manage its use of tax
advantageous investments in an attempt to maximize after-tax earnings.
27
HSB Industrial Risk Insurers
The reinsurance agreements effective January 1, 1998 between The Hartford Steam
Boiler Inspection and Insurance Company (HSBIIC), ERC and IRI, as discussed
below, were terminated with respect to loss or liabilities arising out of
occurrences taking place on or after January 1, 2000. As a result, HSBIIC will
no longer retain 85 percent of the equipment breakdown insurance and 15 percent
of the property insurance of the combined insurance portfolio for risks arising
on or after January 1, 2000. The joint underwriting association that was known
as HSB Industrial Risk Insurers will, from January 1, 2000, be known as
Industrial Risk Insurers (IRI).
Concurrent with the termination of the reinsurance agreements, HSBIIC, ERC and
IRI replaced the operating agreement dated January 1, 1998. The new agreement,
effective January 1, 2000, calls for HSBIIC to retain 0.5 percent membership
share in IRI with the ability to increase its total share up to a maximum of 10
percent, at no cost, at HSBIIC's option. In addition, the agreement also
establishes an arrangement for HSB to perform equipment breakdown engineering
and inspection services for clients of IRI and provides for a fixed fronting fee
in the event that IRI continues to use HSBIIC's licenses. HSBIIC received
payments of $27 million in December 1999 related to the partial settlement of
unearned reinsurance premiums and ceding commissions due to HSBIIC under the
prior agreement. Final settlement is expected to occur in the second half of
2000.
On January 6, 1998, HSBIIC sold its interest in IRI to ERC in accordance with a
previously announced purchase and sale agreement between ERC and IRI's
twenty-three member insurers. HSBIIC received gross proceeds of $49.1 million,
prior to transaction costs, for its 23.5 percent share in IRI. The gain on the
sale of IRI was $36.6 million pre-tax and $23.8 million after-tax. Because the
sale was structured in part as a reinsurance transaction, a portion of HSBIIC's
gross proceeds was utilized to reinsure in-force policies with ERC.
IRI is an unincorporated, voluntary joint underwriting association which
provides property insurance for the class of business known as Highly Protected
Risks (HPR) for larger manufacturing, processing and industrial businesses,
which have invested in protection against loss through the use of sprinklers and
other means. IRI primarily writes policies on a syndicate basis that specifies
to the insured the percentage share of risk accepted by each member of the
association. Each member company, therefore, operates as a direct insurer or
reinsurer on such policies and participates in the premiums and losses generated
thereunder in proportion to its membership interest. In 1997 and 1996, HSBIIC's
membership shares were 23.5 and 14 percent respectively; in 1995 and prior the
shares were 0.5 percent.
In essence, IRI facilitates the proportional sharing of risk under one policy
where each member is essentially considered to be the direct writer for
reporting, premium tax and other regulatory purposes. Liability on such policies
is several and not joint, and therefore, members are not responsible for policy
liabilities of the other members. An increased participation does not expose
HSBIIC to the effect of adverse loss development on claims incurred prior to the
effective date of the increase; conversely a decrease in participation does not
release HSBIIC from the effect of adverse development.
Contemporaneous with the close of the 1998 sale, IRI was reconstituted with ERC
(with a 99.5 percent share) and HSBIIC (with a 0.5 percent share) as the sole
members. The new association was renamed HSB Industrial Risk Insurers. In 1999
and 1998, HSBIIC wrote the business for HSB Industrial Risk Insurers using its
insurance licenses and provided certain other services. In addition, through
various quota share reinsurance agreements with ERC and HSB Industrial Risk
Insurers, HSBIIC transferred its manufacturing book of business to HSB
Industrial Risk Insurers in 1998 and retained 85 percent of the equipment
breakdown insurance and 15 percent of the property insurance of the combined
insurance portfolio. This agreement was the largest contributing factor in the
growth of both gross earned premium and ceded premium. As a result, in both 1999
and 1998 transactions arising from this agreement comprise a significant
28
portion of the reinsurance asset, unearned insurance premiums and ceded
reinsurance payables reflected in the Consolidated Statements of Financial
Position.
In contemplation of HSB's expanded role in HSB Industrial Risk Insurers, on
December 31, 1997 a business trust formed by HSB sold $300 million of 20 year, 7
percent Convertible Capital Securities in a private placement to ERC (see note
13). The Convertible Capital Securities are convertible into shares of HSB
common stock, at any time, subject to regulatory approval, at a conversion price
of $56.67 per share. $250 million of the proceeds were contributed to HSBIIC and
$50 million were retained by HSB.
Discontinued Operations
On January 2, 1998, HSBIIC exercised its option to put its 40 percent share in
Radian LLC to Dow, for approximately $129 million, net of expenses. Radian LLC
was formed in January 1996 as a joint venture with Dow to provide environmental,
engineering, information technology, remediation and strategic chemical
management services to industries and governments worldwide. In connection with
the formation of the new company, HSBIIC contributed substantially all of the
assets and liabilities of its wholly owned subsidiary, Radian Corporation to
Radian LLC. The results of Radian LLC were classified as discontinued operations
following ratification in July 1997 by HSB's Board of Directors of management's
decision to exercise its put. The after-tax gain of $30.3 million recognized in
1998 is net of deferred losses previously noted. Prior to July 1997, HSBIIC's
share of the joint venture's results was recorded as equity in Radian.
Recent Accounting Developments
The Accounting Standards Executive Committee of the American Institute of
Certified Public Accountants (AcSEC) issued three Statements of Position (SOPs)
that became effective for fiscal years beginning after December 15, 1998: SOP
97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related
Assessments," SOP 98-1, "Accounting for the Costs of Computer Software Developed
or Obtained for Internal Use" and SOP 98-5, "Reporting on the Costs of Start-Up
Activities." Because the Company's accounting policies were already in
compliance with these SOPs, the implementation of these statements had no impact
upon the results of operations, financial condition or cash flows.
In June 1998, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative
Instruments and Hedging Activities" subsequently amended by SFAS No. 137. This
statement establishes accounting and reporting standards for derivative
instruments, including certain derivative instruments embedded in other
contracts and for hedging activities. It requires that all derivatives be
recognized as either assets or liabilities in the statement of financial
position and that such instruments be measured at fair value. In addition, all
hedging relationships must be designated, reassessed and documented pursuant to
the provisions of SFAS No. 133. This statement is effective for the Company for
the first quarter of 2001. Based on the Company's current investment policies
and practices, the Company anticipates that the adoption of the provisions of
SFAS No. 133 will not have a significant effect on results of operations,
financial condition or cash flows.
In October 1998, AcSEC issued SOP 98-7, "Deposit Accounting: Accounting for
Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk." The
SOP identifies several methods of deposit accounting and provides guidance on
the application of each method. This SOP became effective for financial
statements for fiscal years beginning after June 15, 1999. Currently the Company
is not party to any contracts that do not comply with the risk transfer
provisions of SFAS No. 113, "Accounting and Reporting for Reinsurance of
Short-Duration and Long-Duration Contracts," and, therefore, does not anticipate
the adoption of SOP 98-7 will have a material impact on results of operations,
financial condition or cash flows.
29
Other Developments
In July 1999, HSBIIC acquired Structural Integrity Associates, Inc. (Structural)
based in San Jose, California. Structural is an engineering consulting and
inspection services firm specializing in the analysis, control and prevention of
structural and equipment failures. It offers a full array of services, from
inspection and condition assessment, to monitoring and remaining life analysis,
repair, remediation and total risk management of critical equipment and
structures.
HSBIIC completed an acquisition of the monoline boiler and machinery business of
Kemper Insurance Companies (Kemper) and Kemper's ASME inspection services
business that certifies boiler and pressure vessel compliance with the codes and
standards of the American Society of Mechanical Engineers, effective July 1,
1998. The two companies also completed an agreement for HSBIIC to reinsure
boiler and machinery coverage written as part of Kemper's commercial package
policies.
On April 21, 1998, the Board of Directors approved a three-for-two stock split
for shares of record on May 1, 1998. The additional shares were distributed on
May 22, 1998. In accordance with SFAS No. 128, "Earnings per Share," all
earnings per share presentations have been adjusted to reflect the impact of the
stock split, including retroactive restatement of prior periods.
In April 1998, HSB acquired Solomon Associates, Inc. (SAI) based in Dallas,
Texas. SAI is an engineering management consulting firm that provides
comparative performance benchmarking consulting to the refining, petrochemical
and power generation industries. SAI establishes efficiency and productivity
benchmarks for 80 percent of the worldwide petroleum refining industry. This
acquisition expands HSB's engineering management consulting services and
benchmarking capability.
Insurance Operations
For the years ended December 31, 1999 1998 1997
- ------------------------------------------------------------------------
Gross earned premiums $ 823.8 $ 770.5 $609.3
Ceded premiums 441.9 374.4 118.1
------------------------------------
Insurance premiums $ 381.9 $ 396.1 $491.2
Claims and adjustment
expenses 165.8 174.9 217.9
Underwriting, acquisition
and other expenses 194.8 180.0 233.5
------------------------------------
Underwriting gain $ 21.3 $ 41.2 $ 39.8
Loss ratio 43.4% 44.2% 44.4%
Expense ratio 51.0% 45.4% 47.3%
Combined ratio 94.4% 89.6% 91.7%
- ------------------------------------------------------------------------
Insurance operations include the underwriting results of HSBIIC, HSB Engineering
Insurance Limited (EIL), The Boiler Inspection and Insurance Company of Canada
(BI&I), The Allen Insurance Company, Ltd., The Hartford Steam Boiler Inspection
and Insurance Company of Connecticut, The Hartford Steam Boiler Inspection and
Insurance Company of Texas and HSBIIC's participation in HSB Industrial Risk
Insurers and various other pools.
Gross earned premiums in 1999 increased 6.9 percent over 1998. Much of this
growth was attributable to the integration of certain commercial books of
business acquired in mid-1998; growth in our client company business and a full
year of writing HSB Industrial Risk Insurers policies utilizing the Company's
licenses. In 1998, a portion of HSB Industrial Risk Insurers policies in-force
were written/renewed utilizing the licenses of other insurers. The increases in
gross premiums were offset by premium declines in certain operations within
Global Special Risks. In some areas of the Company's direct businesses, the
market continued to experience price erosion in 1999 as the number of insurers
offering capacity expanded. HSB
30
will not write business at rates that do not provide sufficient opportunity to
earn a profit. As a result, the Company anticipates that premiums in the Global
Special Risks areas may continue to experience revenue declines. In addition,
the new January 1, 2000 agreement with IRI, previously discussed, will also
result in a decrease in gross earned premiums. In 1998, gross earned premiums
increased 26.5 percent primarily as a result of HSB Industrial Risk Insurers
($155.4 million) as well as the addition of the Kemper portfolio to our
commercial business.
Domestically, exclusive of HSB Industrial Risk Insurers, gross earned premiums
increased $34.8 million or 9.3 percent in 1999 due to the integration of the
Kemper portfolio and growth in our client company business. Gross earned
premiums representing coverage outside the U.S., exclusive of HSB Industrial
Risk Insurers, decreased 12.5 percent to $116.8 from $133.5 million in 1998 due
to price erosion and maintenance of strict underwriting standards.
In 1998, domestic gross earned premiums, excluding the impact of HSB Industrial
Risk Insurers, remained flat as a result of the combination of growth in written
premiums from our client companies offset by reductions in our domestic special
risk premiums. Gross earned premiums representing coverage outside the U.S.,
exclusive of HSB Industrial Risk Insurers, increased 5.4 percent to $133.5
million.
The insurance industry, in general, continues to undergo significant
restructuring and consolidation. Considerable merger and acquisition activity
has occurred over the last several years and, with the advent of financial
services reform, more contraction is possible in the future. Depending on the
specific companies involved in these activities and other market factors, the
level of reinsured business the Company assumes in the future could be impacted.
HSB is positioned to benefit from these changes over the long term due to its
strong market position and reinsurance relationships with approximately 200
multi-line carriers; while over the shorter term, there is both opportunity and
challenge.
The increase in ceded premiums of 18.0 and 217.0 percent in 1999 and 1998,
respectively, was primarily due to the HSB Industrial Risk Insurers arrangement
and related reinsurance with ERC, as well as the increasing effect of the
Company's reinsurance programs which over the past three years have utilized
significantly more quota share reinsurance on certain of our books of business.
Due to changing reinsurance market conditions and the impact of the new IRI
agreement effective January 1, 2000, the Company is in the process of evaluating
and redesigning its current reinsurance programs that will place less reliance
on quota share reinsurance. The Company anticipates this will lead to a reduced
level of ceded premiums.
Due to the new agreement with IRI, coupled with a decline in our Global Special
Risks segment, gross earned premiums are expected to decline in 2000. However,
anticipated changes in the utilization of reinsurance may cause ceded premiums
to decline at a higher rate than gross earned premiums for 2000.
The Company participates in various facultative, quota share and excess of loss
reinsurance agreements to limit its exposure, particularly to catastrophic
losses and high-risk lines and to provide additional capacity to write business.
The Company evaluates its exposures and reinsurance needs annually to implement
a program that corresponds with the level of exposure it is willing to retain.
Because the Company has primary responsibility to its insureds, a careful
evaluation of the financial strength of those reinsurers it cedes business to is
performed. HSB's reinsurance costs continue to be impacted by its prior loss
experience and business growth, as well as the design of its program.
31
For the years ended December 31, 1999 1998 1997
- ------------------------------------------------------------------------
Provision for claims and
adjustment expenses
occurring in the
current year $ 165.4 $ 164.0 $ 209.5
Increase in estimated
claims and adjustment
expenses arising in
prior years 0.4 10.9 8.4
-------------------------------------
Total incurred claims and
adjustment expenses* $ 165.8 $ 174.9 $ 217.9
Loss ratio 43.4% 44.2% 44.4%
- ------------------------------------------------------------------------
* Includes approximately $2.0, $5.0 and $3.3 million of subrogation recoveries,
respectively.
Claims and adjustment expense reserves comprise one of the largest liabilities
on the Company's Consolidated Statements of Financial Position. Reserves are
established to record the Company's estimates of total losses and loss
adjustment expenses that will ultimately be paid under direct and assumed
insurance contracts. Loss reserves include claims and adjustment expenses on
claims that have been reported but not yet settled and those that have been
incurred but not yet reported to the Company. The length of time that reserves
are carried on the Consolidated Statements of Financial Position is a function
of the pay-out patterns associated with the types of coverage involved. The
majority of claims the Company incurs are short-tailed in nature, relative to
the property-casualty industry as a whole, meaning they generally settle shortly
after claims are reported. The Company's loss reserve estimates reflect such
variables as past loss experience and inflation. In addition, due to the nature
of much of the Company's types of coverage, complex engineering judgments are
involved. Previously established loss reserves are regularly adjusted as loss
experience develops and new information becomes available. Adjustments to
previously established reserves are reflected in the financial statements in the
period in which the estimates are changed. The Company does not discount its
loss reserves.
The loss ratio improved 0.8 percentage points in 1999 from 1998. This
improvement was primarily attributable to increased use of reinsurance. The 1999
results were impacted by $10 million of domestic weather-related events and the
Taiwan earthquake as well as $10 million in losses related to medical equipment
insurance contracts. These insurance contracts represented less than 1 percent
of the Company's revenues. The loss ratio decreased 0.2 percentage points in
1998 as compared to 1997. Loss results in 1998 were impacted by severe ice
storms in Canada, as well as a few significant losses in our other international
businesses. Prior year loss development in 1999, 1998 and 1997 added 0.1, 2.8
and 1.7 percentage points to the respective loss ratio. The components of claims
and adjustment expenses, net of reinsurance, are displayed above.
Gross claims and adjustment expenses were $684.7 million in 1999 as compared to
$619.6 million in 1998 and $263.1 million in 1997. This increase was the result
of weather-related events domestically, the Taiwan earthquake and large losses
in our Global Special Risks business, all of which were largely reinsured. The
significant increases in claim reserves and reinsurance assets since December
31, 1998 largely relate to these events. In 1998, the increase in gross claims
was largely due to the Company's role as direct writer of HSB Industrial Risk
Insurers' policies and included approximately $154 million from Hurricane
Georges on exposures written by HSB Industrial Risk Insurers. On a net basis the
impact on HSB from such hurricane losses after cessions to HSB Industrial Risk
Insurers and reinsurance recoveries was $1.9 million.
Although reported claim activity has been negligible at this time,
quantification of the Company's exposure to Year 2000 losses and loss adjustment
expenses are not reasonably estimable as applicable policy and reinsurance
contract wordings have not been legally tested in the context of such losses.
32
The expense ratio increased to 51.0 percent in 1999 from 45.4 percent in 1998
and 47.3 percent in 1997. A portion of the 1999 increase in the expense ratio
was attributable to increases in policy acquisition costs. Increases in
commission rates that reflect changes in the mix of business, primarily in the
commercial segment, increased the expense ratio approximately 1.9 percentage
points. In 1999, the Company's results were negatively impacted by increased
information systems costs of $8 million (including Year 2000 remediation costs)
and $5 million of charges related to a change in management at HSB and
consolidation and relocation of certain businesses. Approximately $11 million of
these amounts were allocated to the insurance operations, thereby increasing the
expense ratio by 2.9 percentage points.
The 1998 expense ratio improvement of 1.9 percentage points over 1997 was
primarily related to the new quota share reinsurance agreements and the HSB
Industrial Risk Insurers arrangement with ERC, both of which resulted in ceding
commissions to HSBIIC that positively impacted our expense ratio by 3.9
percentage points. A portion of such ceding commission was intended to reimburse
HSBIIC for the additional costs of managing HSB Industrial Risk Insurers and to
offset the reduction in net earned premiums.
The following information summarizes key financial results by reportable
insurance segment:
For the years ended December 31, 1999 1998 1997
- ------------------------------------------------------------------------
Commercial:
Net earned premiums $ 335.2 $ 306.3 $ 269.0
Net income 12.8 14.8 13.4
Income taxes 7.2 4.6 6.1
Global Special Risks:
Net earned premiums $ 45.6 $ 83.6 $ 217.1
Net income 6.7 9.8 10.7
Income taxes 2.3 7.7 6.2
- ------------------------------------------------------------------------
The Commercial business has shown strong revenue growth year over year despite
significant price competition as HSB continues to focus on its client company
strategy. Net earned premiums in the Commercial segment rose $28.9 and $37.3
million in 1999 and 1998, respectively, due primarily to the integration of the
Kemper portfolio and growth in our client company business, offset by declines
in direct writings. In 1999, domestic operations posted an underwriting gain at
a lower margin than 1998 due to the increased expense ratio. International
operations posted an improved underwriting gain as 1998 was more severely
impacted by weather-related claims. In 1998, domestic operations posted an
underwriting gain that was partially offset by a difficult claims year
internationally, particularly due to severe ice storms that affected over 30
percent of Canada. The high tax benefit recognized on Canadian losses caused the
effective tax rate to decline from 1997.
Global Special Risks net earned premiums declined $38.0 million in 1999. This
decrease relates primarily to increased ceded premiums related to the HSB
Industrial Risk Insurers business. In addition, price erosion and maintenance of
strict underwriting standards, coupled with changes in reinsurance programs,
contributed to the decline in 1999. In 1998, net earned premiums decreased
$133.5 million primarily due to the increased use of reinsurance and the
arrangement with HSB Industrial Risk Insurers. Global Special Risks net income
decreased in 1999 primarily as a result of the declining book. In 1998, the
international businesses were impacted by adverse claims experience as compared
to 1997. In 1998, income taxes as a percentage of net income increased as a
result of a decreased use of foreign tax credits.
As part of the arrangement with HSB Industrial Risk Insurers, HSBIIC wrote all
direct policies for HSB Industrial Risk Insurers and then ceded back these risks
100 percent to HSB Industrial Risk Insurers. HSBIIC then reinsured ERC's 99.5
percent share of the business resulting in the assumption of 85 percent of the
equipment breakdown business and 15 percent of the property business. As a
result of the termination of the ERC reinsurance agreement and the replacement
of the IRI agreement effective January 1, 2000, as
33
previously discussed, the Company anticipates that Global Special Risks' gross
earned and ceded premiums, as well as the fees/expense reimbursement generated
from managing the IRI business will continue to decline.
Engineering Services Operations
For the years ended December 31, 1999 1998 1997
- ------------------------------------------------------------------------
Engineering services
Revenues $119.6 $ 93.5 $ 61.3
Engineering services
Expenses 116.6 86.2 57.0
-----------------------------------
Operating gain $ 3.0 $ 7.3 $ 4.3
Operating margin 2.5% 7.8% 7.0%
- ------------------------------------------------------------------------
Engineering services operations include the results of HSBIIC's, EIL's and
BI&I's engineering services, HSB Reliability Technologies (HSBRT), HSB
Professional Loss Control, HSB International, SAI, Structural and the Company's
interest in Integrated Process Technologies, LLC (IPT).
Engineering services revenues increased 27.9 percent in comparison to 1998. The
growth in revenues is primarily due to significant increases related to IPT, a
full year's integration of the SAI acquisition which occurred in April 1998, the
Structural acquisition in July 1999 and EIL's engineering services revenues
generated through other acquisitions. In 1998, revenue increases of 52.5 percent
were generated by HSBRT; EIL's acquisition of Haughton's engineering in the last
quarter of 1997; and the addition of SAI in April 1998.
Operating margins decreased to 2.5 percent from 7.8 percent in 1998. The decline
in operating margin from the previous year reflects the investment of operating
funds to develop new products and establish start-up operations coupled with
reduced volume and profits in certain of our traditional engineering businesses,
particularly HSBRT. In addition, the Company recorded a charge of $0.7 million
related to costs associated with the consolidation of certain engineering
activities. Margins increased 0.8 percentage points in 1998 as a result of
improved field service staff utilization and cost efficiencies, which were
offset somewhat by the start-up costs of integrating certain acquisitions.
In July 1999, HSBIIC acquired Structural based in San Jose, California.
Structural is an engineering consulting firm that specializes in prevention,
control and repair of structural and mechanical failures. The Company continues
to focus on identifying and evaluating acquisition candidates in the niche
engineering management consulting service business, primarily in process
industries, in order to expand or complement its engineering service
capabilities.
Investment Operations
For the years ended December 31, 1999 1998 1997
- ---------------------------------------------------------------------------
Net investment income $ 64.1 $ 64.2 $ 36.8
Realized investment gains 40.6 25.4 14.1
----------------------------------
Income from investment
operations $ 104.7 $ 89.6 $ 50.9
Total cash and invested
assets, at fair value $ 998.1 $1,094.8 $ 996.7
Unrealized gains, pre-tax $ 4.7 $ 113.1 $ 95.3
- ---------------------------------------------------------------------------
The Company's investment strategy is to maximize total return on the investment
portfolio through investment income and capital appreciation. Investment
strategies for any given year are developed based on many factors including
operational results, tax implications, regulatory requirements, interest rates,
dividends to stockholders, servicing requirements of capital securities and
market conditions. The
34
investment portfolio includes a wide variety of high quality equity securities
and both domestic and foreign fixed maturities. The Company continues to manage
its use of tax advantageous investments in an attempt to maximize after-tax
investment earnings. The Company does not engage in cash flow underwriting; it
seeks to have underwriting profit each year.
None of the Company's claim reserves are discounted as most claims settle, on
average, within one year. Therefore, the Company does not use duration
measurements in managing its interest rate exposure. Instead, HSB manages its
portfolio on a segmented basis. Approximately $300 million (cost basis) of the
Company's invested assets (comprised of perpetual and redeemable preferred
stocks and corporate bonds) are utilized to provide interest coverage and
potential principal repayment over the life of the convertible capital
securities issued on December 31, 1997. The remainder of the Company's invested
assets, exclusive of cash and cash equivalents, short-term securities and common
stocks are invested to provide income for the future. There are three portfolio
areas with quite different maturity/call characteristics. The portfolio of
traditional bonds of approximately $245 million has an average life of 22 years,
with over 50 percent of that portfolio callable in less than ten years. The
sinking fund preferred portfolio of $43 million, based on expected calls, has an
estimated life of three years. The $52 million adjustable rate preferred stock
portfolio, based on expected calls, has an estimated life of five years.
The Company believes the expected cash flows from the Company's operations,
maturities and calls are adequate to enable the Company to respond to the
previously discussed parameters that impact its investment strategy.
Net investment income for 1999 remained flat compared to 1998 and increased
$27.4 million in 1998 as compared to 1997 due to the investment of proceeds from
capital securities issued during the second half of 1997. In addition, proceeds
from the January 1998 sale of HSB's interests in IRI and Radian LLC
significantly increased investable funds. Declining yields available on new
fixed maturities relative to higher yields on maturing investments over the past
few years have also moderated investment income growth. Net investment income
has also been impacted by calls of high yielding preferred stocks.
Realized investment gains increased $15.2 million in 1999 as a result of
repositioning the investment portfolio due to market fluctuations and to keep
the absolute amount of common equities from exceeding a certain targeted
percentage of the Company's GAAP capital. In 1998, realized gains increased
$11.3 million as a result of call premiums on fixed income investments and sales
of certain convertible securities and common stocks in response to market
conditions.
In 1997, realized gains were reduced by $30.7 million (all of which were offset
by and represented portfolio appreciation and returns that were realized) to
reflect the estimated fair value of three "zero cost collar contracts" entered
into at the end of 1996 to mitigate the effects of market risk on the Company's
U.S. common stock portfolio (which, for management purposes, included certain
convertible preferreds). Each contract had a notional value of $50 million and
maturity dates ranging from November 1997 to January 1998. The contracts were
European style, which means they only settled upon maturity. The contracts,
which were entered into when the Standard & Poor's 500 Index (S&P 500 Index) was
744.3, allowed HSBIIC to recover from the counterparty if the index was below
695.2 at the time of maturity, and required HSBIIC to reimburse the counterparty
if the index was above a range of 811.3 to 818.7 at the time of maturity.
Through its U.K. subsidiary, EIL, the Company writes business in Malaysia and is
required to maintain ringgit denominated investments based on the level of
premiums written in Malaysia. At December 31, 1999, 1998 and 1997, the Company's
deposits were 20, 29 and 50 million ringgits, respectively. This equated to
$5.1, $7.1 and $12.8 million at December 31, 1999, 1998 and 1997, respectively.
In 1997, due to currency fluctuation in Southeast Asia, realized investment
gains were negatively impacted by $7.4 million.
HSB's investment portfolio continues to consist of high-grade domestic and
foreign investments. Excluding short-term investments, HSB's investments are
primarily comprised of publicly traded, highly liquid
35
securities. At the end of 1999, HSB's fixed maturities portfolio comprised 52.9
percent of the value of the invested assets. The credit quality of HSB's bond
investments at December 31, 1999, averaged an A rating. HSB's portfolio does not
include any bonds in default as to either principal or interest. Bonds held at
December 31, 1999 had a fair value of $299.8 million. Redeemable preferred
stocks averaged a BBB rating. During 1999 bond yields continued to move up, the
impact of which has caused a reduction in the Company's unrealized gains with
respect to fixed income securities by approximately $64.5 million pre-tax.
The carrying value of the equity securities portfolio represented 41.3 percent
of the investments at December 31, 1999. This included $65.3 million of pre-tax
unrealized investment gains of which $92.6 million related to common equities,
offset by $27.3 million of preferred unrealized investment losses. The Company's
common equities, which are comprised of primarily Standard & Poor's 500 (S&P
500) "large cap" stocks, essentially modeled the performance of the S&P 500
Index in 1999. HSB also recorded $22.1 million of dividends and $43.5 million of
net pre-tax realized gains from this portfolio in 1999. The Company's largest
single holding accounted for less than 1 percent of total consolidated assets.
Realized investment gains increased in 1999 over 1998 (and in 1998 over 1997
taking into account the $30.7 million loss on the "zero cost collar contracts")
as HSB managed its portfolio to respond to changing market conditions and tax
planning opportunities.
Market Risk
Market risk generally encompasses systemic risks or risks associated with macro
factors relating to economic losses due to adverse changes in the fair value of
a financial instrument. Market risk relates to the variability of market prices
and/or cash flows associated with changes in interest rates, securities prices,
market indices, yield curves or currency exchange rates and is inherent to all
financial instruments. The Company's investment strategy is to maximize total
return on the investment portfolio through investment income and capital
appreciation and is based on such factors as operational results, tax
implications, regulatory requirements, interest rates, dividends to
stockholders, servicing requirements of capital securities and market
conditions.
The focus of this disclosure is on one element of market risk - price risk. For
the Company, price risk relates to changes in the level of prices of financial
instruments due to changes in interest rates, equity prices or foreign exchange
rates. The primary price risk exposures of the Company relate to interest rate
and equity price risk.
For purposes of this disclosure market risk sensitive instruments are
categorized as instruments entered into for trading purposes and instruments
entered into for purposes other than trading. The Company does not hold any
financial instruments entered into for trading purposes and, therefore, market
risk sensitive instruments are classified as held for purposes other than
trading.
Interest Rate Risk
Interest rate risk is the major price risk facing the Company's fixed income
portfolio. Such exposure can subject the Company to economic losses due to
changes in the level or volatility of interest rates. Bond prices change
inversely with the direction of interest rates. Generally, as interest rates
rise, prices for fixed income instruments will fall. As rates decline the
inverse is true. The Company attempts to mitigate this risk by investing in high
quality issues using a buy and hold approach.
Equity Market Risk
Equity market risk is defined as the chance that market influences will affect
the expected returns of all equities. Returns are influenced not only by the
fundamental attributes of investment securities, but by the price movements of
the general marketplace. Much of this depends on the sensitivity of the
individual issue
36
to the overall market. The Company attempts to reduce this risk through
diversification and a focus on high quality, blue chip investments.
Foreign Exchange Risk
Foreign exchange risk arises from the possibility that changes in foreign
currency exchange rates will adversely impact the value of financial
instruments. The Company has foreign exchange exposure when it buys or sells
foreign currencies or financial instruments denominated in a foreign currency.
The Company's foreign transactions are primarily denominated in Canadian
dollars.
Sensitivity Analysis
The following analysis illustrates the sensitivity of the market value of the
Company's financial instruments to selected changes in market rates and prices.
The range of changes selected reflects the Company's view of reasonably possible
market movements over a one-year period. The range of values selected should not
be interpreted as the Company's prediction of future market events, but rather
an illustration of the impact of such events.
The analysis assumes that the composition of the Company's interest rate
sensitive assets and liabilities existing at the beginning of the period remains
constant over the period being measured and also assumes that a particular
change in interest rates is reflected uniformly across the yield curve
regardless of the time to maturity. Also, the interest rates on certain types of
assets and liabilities may fluctuate in advance of changes in market interest
rates, while interest rates on other types may lag behind changes in market
rates. Accordingly, the analysis may not be indicative of, is not intended to
provide and does not provide a precise forecast of the effect of changes of
market interest rates on the Company's income or stockholders' equity. Further,
the computations do not contemplate any actions the Company would undertake in
response to changes in interest rates.
The sensitivity analysis assumes an instantaneous shift in market interest
rates, with scenarios of interest rates increasing and decreasing 100 and 150
basis points from their levels at December 31, 1999 and 1998 with all other
variables held constant. The analysis assumes the yield to worst methodology. A
100 and 150 basis point increase in the market interest rates would result in a
pre-tax decrease in the net financial instrument position of $50.1 and $38.1
million for 1999 and 1998 and $67.4 and $55.1 million for 1999 and 1998,
respectively. Similarly, a 100 and 150 basis point decrease in market interest
rates would result in a pre-tax increase in the net financial instrument
position of $50.1 and $38.1 million for 1999 and 1998 and $67.4 and $55.1
million for 1999 and 1998, respectively.
Portfolio sensitivity to these variables tends to change over time due to
changes in portfolio composition and changes in market environment. For the
fixed maturity portfolio, sensitivity, as measured by duration, increased from
5.48 at December 31, 1998 to 8.37 at December 31, 1999. This increase in
duration is due primarily to changes that occurred in the interest rate
environment during the period. The Company uses a yield to worst methodology to
calculate duration. This assumes that an issuer, given the current rate
environment, will call higher coupon debt if appropriate. As interest rates
increased during the year, the call feature on many issues became
non-applicable. This change in the environment caused portfolio duration to
increase and a corresponding increase in sensitivity to interest rates.
The Company's long-term debt and convertible capital securities have been issued
at fixed rates, and as such, interest expense would not be impacted by interest
rate shifts. The impact of 100 and 150 basis point increases in interest rates
on the fixed rate debt would result in a decrease in the market value of the
debt by $0.3 million in 1999 and 1998 and $0.5 million in 1999 and 1998. The
effect of 100 and 150 basis point increases in interest rates on the $300
million convertible capital securities would result in an estimated market value
of $247.6 and $296.4 million in 1999 and 1998, and $237.0 and $289.4 million in
1999 and 1998, respectively, and is calculated without giving any effect to the
relationship of the conversion price to the current market price of HSB Group,
Inc. common stock. The impact of 100 and 150 basis point
37
increases in interest rates on the variable rate capital securities would result
in an additional charge to pre-tax income of $1.1 million in 1999 and 1998 and
$1.6 million in 1999 and 1998, respectively, per year. A 100 and 150 basis point
decrease in interest rates would increase pre-tax income by $1.1 million in 1999
and 1998 and $1.6 million in 1999 and 1998, respectively, per year.
Equity price risk was measured assuming an instantaneous 10 percent and 25
percent change in the S&P 500 Index from its level at December 31, 1999 and 1998
with all other variables held constant. The Company's equity holdings (comprised
of common stocks and non-redeemable preferreds) were assumed to be 100 percent
correlated to this index. A 10 percent and 25 percent increase or decrease in
the S&P 500 Index would result in a $21.4 and $24.9 million increase or decrease
in 1999 and 1998 and $53.4 and $62.4 million increase or decrease in 1999 and
1998, respectively, in the net financial instrument position. The Company's
equity instruments' sensitivity to equity market risk, as measured by portfolio
beta, decreased from 1.02 at December 31, 1998 to 0.98 at December 31, 1999.
This change is generally attributed to portfolio repositioning during the
period.
The sensitivity analysis also assumes an instantaneous 10 percent and 20 percent
change in the foreign currency exchange rates versus the U.S. dollar from their
levels at December 31, 1999 and 1998 with all other variables held constant. A
10 percent and 20 percent strengthening of the U.S. dollar would result in
decreases of $6.1 and $6.4 million in 1999 and 1998 and $12.2 and $12.4 million
in 1999 and 1998, respectively, in the net financial instrument position.
Weakening of the U.S. dollar versus all other currencies would result in like
increases in the net financial instrument position.
The following table reflects the estimated effects on the market value of the
Company's financial instruments due to an increase in interest rates of 100
basis points, a 10 percent decline in the S&P 500 Index and a decline of 10
percent in foreign currency exchange rates.
Held For Other Than Trading Purposes
Market Interest Currency Equity
At December 31, 1999 Value Rate Risk Risk Risk
- --------------------------------------------------------------------------
Fixed maturity
securities $ 489.8 $ (37.3) $ (2.6) $ --
Equity securities 381.8 (12.1) (2.0) (21.4)
Short-term investments 53.5 (0.7) (1.5) --
----------------------------------------------
Total all securities $ 925.1 $ (50.1) $ (6.1) $ (21.4)
- --------------------------------------------------------------------------
Held For Other Than Trading Purposes
Market Interest Currency Equity
At December 31, 1998 Value Rate Risk Risk Risk
- -------------------------------------------------------------------------
Fixed maturity
securities $ 577.1 $ (27.1) $ (2.1) $ --
Equity securities 437.1 (10.1) (1.9) (24.9)
Short-term investments 62.3 (0.9) (2.4) --
--------------------------------------------
Total all securities $1,076.5 $ (38.1) $ (6.4) $ (24.9)
- --------------------------------------------------------------------------
The following table reflects the estimated effects on the market value of the
Company's financial instruments due to an increase in interest rates of 150
basis points, a 25 percent decline in the S&P 500 Index and a decline of 20
percent in foreign currency exchange rates.
38
Held For Other Than Trading Purposes
Market Interest Currency Equity
At December 31, 1999 Value Rate Risk Risk Risk
- -------------------------------------------------------------------------
Fixed maturity
securities $ 489.8 $ (49.1) $ (5.2) $ --
Equity securities 381.8 (17.2) (4.1) (53.4)
Short-term investments 53.5 (1.1) (2.9) --
---------------------------------------------
Total all securities $ 925.1 $ (67.4) $ (12.2) $ (53.4)
- --------------------------------------------------------------------------
Held For Other Than Trading Purposes
Market Interest Currency Equity
At December 31, 1998 Value Rate Risk Risk Risk
- -------------------------------------------------------------------------
Fixed maturity
securities $ 577.1 $ (39.4) $ (4.2) $ --
Equity securities 437.1 (14.4) (3.7) (62.4)
Short-term investments 62.3 (1.3) (4.5) --
--------------------------------------------
Total all securities $1,076.5 $ (55.1) $ (12.4) $ (62.4)
- --------------------------------------------------------------------------
Statement of Comprehensive Income
In addition to the impact of HSB's results of operations, the Consolidated
Statements of Comprehensive Income display the effects of price movements on
HSB's invested assets. In 1999, the impact of rising interest rates on the
carrying values of the Company's fixed income investments more than offset the
strong performance of its common equities such that 1999 cumulative holding
gains, net of taxes, decreased $45.2 million as compared to the increase of
$28.1 million in 1998 and $21.3 million in 1997.
Liquidity and Capital Resources
At December 31, 1999 1998
- ------------------------------------------------------------------------
Total assets $2,263.2 $2,138.6
Short-term investments 53.5 62.3
Cash and cash equivalents 73.0 18.3
Short-term borrowings 41.5 21.0
Long-term borrowings 25.1 25.1
Capital securities of subsidiary Trust I 109.0 108.9
Capital securities of subsidiary Trust II 300.0 300.0
Common shareholders' equity $ 376.5 $ 419.3
- ------------------------------------------------------------------------
Liquidity refers to the Company's ability to generate sufficient funds to meet
the cash requirements of its business operations and financing obligations. HSB
is a holding company whose principal subsidiary is HSBIIC. HSB relies on
investment income, primarily in the form of dividends from HSBIIC, in order to
meet its short and long-term liquidity requirements including the service
requirements for its capital securities. The Company receives a regular inflow
of cash from maturing investments, engineering services and insurance
operations. The mix of the investment portfolio is managed to respond to
expected claim pay-out patterns and the service requirements of the Company's
capital securities. HSB also maintains cash equivalents and a highly liquid
short-term portfolio to provide for immediate cash needs and to offset a portion
of interest rate risk relating to $110 million of Global Floating Rate Capital
Securities. During 1999, HSB received $152.7 million in dividends from HSBIIC
and at December 31, 1999 the holding company had $143.2 million of cash and
invested assets as compared to $92.8 million at December 31, 1998. Current
estimates are that HSBIIC has the capacity to dividend to HSB approximately $80
million in 2000 without regulatory approval.
39
On July 15, 1997, a trust sponsored and wholly owned by the Company issued $110
million aggregate liquidation amount of capital securities in a private
placement and 3,403 shares of common securities to the Company, the proceeds of
which were invested by the trust in $113.4 million aggregate principal amount of
the Company's debt securities. On November 5, 1997, an exchange offer was
commenced, pursuant to which the capital securities originally issued in the
private placement were exchanged for capital securities that were registered
with the Securities and Exchange Commission (the Capital Securities) and the
debt securities were exchanged for debt securities that were registered with the
Securities and Exchange Commission (the Debt Securities).
The Debt Securities represent all of the assets of the trust. The proceeds from
the issuance of the Debt Securities were used by the Company for general
corporate purposes. The Debt Securities and related income statement effects are
eliminated in the Company's consolidated financial statements. The $113.4
million principal amount of Debt Securities accrue and pay cash distributions
quarterly in arrears at a variable rate equal to the 90 day LIBOR plus 0.91
percent of the stated liquidation amount of $1,000 per Debt Security and are
scheduled to mature on July 15, 2027.
The Capital Securities accrue and pay cash distributions quarterly in arrears at
a variable rate equal to the 90 day LIBOR plus 0.91 percent of the stated
liquidation amount of $1,000 per Capital Security. The current coupon is 7.1
percent. HSB has the right to defer payment of distributions on the securities
at any time or from time to time for a period not exceeding 20 consecutive
quarterly periods with respect to each deferral period. During an extension
period, interest will continue to accrue and the amount of distributions to
which holders of the Capital Securities are entitled will accumulate, and the
Company will be prohibited from paying any cash dividends on its common stock.
The Capital Securities are generally non-callable for ten years, but may be
called earlier by HSB upon the occurrence of certain tax events including loss
of deductibility of interest on the securities. The Capital Securities are
mandatorily redeemable upon the maturity of the Debt Securities on July 15,
2027, or earlier to the extent of any redemption by the Company of any Debt
Securities. The redemption price in either such case will be $1,000 per share
plus accrued and unpaid distributions to the date fixed for redemption.
The terms of the Debt Securities, the guarantee of the Company with respect to
the Capital Securities, the Indenture and the Trust Agreement together provide a
full guarantee of amounts due on the Capital Securities. The Capital Securities
are currently rated BBB- by Standard & Poor's and BBB+ by Duff & Phelps credit
rating agencies.
On December 31, 1997, HSB Group, Inc. sold $300 million of 20 year Convertible
Capital Securities in a private placement to ERC. The Convertible Capital
Securities are callable by the Company at its option (i) at any time after seven
years; (ii) upon the occurrence of certain tax events including loss of
deductibility of the interest on the securities; (iii) in the event that HSB
vetoes a prospective purchaser of the Convertible Capital Securities; or (iv) in
the event of a change in control of ERC. The Convertible Capital Securities are
mandatorily redeemable on December 31, 2017 and are redeemable at par plus a
redemption premium, at the option of ERC, in the event of a change in control of
HSB within five years following issuance of the securities.
The Convertible Capital Securities are convertible, in whole or in part, at
ERC's option at any time, subject to regulatory approval, into shares of HSB
common stock at a conversion price of $56.67 per share, subject to adjustment.
HSB has provided certain registration rights to ERC in connection with the
common stock into which the Convertible Capital Securities are convertible
pursuant to a Registration Rights Agreement dated December 31, 1997. If ERC were
to exercise its conversion rights in total, it would hold at December 31, 1999,
on a fully diluted basis, approximately 15.4 percent of HSB's common stock.
Pursuant to certain provisions contained in the Purchase Agreement dated
December 31, 1997, ERC has agreed to certain "standstill" arrangements which for
a period of five years will preclude ERC from purchasing any common
40
stock of HSB, other than by exercise of its conversion rights, and will limit
its ability to take certain other actions with respect to HSB during that
period.
The securities were issued through HSB Capital II (Trust II), a Delaware
business trust created by HSB, at a 7 percent coupon, payable semi-annually. The
Convertible Capital Securities rank pari passu with the Global Floating Rate
Capital Securities issued in July 1997. Holders of the Convertible Capital
Securities will be entitled to receive preferential cumulative cash
distributions accumulating from the date of original issuance and payable
semi-annually in arrears. HSB has the right to defer payment of interest at any
time or from time to time for a period not exceeding 10 consecutive semi-annual
periods with respect to each deferral period. During an extension period,
interest will continue to accrue and the amount of distributions to which
holders of the Convertible Capital Securities are entitled will accumulate, and
HSB will be prohibited from paying any cash dividends on its common stock. HSB
has irrevocably and unconditionally guaranteed all of Trust II's obligations
under the Convertible Capital Securities.
Cash provided from operations decreased to $43.2 million in 1999 as compared to
$55.6 million in 1998. The decrease was primarily attributable to a $22 million
decline in net cash flows from HSBIIC's participation in HSB Industrial Risk
Insurers, offset by an increase in insurance operating cash flows. Net cash
flows from HSB Industrial Risk Insurers were favorably impacted by a $27 million
accelerated collection of receivables pursuant to the termination of certain
reinsurance agreements between HSBIIC, ERC and IRI, as previously discussed.
Operating cash flows from insurance, excluding HSB Industrial Risk Insurers,
were positively impacted by a decline in net claims paid of 10.3 percent, as
well as, a decrease in payments to reinsurers for ceded premiums of 9.1 percent
offset by a decrease in premiums collected of 5.5 percent.
Cash provided from operations increased $29.5 million in 1998 as compared to
1997. Insurance operations cash flows, excluding HSB Industrial Risk Insurers,
were impacted by a decline in net claims paid of 2.9 percent while premiums
collected increased 6.5 percent. Payments to reinsurers for ceded premiums
increased 70.5 percent from 1997. HSBIIC's participation in HSB Industrial Risk
Insurers positively impacted cash flow from operations $35.3 million.
Capital resources consist of shareholders' equity, capital securities and debt
outstanding and represent those funds deployed, or available to be deployed, to
support business operations. Common shareholders' equity of $376.5 million at
December 31, 1999 decreased $42.8 million since December 31, 1998. The decrease
primarily reflects net income of $72.8 million and net stock issuance of $7.7
million, offset by a decrease in unrealized investment gains, net of tax, of
$69.8 million and dividends of $49.9 million. The decrease in unrealized
investment gains of $69.8 million results principally from realized gains of
$26.4 million and unrealized depreciation of fixed maturities and non-redeemable
preferreds of $63.2 million, the sum of which is offset by net unrealized
appreciation of common stocks and convertible preferreds of $18.0 million.
On January 24, 2000, the Board renewed the authorization to repurchase up to 3
million shares of common stock. HSB repurchased approximately 0.1, 1.2 and 1.5
million shares at a cost of $4.4, $47.7 and $54.0 million during 1999, 1998 and
1997, respectively.
At December 31, 1999, HSBIIC had significant short-term borrowing capacity.
HSBIIC is currently authorized to issue up to $75 million of commercial paper.
Commercial paper outstanding at December 31, 1999 and 1998 was $38.6 and $20.0
million, respectively. The weighted-average interest rate was 6.0 percent and
5.2 percent at December 31, 1999 and 1998, respectively. In 1999, Standard &
Poor's and Duff & Phelps credit rating services reaffirmed their highest ratings
for the commercial paper.
The Company writes business in European markets primarily through its U.K.
subsidiary, EIL. The adoption of a common currency (the euro) by eleven of the
fifteen member countries of the European Union on January 1, 1999 did not result
in a substantial change in the business or a significant increase in costs. In
part, this is due to the fact that much of EIL's business is U.S. dollar
denominated. Also, the U.K. is not a
41
first wave euro country. The Company will continue to monitor developments and
assess impacts on markets, pricing and reporting.
Year 2000
In 1996, the Company began a comprehensive effort to assess and address issues
affecting the Company, which related to the inability of computer equipment and
embedded computer chips to distinguish between the year 1900 and the year 2000.
Year 2000 problems could result in system failures, product failures or
miscalculations causing disruptions of operations. If the computer systems,
software products and devices do not correctly process dates after December 31,
1999, business could be adversely affected.
As a part of this effort, the Company established a Year 2000 Program to address
four key areas: (i) applications software, primarily consisting of the Company's
policy management, claims, financial recording and reporting, human resource
systems and engineering databases and systems; (ii) infrastructures, such as
mainframe and corporate servers, workstations and networking components; (iii)
embedded technology in facilities in which the Company conducts its operations
and in testing equipment used by the Company's engineering staff; and (iv) key
business partners and suppliers. In addition, the Company has evaluated and
continues to evaluate its potential insurance coverage exposures arising out of
the Year 2000 and its impact on insured equipment.
The Company has completed all stages of its Year 2000 Program: (i) assessment
and analysis; (ii) development, renovation and replacement; (iii)
implementation; (iv) testing and validation; (v) contingency planning; and (vi)
audit and review.
The Company continues to monitor information systems and transaction processing
with the objective of identifying and correcting any undetected errors of
omission or commission which may have occurred in the execution of its Year 2000
Program.
Subsequent to January 1, 2000, HSB has not encountered any disruptions or
anomalies that affected any critical internal system nor experienced any
material disruption in its business due to the inability of any of its key
business partners and suppliers to deliver information and services due to Year
2000 problems.
Costs
The Company's aggregate spending in connection with the Year 2000 Program was
approximately $28 million. Certain of these costs were expensed as incurred and
funded through operating cash flow. The Company has expensed $6.9, $5.1 and $1.5
million in 1999, 1998 and 1997, respectively. The remainder of the $28 million
related to systems that the Company anticipated replacing in the normal course
of information technology development but the timetable for which was
accelerated in contemplation of the Year 2000 event. Costs of replacement of
information systems and infrastructure that would have occurred in the normal
course of business without the advent of the Year 2000 event are excluded from
these expensed amounts.
Insurance Coverage Issues
The Company continues to evaluate the potential coverage exposures arising out
of the Year 2000 event and its impact on insured equipment. The Company had
filed with the various jurisdictions an endorsement to its equipment breakdown
forms which reiterated that coverage was not provided for the inherent inability
of computers and computerized equipment to properly recognize a particular date
or time, such as the year 2000. The endorsement was included in policies in all
states that approved the endorsement. In the four jurisdictions that did not
approve the endorsement, a notice reiterating the Company's coverage intent with
respect to Year 2000 exposures was sent to policyholders. The Company filed a
similar endorsement for use with its all-risk policy. Many of the insurers that
the Company reinsures for equipment breakdown coverage issued similar
endorsements to their policies.
42
Although reported claim activity has been negligible at this time,
quantification of the Company's exposure to Year 2000 losses and loss adjustment
expenses are not reasonably estimable as applicable policy and reinsurance
contract wordings have not been legally tested in the context of such losses.
Forward-Looking Statements
Certain statements contained in this report are forward-looking and are based on
management's current expectations. Actual results may differ materially from
such expectations depending on the outcome of certain factors described with
such forward-looking statements and other factors including: significant natural
disasters and severe weather conditions; changes in interest rates and the
performance of the financial markets; changes in the availability, cost and
collectibility of reinsurance; changes in domestic and foreign laws, regulations
and taxes, in particular the passage of financial services reform legislation;
the entry of new or stronger competitors and the intensification of pricing
competition; the loss of current customers or the inability to obtain new
customers; changes in the coverage terms selected by insurance customers,
including higher deductibles and lower limits; the adequacy of loss reserves;
changes in asset valuations; consolidation and restructuring in the insurance
industry; changes in the Company's participation in joint underwriting
associations, and in particular its new agreement with IRI; changes in the
demand and customer base for engineering and inspection services offered by the
Company, whether resulting from changes in the law or otherwise and other
general market conditions.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk.
See "Market Risk" in Management's Discussion and Analysis of Consolidated
Financial Condition and Results of Operations in Item 7.
Item 8. Financial Statements and Supplementary Data.
INDEX TO FINANCIAL STATEMENTS
AND FINANCIAL STATEMENT SCHEDULES
Page No.
Report of Independent Accountants 45
Financial Statements 46
Consolidated Statements of Operations
for the years ended December 31, 1999,
1998 and 1997. 46
Consolidated Statements of Comprehensive Income
for the years ended December 31, 1999,
1998 and 1997. 47
Consolidated Statements of Financial Position -
December 31, 1999 and 1998. 48
Consolidated Statements of Cash Flows
for the years ended December 31, 1999,
1998 and 1997. 49
43
Consolidated Statements of Changes in
Shareholders' Equity for the years ended
December 31, 1999, 1998 and 1997. 51
Notes to Consolidated Financial Statements 52
Schedule I - Summary of investments-
other than investments in related parties 77
Schedule II - Condensed Financial Information of
HSB Group, Inc. 78
Schedule III - Supplementary Insurance Information 81
Schedule IV - Reinsurance 82
Schedule V - Valuation and Qualifying Accounts 83
Schedule VI - Supplemental Information Concerning
Property-Casualty Insurance Operations 84
Schedules other than the ones listed above are omitted for the reason that they
are not required or are not applicable or the required information is shown in
the financial statements or notes thereto.
44
REPORT OF INDEPENDENT ACCOUNTANTS
To the Shareholders and Board of Directors of HSB Group, Inc.:
In our opinion, the consolidated financial statements listed in the accompanying
index present fairly, in all material respects, the financial position of HSB
Group, Inc. and its subsidiaries at December 31, 1999 and 1998, and the results
of their operations and their cash flows for each of the three years in the
period ended December 31, 1999, in conformity with generally accepted accounting
principles. In addition, in our opinion, the financial statement schedules
listed in the accompanying index present fairly, in all material respects, the
information set forth therein when read in conjunction with the related
consolidated financial statements. These financial statements and financial
statement schedules are the responsibility of the Company's management; our
responsibility is to express an opinion on these financial statements and
financial statement schedules based on our audits. We conducted our audits of
these statements in accordance with generally accepted auditing standards which
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for the opinion expressed above.
PricewaterhouseCoopers LLP
Hartford, Connecticut
January 24, 2000
45
Financial Statements
Consolidated Statements of Operations
For the years ended December 31, (in millions, except per share amounts)
1999 1998 1997
- -------------------------------------------------------------------------------------------------
Revenues:
Gross earned premiums $ 823.8 $ 770.5 $ 609.3
Ceded premiums 441.9 374.4 118.1
-------------------------------------
Insurance premiums 381.9 396.1 491.2
Engineering services 119.6 93.5 61.3
Net investment income 64.1 64.2 36.8
Realized investment gains 40.6 25.4 14.1
-------------------------------------
Total revenues 606.2 579.2 603.4
-------------------------------------
Expenses:
Claims and adjustment 165.8 174.9 217.9
Policy acquisition 89.2 66.3 90.7
Underwriting and inspection 105.6 113.7 142.8
Engineering services 116.6 86.2 57.0
Interest 2.3 0.8 1.3
-------------------------------------
Total expenses 479.5 441.9 509.7
-------------------------------------
Gain on sale of IRI -- 36.6 --
Income from continuing operations before income taxes
and distributions on capital securities 126.7 173.9 93.7
Income taxes:
Current 35.1 45.0 23.8
Deferred 0.6 6.4 1.3
-------------------------------------
Total income taxes 35.7 51.4 25.1
-------------------------------------
Distributions on capital securities of subsidiary trusts,
net of income tax benefits of $9.8; $9.9; and $1.2 18.2 18.4 2.3
-------------------------------------
Income from continuing operations 72.8 104.1 66.3
-------------------------------------
Discontinued operations:
Loss from operations, net of income tax
benefits of $-; $3.2; and $0.1 -- (6.6) --
Gain on disposal, net of income taxes
of $-; $23.7; and $- -- 36.9 --
-------------------------------------
Total discontinued operations -- 30.3 --
-------------------------------------
Net income $ 72.8 $ 134.4 $ 66.3
-------------------------------------
Earnings per common share - basic:
Income from continuing operations $ 2.51 $ 3.55 $ 2.21
Discontinued operations -- 1.04 --
-------------------------------------
Net income $ 2.51 $ 4.59 $ 2.21
-------------------------------------
Weighted-average common shares outstanding 29.0 29.3 29.5
Earnings per common share - assuming dilution:
Income from continuing operations $ 2.50 $ 3.35 $ 2.20
Discontinued operations -- 0.86 --
-------------------------------------
Net income $ 2.50 $ 4.21 $ 2.20
-------------------------------------
Diluted weighted-average common shares outstanding 34.6 35.2 30.2
- --------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
46
Consolidated Statements of Comprehensive Income
For the years ended December 31, (in millions)
1999 1998 1997
- -------------------------------------------------------------------------------------------------------------
Net income: $ 72.8 $ 134.4 $ 66.3
Other comprehensive income, net of tax:
Unrealized (losses) gains on securities:
Unrealized holding (losses) gains arising
during the period,net of income (benefit)
taxes of $(24.5); $16.6; and $15.7 (45.2) 28.1 21.3
Add: reclassification adjustments for gains
included in net income (26.4) (16.0) (13.5)
-------------------------------------
Total unrealized (losses) gains on securities (71.6) 12.1 7.8
Minimum pension liability adjustments, net of income taxes 1.1 (0.1) (0.3)
Foreign currency translation adjustments, net of income taxes 1.8 (1.1) (0.8)
-------------------------------------
Other comprehensive (loss) income (68.7) 10.9 6.7
-------------------------------------
Comprehensive income $ 4.1 $ 145.3 $ 73.0
- -------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
47
Consolidated Statements of Financial Position
At December 31, (in millions, except per share amounts)
1999 1998
- --------------------------------------------------------------------------------
Assets:
Cash and cash equivalents $ 73.0 $ 18.3
Short-term investments, at cost 53.5 62.3
Fixed maturities, at fair value
(cost - $545.7; $568.5) 489.8 577.1
Equity securities, at fair value
(cost - $316.5; $326.3) 381.8 437.1
--------------------------
Total cash and invested assets 998.1 1,094.8
Reinsurance assets 850.3 625.0
Insurance premiums receivable 104.4 146.7
Engineering services receivable 39.1 26.1
Fixed assets 58.2 54.9
Prepaid acquisition costs 52.9 46.6
Capital lease 13.8 14.6
Other assets 146.4 129.9
--------------------------
Total assets $ 2,263.2 $ 2,138.6
--------------------------
Liabilities:
Unearned insurance premiums $ 420.1 $ 464.6
Claims and adjustment expenses 782.3 558.2
Short-term borrowings 41.5 21.0
Long-term borrowings 25.1 25.1
Capital lease 27.8 27.9
Deferred income taxes 2.8 42.7
Dividends and distributions
on capital securities 24.0 23.2
Ceded reinsurance payable 66.3 64.1
Other liabilities 87.8 83.6
--------------------------
Total liabilities 1,477.7 1,310.4
--------------------------
Company obligated mandatorily redeemable
capital securities of subsidiary Trust
I holding solely junior subordinated
deferrable interest debentures
of the Company, net of unamortized discount
of $1.0; $1.1 109.0 108.9
Company obligated mandatorily redeemable
convertible capital securities of
subsidiary Trust II holding solely
junior subordinated deferrable interest
debentures of the Company 300.0 300.0
Shareholders' equity:
Common stock (stated value; shares
authorized 50.0; shares issued and
outstanding 29.1; 28.9) 10.0 10.0
Additional paid-in capital 36.2 33.5
Accumulated other comprehensive income (1.9) 66.8
Retained earnings 339.1 311.2
Benefit plans (6.9) (2.2)
--------------------------
Total shareholders' equity 376.5 419.3
--------------------------
Total $ 2,263.2 $ 2,138.6
--------------------------
Common shareholders' equity per common share $ 12.95 $ 14.53
- --------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
48
Consolidated Statements of Cash Flows
For the years ended December 31, (in millions)
1999 1998 1997
- ----------------------------------------------------------------------------------------------------------
Operating activities:
Net income $ 72.8 $ 134.4 $ 66.3
Adjustments to reconcile net income to
cash provided by operating activities:
Depreciation and amortization 20.9 15.9 9.5
Deferred income taxes 0.6 6.4 1.3
Realized investment gains, including
market adjustments for collar contracts (40.6) (25.4) (14.1)
Distributions on capital securities 28.0 28.3 3.5
Gain from disposition of Radian,
net of income taxes -- (30.3) --
Gain from disposition of IRI,
net of income taxes -- (23.8) --
Change in balances, net of effects
from purchases and sales of subsidiaries:
Insurance premiums receivable 42.3 (8.7) (31.6)
Engineering services receivable (9.6) (11.2) (0.5)
Prepaid acquisition costs (6.3) (4.1) (4.9)
Reinsurance assets (225.3) (500.5) 38.4
Unearned insurance premiums (44.5) 177.3 19.7
Ceded reinsurance payable 2.2 60.2 (1.5)
Claims and adjustment expenses 224.1 281.5 (26.2)
Investment in Radian -- -- (3.7)
Other (21.4) (44.4) (30.1)
-----------------------------------------
Cash provided by operating activities 43.2 55.6 26.1
-----------------------------------------
Investing activities:
Fixed asset additions, net (13.3) (20.8) (10.4)
Investments:
Sale (purchase) of short-term investments, net 8.8 69.0 (78.7)
Purchase of fixed maturities (186.7) (423.5) (60.6)
Proceeds from sale of fixed maturities 192.5 66.5 27.9
Redemption of fixed maturities 19.2 30.8 14.4
Purchase of equity securities (304.9) (326.7) (252.9)
Proceeds from sale of equity securities 359.5 251.8 254.1
Proceeds from disposition of Radian -- 128.9 --
Proceeds from disposition of IRI -- 49.1 --
Purchase of Solomon Associates Inc.,
net of cash acquired -- (2.1) --
Purchase of Kemper books of business -- (27.5) --
Purchase of Structural Integrity Associates,
Inc., net of cash acquired (5.3) -- --
Settlement of collar contracts -- -- (30.7)
-----------------------------------------
Cash provided by (used in) investment activities 69.8 (204.5) (136.9)
-----------------------------------------
Financing activities:
Proceeds from Company obligated mandatorily redeemable
capital securities of subsidiary Trust I -- -- 108.9
Proceeds from Company obligated mandatorily redeemable
convertible capital securities of subsidiary Trust II -- -- 300.0
Increase (decrease) in short-term borrowings 19.2 (21.4) 39.1
Dividends and distribution on capital securities (77.1) (66.2) (46.7)
Reacquisition of stock (4.4) (47.7) (54.0)
Exercise of stock options 4.0 9.3 7.0
-----------------------------------------
Cash (used in) provided by financing activities (58.3) (126.0) 354.3
-----------------------------------------
Net increase (decrease) in cash and cash equivalents 54.7 (274.9) 243.5
Cash and cash equivalents at beginning of period 18.3 293.2 49.7
-----------------------------------------
Cash and cash equivalents at end of period $ 73.0 $ 18.3 $ 293.2
-----------------------------------------
Interest paid $ 4.1 $ 2.5 $ 3.2
-----------------------------------------
Federal income tax paid $ 28.3 $ 52.4 $ 33.8
-----------------------------------------
49
Non-cash investing and financing activities:
Conversion of HSB convertible preferred stock into HSB common stock in 1997 and
issuance of HSB common stock in connection with the acquisition of Solomon
Associates, Inc. in 1998 (see note 3).
- --------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
50
Consolidated Statements of Changes in Shareholders' Equity
For the years ended December 31, (in millions)
Total Accumulated
Share- Additional Other
holders' Common Paid-in Comprehensive Retained Benefit
Equity Stock Capital Income Earnings Plans
- ----------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1996 $ 345.6 $ 10.0 $ 32.0 $ 49.2 $ 255.1 $ (0.7)
- ----------------------------------------------------------------------------------------------------------------------------
Net income 66.3 -- -- -- 66.3 --
Dividends declared (47.0) -- -- -- (47.0) --
Change in accumulated other
comprehensive income, net of tax 6.7 -- -- 6.7 -- --
Benefit plans (0.3) -- -- -- -- (0.3)
Reacquisition of stock (54.0) -- (1.8) -- (52.2) --
Conversion of redeemable preferred stock 20.0 -- 0.7 -- 19.3 --
Exercise of stock options 7.0 -- 0.5 -- 6.5 --
Issuance of reacquired stock,
net of forfeitures 1.0 -- 0.2 -- 0.8 --
- -----------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1997 $ 345.3 $ 10.0 $ 31.6 $ 55.9 $ 248.8 $ (1.0)
- -----------------------------------------------------------------------------------------------------------------------------
Net income 134.4 -- -- -- 134.4 --
Dividends declared (47.9) -- -- -- (47.9) --
Change in accumulated other
comprehensive income, net of tax 10.9 -- -- 10.9 -- --
Benefit plans (1.2) -- -- -- -- (1.2)
Reacquisition of stock (47.7) -- (5.0) -- (42.7) --
Exercise of stock options 9.3 -- 1.8 -- 7.5 --
Issuance of reacquired stock,
net of forfeitures 16.2 -- 5.1 -- 11.1 --
- -----------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1998 $ 419.3 $ 10.0 $ 33.5 $ 66.8 $ 311.2 $ (2.2)
- -----------------------------------------------------------------------------------------------------------------------------
Net income 72.8 -- -- -- 72.8 --
Dividends declared (49.9) -- -- -- (49.9) --
Change in accumulated other
comprehensive income, net of tax (68.7) -- -- (68.7) -- --
Benefit plans (4.7) -- -- -- -- (4.7)
Reacquisition of stock (4.4) -- (1.2) -- (3.2) --
Exercise of stock options 4.0 -- 1.5 -- 2.5 --
Issuance of reacquired stock,
net of forfeitures 8.1 -- 2.4 -- 5.7 --
- -----------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1999 $ 376.5 $ 10.0 $ 36.2 $ (1.9) $ 339.1 $ (6.9)
- -----------------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
51
Notes to Consolidated Financial Statements
(in millions, except per share amounts)
1. Accounting Policies
Consolidation
The accompanying financial statements present the consolidated accounts of HSB
Group, Inc. and its subsidiaries (collectively, HSB or the Company) and are
prepared in accordance with Generally Accepted Accounting Principles (GAAP)
within the U.S. Significant intercompany transactions and balances have been
eliminated in consolidation. The preparation of financial statements in
accordance with GAAP requires the use of estimates in reporting certain assets
and liabilities. Actual results could differ from those estimates. Certain
amounts for 1998 and 1997 have been reclassified to conform with the 1999
presentation.
Insurance
Insurance premium revenues are net of reinsurance ceded and are generally earned
on a pro rata basis over the contract period. The portion of gross insurance
premiums not earned at the end of the period is recorded as unearned insurance
premiums on the Consolidated Statements of Financial Position.
Prepaid acquisition costs, consisting principally of commissions, premium taxes
and certain underwriting expenses are amortized as the related insurance
premiums are earned. Unearned ceded commissions arising from certain reinsurance
transactions are netted in prepaid acquisition costs. All other acquisition
costs are charged to operations as incurred.
Liabilities for claims and adjustment expenses for boiler and machinery,
property and other coverages represent estimated reserves on claims and
adjustment expenses reported but not yet settled and the cost of claims and
adjustment expenses incurred but not yet reported. Reserves for claims and
adjustment expenses are undiscounted and are gross of amounts recoverable from
reinsurers. Reserves are reduced for estimated amounts of salvage and
subrogation and deductibles from customers. HSB records subrogation when
recoverability is probable, such as when a judgment is returned, liability is
admitted or settlement is reached. The length of time that reserves for claims
and adjustment expenses are carried on the Consolidated Statements of Financial
Position is a function of the pay-out patterns associated with the types of
coverages involved. Estimates for these reserves reflect such variables as past
loss experience, changes in judicial interpretation of legal liability, policy
coverage and inflation. The establishment of such reserves frequently requires
complex engineering judgements. Due to the nature of the variables involved in
the reserving process, subjective judgments are an integral component.
Previously estimated reserves are regularly adjusted as loss experience develops
and new information becomes available. Since reserves are based on estimates,
the ultimate liability may be more or less than such reserves. The effects of
changes in estimated reserves are included in the results of operations in the
period in which the estimates change (see note 11).
Reinsurance assets represent amounts due from reinsurers for paid and unpaid
claims, paid and unpaid loss adjustment expenses and the unearned portion of
premiums ceded through reinsurance agreements.
Engineering Services
HSB recognizes the majority of its engineering services revenues as the service
is provided. Costs on such contracts are included in operations as incurred.
Provisions are made for losses on contracts at the time such losses become
known.
52
Investments
Cash and cash equivalents include cash on hand and short-term highly liquid
investments with maturities of three months or less. Short-term investments have
a maturity of one year or less and are carried at cost which, together with
accrued interest thereon, approximates fair value. Fixed maturities include
bonds, notes and redeemable preferred stocks. Equity securities include common
and non-redeemable preferred stocks. All fixed maturities and equity securities
are classified as available for sale. Accordingly, these investments are carried
at estimated fair value. Estimated fair values of securities classified as
available for sale are based principally upon quoted market prices. Unrealized
gains and losses on investments classified as available for sale and foreign
exchange gains and losses on certain investments in foreign operations where the
U.S. dollar is not the functional currency are included net of income tax in
shareholders' equity.
Investment income is net of investment expenses. Realized investment gains and
losses are determined on the basis of costs related to those investments sold
and are recorded on the trade date. Also, included in realized investment gains
and losses are losses arising from declines in the realizable value of
investments considered to be other than temporary.
The carrying values of short-term investments, investment income accrued and
securities transactions in the course of settlement approximate their fair value
because of the relatively short period of time between origination of the
instruments and their expected realization.
Financial instruments which qualify for hedge accounting are recorded at market
with gains and losses reflected in shareholders' equity. To the extent such
instruments do not qualify for hedge accounting, related gains and losses are
reflected in results of operations.
Income Taxes
Deferred tax assets and liabilities are generally determined based on the
difference between financial statement and tax basis for certain assets and
liabilities using tax rates in effect for the year in which the differences are
expected to reverse. Deferred tax assets are allowed if future realization is
more likely than not. Deferred income taxes are provided for unrealized
appreciation/depreciation on fixed maturities and equity securities available
for sale, prepaid acquisition costs, loss reserve discounting, unearned
premiums, certain employee benefit costs and other items which are the result of
temporary differences in the treatment of such items for tax and financial
statement purposes (see note 12).
Fixed Assets
Fixed assets include real and personal property and certain eligible capitalized
system development costs. Fixed assets are carried at cost less accumulated
depreciation and amortization. Depreciation and amortization is calculated on
the basis of estimated useful lives using straight-line and accelerated methods.
Upon retirement or replacement, any gain or loss is included in results of
operations.
Goodwill and Other Intangible Assets
Goodwill represents the cost of acquiring a business which is in excess of the
fair value of its net assets. Goodwill is generally amortized over 3 to 20 years
and other intangible assets over their estimated useful lives. These assets are
included in other assets on the Consolidated Statements of Financial Position
and amounted to $56.7 and $57.7 million (net of accumulated amortization of
$12.5 and $5.5 million) at December 31, 1999 and 1998, respectively. HSB
evaluates the realizability of goodwill based upon projections of undiscounted
cash flows.
53
2. Changes in Accounting Principles
The Accounting Standards Executive Committee of the American Institute of
Certified Public Accountants (AcSEC) issued three Statements of Position (SOPs)
that became effective for fiscal years beginning after December 15, 1998: SOP
97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related
Assessments," SOP 98-1, "Accounting for the Costs of Computer Software Developed
or Obtained for Internal Use" and SOP 98-5, "Reporting on the Costs of Start-Up
Activities." Because the Company's accounting policies were already in
compliance with these SOPs, the implementation of these statements had no impact
upon the results of operations, financial condition or cash flows.
In June 1998, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative
Instruments and Hedging Activities" subsequently amended by SFAS No. 137. This
statement establishes accounting and reporting standards for derivative
instruments, including certain derivative instruments embedded in other
contracts and for hedging activities. It requires that all derivatives be
recognized as either assets or liabilities in the statement of financial
position and that such instruments be measured at fair value. In addition, all
hedging relationships must be designated, reassessed and documented pursuant to
the provisions of SFAS No. 133. This statement is effective for the Company for
the first quarter of 2001. Based on the Company's current investment policies
and practices, the Company anticipates that the adoption of the provisions of
SFAS No. 133 will not have a significant effect on results of operations,
financial condition or cash flows.
In October 1998, AcSEC issued SOP 98-7, "Deposit Accounting: Accounting for
Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk." The
SOP identifies several methods of deposit accounting and provides guidance on
the application of each method. This SOP became effective for financial
statements for fiscal years beginning after June 15, 1999. Currently the Company
is not party to any contracts that do not comply with the risk transfer
provisions of SFAS No. 113, "Accounting and Reporting for Reinsurance of
Short-Duration and Long-Duration Contracts," and, therefore, does not anticipate
the adoption of SOP 98-7 will have a material impact on results of operations,
financial condition or cash flows.
3. Corporate Activity
Acquisitions / Divestitures
Structural Integrity Associates
In July 1999, The Hartford Steam Boiler Inspection and Insurance Company
(HSBIIC) acquired Structural Integrity Associates, Inc. (Structural) based in
San Jose, California. Structural is an engineering consulting and inspection
services firm specializing in the analysis, control and prevention of structural
and equipment failures. It offers a full array of services, from inspection and
condition assessment, to monitoring and remaining life analysis, repair,
remediation and total risk management of critical equipment and structures.
HSB Industrial Risk Insurers
The reinsurance agreements effective January 1, 1998 between HSBIIC, Employers
Reinsurance Corporation (ERC) and Industrial Risk Insurers (IRI), as discussed
below, were terminated with respect to loss or liabilities arising out of
occurrences taking place on or after January 1, 2000. As a result, HSBIIC will
no longer retain 85 percent of the equipment breakdown insurance and 15 percent
of the property insurance of the combined insurance portfolio for risks arising
on or after January 1, 2000. The joint underwriting association that was known
as HSB Industrial Risk Insurers will, from January 1, 2000, be known as
Industrial Risk Insurers (IRI).
54
Concurrent with the termination of the reinsurance agreements, HSBIIC, ERC and
IRI replaced the operating agreement dated January 1, 1998. The new agreement,
effective January 1, 2000, calls for HSBIIC to retain 0.5 percent membership
share in IRI with the ability to increase its total share up to a maximum of 10
percent, at no cost, at HSBIIC's option. In addition, the agreement also
establishes an arrangement for HSB to perform engineering and inspection
services for clients of IRI and provides for a fixed fronting fee in the event
that IRI continues to use HSBIIC's licenses. HSBIIC received payments of $27
million in December 1999 related to the partial settlement of unearned
reinsurance premiums and ceding commissions due to HSBIIC under the agreement.
Final settlement is expected to occur in the second half of 2000.
On January 6, 1998, HSBIIC sold its interest in IRI to ERC in accordance with a
previously announced purchase and sale agreement between ERC and IRI's
twenty-three member insurers. HSBIIC received gross proceeds of $49.1 million,
prior to transaction costs, for its 23.5 percent share in IRI. The gain on the
sale of IRI was $36.6 million pre-tax and $23.8 million after-tax. Because the
sale was structured in part as a reinsurance transaction, a portion of HSBIIC's
gross proceeds was utilized to reinsure in-force policies with ERC.
IRI is an unincorporated, voluntary joint underwriting association which
provides property insurance for the class of business known as Highly Protected
Risks (HPR) for larger manufacturing, processing and industrial businesses,
which have invested in protection against loss through the use of sprinklers and
other means. IRI primarily writes policies on a syndicate basis that specifies
to the insured the percentage share of risk accepted by each member of the
association. Each member company, therefore, operates as a direct insurer or
reinsurer on such policies and participates in the premiums and losses generated
thereunder in proportion to its membership interest. In 1997 and 1996, HSBIIC's
membership shares were 23.5 and 14 percent respectively; in 1995 and prior the
shares were 0.5 percent.
Contemporaneous with the close of the sale, IRI was reconstituted with ERC (with
a 99.5 percent share) and HSBIIC (with a 0.5 percent share) as the sole members.
The new association had been renamed HSB Industrial Risk Insurers. In 1999 and
1998, HSBIIC wrote the business for HSB Industrial Risk Insurers using its
insurance licenses and provided certain other management and technical services.
In addition, through various quota share reinsurance agreements with ERC and HSB
Industrial Risk Insurers, HSBIIC transferred its manufacturing book of business
to HSB Industrial Risk Insurers and retained 85 percent of the equipment
breakdown insurance and 15 percent of the property insurance of the combined
insurance portfolio.
To support HSB's expanded role, on December 31, 1997, a business trust formed by
HSB sold $300 million of 20 year, 7 percent Convertible Capital Securities in a
private placement to ERC (see note 13). These capital securities are convertible
into HSB common stock, at any time, subject to regulatory approval, at a
conversion price of $56.67 per share. $250 million of the proceeds were
contributed to HSBIIC and $50 million were retained by HSB.
Radian LLC
On January 2, 1998, HSBIIC exercised its option to put its 40 percent share in
Radian International LLC (Radian LLC) to The Dow Chemical Company (Dow), for
approximately $129 million, net of expenses. Radian LLC was formed in January
1996 as a joint venture with Dow to provide environmental, engineering,
information technology, remediation and strategic chemical management services
to industries and governments worldwide. In connection with the formation of the
new company, HSBIIC contributed substantially all of the assets and liabilities
of its wholly owned subsidiary, Radian Corporation to Radian LLC. The results of
Radian LLC were classified as discontinued operations following ratification on
July 28, 1997 by HSB's Board of Directors of management's decision to exercise
its put. HSBIIC's share of Radian LLC's losses incurred subsequent to such
decision of approximately $6.6 million after-tax was deferred and recognized at
the time the gain was recognized in 1998. This transaction resulted in an
after-tax gain of approximately $36.9 million, which was recorded in the
55
first quarter of 1998. Prior to July 1997, HSBIIC's share of the joint venture's
results were recorded as equity in Radian LLC.
As of December 31, 1997, Radian LLC had assets of $159.7 million, liabilities of
$88.4 million, revenues of $288.0 million and expenses of $314.0 million. As of
December 31, 1997, HSBIIC's interest in Radian LLC was 40 percent.
Kemper
HSBIIC completed an acquisition of the monoline boiler and machinery business of
Kemper Insurance Companies (Kemper) and Kemper's ASME inspection services
business that certifies boiler and pressure vessel compliance with the codes and
standards of the American Society of Mechanical Engineers, effective July 1,
1998. The two companies also completed an agreement for HSBIIC to reinsure
boiler and machinery coverage written as part of Kemper's commercial package
policies.
Solomon Associates, Inc.
In April 1998, HSB acquired Solomon Associates, Inc. (SAI) based in Dallas,
Texas. SAI is an engineering management consulting firm that provides
comparative performance benchmarking consulting to the refining, petrochemical
and power generation industries.
Stock Split
On April 21, 1998, the Board of Directors approved a three-for-two stock split
for shares held of record on May 1, 1998. Additional shares of HSB's stock
resulting from the split were distributed on May 22, 1998. In accordance with
SFAS No. 128 "Earnings per Share" (EPS), all earnings per share presentations
have been adjusted to reflect the impact of the stock split, including
retroactive restatement of prior periods. Shares have also been restated for
comparative purposes.
Capital Securities
On July 15, 1997, HSB sold $110 million of 30 year Global Floating Rate Capital
Securities in a private placement. On December 31, 1997, HSB issued $300 million
of 20 year fixed rate Convertible Capital Securities to ERC (see note 13).
56
4. Earnings per Share
The following table presents a reconciliation of the numerator and denominator
of the calculation of basic and diluted EPS for income from continuing
operations:
1999 1998 1997
- ------------------------------------------------------------------------
Income from continuing
Operations $ 72.8 $ 104.1 $ 66.3
Dividends on preferred shares -- -- (1.1)
-----------------------------
Income applicable to
common stock 72.8 104.1 65.2
Convertible preferred stock -- -- 1.1
After-tax distributions on
convertible capital securities (1) 13.7 13.7 --
-----------------------------
Adjusted for diluted
Computation $ 86.5 $ 117.8 $ 66.3
- ------------------------------------------------------------------------
Weighted-average common
shares outstanding (2) 29.0 29.3 29.5
Convertible capital securities 5.3 5.3 --
Convertible preferred stock -- -- 0.5
Stock options (3) 0.3 0.6 0.2
-----------------------------
Adjusted for diluted
Computation 34.6 35.2 30.2
- ------------------------------------------------------------------------
From continuing operations:
Earnings per share - basic (4) $ 2.51 $ 3.55 $ 2.21
Earnings per share - assuming
Dilution $ 2.50 $ 3.35 $ 2.20
- ------------------------------------------------------------------------
(1) See note 13.
(2) Weighted-average shares reflect the repurchase of approximately 0.1, 1.2
and 1.5 million shares in 1999, 1998 and 1997, respectively.
(3) Includes the dilutive effect of stock options computed using the treasury
stock method and shares issuable under deferred stock awards (see note 15).
(4) Represents income applicable to common stock divided by weighted-average
common shares outstanding.
5. Segment Information
HSB has four reportable segments - Commercial insurance, Global Special Risks
insurance, Engineering services and Investments. HSB is a multi-national company
operating primarily in North American, European and Asian markets. Through its
Commercial segment operations, HSB provides risk modification services,
equipment breakdown insurance and loss recovery services to commercial
businesses. The Global Special Risks operating segment focuses on the needs of
equipment-intensive industries by offering all-risk coverage with customized
engineering consulting and risk management. HSB's Engineering services
operations offer professional scientific and technical consulting for industry
and government on a worldwide basis. The Company's investment assets are managed
by its Investment operating segment.
The accounting policies of the segments are the same as those described in
"Accounting Policies" (see note 1), except for certain benefit charges which
comprise the Corporate Account. HSB evaluates the performance of its
57
segments and allocates resources to them based on net income (loss). Segment
assets are not included in this evaluation process. Interest income and expense
are included in the results of Investment operations.
HSB's foreign operations (primarily insurance) are widely dispersed such that no
country or logical aggregation of countries in a geographic area comprises a
significant concentration with respect to either revenues or identifiable
assets. Export sales from HSB's domestic operations are minimal due to the
existence of the Company's foreign subsidiaries which are responsible for
virtually all of the Company's foreign sales.
The following presents financial data of the Company based on geographic
location:
For the years ended December 31, 1999 1998 1997
- --------------------------------------------------------------------------
Revenues from continuing operations:
U.S. $ 526.1 $ 491.0 $ 483.1
Non-U.S. 80.1 88.2 120.3
-----------------------------------
Total $ 606.2 $ 579.2 $ 603.4
-----------------------------------
Income from continuing operations
before taxes and distributions
on capital securities:
U.S. $ 114.7 $ 168.2 $ 78.4
Non-U.S. 12.0 5.7 15.3
----------------------------------
Total $ 126.7 $ 173.9 $ 93.7
- --------------------------------------------------------------------------
At December 31, 1999 1998 1997
- --------------------------------------------------------------------------
Identifiable assets:
U.S. $ 1,822.8 $ 1,755.9 $ 1,244.7
Non-U.S. 440.4 382.7 292.5
----------------------------------------
Total $ 2,263.2 $ 2,138.6 $ 1,537.2
- --------------------------------------------------------------------------
The following table presents revenue and net income from the Company's
reportable segments and reconciles these amounts to the corresponding
consolidated totals.
For the years ended December 31, 1999 1998 1997
- --------------------------------------------------------------------------------
Revenues from continuing operations:
Insurance premiums:
Commercial $ 335.2 $ 306.3 $ 269.0
Global Special Risks 45.6 83.6 217.1
Engineering services 119.6 93.5 61.3
Net investment income and realized
investment gains 104.7 89.6 50.9
-------------------------------
Total revenues from reportable segments 605.1 573.0 598.3
Other segments 1.1 6.2 5.1
-------------------------------
Total revenues $ 606.2 $ 579.2 $ 603.4
-------------------------------
Net income (loss):
Commercial $ 12.8 $ 14.8 $ 13.4
Global Special Risks 6.7 9.8 10.7
Engineering services 0.7 4.6 3.0
Investments 73.8 65.1 37.7
-------------------------------
Total net income from reportable segments 94.0 94.3 64.8
Other segments (1) (9.4) (0.3) (1.3)
Corporate account 6.4 4.7 5.1
Distributions on capital securities (18.2) (18.4) (2.3)
Discontinued operations -- 30.3 --
Gain on sale of IRI, net of income taxes -- 23.8 --
-------------------------------
Net income $ 72.8 $ 134.4 $ 66.3
- --------------------------------------------------------------------------------
58
(1) In 1999, other segments includes an after-tax charge of $6.5 million for
losses related to medical equipment insurance contracts.
Specified items included in the measure of net income for reportable segments
are as follows:
For the years ended December 31, 1999 1998 1997
- ------------------------------------------------------------------------------
Depreciation and amortization expense:
Commercial $ 9.9 $ 7.3 $ 3.4
Global Special Risks 2.1 2.2 3.2
Engineering services 8.1 5.9 2.7
Investments 0.4 0.3 --
Income tax expense:
Commercial 7.2 4.6 6.1
Global Special Risks 2.3 7.7 6.2
Engineering services 0.4 1.6 0.1
Investments 27.6 22.5 10.3
- ------------------------------------------------------------------------------
6. Statutory Financial Information
HSBIIC is a Connecticut domiciled insurance company which is licensed to conduct
business in all 50 states, the District of Columbia, Puerto Rico and the U.S.
Virgin Islands. The annual statements for state insurance regulatory authorities
are currently prepared using accounting methods prescribed or permitted by such
authorities (statutory basis) and are not consolidated. Statutory accounting
practices (SAP) also differ in certain other respects from GAAP. With respect to
HSBIIC, these differences are primarily comprised of the accounting for prepaid
acquisition costs, deferred income taxes, fixed maturity investments, valuation
of certain non-insurance affiliates and employee benefit plans. At December 31,
1999 and 1998, policyholders' surplus on a statutory basis was $428.8 and $612.6
million, respectively. Statutory net income, adjusted to include the earnings of
all HSBIIC domestic insurance subsidiaries for 1999, 1998 and 1997 was $81.1,
$202.5 and $42.9 million, respectively.
HSBIIC and its insurance subsidiaries are currently subject to various
regulations that limit the maximum amount of dividends available to HSBIIC's
parent company without prior approval of insurance regulatory authorities. Under
SAP, approximately $80 million of statutory surplus is available for
distribution to HSB Group, Inc. in 2000 without prior regulatory approval.
In 1998, the National Association of Insurance Commissioners (NAIC) adopted the
Codification of Statutory Accounting Principles guidance, which will replace the
current Accounting Practices and Procedures manual as the NAIC's primary
guidance on statutory accounting. The NAIC is now considering amendments to the
Codification guidance that would be effective upon implementation. The NAIC has
recommended an effective date of January 1, 2001. The Company has not estimated
the potential effect of the Codification guidance adopted by the Connecticut
Insurance Department.
59
7. Investments
For the years ended December 31, 1999 1998 1997
- -----------------------------------------------------------------------------
Income from Investment Operations:
Net investment income:
Short-term interest $ 5.0 $ 8.7 $ 6.7
Fixed maturities:
Taxable interest 24.7 31.9 9.6
Tax exempt interest 2.0 2.5 2.1
Redeemable preferred dividends 17.3 5.9 7.2
Equity securities:
Common dividends 6.5 6.4 4.7
Non-redeemable preferred dividends 15.6 14.0 8.3
Other 2.0 0.2 2.1
------------------------------
Total investment income 73.1 69.6 40.7
Investment expenses (9.0) (5.4) (3.9)
------------------------------
Net investment income $ 64.1 $ 64.2 $ 36.8
Realized investment gains (losses):
Fixed maturities:
Bonds:
Gains $ 0.3 $ 2.1 $ 0.5
Losses (1.3) (0.2) (0.3)
------------------------------
Net (losses) gains (1.0) 1.9 0.2
Redeemable preferred stocks:
Gains 0.7 2.3 0.4
Losses (2.6) (0.1) (0.3)
------------------------------
Net (losses) gains (1.9) 2.2 0.1
Equity securities:
Common stocks:
Gains 50.7 20.5 48.1
Losses (12.2) (7.0) (5.1)
------------------------------
Net gains 38.5 13.5 43.0
Non-redeemable preferred stocks:
Gains 7.8 10.3 7.7
Losses (2.8) (3.1) (0.2)
------------------------------
Net gains 5.0 7.2 7.5
Foreign exchange (losses) gains (0.1) 0.3 (7.4)
Collar contracts losses -- -- (30.7)
Other gains 0.1 0.3 1.4
------------------------------
Realized investment gains $ 40.6 $ 25.4 $ 14.1
- ---------------------------------------------------------------------------
There were no material declines in the realizable value of investments
considered to be other than temporary for 1999, 1998 and 1997.
60
At December 31, 1999 1998 1997
- -------------------------------------------------------------------------------
Unrealized Investment Gains, Net of Tax
Fixed maturities:
Gains $ 2.7 $ 13.0 $ 7.9
Losses (58.6) (4.4) (0.6)
-------------------------------
Net (losses) gains (55.9) 8.6 7.3
Equity securities:
Gains 103.7 122.9 94.3
Losses (38.4) (12.1) (1.8)
-------------------------------
Net gains 65.3 110.8 92.5
Foreign exchange losses (4.7) (6.3) (4.5)
-------------------------------
Total unrealized investment gains 4.7 113.1 95.3
Income taxes (3.7) (42.3) (35.5)
-------------------------------
Unrealized investment gains,
net of tax $ 1.0 $ 70.8 $ 59.8
- -------------------------------------------------------------------------------
Fixed Maturities
The amortized cost, estimated fair values (based principally upon quoted market
prices) and gross unrealized gains and losses of fixed maturities at December
31, were as follows:
1999
- ------------------------------------------------------------------------------
Category Amortized Estimated Gross Gross
Cost Fair Unrealized Unrealized
Value Gains Losses
- ------------------------------------------------------------------------------
Redeemable preferred stocks $214.8 $190.0 $1.6 $26.4
States and municipalities 37.7 36.6 0.6 1.7
Foreign governments 16.5 16.6 0.3 0.2
Corporate and other 276.7 246.6 0.2 30.3
---------------------------------------------
Total fixed maturities $545.7 $489.8 $2.7 $58.6
- ------------------------------------------------------------------------------
1998
- --------------------------------------------------------------------------------
Category Amortized Estimated Gross Gross
Cost Fair Unrealized Unrealized
Value Gains Losses
- -------------------------------------------------------------------------------
Redeemable preferred stocks $215.5 $219.2 $ 5.0 $1.3
States and municipalities 47.4 49.3 2.1 0.2
Foreign governments 21.0 21.3 0.4 0.1
Corporate and other 284.6 287.3 5.5 2.8
-----------------------------------------------
Total fixed maturities $568.5 $577.1 $13.0 $4.4
- -------------------------------------------------------------------------------
61
The amortized cost and estimated fair value of fixed maturities at December 31,
by contractual years-to-maturity is as follows (actual maturities may differ
from contractual maturities because borrowers may have the right to prepay
obligations):
1999
- ---------------------------------------------------------------------
Maturity Amortized Estimated
Cost Fair
Value
- ----------------------------------------------------------------------
One year or less $ 39.2 $ 38.1
Over one year through five years 51.0 50.5
Over five years through ten years 53.8 52.0
Over ten years 401.7 349.2
--------------------------
Total fixed maturities $ 545.7 $ 489.8
- ---------------------------------------------------------------------
Equity Securities
The cost, estimated fair values (based principally upon quoted market prices)
and gross unrealized gains and losses of equity securities at December 31, were
as follows:
1999
- --------------------------------------------------------------------------------
Gross Gross
Estimated Unrealized Unrealized
Cost Fair Value Gains Losses
- --------------------------------------------------------------------------------
Common stocks $128.6 $221.2 $100.5 $ 7.9
Non-redeemable preferred stocks 187.9 160.6 3.2 30.5
-----------------------------------------------
Total equity securities $316.5 $381.8 $103.7 $38.4
- --------------------------------------------------------------------------------
1998
- --------------------------------------------------------------------------------
Gross Gross
Estimated Unrealized Unrealized
Cost Fair Value Gains Losses
- --------------------------------------------------------------------------------
Common stocks $141.3 $249.3 $112.3 $ 4.3
Non-redeemable preferred stocks 185.0 187.8 10.6 7.8
------------------------------------------------
Total equity securities $326.3 $437.1 $122.9 $12.1
- --------------------------------------------------------------------------------
On December 19, 1996, HSBIIC entered into three "zero cost collar contracts" to
mitigate the effects of market risk on its U.S. common stock portfolio (which,
for management purposes, included certain convertible preferreds). In the fourth
quarter of 1997, HSBIIC settled all of its outstanding contracts resulting in
realized losses of $30.7 million for the year, all of which were offset by and
represented portfolio appreciation and returns that were realized. During the
year ended December 31, 1997, the Company's U.S. common stock portfolio had
experienced a total return of $57 million (which included price appreciation of
approximately $54 million) and had a price movement correlation with the S&P 500
Index well in excess of 80 percent.
The collar subjected the Company to market and counterparty credit risk. The
Company managed this exposure by frequently modeling the effects of potential
future price movements on the value of the collar and HSB's portfolio and by
entering into contracts with internationally recognized financial institutions,
which were expected to perform under the terms of the contract, and by
evaluating the credit worthiness of such institutions by taking into account
credit ratings and other factors.
62
8. Fixed Assets
Fixed assets are summarized as follows:
At December 31, 1999 1998
- ------------------------------------------------------------------------------
Land and buildings $ 4.9 $ 5.1
Furniture, equipment, leasehold improvements and other 72.8 68.0
Systems development costs 32.5 23.9
---------------------
110.2 97.0
Less accumulated depreciation and amortization (52.0) (42.1)
---------------------
Total fixed assets $ 58.2 $ 54.9
- ------------------------------------------------------------------------------
Property and equipment are stated at cost. Depreciation expense is computed
using straight-line and accelerated methods over the estimated useful lives of
31.5 years for buildings and 3 to 10 years for equipment and furniture.
Leasehold improvements are amortized over the shorter of the assets' useful
lives or their remaining contractual lease terms.
The Company has a policy of capitalizing certain systems development costs.
Systems development costs are amortized over estimated useful lives of 3 to 10
years. In 1998, approximately $6.5 million of systems development costs related
to the allocation of purchase price for SAI.
In 1996, the Company began a comprehensive effort to assess and address issues
relating to the ability of its policy processing and other operational systems
to properly recognize calendar dates beginning in the year 2000. As part of this
effort, the Company established a Year 2000 Program to address the areas of
applications software, infrastructures, embedded technology and key business
partners and suppliers. The Company's aggregate spending in connection with the
Year 2000 Program was approximately $28 million. Certain of these costs were
expensed as incurred and funded through operating cash flow. The Company has
expensed $6.9, $5.1 and $1.5 million in 1999, 1998 and 1997, respectively. The
remainder of the $28 million related to systems that the Company anticipated
replacing in the normal course of information technology development but the
timetable for which was accelerated in contemplation of the Year 2000 event.
Costs of replacement of information systems and infrastructure that would have
occurred in the normal course of business without the advent of the Year 2000
event are excluded from these amounts, and are being capitalized in accordance
with the Company's existing capitalization policy.
9. Leases
The Company leases its home office facility at One State Street under a
long-term capital lease with the One State Street Limited Partnership
(Partnership). The lease obligation of $26.1 million was recorded at July 1,
1983 at an interest rate of 15 percent. An asset of $26.1 million was also
recorded in 1983. Accumulated amortization on the asset was $12.3 and $11.5
million at December 31, 1999 and 1998, respectively. Terms of the lease require
annual minimum lease payments of approximately $4.2 million a year through June
30, 2018. In addition, the Company is required to pay over the lease term a
proportional share of the facility's variable operating expenses. This amounted
to approximately $2.7, $2.9 and $2.6 million for the years ended 1999, 1998 and
1997, respectively.
The Company owns the One State Street land and leases it to the Partnership. The
Company receives a base rent for the land and a participation in the net cash
flow of the Partnership. If the facility is sold, the Company will receive 50
percent or more of the sales proceeds in excess of the mortgages, all operating
expenses and costs of sale and the rental obligations pursuant to the land
lease. Under certain circumstances, the Company has the right to purchase the
facility.
63
In addition to its home office facility, the Company leases facilities and
certain equipment which are accounted for as operating leases. Lease expenses
amounted to $12.0, $10.2 and $8.4 million in 1999, 1998 and 1997, respectively.
At December 31, 1999, future minimum rental commitments under noncancelable
leases accounted for as operating leases with initial or remaining terms of more
than one year were as follows:
2000 $ 6.9
2001 6.3
2002 5.7
2003 5.1
2004 3.7
2005 and thereafter 2.1
--------
Total $29.8
--------
10. Reinsurance
The components of net written and net earned insurance premiums were as follows:
For the years ended December 31, 1999 1998 1997
- -------------------------------------------------------------------------
Written premiums:
Direct $ 416.6 $ 478.2 $ 361.4
Assumed 363.3 318.5 257.1
Ceded (413.2) (444.1) (120.0)
-----------------------------------
Net written premiums $ 366.7 $ 352.6 $ 498.5
Earned premiums:
Direct $ 452.8 $ 408.8 $ 370.1
Assumed 371.0 361.7 239.2
Ceded (441.9) (374.4) (118.1)
-----------------------------------
Insurance premiums $ 381.9 $ 396.1 $ 491.2
- -------------------------------------------------------------------------
In 1999 and 1998, HSBIIC was the direct writer of business written on behalf of
HSB Industrial Risk Insurers. This business was ceded to that entity and
HSBIIC's share of the equipment breakdown and property business was assumed back
in accordance with the reinsurance agreements in place with ERC (see note 3).
This has resulted in growth in gross and ceded premiums and claims and
adjustment expenses.
The Company writes direct business, which in 1999 and 1998 included HSB
Industrial Risk Insurers business, through agencies and brokerage firms. In
addition, the Company assumes boiler and machinery exposures from approximately
200 insurance companies and several insurance pools. Under the reinsurance
agreements, the Company's reinsured companies may include equipment breakdown
exposures in their multi-peril policies, and such risks will be assumed by the
Company under the terms of the agreement. These agreements generally provide
that the Company will assume 100 percent of each boiler and machinery risk,
subject to the capacity specified in the agreement, and will receive the entire
equipment breakdown premium except for a ceding commission, which will be
retained by the reinsured company for commissions to agents and brokers, premium
taxes and handling expenses.
Although the Company assumes the role of reinsurer, it continues to have selling
and underwriting responsibilities as well as involvement in inspecting and
claims adjusting. In effect, the Company becomes the equipment breakdown
insurance department of the reinsured company and provides all equipment
breakdown underwriting (that is, the examination and evaluation of the risk
based on its engineering judgments), claims and engineering services as if it
were part of that organization. Traditionally, as part of the underwriting
process, the Company retains the right to decline or restrict coverage in the
same manner as it does for its own business. In 1996, the Company began to write
a simplified program (referred to as ReSource) under which a reinsured company
agrees
64
to include equipment breakdown insurance on an entire portfolio of accounts
meeting specific underwriting guidelines and occupancy parameters, which the
Company agrees to reinsure for equipment breakdown losses.
The insurance industry, in general, continues to undergo significant
restructuring and consolidation. Considerable merger and acquisition activity
has occurred over the last several years and, with the advent of financial
services reform, more contraction is possible in the future. Depending on the
specific companies involved in these activities and other market factors, the
level of reinsured business the Company assumes in the future could be impacted.
For 1999 approximately 26 percent of the Company's gross written premium, which
includes HSB Industrial Risk Insurers, was produced by J&H Marsh & McLennan and
Sedgwick Group.
As a property insurer, the Company is subject to losses that may arise from
catastrophic events. The Company participates in various facultative, quota
share and excess of loss reinsurance agreements to limit its exposure,
particularly to catastrophic losses, and to provide additional capacity to write
business. In the unlikely event that ceded reinsurers are unable to meet their
obligations, the Company would continue to have primary liability to
policyholders for losses incurred. Reinsurance recoverable on unpaid claims and
the unearned portion of ceded reinsurance premiums are reported as assets,
rather than netted against the related liability accounts. The Company is not
party to any contracts which do not comply with the risk transfer provisions of
SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and
Long-Duration Contracts." The Company recorded $503.4, $444.7 and $45.2 million
of reinsurance recoveries as a reduction of its claims and adjustment expenses
for the years ended December 31, 1999, 1998 and 1997, respectively. Reinsurance
recoverable on paid claims and adjustment expenses was $22.9 and $14.6 million
at December 31, 1999 and 1998, respectively.
11. Reconciliation of Liability for Claims and Adjustment Expenses
The following tables provide reconciliations of the beginning and ending
reserves for claims and adjustment expenses on both a gross liability and net
(of reinsurance) liability basis:
Reconciliation of Gross Liability for Claims and Adjustment Expenses
1999 1998 1997
- -------------------------------------------------------------------------------------------
Gross liability for claims and adjustment
expenses at January 1, $ 558.2 $ 276.7 $ 302.9
Plus:
Provision for claims and adjustment
expenses occurring in the current year 653.0 572.7 263.3
Increase (decrease) in estimated claims and
adjustment expenses arising in prior years (1) 31.7 46.9 (0.2)
--------------------------------
Total incurred claims and adjustment expenses $ 684.7 $ 619.6 $ 263.1
--------------------------------
Less:
Payment for claims arising in:
Current year 164.9 141.0 90.6
Prior years 295.7 197.1 198.7
--------------------------------
Total payments $ 460.6 $ 338.1 $ 289.3
--------------------------------
Gross liability for claims and adjustment
expenses at December 31, $ 782.3 $ 558.2 $ 276.7
- ------------------------------------------------------------------------------------------
(1) The 1998 increase primarily resulted from the decision rendered under an
arbitration proceeding and adverse claims experience in international
operations.
65
Reconciliation of Net Liability for Claims and Adjustment Expenses
1999 1998 1997
- ----------------------------------------------------------------------------------------
Net liability for claims and adjustment
expenses at January 1, $ 169.7 $ 190.8 $ 177.8
Plus:
Provision for claims and adjustment expenses
occurring in the current year 165.4 164.0 209.5
Increase (decrease) in estimated claims and
adjustment expenses arising in prior years 0.4 10.9 8.4
--------------------------------
Total incurred claims and adjustment expenses $ 165.8 $ 174.9 $ 217.9
--------------------------------
Less:
Payment for claims arising in:
Current year 80.0 84.2 82.3
Prior years 99.4 111.8 122.6
--------------------------------
Total payments $ 179.4 $ 196.0 $ 204.9
--------------------------------
Net liability for claims and adjustment
expenses at December 31, $ 156.1 $ 169.7 $ 190.8
- ----------------------------------------------------------------------------------------
1999, 1998 and 1997 net claims and adjustment expenses incurred have been
reduced by subrogation recoveries of approximately $2.0, $5.0 and $3.3 million,
respectively.
A reconciliation of the net liability to the gross liability for claims and
adjustment expenses is as follows:
At December 31, 1999 1998 1997
- --------------------------------------------------------------------------
Net liability for claims and
adjustment expenses $ 156.1 $ 169.7 $ 190.8
Reinsurance recoverable on unpaid
claims and adjustment expenses 626.2 388.5 85.9
-------------------------------
Gross liability for claims and
adjustment expenses $ 782.3 $ 558.2 $ 276.7
- --------------------------------------------------------------------------
The Company utilizes well-capitalized domestic and international reinsurance
companies and syndicates for its reinsurance program and monitors their
financial condition on an on-going basis. For reinsurers that are not accredited
in their state of domicile, the Company requires collateral for reinsurance
recoverable from such carriers. Uncollectible reinsurance recoverables have not
had, and are not expected by management to have in the future, a material
adverse effect on the consolidated results of operations or financial position
of the Company.
The following table displays information concerning the primary participants in
the Company's current reinsurance program as of December 31, 1999:
Reinsurer Ceded
Written Reinsurance 1999 A.M. Best's
Premium Asset Rating
- --------------------------------------------------------------------------------
Employers Reinsurance Corporation* $ 141.5 $ 292.6 A++ (Superior)
General Reinsurance Corporation 39.7 83.5 A++ (Superior)
Scottsdale Insurance Company 5.3 29.1 A+ (Superior)
Gerling-Konzern Globale 10.9 22.4 n/a
Hartford Fire Insurance Company 10.6 21.8 A+ (Superior)
Terra Nova Insurance Company LTD 7.7 18.4 n/a
Mid Ocean Reinsurance Company 7.8 17.3 n/a
NAC Reinsurance Corporation 7.0 16.5 A+ (Superior)
Frankona Ruckversicherungs AG 6.4 15.7 n/a
Lloyds 376 JHV 9.9 15.6 n/a
- -----------------------------------------------------------------------------
* Net of business assumed by HSB from ERC
As of December 31, 1999, no other reinsurance asset of the Company from any
single reinsurer exceeded 3.0 percent of shareholders' equity. Certain Lloyd's
syndicates participate in the excess of loss reinsurance program, primarily in
the excess layers. The highest aggregate percentage participation of such
syndicates, at 32.4 percent,
66
is in the $50 million excess of $100 million layer. No individual syndicate has
more than 7.2 percent participation in any of the excess layers. In addition,
certain syndicates participate in three of our quota share treaties, aggregating
10.6, 12.7 and 82.9 percent in each of the three treaties. Lloyd's participation
in our catastrophe cover is 71.4 percent with no individual syndicate retaining
more than 6.7 percent. The Company's reinsurance asset in the aggregate from
over 100 Lloyd's syndicates, excluding the syndicate disclosed above, is 12
percent of shareholders' equity at December 31, 1999. Lloyd's has historically
participated more heavily in the higher treaty layers.
The Company is involved in various legal proceedings as defendant or
co-defendant that have arisen in the normal course of its business. In the
judgment of management, after consultation with counsel, it is improbable that
any liabilities which may arise from such litigation will have a material
adverse impact on the results of operations or the financial position of the
Company.
12. Income Taxes
Tax Provision
A reconciliation of income taxes at U.S. statutory rates to the income taxes as
reported is as follows:
1999 1998 1997
% of % of % of
Pre-tax Pre-tax Pre-tax
Amount Income Amount Income Amount Income
- ------------------------------------------------------------------------------------------------------------------
Income from continuing operations
before income taxes and distributions
on capital securities $ 126.7 100% $ 173.9 100% $ 93.7 100%
-----------------------------------------------------------------
Tax at statutory rates $ 44.3 35% $ 60.9 35% $ 32.8 35%
Income (loss) taxed at foreign rates 0.4 -- (0.6) -- 1.0 1
Dividends received deduction (4.0) (3) (4.3) (2) (4.9) (5)
Tax exempt interest (0.7) (1) (0.9) (1) (0.8) (1)
Tax credits and other (4.3) (3) (3.7) (2) (3.0) (3)
-----------------------------------------------------------------
Total income taxes and effective tax rate $ 35.7 28% $ 51.4 30% $ 25.1 27%
- ------------------------------------------------------------------------------------------------------------------
Income taxes consisted of the following:
1999 1998 1997
- ------------------------------------------------------------------------
Current provision (benefit):
U.S. $ 31.1 $ 45.3 $ 16.8
Foreign 4.0 (0.3) 7.0
-----------------------------
Total current provision 35.1 45.0 23.8
Deferred provision (benefit):
U.S. (0.4) 6.2 1.1
Foreign 1.0 0.2 0.2
-----------------------------
Total deferred provision 0.6 6.4 1.3
-----------------------------
Total income taxes $ 35.7 $ 51.4 $ 25.1
- ------------------------------------------------------------------------
67
Deferred Income Taxes
Deferred income taxes reflect the net tax effect of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Components of the
Company's deferred tax liabilities and assets as of December 31, 1999 and 1998
are as follows:
1999 1998
- -------------------------------------------------------------------------
Deferred tax liabilities:
Prepaid acquisition costs $ 19.4 $ 17.1
Depreciation and amortization 9.6 6.2
Pension asset 16.0 14.4
Unrealized investment gains 3.7 42.3
Other 5.1 8.3
------------------
Total deferred tax liabilities 53.8 88.3
------------------
Deferred tax assets:
Benefit plans 9.0 9.2
Capital lease 4.9 4.7
Unearned insurance premiums 11.8 12.1
Loss reserve discounting and subrogation 7.7 7.0
Other 17.6 12.6
------------------
Total deferred tax assets 51.0 45.6
------------------
Net deferred tax liabilities $ 2.8 $ 42.7
- -------------------------------------------------------------------------
Other Information
U.S. federal tax return examinations have been completed for years through 1995.
The Company believes adequate provisions for income tax have been recorded for
all years.
13. Capital Structure
HSB's capital structure is as follows at December 31:
1999 1998
- ------------------------------------------------------------------------
Short-term borrowings $ 41.5 $ 21.0
Long-term borrowings * $ 25.1 $ 25.1
Company obligated mandatorily redeemable
capital securities of subsidiary Trust I
holding solely junior subordinated
deferrable interest debentures of the Company,
net of unamortized discount of $1.0; $1.1 $ 109.0 $108.9
Company obligated mandatorily
redeemable convertible capital
securities of subsidiary Trust II holding
solely junior subordinated deferrable interest
debentures of the Company $ 300.0 $300.0
Common shareholders' equity $ 376.5 $419.3
- ------------------------------------------------------------------------
* Excludes capital lease (see note 9).
Short-term and Long-term Borrowings
HSBIIC has a commercial paper program with a limit of $75 million. Commercial
paper outstanding at December 31, 1999 and 1998 was $38.6 and $20.0 million,
respectively. The weighted-average interest rate was 6.0 percent and 5.2 percent
at December 31, 1999 and 1998, respectively. Commercial paper outstanding at
year end 1999
68
matures on or before March 14, 2000. Long-term debt includes $25.1 million of
senior notes due May 15, 2000 at an interest rate of 6.83 percent. Current
market value is estimated to be $25.3 million.
Capital Securities
On July 15, 1997, a trust sponsored and wholly owned by the Company issued $110
million aggregate liquidation amount of capital securities in a private
placement and 3,403 shares of common securities to the Company, the proceeds of
which were invested by the trust in $113.4 million aggregate principal amount of
the Company's debt securities. On November 5, 1997, an exchange offer was
commenced, pursuant to which the capital securities originally issued in the
private placement were exchanged for capital securities that were registered
with the Securities and Exchange Commission (the Capital Securities) and the
debt securities were exchanged for debt securities that were registered with the
Securities and Exchange Commission (the Debt Securities).
The Debt Securities represent all of the assets of the trust. The proceeds from
the issuance of the Debt Securities were used by the Company for general
corporate purposes. The Debt Securities and related income statement effects are
eliminated in the Company's consolidated financial statements. The $113.4
million principal amount of Debt Securities accrue and pay cash distributions
quarterly in arrears at a variable rate equal to the 90 day LIBOR plus 0.91
percent of the stated liquidation amount of $1,000 per Debt Security and are
scheduled to mature on July 15, 2027.
The Capital Securities accrue and pay cash distributions quarterly in arrears at
a variable rate equal to the 90 day LIBOR plus 0.91 percent of the stated
liquidation amount of $1,000 per Capital Security. The current coupon is 7.1
percent. HSB has the right to defer payment of distributions on the securities
at any time or from time to time for a period not exceeding 20 consecutive
quarterly periods with respect to each deferral period. During an extension
period, interest will continue to accrue and the amount of distributions to
which holders of the Capital Securities are entitled will accumulate, and the
Company will be prohibited from paying any cash dividends on its common stock.
The Capital Securities are generally non-callable for ten years, but may be
called earlier by HSB upon the occurrence of certain tax events including loss
of deductibility of interest on the securities. The Capital Securities are
mandatorily redeemable upon the maturity of the Debt Securities on July 15,
2027, or earlier to the extent of any redemption by the Company of any Debt
Securities. The redemption price in either such case will be $1,000 per share
plus accrued and unpaid distributions to the date fixed for redemption.
The terms of the Debt Securities, the guarantee of the Company with respect to
the Capital Securities, the Indenture and the Trust Agreement together provide a
full guarantee of amounts due on the Capital Securities. The Capital Securities
are currently rated BBB- by Standard & Poor's and BBB+ by Duff & Phelps credit
rating agencies.
On December 31, 1997, HSB Group, Inc. sold $300 million of 20 year Convertible
Capital Securities in a private placement to ERC. The Convertible Capital
Securities are callable by the Company at its option (i) at any time after seven
years; (ii) upon the occurrence of certain tax events including loss of
deductibility of the interest on the securities; (iii) in the event that HSB
vetoes a prospective purchaser of the Convertible Capital Securities; or (iv) in
the event of a change in control of ERC. The Convertible Capital Securities are
mandatorily redeemable on December 31, 2017 and are redeemable at par plus a
redemption premium, at the option of ERC, in the event of a change in control of
HSB within five years following issuance of the securities.
The Convertible Capital Securities are convertible, in whole or in part, at
ERC's option at any time, subject to regulatory approval, into shares of HSB
common stock at a conversion price of $56.67 per share, subject to adjustment.
HSB has provided certain registration rights to ERC in connection with the
common stock into which the Convertible Capital Securities are convertible
pursuant to a Registration Rights Agreement dated December 31,
69
1997. If ERC were to exercise its conversion rights in total, it would hold at
December 31, 1999, on a fully diluted basis, approximately 15.4 percent of HSB's
common stock. Pursuant to certain provisions contained in the Purchase Agreement
dated December 31, 1997, ERC has agreed to certain "standstill" arrangements
which for a period of five years will preclude ERC from purchasing any common
stock of HSB, other than by exercise of its conversion rights, and will limit
its ability to take certain other actions with respect to HSB during that
period.
The securities were issued through HSB Capital II (Trust II), a Delaware
business trust created by HSB, at a 7 percent coupon, payable semi-annually. The
Convertible Capital Securities rank pari passu with the Global Floating Rate
Capital Securities issued July 1997. Holders of the Convertible Capital
Securities will be entitled to receive preferential cumulative cash
distributions accumulating from the date of original issuance and payable
semi-annually in arrears. HSB has the right to defer payment of interest at any
time or from time to time for a period not exceeding 10 consecutive semi-annual
periods with respect to each deferral period. During an extension period,
interest will continue to accrue and the amount of distributions to which
holders of the Convertible Capital Securities are entitled will accumulate, and
HSB will be prohibited from paying any cash dividends on its common stock. HSB
has irrevocably and unconditionally guaranteed all of Trust II's obligations
under the Convertible Capital Securities.
The estimated fair value of the Capital Securities issued by Trust I is equal to
their carrying value. The estimated fair value of the Convertible Capital
Securities issued by Trust II is $272.2 million and is calculated without giving
any effect to the relationship of the conversion price to the current market
price of HSB Group, Inc. common stock.
Other Comprehensive Income
The components of accumulated other comprehensive income (net of income taxes)
are as follows:
Total
Accumulated Unrealized Minimum
Other Gains Pension Foreign
Comprehensive on Liability Exchange
Income Securities Adjustment Losses
- --------------------------------------------------------------------------------
Balances at December 31, 1997 $ 55.9 $ 62.4 $ (3.9) $(2.6)
Current period change 10.9 12.1 (0.1) (1.1)
- -------------------------------------------------------------------------------
Balances at December 31, 1998 $ 66.8 $ 74.5 $ (4.0) $(3.7)
Current period change (68.7) (71.6) 1.1 1.8
- -------------------------------------------------------------------------------
Balances at December 31, 1999 $ (1.9) $ 2.9 $ (2.9) $(1.9)
- -------------------------------------------------------------------------------
14. Pension and Other Benefit Programs
HSB maintains various types of pension and postretirement medical plans covering
employees of the Company and certain subsidiaries. The pension plans are
non-contributory and benefits are based upon an employee's years of service and
final average pay based upon the highest three out of five years. Vesting occurs
after five years of service in compliance with the provisions of the Tax Reform
Act of 1986.
Under the terms of the HSB Group, Inc. Thrift Incentive Plan, a defined
contribution plan, covered employees are allowed to contribute up to 15 percent
of their pay, on a pre-tax basis, limited by the maximum allowed under Internal
Revenue Service regulations. The Company makes a matching contribution of 50
percent of employee contributions up to 6 percent of compensation. Total expense
for the plan was $2.4, $2.1 and $1.7 million for 1999, 1998 and 1997,
respectively.
The Company makes available health care and life insurance benefits for retired
employees of the Company and certain subsidiaries. The Company makes
contributions to the plans as claims are incurred. Retirees'
70
contributions to these plans vary, based upon retiree's age, years of service
and coverage elected. The Company periodically amends the plan changing the
contribution rate of retirees and amounts of coverage.
The following chart summarizes the balance sheet impact, as well as the benefit
obligations, assets, funded status and rate assumptions associated with the U.S.
pension and postretirement medical benefit plans:
Pension Benefits Other Benefits
- -------------------------------------------------------------------------------------------------------
1999 1998 1999 1998
- -------------------------------------------------------------------------------------------------------
Change in benefit obligation:
Benefit obligation at beginning of year $ 180.2 $ 156.0 $ 28.7 $ 29.9
Service cost 6.9 5.3 0.4 0.3
Interest cost 12.7 11.9 1.8 1.9
Net benefit payments (10.8) (10.3) (2.1) (1.9)
Liability loss (gain) 5.3 0.7 (1.9) (2.7)
Assumption changes (16.8) 9.6 (1.4) 1.2
Acquisitions -- 4.2 -- --
Amendments -- 2.8 -- --
-------------------------------------------------
Benefit obligation at end of year $ 177.5 $ 180.2 $ 25.5 $ 28.7
Change in plan assets:
Fair value of plan assets at beginning of year $ 249.1 $ 213.0 $ -- $ --
Actual return on plan assets 29.2 40.8 -- --
Acquisitions -- 3.5 -- --
Employer contributions 0.4 0.4 1.8 1.5
Participants' contributions -- -- 0.4 0.4
Benefits paid (8.9) (8.6) (2.2) (1.9)
-------------------------------------------------
Fair value of plan assets at end of year $ 269.8 $ 249.1 $ -- $ --
Funded status:
Funded status at end of year $ 92.3 $ 68.9 $ (25.5) $ (28.7)
Unrecognized actuarial (gain) loss (44.4) (25.6) 0.8 4.0
Unrecognized transition amount (3.1) (4.7) -- --
Unrecognized prior service cost 3.6 4.2 -- --
-------------------------------------------------
Net amount recognized $ 48.4 $ 42.8 $ (24.7) $ (24.7)
Amounts recognized in the consolidated statements
of financial position consist of:
Prepaid benefit cost $ 42.6 $ 34.6 $ -- $ --
Accrued benefit liability -- -- (24.7) (24.7)
Intangible asset 1.3 2.0 -- --
Accumulated other comprehensive income 4.5 6.2 -- --
-------------------------------------------------
Net amount recognized $ 48.4 $ 42.8 $ (24.7) $ (24.7)
Weighted-average assumptions as of December 31:
Discount rate 7.75% 6.75% 7.75% 6.75%
Long-term rate of return on assets 11.00% 11.00% n/a n/a
Rate of increase in future compensation levels 5.25% 4.25% n/a n/a
Current year health care cost trend rate n/a n/a 5.00% 6.00%
Ultimate health care cost trend rate n/a n/a 4.25% 4.25%
- -------------------------------------------------------------------------------------------------------
For measurement purposes, the annual rate of increase in the per capita cost of
covered health care benefits ranges from 5.0 percent in 1999 decreasing
gradually to 4.25 percent by the year 2001 and remaining level thereafter.
Assets available for pension plan benefits include approximately $25.2 and $24.2
million of Company stock at December 31, 1999 and 1998, respectively.
71
The following chart summarizes the cost components associated with the pension
and postretirement medical benefit plans:
Pension Benefits Other Benefits
- ------------------------------------------------------------------------------------------------------------
For the years ended December 31, 1999 1998 1997 1999 1998 1997
- ------------------------------------------------------------------------------------------------------------
Components of net periodic
benefit (credit) cost
Service cost $ 6.9 $ 5.3 $ 4.1 $ 0.4 $ 0.3 $ 0.3
Interest cost 12.7 11.9 10.7 1.8 1.9 2.1
Expected return on plan assets (23.0) (18.5) (16.8) -- -- --
Amortization of transition amount (1.8) (1.9) (1.8) -- -- --
Amortization of prior service cost 0.7 0.8 0.5 -- -- --
Recognized actuarial loss 1.0 1.0 0.5 -- -- 0.1
-----------------------------------------------------------------------
Net periodic benefit (credit) cost $ (3.5) $ (1.4) $ (2.8) $ 2.2 $ 2.2 $ 2.5
- ------------------------------------------------------------------------------------------------------------
The projected benefit obligation, accumulated benefit obligation and fair value
of plan assets for the pension plan with accumulated benefit obligations in
excess of plan assets were $37.7, $30.1 and $2.8 million, respectively, as of
December 31, 1999 and $36.6, $29.7 and $3.2 million, respectively, as of
December 31, 1998.
The Company's acquisition of SAI in April 1998, resulted in the increase of the
pension benefit obligation by $4.2 million and pension plan assets by $3.5
million.
Assumed health care cost trend rates have an effect on the amounts reported for
the health care plan. A one percentage point change in the assumed health care
cost trend rates would have the following effects:
1% 1%
Point Point
Increase Decrease
- --------------------------------------------------------------------------------
Effect on total of service and interest cost components $ 0.1 $ (0.1)
Effect on postretirement benefit obligation 1.2 (1.1)
- --------------------------------------------------------------------------------
15. Stock Compensation Plans
HSB has a Stock Option Plan under which key employees may be granted restricted
stock and stock options.
HSB's Long-Term Incentive Plan grants senior management awards contingent upon
achievement of specified performance objectives over a three year period, which
may be paid out in cash or shares of common stock (which may be restricted
shares). The number of shares subject to issuance under this plan cannot exceed
375,000.
HSB's restricted stock is an award of common shares that may not be sold or
transferred during the restriction period, usually three years under the Stock
Option Plan and five years under the Long-Term Incentive Plan, from the date on
which the award is granted. During the restriction period, the employee is the
registered owner, receives dividends and may vote the restricted shares.
Compensation expense is based on the market value of the Company's common stock
at the date of grant and is recognized over the period of the restriction.
Compensation expense for this benefit was $3.7, $1.0 and $0.6 million in 1999,
1998 and 1997, respectively. The unamortized compensation expense related to
this plan is included in benefit plans as a component of shareholders' equity.
These amounts were $6.9 and $2.2 million in 1999 and 1998, respectively.
A summary of grants follows:
1999 1998 1997
- ---------------------------------------------------------------------------
Restricted shares awarded 222,227 54,434 30,594
Weighted-average fair value
of shares on grant date $ 36.08 $ 39.86 $ 31.93
- ---------------------------------------------------------------------------
A stock option award under the HSB's Stock Option Plan allows for the purchase
of HSB common stock at no less than the market price on the date of grant.
Options granted to date are exercisable no earlier than one year after the
72
grant date and expire no more than ten years from the date of grant. The number
of shares available for delivery under this plan cannot exceed 4.2 million.
A summary of the status of HSB's stock options as of December 31, 1999, 1998 and
1997 and changes during the years ended on those dates is presented below:
1999 1998 1997
- --------------------------------------------------------------------------------------------------------------------------
Weighted- Weighted- Weighted-
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
- --------------------------------------------------------------------------------------------------------------------------
Outstanding at beginning of year 2,730,225 $ 33.92 2,227,125 $ 32.03 1,979,475 $ 32.44
Granted 1,046,000 36.52 814,500 39.34 558,750 32.55
Exercised (139,400) 33.99 (279,450) 34.21 (235,500) 31.12
Forfeited (14,450) 36.84 (31,950) 37.81 (75,600) 33.49
-------------------------------------------------------------------------------
Outstanding at end of year 3,622,375 $ 34.66 2,730,225 $ 33.92 2,227,125 $ 32.03
-------------------------------------------------------------------------------
Options exercisable at end of year 2,588,875 $ 33.92 1,923,225 $ 31.65 1,681,875 $ 32.51
Weighted-average fair value of options
granted during the year $ 6.05 $ 4.68 $ 4.24
- --------------------------------------------------------------------------------------------------------------------------
The following table summarizes information about stock options outstanding as of
December 31, 1999:
Options Outstanding Options Exercisable
- ------------------------------------------------------------------------------------------------------------------
Range of Weighted- Weighted Weighted-
Exercise Number Average Average Number Average
Prices Outstanding Remaining Exercise Price Exercisable Exercise Price
Contractual Life
- ------------------------------------------------------------------------------------------------------------------
$27-$30.99 1,077,750 5.09 $29.98 1,077,750 $29.98
$31-$34.99 789,000 6.48 $33.43 619,000 $33.16
$35-$38.99 1,605,625 8.16 $37.72 742,125 $38.63
$39-$42.99 150,000 8.11 $42.02 150,000 $42.02
--------- ---------
3,622,375 2,588,875
- ------------------------------------------------------------------------------------------------------------------
SFAS No. 123, "Accounting for Stock Based Compensation" allows the use of a fair
value based method of accounting for an employee stock option or similar equity
instruments or the intrinsic value based method prescribed by Accounting
Principals Board Opinion No. 25, "Accounting for Stock Issued to Employees" with
pro forma disclosures of net income and earnings per share as if the fair value
based method of accounting had been applied. The Company has elected to continue
using the intrinsic value based method. Had the Company elected to recognize
compensation cost using the fair value based method, compensation would have
been measured at date of grant and recognized over the service period. Pro forma
net income and earnings per share would have been imputed as follows:
1999 1998 1997
- -------------------------------------------------------------------------------
Net income As Reported $ 72.8 $ 134.4 $ 66.3
Pro Forma 68.0 131.4 64.5
Earnings per common share -
basic As Reported $ 2.51 $ 4.59 $ 2.21
Pro Forma 2.35 4.49 2.15
Earnings per common share -
assuming dilution As Reported $ 2.50 $ 4.21 $ 2.20
Pro Forma 2.32 4.12 2.13
- -------------------------------------------------------------------------------
73
These pro forma disclosure amounts derived by the use of SFAS No. 123 are not
indicative of future amounts. SFAS No. 123 is not applicable to options granted
prior to 1995, and additional options may be granted in future years.
The fair value of each option grant was estimated on the date of grant using the
Black-Scholes option-pricing model with the following assumptions:
1999 1998 1997
- -------------------------------------------------------------
Risk-free interest rate 5.0% 4.9% 6.3%
Expected life 6 years 6 years 6 years
Expected volatility 22.2% 15.7% 15.8%
Expected dividend yield 4.7% 4.7% 5.0%
- -------------------------------------------------------------
16. Stock Purchase Rights
On September 21, 1998, the Board of Directors approved the adoption of a new
shareholder rights plan to replace the plan that was set to expire on November
28, 1998. Pursuant to the new plan, which is substantially similar to the old
plan, the Board declared a dividend of one right for each outstanding share of
common stock to shareholders of record on November 28, 1998.
The rights will separate from the common stock and become exercisable if a
person or group acquires ownership of 15 percent or more of the outstanding
common stock of the Company or commences a tender or exchange offer to acquire
15 percent or more of the outstanding shares.
Each right entitles a holder to purchase one two-hundredth of a share of Series
A Junior Participating Preferred Stock, without par value at an exercise price
of $162.00 per share, subject to adjustment. If an acquirer obtains 15 percent
or more of the Company's common stock and the Board of Directors determines that
such acquisition is not in the best interest of the shareholders, the rights of
shareholders other than the acquirer will entitle the holder to purchase common
shares of the Company (or, under certain circumstances, of the acquirer) at a 50
percent discount. Under the plan ERC will not be deemed an acquirer in the event
of the conversion of the Convertible Capital Securities it holds into common
stock of the Company unless it acquires one percent or more additional shares.
The rights expire on November 28, 2008 and may be redeemed by the Company for
$.01 per right any time until the tenth business day following public
announcement that a 15 percent position has been acquired.
74
17. Consolidated Quarterly Data (unaudited)
1999 First Second Third Fourth
Quarter Quarter Quarter Quarter Year
- --------------------------------------------------------------------------------------------
Gross earned premiums $ 208.9 $ 206.8 $ 200.6 $ 207.5 $823.8
Ceded premiums 112.4 113.1 107.9 108.5 441.9
-------------------------------------------------
Insurance premiums 96.5 93.7 92.7 99.0 381.9
Engineering services 27.6 27.8 30.6 33.6 119.6
Net investment income 15.7 16.6 16.5 15.3 64.1
Realized investment gains 7.1 10.2 13.5 9.8 40.6
-------------------------------------------------
Total revenues $ 146.9 $ 148.3 $ 153.3 $ 157.7 $606.2
-------------------------------------------------
Income from continuing operations
before income taxes and distributions
on capital securities (1) $ 36.4 $ 38.7 $ 32.7 $ 18.9 $126.7
Income taxes 10.9 11.4 9.3 4.1 35.7
Distributions on capital securities
of subsidiary trusts, net of income tax 4.5 4.5 4.6 4.6 18.2
-------------------------------------------------
Net income $ 21.0 $ 22.8 $ 18.8 $ 10.2 $ 72.8
-------------------------------------------------
Earnings per common share - basic $ 0.72 $ 0.79 $ 0.65 $ 0.35 $ 2.51
-------------------------------------------------
Earnings per common share -
assuming dilution(2) $ 0.71 $ 0.76 $ 0.64 $ 0.35 $ 2.50
-------------------------------------------------
Dividends declared per common share $ 0.42 $ 0.42 $ 0.44 $ 0.44 $ 1.72
-------------------------------------------------
Common stock price ranges:
High $ 41.31 $ 41.88 $ 41.94 $ 38.38 $ 41.94
Low $ 35.50 $ 35.50 $ 34.19 $ 31.88 $ 31.88
Close $ 37.13 $ 41.19 $ 35.19 $ 33.81 $ 33.81
Shareholders at December 31, 4,864
- ------------------------------------------------------------------------------------------
(1) Fourth quarter results reflect pre-tax charges of $5 million related to
change in management costs and consolidation and relocation of certain
businesses as well as $7 million in losses related to medical equipment
insurance contracts.
(2) In the fourth quarter, the assumed conversion of the Company's convertible
capital securities is not used in the computation of earnings per share since
such inclusion would be antidilutive. Therefore, the quarterly earnings per
share will not equal the full year earnings per share.
75
1998 First Second Third Fourth
Quarter Quarter Quarter Quarter Year
- ----------------------------------------------------------------------------------------------------
Gross earned premiums $ 179.7 $ 175.7 $ 212.5 $ 202.6 $770.5
Ceded premiums 80.3 85.3 113.0 95.8 374.4
-------------------------------------------------
Insurance premiums 99.4 90.4 99.5 106.8 396.1
Engineering services 19.7 22.7 25.3 25.8 93.5
Net investment income 15.2 15.9 15.5 17.6 64.2
Realized investment gains 3.2 7.3 7.9 7.0 25.4
-------------------------------------------------
Total revenues $ 137.5 $ 136.3 $ 148.2 $ 157.2 $579.2
-------------------------------------------------
Income from continuing operations
before income taxes and
distributions on capital securities $ 69.6 $ 34.8 $ 36.1 $ 33.4 $173.9
Income taxes 22.5 9.3 9.3 10.3 51.4
Distributions on capital securities
of subsidiary trusts, net of income tax 4.5 4.7 4.6 4.6 18.4
-------------------------------------------------
Income from continuing operations $ 42.6 $ 20.8 $ 22.2 $ 18.5 $104.1
Discontinued operations:
Loss from operations,
net of income tax benefits $ (6.6) $ -- $ -- $ -- $ (6.6)
Gain on disposal, net of income taxes 36.9 -- -- -- 36.9
-------------------------------------------------
Total discontinued operations $ 30.3 $ -- $ -- $ -- $ 30.3
-------------------------------------------------
Net income $ 72.9 $ 20.8 $ 22.2 $ 18.5 $134.4
-------------------------------------------------
Earnings per common share - basic:
Income from continuing operations $ 1.45 $ 0.71 $ 0.75 $ 0.64 $ 3.55
Discontinued operations 1.04 -- -- -- 1.04
-------------------------------------------------
Net income $ 2.49 $ 0.71 $ 0.75 $ 0.64 $ 4.59
-------------------------------------------------
Earnings per common share - assuming dilution:
Income from continuing operations $ 1.31 $ 0.68 $ 0.72 $ 0.63 $ 3.35
Discontinued operations 0.86 -- -- -- 0.86
-------------------------------------------------
Net income $ 2.17 $ 0.68 $ 0.72 $ 0.63 $ 4.21
-------------------------------------------------
Dividends declared per common share $ 0.40 $ 0.40 $ 0.42 $ 0.42 $ 1.64
-------------------------------------------------
Common stock price ranges:
High $ 44.92 $ 53.50 $ 57.63 $ 42.00 $ 57.63
Low $ 36.45 $ 43.17 $ 40.38 $ 36.00 $ 36.00
Close $ 44.92 $ 53.50 $ 40.38 $ 41.06 $ 41.06
Shareholders at December 31, 5,045
- ---------------------------------------------------------------------------------------------------
76
Schedule I
HSB Group, Inc.
Summary of investments - other than investments in related parties
At December 31, (in millions)
1999 1998
------------------------------------------------- ------------------------------------------
Column A Column B Column C Column D Column E Column F Column G
- -------------------------------- ----------------- -------------- -------------- -------------- ------------- ------------
Amount Amount
Shown Shown
In The In The
Market Balance Market Balance
Type of Investment Cost Value Sheet Cost Value Sheet
- --------------------------------------------------- -------------- -------------- ------------- ------------ -------------
Fixed Maturities:
Bonds:
U.S. government and government
agencies and authorities $ 0.0 $ 0.0 $ 0.0 $ 0.0 $ 0.0 $ 0.0
States, municipalities and
political subdivisions 37.7 36.6 36.6 47.4 49.3 49.3
Foreign governments 16.5 16.6 16.6 21.0 21.3 21.3
Public utilities 0.0 0.0 0.0 0.0 0.0 0.0
Convertibles and bonds with
warrants attached 0.0 0.0 0.0 0.0 0.0 0.0
All other corporate bonds 265.9 235.8 235.8 273.5 276.2 276.2
Certificates of deposit 0.0 0.0 0.0 0.0 0.0 0.0
Mortgage receivable 10.8 10.8 10.8 11.1 11.1 11.1
Redeemable preferred stocks 214.8 190.0 190.0 215.5 219.2 219.2
---------------------------------------------- -----------------------------------------
Total fixed maturities $545.7 $489.8 $489.8 $568.5 $577.1 $577.1
Equity securities:
Common stocks:
Public utilities 24.2 23.5 23.5 16.6 19.1 19.1
Banks and insurance 13.3 19.1 19.1 39.9 48.7 48.7
Industrial and other 91.1 178.6 178.6 84.8 181.5 181.5
Non-Redeemable preferred stocks 187.9 160.6 160.6 185.0 187.8 187.8
---------------------------------------------- -----------------------------------------
Total equity securities $316.5 $381.8 $381.8 $326.3 $437.1 $437.1
Short-term investments and cash: $126.5 $126.5 $126.5 $80.6 $80.6 $80.6
---------------------------------------------- -----------------------------------------
Total investments $988.7 $998.1 $998.1 $975.4 $1,094.8 $1,094.8
============================================== =========================================
77
Schedule II
HSB Group, Inc. (Registrant)
Condensed Financial Information of HSB Group, Inc.
Balance Sheet Information
At December 31, (in millions)
1999 1998
------------------------------
Assets
Cash $ 0.1 $ 0.1
Short-term investments, at cost 7.4 2.1
Investment in subsidiaries 664.3 780.2
Fixed maturities, at fair value (cost-$90.1; $47.9) 79.4 47.2
Equity securities, at fair value (cost-$70.1; $45.2) 56.4 43.4
Other assets 15.1 2.9
-------------------------------
Total assets $822.7 $875.9
==============================
Liabilities
Dividends and distributions on capital securities $ 24.0 $ 23.2
Other liabilities 13.2 24.5
------------------------------
Total liabilities 37.2 47.7
------------------------------
Company obligated mandatorily redeemable capital
securities of subsidiary Trust I holding solely
junior subordinated deferrable interest
debentures of the Company, net of unamortized
discount of $1.0 and $1.1 109.0 108.9
Company obligated mandatorily redeemable convertible
capital securities of subsidiary Trust II
holding solely junior subordinated
deferrable interest debentures of the Company 300.0 300.0
Shareholders' Equity
Common stock 10.0 10.0
Additional paid-in capital 36.2 33.5
Accumulated other comprehensive income (1.9) 66.8
Retained earnings 339.1 311.2
Benefit plans (6.9) (2.2)
------------------------------
Total shareholders' equity 376.5 419.3
------------------------------
Total liabilities and shareholders' equity $ 822.7 $875.9
==============================
These condensed financial statements should be read in conjunction with the
consolidated financial statements and accompanying footnotes of HSB Group, Inc.
(see pages 46 through 76).
78
Schedule II (continued)
HSB Group, Inc. (Registrant)
Condensed Financial Information of HSB Group, Inc.
Condensed Statement of Income Information
For the years ended December 31, (in millions)
1999 1998
------------------------
Revenues:
Net investment income $ 9.6 $ 6.4
Realized investment (losses) gains (0.4) 1.0
------------------------
Income before income taxes and
distributions on capital securities 9.2 7.4
Income taxes 3.2 2.5
Distributions on capital securities
of subsidiary trusts, net of
income taxes of $9.8 and $9.9 18.2 18.4
------------------------
Net Loss - Parent only (12.2) (13.5)
Equity in net income of subsidiaries 85.0 147.9
------------------------
Net income $ 72.8 $ 134.4
========================
These condensed financial statements should be read in conjunction with the
consolidated financial statements and accompanying footnotes of HSB Group, Inc.
(see pages 46 through 76).
79
Schedule II (continued)
HSB Group, Inc. (Registrant)
Condensed Financial Information of HSB Group, Inc.
Condensed Statement of Cash Flows Information
For the years ended December 31, (in millions)
1999 1998
-------------------------
Operating Activities:
Net income $ 72.8 $ 134.4
Adjustments to reconcile Net Income
to cash provided by operating activities:
Amortization 0.1 -
Deferred income taxes 0.2 -
Undistributed earnings loss (earnings)
of subsidiaries * 67.7 (91.8)
Distributions on capital securities 28.0 28.3
Realized investment losses (gains) 0.4 (1.0)
Change in balances, net of effects from
purchases of subsidiary:
Decrease in other assets (0.1) 9.2
(Decrease) increase in other liabilities (18.8) 22.2
-------------------------
Cash provided by operating activities 150.3 101.3
-------------------------
Investing Activities:
(Purchase) sale of short-term investments, net (5.3) 58.4
Purchase of fixed maturities (80.2) (48.0)
Proceeds from sale of fixed maturities 37.3 12.3
Purchase of equity securities (28.2) (26.6)
Proceeds from sale of equity securities 3.6 8.7
Purchase of Solomon Associates, Inc.,
net of cash acquired - (2.1)
-------------------------
Cash (used in) provided by investing activities (72.8) 2.7
-------------------------
Financing Activities:
Dividends and distributions on capital securities (77.1) (66.2)
Exercise of stock options 4.0 9.3
Reacquisition of stock (4.4) (47.7)
-------------------------
Cash used in financing activities (77.5) (104.6)
-------------------------
Change in cash
- (0.6)
Cash at beginning of period
0.1 0.7
Cash at end of period $ 0.1 $ 0.1
=========================
* Dividends received from The Hartford Steam Boiler Inspection and Insurance
Company were $152.7 million and $56.1 million in 1999 and 1998,
respectively.
These condensed financial statements should be read in conjunction with the
consolidated financial statements and accompanying footnotes of HSB Group, Inc.
(see pages 46 through 76).
80
Schedule III
HSB Group, Inc.
Supplementary Insurance Information
At December 31 and for the years then ended (in millions)
Column A Column B* Column C* Column D* Column E* Column F Column G** Column H Column I Column J Column K
- ------------ ------------ ---------- ----------- ----------- ----------- ---------- ----------- -------------- ----------- --------
Segment Deferred Future Unearned Other Premium Net Benefits, Amortization Other Premiums
acquisition policy premiums policy revenue investment claims, of prepaid operating written
costs Benefits Claims and income losses and policy expense
and Benefits settlement acquisition
Losses, Payable expenses claims
And loss
Expenses
- ------------------------------------------------------------------------------------------------------------------------------------
1999:
Commercial $ - $ - $ - $ - $ 335.2 $ - $130.0 $ 78.1 $ 107.1 $351.7
Global
Special
Risk - - - - 45.6 - 24.0 12.8 (0.5) 11.8
Other
Segments - - - - 1.1 - 11.8 (1.7) (1.0) 3.2
---------- ------------ --------- ------------ ---------- ----------- ---------- ------------- ------------ ----------
Total $ - $ - $ - $ - $ 381.9 $ - $165.8 $ 89.2 $105.6 $366.7
========== ============ ========= ============ ========== =========== ========== ============= ============ ==========
1998:
Commercial $ - $ - $ - $ - $ 306.3 $ - $124.6 $ 67.6 $ 95.6 $327.5
Global
Special
Risk - - - - 83.6 - 46.6 0.9 18.1 20.3
Other
Segments - - - - 6.2 - 3.7 (2.2) - 4.8
---------- ------------- --------- ------------ ---------- ----------- ---------- ------------- ------------ ----------
Total $ - $ - $ - $ - $ 396.1 $ - $174.9 $ 66.3 $113.7 $352.6
========== ============= ========= ============ ========== =========== ========== ============= =========== ==========
1997:
Commercial $ - $ - $ - $ - $ 269.0 $ - $103.9 $ 59.5 $ 83.2 $277.4
Global
Special
Risk - - - - 217.1 - 111.4 31.0 58.3 217.3
Other
Segments - - - - 5.1 - 2.6 0.2 1.3 3.8
---------- ------------- --------- ------------ ---------- ---------- ---------- ------------- ------------ ----------
Total $ - $ - $ - $ - $ 491.2 $ - $217.9 $ 90.7 $142.8 $498.5
========== ============= ========== ============ ========== ========== =========== ============= =========== ==========
* Segment assets are not included in management's evaluation and allocation of
resources to segments.
** Investment assets are managed by and investment income is allocated to the
Company's Investment segment.
81
Schedule IV
HSB Group, Inc.
Reinsurance
For the years ended December 31, (in millions)
Column A Column B Column C Column D Column E Column F
Insurance Gross Ceded to Assumed Net Percentage of
Premiums Amount Other From Other Amount Amount
Companies Companies Assumed to Net
- -------------------------------------------------------------------------------------------------------------------------
1999
Property and
Liability
Insurance $452.8 $441.9 $371.0 $381.9 97.1%
1998
Property and
Liability
Insurance $408.8 $374.4 $361.7 $396.1 91.3%
1997
Property and
Liability
Insurance $370.1 $118.1 $239.2 $491.2 48.7%
82
Schedule V
HSB Group, Inc.
Valuation and Qualifying Accounts
At December 31, (in millions)
Column A Column B Column C Column D Column E Column F
- ----------------------------------------------------------------------------------------------------------------------------------
Balance at Charged to Charged to Balance
Beginning of Costs and Other Deductions At End of
Description Period Expenses Accounts Describe (a) Period
- ----------------------------------------------------------------------------------------------------------------------------------
1999
Reserve for Accounts Receivable $3.9 $2.0 $0.0 $1.0 $4.9
1998
Reserve for Accounts Receivable $3.6 $0.5 $0.0 $0.2 $3.9
1997
Reserve for Accounts Receivable $3.0 $0.9 $0.0 $0.3 $3.6
(a) Engineering Services and Insurance Premium Receivables written off as
uncollectible.
83
Schedule VI
HSB Group, Inc.
Supplemental Information Concerning Property-Casualty Insurance Operations
At December 31 and for the years then ended (in millions)
Column A Column B Column C Column D Column E Column F Column G Column H Column I Column J Column K
- ------------ ----------- ------------ ------------ ---------- -------- --------- ----------------- -------------- --------- --------
Reserves for Claims and Claims Amortization
Unpaid Claims Discount Net Adjustment Expenses of Prepaid Paid Claims
Affiliation Prepaid And Claim if any, Invest- Incurred Related to Policy and Claim
with Acquisition Adjustment deducted Unearned Earned ment Current Prior Acquisition Adjustment Premiums
Registrant(a) Costs Expenses in Column C Premiums Premiums Income Year Year Costs Expenses Written
- ------------------------------------------------------------------------------------------------------------------------------------
1999 52.9 782.3 - 420.1 381.9 64.1 165.4 0.4 89.2 179.4 366.7
1998 46.6 558.2 - 464.6 396.1 64.2 164.0 10.9 66.3 196.0 352.6
1997 42.5 276.7 - 287.3 491.2 36.8 209.5 8.4 90.7 204.9 498.5
(a) Consolidated property-casualty entities
84
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure.
None.
PART III
Item 10. Directors and Executive Officers of the Registrant.
"Nominees for Election to the Board of Directors for Three-Year Term
Expiring in 2003" and "Members of the Board of Directors Continuing in Office"
on pages 2-4 of the Company's Proxy Statement dated March 16, 2000 are
incorporated herein by reference. Also see pages 22 -- 23 herein.
Item 11. Executive Compensation.
"Meetings and Remuneration of the Directors" on pages 5-6, "Human Resources
Committee Report on Executive Compensation" on pages 8-11, "Summary Compensation
Table" on page 12, "Stock Option and Long-Term Incentive Plan Tables" on pages
13-14, "Retirement Plans" on pages 14-15, "Employment Arrangements" on pages
15-17, "Compensation Committee Interlocks and Insider Participation" on page 17,
and "Performance Graph" on page 17 of the Company's Proxy Statement dated March
16, 2000 are incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners
and Management.
"Security Ownership of Certain Beneficial Owners and Management" on pages
6-8 of the Company's Proxy Statement dated March 16, 2000 is incorporated herein
by reference.
Item 13. Certain Relationships and Related Transactions.
"Compensation Committee Interlocks and Insider Participation" on page 17 of
the Company's Proxy Statement dated March 16, 2000 is incorporated herein by
reference.
PART IV
Item 14. Exhibits, Financial Statement Schedules, and
Reports on Form 8-K.
(a) The financial statements and schedules listed in the Index to
Financial Statements and Financial Statement Schedules on page 43
herein are filed as part of this report.
(b) Reports on Form 8-K -
(i) Form 8-K dated October 25, 1999 to report third quarter 1999
results of Registrant;
(ii) Form 8-K dated November 29, 1999 to report election of Richard
Booth as President and Chief Executive Officer and retirement of
Gordon W. Kreh;
(iii)Form 8-K dated November 30, 1999 to report declaration of
dividend by Registrant;
(iv) Form 8-K dated January 18, 2000 to announce Registrant's
anticipated 1999 net income;
85
(v) Form 8-K dated January 24, 2000 to report fourth quarter 1999
results of Registrant and declaration of dividend by Registrant;
(vi) Form 8-K dated March 6, 2000 to announce election of Richard
Booth as Chairman.
(c) The exhibits listed in the accompanying Index to Exhibits are filed as
part of this report.
86
SIGNATURES
Pursuant to the requirements of Section 13 of the Securities Exchange Act
of 1934, the Registrant has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized.
HSB GROUP, INC.
(Registrant)
By: /s/ Richard H. Booth
Richard H. Booth
Chairman, President and Chief
Executive Officer
March 29, 2000
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
(Signature) (Title)
By:/s/ Richard H. Booth
Richard H. Booth Chairman, President,
March 29, 2000 Chief Executive Officer
and Director
/s/ Saul L. Basch Senior Vice President, Treasurer
Saul L. Basch and Chief Financial Officer
March 29, 2000 (Principal Financial Officer and
Principal Accounting Officer)
/s/ Robert C. Walker
Robert C. Walker Senior Vice President and General
March 29, 2000 Counsel
(Joel B Alvord)* Director
(Colin G. Campbell)* Director
(Richard G. Dooley)* Director
(William B. Ellis)* Director
(Henrietta Holsman Fore)* Director
87
(E. James Ferland)* Director
(Simon W. Leathes)* Director
*By: /s/ Robert C. Walker
Robert C. Walker
(Attorney-in-Fact)
March 29, 2000
88
INDEX TO EXHIBITS
Exhibit
Number Description
**(3)(i) Certificate of Incorporation of HSB Group, Inc., incorporated by
reference to Exhibit 3(i) to the Registrant's Form 10-K for the
year ended December 31, 1997, File Number 001-13135.
(3)(ii) By-laws of HSB Group, Inc.
**(4)(i) Rights Agreement dated as of November 28, 1998 between HSB Group,
Inc. and BankBoston, N.A., as Rights Agent, incorporated by
reference to the Registrant's Report on Form 8-K dated September
21, 1998, File Number 001-13135.
**(4)(ii) Documents related to HSB Capital I:
(a) Indenture of Registrant relating to the Junior
Subordinated Debentures, incorporated by reference to
Exhibit 4 to Registrant's Quarterly Report on Form 10-Q
for the quarter ended June 30, 1997, File No. 001-13135.
(b) First Supplemental Indenture of Registrant, incorporated
by reference to Exhibit 4 to Registrant's Quarterly Report
on Form 10-Q for the quarter ended June 30, 1997, File No.
001-13135.
(c) Form of Certificate of Exchange Junior Subordinated
Debentures, incorporated by reference to Exhibit 4.3 to
Registrant's and HSB Capital I's Registration Statement on
Form S-4 filed with the Commission on October 10, 1997,
Registration No. 333-37581.
(d) Certificate of Trust of HSB Capital I, incorporated by
reference to Exhibit 4.4 to Registrant's and HSB Capital
I's Registration Statement on Form S-4 filed with the
Commission on October 10, 1997, Registration No.
333-37581.
(e) Amended and Restated Trust Agreement of HSB Capital I,
incorporated by reference to Exhibit 4 to Registrant's
Quarterly Report on Form 10-Q for the quarter ended June
30, 1997, File No. 001-13135.
(f) Form of Exchange Capital Security Certificate for HSB
Capital I, incorporated by reference to Exhibit 4.6 to
Registrant's and HSB Capital I's Registration Statement on
Form S-4 filed with the Commission on October 10, 1997,
Registration No. 333-37581.
(g) Form of Exchange Guarantee of Registrant relating to the
Exchange Capital Securities, incorporated by reference to
Exhibit 4.7 to Registrant's and HSB Capital I's
Registration Statement on Form S-4 filed with the
Commission on October 10, 1997, Registration No.
333-37581.
89
Documents related to HSB Capital II:
(a) Purchase Agreement as of December 31, 1997 among Employers
Reinsurance Corporation, ERC Life Reinsurance Corporation
and Registrant, incorporated by reference to Registrant's
Current Report on Form 8-K. File No. 001-13135, filed
January 12, 1998 (the "January 12, 1998 8-K).
(b) Indenture of Registrant relating to the 7.0% Convertible
Subordinated Deferrable Interest Debentures Due December 31,
2017, incorporated by reference to the January 12, 1998 8-K.
(c) Form of Certificate of 7.0% Convertible Subordinated
Deferrable Interest Debentures due December 31, 2017,
incorporated by reference to the January 12, 1998 8-K.
(d) Certificate of Trust of HSB Capital II, incorporated by
reference to the January 12, 1998 8-K.
(e) Trust Agreement dated as of December 31, 1997 among
Registrant, The First National Bank of Chicago, First
Chicago Delaware Inc. and The Administrative Trustees named
therein, incorporated by reference to the January 12, 1998
8-K.
(f) Form of Capital Securities Certificate of HSB Capital II,
incorporated by reference to the January 12, 1998 8-K.
(g) Guarantee Agreement between Registrant and The First
National Bank of Chicago dated as of December 31, 1997
relating to HSB Capital II, incorporated by reference to the
January 12, 1998 8-K.
(h) Registration Rights Agreement dated as of December 31, 1997
among Employers Reinsurance Corporation, ERC Life
Reinsurance Corporation and Registrant, incorporated by
reference to the January 12, 1998 8-K.
**(10)(i) (a) Lease Agreement between HSBIIC and One State Street
Limited Partnership; incorporated by reference to Exhibit
(10)(i) to HSBIIC's Form 10. File No. 0-13300, filed March
18, 1985.
(10)(iii) **(a) Employment Agreement dated February 3, 1997
between HSBIIC and various executive officers, assumed by
Registrant; incorporated by reference to HSBIIC's Form 10-K
for the year ended December 31, 1996, filed with the
Commission on March 31, 1997, File No. 001-10527 (the "1996
10-K").*
(b) Employment Agreement dated November 29, 1999 between
Registrant and Richard H. Booth.*
**(c) HSB Group, Inc. Long-Term Incentive Plan, as amended and
restated effective September 21, 1998, incorporated by
reference to Exhibit 10(iii)(c) to the Registrant's
Quarterly Report on Form 10-Q for the quarter ended
September 30, 1998, File Number 001-13135.*
**(d) HSB Group, Inc. Short-Term Incentive Plan, as amended and
restated effective January 1, 1998, incorporated by
reference to Exhibit (iii)(b) to the Registrant's Quarterly
Report on Form 10-Q for the quarter ended March 31, 1998,
File Number 001-13135.*
90
**(e) HSB Group, Inc. 1985 Stock Option Plan, as amended and
restated as of September 21, 1998, incorporated by reference
to Exhibit 10(iii)(a) to the Registrant's Quarterly Report
on Form 10-Q for the quarter ended September 30, 1998, File
Number 001-13135.*
(f) HSB Group, Inc. 1995 Stock Option Plan, as amended and
restated effective April 20, 1999. *
** (g) Pre-Retirement Death Benefit and Supplemental Pension
Agreement between HSBIIC and various executive officers, as
amended and restated effective March 14, 1997, assumed by
Registrant, incorporated by reference to the 1996 10-K. *
**(h) Pre-Retirement Death Benefit and Supplemental Pension
Agreement between HSBIIC and William A. Kerr, dated March
14, 1997, assumed by Registrant, incorporated by reference
to the 1996 10-K. *
**(i) Pre-Retirement Death Benefit and Supplemental Pension
Agreement between HSBIIC and Robert C. Walker, dated March
14, 1997, assumed by Registrant, incorporated by reference
to the 1996 10-K.*
(j) Pre-Retirement Death Benefit and Supplemental Pension
Agreement between Registrant and Richard H. Booth, dated
November 29, 1999.*
(k) Continuing Services and Retirement Agreement between
Registrant and Gordon W. Kreh dated March 3, 2000.*
**(l) HSB Group, Inc. Directors Stock and Deferred Compensation
Plan, as amended and restated effective September 21, 1998,
incorporated by reference to Exhibit 10(iii)(b) to the
Registrant's Quarterly Report on Form 10-Q for the quarter
ended September 30, 1998, File Number 001-13135.*
**(m) Description of certain arrangements not set forth in any
formal documents, as described on pages 5 - 6 , with respect
to directors' compensation, and on pages 8 -16, with respect
to executive officer's compensation, which pages are
incorporated by reference to Registrant's Proxy Statement
dated and filed March 16, 2000. *
(21) Subsidiaries of the Registrant.
(23) Consent of experts and counsel - consent of PricewaterhouseCoopers LLP.
(24) Power of attorney.
(27) Financial Data Schedule.
* Management contract, compensatory plan or arrangement required to be filed as
an exhibit pursuant to Item 14(c) of this report.
** Previously filed.
91