SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
/x/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 1997
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)
(860) 722-1866
(Registrant's telephone number, including area code)
The Hartford Steam Boiler Inspection and Insurance Company
(Former name, former address and former fiscal year,
if changed since the last report.)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
The number of shares outstanding of the registrant's common stock without par
value, as of June 30, 1997: 19,761,598
1
HSB GROUP, INC.
INDEX
PART I FINANCIAL INFORMATION PAGE
----
Consolidated Statements of Operations for the
Quarters Ended June 30, 1997 and 1996 (unaudited).................. 3
Consolidated Statements of Financial Position as
of June 30, 1997 (unaudited) and December 31,
1996............................................................... 4
Consolidated Statements of Cash Flows for the
Six Months Ended June 30, 1997 and 1996
(unaudited)........................................................ 5
Notes to Consolidated Financial Statements (unaudited)............. 6
Management's Discussion and Analysis of
Consolidated Financial Condition and Results
of Operations..................................................... 12
PART II OTHER INFORMATION
Item 1 - Legal Proceedings........................................ 21
Item 2 - Changes in Securities.................................... 22
Item 5 - Submission of Matters to a Vote of Security Holders...... 23
Item 6 - Exhibits and Reports on Form 8-K......................... 24
SIGNATURES................................................................. 25
2
HSB GROUP, INC.
Consolidated Statements of Operations
Unaudited
(In millions, except per share data)
Quarter Six Months
Ended June 30 Ended June 30
Revenues: 1997 1996 1997 1996
----------- ----------- ----------- -----------
Insurance premiums $ 117.2 $ 112.9 $ 239.5 $ 221.3
Net engineering services 15.0 14.1 29.7 26.8
Net investment income 8.8 7.9 16.7 15.9
Realized investment gains 3.4 5.1 4.0 6.0
----------- ----------- ----------- -----------
Total revenues 144.4 140.0 289.9 270.0
----------- ----------- ----------- -----------
Expenses:
Claims and adjustment 51.4 56.0 102.9 100.9
Policy acquisition 20.4 21.9 43.9 42.5
Underwriting and inspection 36.0 34.4 71.3 68.1
Net engineering services 14.1 12.3 27.7 23.6
Interest 0.4 0.1 0.6 0.3
----------- ----------- ----------- -----------
Total expenses 122.3 124.7 246.4 235.4
----------- ----------- ----------- -----------
Income from continuing operations
before income taxes 22.1 15.3 43.5 34.6
Income taxes:
Current 6.1 5.2 12.7 10.4
Deferred (0.4) (1.9) (1.4) (2.2)
----------- ----------- ----------- -----------
Total income taxes 5.7 3.3 11.3 8.2
Income from continuing operations 16.4 12.0 32.2 26.4
Discontinued operations:
Income from operations
of Radian International LLC
net of income taxes of $(.8);
$1.0; $0; and $2.8 - 1.4 0.0 4.0
----------- ----------- ----------- -----------
Net income $ 16.4 $ 13.4 $ 32.2 $ 30.4
=========== =========== =========== ===========
Net income per common share:
Income from continuing operations $ 0.80 $ 0.59 $ 1.58 $ 1.29
Discontinued operations - 0.07 - 0.20
----------- ----------- ----------- -----------
Net income $ 0.80 $ 0.66 $ 1.58 $ 1.49
=========== =========== =========== ===========
Dividends declared per common share $ 0.57 $ 0.57 $ 1.14 $ 1.14
Average common shares outstanding
and common stock equivalents 20.5 20.3 20.5 20.3
See Notes to Consolidated Financial Statements.
3
HSB GROUP, INC.
Consolidated Statements of Financial Position
(In millions, except per share data)
June 30, December 31,
1997 1996
(Unaudited)
----------- ------------
Assets:
Cash $ 4.7 $ 4.5
Short-term investments, at cost 98.5 97.9
Fixed maturities, at fair value
(cost -$242.8; $231.3) 247.9 235.8
Equity securities, at fair value
(cost - $189.1; $182.9 ) 286.4 262.7
----------- --------------
Total cash and invested assets 637.5 600.9
Insurance premiums receivable 133.7 106.4
Engineering services receivable 11.9 11.7
Fixed assets 30.7 31.7
Prepaid acquisition costs 43.7 40.6
Capital lease 15.7 16.1
Investment in Radian 83.0 79.7
Reinsurance assets 147.6 162.9
Other assets 77.4 66.3
----------- ------------
Total assets $ 1,181.2 $ 1,116.3
=========== ============
Liabilities:
Unearned insurance premiums $ 295.6 $ 270.6
Claims and adjustment expenses 282.3 302.9
Short-term borrowings 26.4 3.2
Long-term borrowings 25.1 25.1
Capital lease 27.9 27.9
Deferred income taxes 29.3 23.7
Dividends payable 11.4 11.4
Other liabilities 113.7 85.9
----------- ------------
Total liabilities 811.7 750.7
----------- ------------
Convertible redeemable preferred stock-
Series B (stated and redemption
value; shares authorized,
issued and outstanding .002) 20.0 20.0
Shareholders' equity:
Common stock (stated value; shares
authorized 50.0; shares issued 21.3;
shares outstanding 19.7; 20.0) 10.0 10.0
Additional paid-in capital 31.5 32.0
Unrealized investment gains, net of tax 63.7 52.8
Retained earnings 249.2 255.1
Benefit plans (4.9) (4.3)
----------- ------------
Total shareholders' equity 349.5 345.6
------------ ------------
Total $ 1,181.2 $ 1,116.3
=========== ============
Shareholders' equity per common
share $ 17.71 $ 17.25
See Notes to Consolidated Financial Statements.
4
HSB Group, Inc.
Consolidated Statements of Cash Flows
(In millions)
Six Months Ended
June 30,
--------------------------
1997 1996
----------- -----------
Operating activities:
Net income $ 32.2 $ 30.4
Adjustments to reconcile net income to
Cash provided by operating activities:
Depreciation and amortization 3.3 5.9
Deferred income taxes (1.4) (2.2)
Realized investment gains, including
market adjustment for derivative instruments (4.0) (6.0)
Change in:
Insurance premiums receivable (27.3) (29.4)
Engineering services receivable (0.2) (1.5)
Prepaid acquisition costs (3.1) (6.2)
Reinsurance assets 15.3 (46.7)
Unearned insurance premiums 25.0 47.5
Claims and adjustment expenses (20.6) 42.8
Investment in Radian (3.3) 8.6
Other (2.8) (6.7)
----------- -----------
Cash provided by operating activities 13.1 36.5
----------- -----------
Investing activities:
Fixed asset additions, net (2.0) (3.9)
Investments:
Purchase of short-term investments, net (0.6) 0.5
Purchase of fixed maturities (28.0) (54.3)
Proceeds from sale of fixed maturities 7.4 71.6
Redemption of fixed maturities 8.7 3.3
Purchase of equity securities (90.1) (66.7)
Proceeds from sale of equity securities 107.3 57.3
Cash transferred to investment in Radian - (0.8)
----------- -----------
Cash provided by investment activities 2.7 7.0
----------- -----------
Financing activities:
Increase (decrease) in short-term borrowings 23.2 (10.3)
Dividends paid to shareholders (23.5) (23.1)
Reacquisition of stock (16.6) (4.0)
Exercise of stock options 1.3 1.1
----------- -----------
Cash used in financing activities (15.6) (36.3)
----------- -----------
Net increase in cash 0.2 7.2
Cash at beginning of period 4.5 8.6
----------- -----------
Cash at end of period $ 4.7 $ 15.8
=========== ===========
Interest paid $ 0.6 $ 1.1
----------- -----------
Federal income tax paid $ 13.1 $ 8.8
----------- -----------
See Notes to Consolidated Financial Statements.
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. General
The interim consolidated financial statements in this report include
adjustments based on management's best estimates and judgments,
including estimates of future loss payments, which are necessary to
present a fair statement of the results for the interim periods
reported. These adjustments are of a normal, recurring nature. The
financial statements are prepared on the basis of generally accepted
accounting principles and should be read in conjunction with the
financial statements and related notes in the 1996 Annual Report.
Certain amounts for 1996 have been reclassified to conform with the
1997 presentation.
2. Discontinued Operations
In 1996, the Company entered into a joint venture agreement with The
Dow Chemical Company (Dow) to form a new company, Radian International
LLC (Radian LLC). The terms of the agreement provided that HSB
contribute the net assets of its Radian Corp. subsidiary into this
joint venture for a 40% ownership. Income was subject to a preference
return to HSB in the first two years. The agreement provided HSB the
option to put its share of the venture to Dow any time during the
period from December 31, 1997 to December 31, 1998 upon giving
appropriate notice. On July 28, 1997 the HSB Board of Directors
ratified management's decision to put its share of Radian LLC to Dow
on or about January 1, 1998 for approximately $145 million. This
amount is not subject to any material adjustment due to the future
operating results of Radian LLC; therefore this will result in a
pre-tax gain of approximately $60 million. Due to this decision, the
results of Radian LLC have been classified as discontinued operations.
HSB's share of Radian LLC's results has been immaterial to the
consolidated results during the first six months of 1997.
3. Industrial Risk Insurers
On December 1, 1996 HSB increased its participation in Industrial Risk
Insurers (IRI) from 14% to 23.5%. IRI is an unincorporated, voluntary
property underwriting association currently comprised of twenty-three
property casualty insurance companies. IRI primarily writes policies on
a syndicate basis which 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 essence, the 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
6
therefore, members are not responsible for policy liabilities of the
other members. An increased participation does not expose the Company
to the effect of adverse loss development on claims incurred prior to
the effective date of the increase.
Other than a nominal deposit, which is refunded if participation
ceases, there is no cost to becoming a member of the IRI. Members can
change or terminate their participation on an annual basis. Typically
participation levels vary based on a member's expectations of future
profits.
4. Shareholders' Equity
The Connecticut Business Corporation Act, which became effective on
January 1, 1997, eliminated the concept of treasury shares. Therefore,
shares reacquired by the Company constitute authorized but unissued
shares. As a result of this change in law, the Company eliminated the
caption Treasury Stock from its balance sheet and reclassified the
amounts to additional paid-in capital and retained earnings. These
amounts were $74.8 million as of June 30, 1997 and $59.5 million as of
December 31, 1996. The reclassifications were distributed as follows:
June 30, 1997 December 31, 1996
------------- -----------------
Additional Paid In $ 2.5 $ 2.0
Retained Earnings 72.3 57.5
---------- ----------
Total $ 74.8 $ 59.5
On December 30, 1996, the Company issued Convertible Redeemable
Preferred Stock. The Stock is convertible into 398,406 shares of HSB
common stock at a price of $50.20 per share and may be redeemed at the
option of the Company on or after the fifth anniversary of issuance and
by the holder after the eighth anniversary. As a result of the stock's
redemption features, it has been included in the "mezzanine" section of
the balance sheet located between liabilities and shareholders' equity.
Prior year amounts now conform to these presentations.
5. Derivative Instruments
On December 19, 1996, the Company 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). Each contract had a notional value of $50
million and maturity dates ranging from November 1997 to January 1998.
The contracts are European style, which means they only settle upon
maturity. The contracts, which were entered into when the S&P 500 Index
was 744.3, allow the Company to recover from the counterparty if the
index is below 695.2 at the time of maturity, and requires the Company
to reimburse the counterparty if the index is above a range of 811.3 to
818.7 at the time of maturity.
7
The Company entered into these contracts with the intent to hold such
contracts until maturity. However, based upon price movements in the
S&P 500 Index since December 31, 1996, the contracts do have a current
estimated market value of $(19.4) million, which represents the cost
the Company would incur if it had canceled the contracts at June 30,
1997. As of June 30, 1997, the Company recorded the mark to market
valuation of $19.4 million as a reduction of realized investment gains.
At present such contracts are included in other liabilities in the
Statement of Financial Position.
At June 30, 1997, the S&P 500 Index was 885.14, which is outside the
bounds of the collar. If the contracts had reached their expiration
dates at the end of the quarter, HSB would have been required to pay
approximately $14.0 million to its counterparty and an additional $5.4
million of realized gains would have been recognized in the statement
of income.
The Company's U.S. common stock portfolio has experienced a total
return of $37 million (which includes price appreciation of
approximately $34 million) since December 31, 1996, and has had a price
movement correlation with the S&P 500 Index well in excess of 80%.
The collar subjects the Company to market and counterparty credit risk.
The Company manages 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 are 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.
6. Recent Accounting Developments
In February 1997, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 128, "Earnings per
Share". This statement establishes standards for computing and
presenting earnings per share (EPS). It replaces the presentation of
primary EPS with a presentation of basic EPS. It also requires dual
presentation of basic and diluted EPS on the face of the income
statement and a reconciliation of the numerator and denominator of the
basic EPS computation to the numerator and denominator of the diluted
EPS computation. The requirements of this statement will be effective
for year end 1997 financial statements. Had this standard been in
effect as of the first quarter 1996, EPS would have been as follows:
June 30, 1997 June 30, 1996
------------- -------------
Quarter YTD Quarter YTD
------- ----- ------- ----
Basic $ .81 $1.58 $ .66 $1.50
Diluted $ .80 $1.58 $ .66 $1.49
As Reported $ .80 $1.58 $ .66 $1.49
8
In June 1997 the FASB issued SFAS 130 " Reporting Comprehensive Income"
which requires items that comprise comprehensive income be reported in
a financial statement display with the same prominence as other
financial statements. This presentation will include such items as
market value adjustments of securities, foreign currency translation,
and certain adjustments made for benefit plans, which are currently
reported as components of the changes in shareholders' equity. This
statement will be effective beginning in 1998 with retroactive
restatement of prior periods required.
Also in June of 1997 the FASB issued SFAS No. 131 "Disclosures about
Segments of an Enterprise and Related Information". This standard
requires companies to report financial and descriptive information
about reportable operating segments. It includes disclosure
requirements relating to products and services, geographic areas and
major customers. This statement will be effective beginning in 1998.
7. Legal Proceedings
The Company is involved in three arbitration or litigation proceedings
regarding the extent to which certain explosion events are insured
under boiler and machinery policies of the Company or under the
all-risk property insurance policies issued by other companies.
Management believes the Company's policies do not provide coverage for
losses resulting from the explosion events that are the subject of
these proceedings.
A lower court ruling in one of these cases held that an explosion did
occur, and that the Company was not liable for losses of the insured
resulting from the explosion. In a further action, the court denied the
Company's motion for summary judgment on certain issues, thus leaving
the Company potentially liable for certain unquantified losses
resulting from events prior to the explosion. In the first quarter of
1997 the Company and the property insurer jointly settled the case with
the insured. The Company's ultimate share of the settlement will be
determined in an arbitration proceeding with the property insurer. The
Company has incurred gross losses and LAE of $40.7 million and a net
loss after taking into account reinsurance recoverables of $6.4
million, of which $5 million represents claim cost and the remaining
$1.4 million represents loss adjustment expenses. As a result of
payments made to date, at June 30, 1997 the Company carried gross loss
and LAE reserves of $2.8 million and recoverables from reinsurers of
$2.9 million.
The Company has accrued $6.5 million with respect to the other two
cases for potential loss adjustment expenses, including legal costs to
defend the Company's position. One case is in the process of pre-trial
summary judgment motions and appeals; the other case is involved in
both arbitration and litigation proceedings. A trial date has not been
set for either case. In the event that the Company is held liable for
one or both of the remaining claims, amounts in excess of the Company's
net maximum aggregate retention of $8.5 million is recoverable from the
9
Company's reinsurers. Claim amounts potentially recoverable from
reinsurers in the event of a possible adverse outcome in these cases
could range, in the aggregate, from $40 million to $195 million.
The obligations of the Company's reinsurers with respect to these cases
are not in dispute. Therefore, management believes that any adverse
outcomes in these cases will not, in the aggregate, have a material
effect on either the results of operations or financial condition of
the Company. The Company's reinsurance contracts do not require the
Company to reimburse its reinsurers for any losses such reinsurers
might incur should these cases not be decided in the Company's favor.
Nevertheless, reinsurers often quote rates for future coverages based
upon their or other reinsurer's experience on a particular account.
Therefore, in the event the Company's reinsurers pay significant sums
pursuant to the arbitration or litigation proceedings described above,
it is likely the Company's reinsurance rates would increase in future
periods. However, given the insured capacity that exists in reinsurance
markets worldwide, coupled with the Company's ability to negotiate a
redesign or restructuring of its reinsurance program, it does not
necessarily mean that such an increase would be material.
The Company is also involved in various other 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.
8. Holding Company Formation
At a special meeting of the Company on June 23, 1997, shareholders
voted to approve a proposal which enabled the Company to form a new
holding company, HSB Group, Inc. Shareholders of Hartford Steam
Boiler's common stock automatically became holders of HSB Group's
common stock through a share exchange approved by the shareholders, and
certificates representing Hartford Steam Boiler common stock
automatically represent the corresponding shares of HSB Group common
stock.
9. Capital Securities
On July 10, 1997, HSB Group, Inc. announced the sale of $110 million of
30 year Capital Securities in a private placement. The securities are
non-callable for ten years and may be called earlier upon the
occurrence of a Tax Event. The securities were issued through HSB
Capital I, a Delaware business trust created by HSB Group, Inc. at a
floating rate tied to 90 day LIBOR. The initial coupon is approximately
6.7 percent. Holders of the Capital Securities will be entitled to
receive preferential cumulative cash distributions accumulating from
the date of
10
original issuance and payable quarterly in arrears. The Company has
the right to defer payment of interest 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 Company has irrevocably and unconditionally
guaranteed all of the Issuer Trust's obligations under the Capital
Securities. The Company expects to use the proceeds for general
corporate purposes, which may include the repurchase of HSB common
stock; funding investments in, or extensions of credit to,
subsidiaries; repayment of maturing debt; and financing possible
future acquisitions.
10. Computation of Earnings Per Share
Quarter Ended Year to Date
June 30, 1997 June 30, 1997
------------- -------------
Net Income $16.4 (A) $ 32.2 (A)
===== =======
Weighted Average Common
Shares Outstanding 19.9 20.0
Common Stock Equivalents
Preferred Stock -
assuming conversion .4 .4
Options .2 .1
---- -------
20.5 (B) 20.5 (B)
===== =======
EPS - (A)/(B) $0.80 $1.58*
*Computation excludes rounding
11
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF CONSOLIDATED FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
JUNE 30, 1997
RESULTS OF OPERATIONS
(dollar amounts in millions)
Consolidated Overview
Quarter Ended Six Months Ended
June 30 June 30
--------------------- -----------------------
1997 1996 1997 1996
---- ---- ---- ----
Insurance premium $ 117.2 $ 112.9 $ 239.5 $ 221.3
Net engineering services revenue 15.0 14.1 29.7 26.8
Net investment income 8.8 7.9 16.7 15.9
Realized investment gains 3.4 5.1 4.0 6.0
-------- ------- -------- -------
Total revenues $ 144.4 $ 140.0 $ 289.9 $ 270.0
====== ======= ======== =======
Income from continuing operations $ 16.4 $ 12.0 $ 32.2 $ 26.4
-------- ------- -------- -------
Net income $ 16.4 $ 13.4 $ 32.2 $ 30.4
======= ======= ======== =======
Income from continuing operations
per common share $ 0.80 $ 0.59 $ 1.58 $ 1.29
-------- ------- -------- -------
Net income per common share $ 0.80 $ 0.66 $ 1.58 $ 1.49
======== ======= ======== =======
Net income per common share for the second quarter of 1997 increased 21 percent
from the second quarter of 1996 and increased 6 percent in the first six months
of 1997 compared to 1996 due to significantly higher underwriting gains in the
Company's insurance operations. There were no earnings from HSB's interest in
its joint venture, Radian International LLC during the quarter and year to date
through June 30, 1997. Continued softness in Radian's businesses due to delays
associated with the transition of their client mix to one that is more
commercial based than government based accounted for the decrease. On July 28,
1997 the HSB Board ratified management's decision to exercise its option to put
its share of Radian International LLC to Dow on or about January 1, 1998 for
approximately $145 million. Due to this decision, the results of Radian
International LLC have been classified as discontinued operations. In comparison
to 1996 results, income per share from continuing operations increased 36
percent and 22 percent for the second quarter and year to date respectively.
Insurance premiums grew 4 percent in the quarter and 8 percent year to date,
with the increased participation in IRI a contributing factor as well as growth
in both the domestic and international
12
books of business. The second quarter combined ratio improved from 99.0 percent
in 1996 to 91.8 percent in 1997. Net engineering services revenue increased 7
percent for the second quarter and 11 percent year to date compared to
comparable periods last year.
The effective tax rates for the second quarter and year to date were 26 percent
compared to 22 percent and 24 percent for the comparable prior periods. Tax rate
fluctuations occur as underwriting and engineering services results change the
mix of pre-tax income between fully taxable earnings and tax preferred earnings.
The Company continues to manage its use of tax advantageous investments to
maximize after tax earnings.
Recent Accounting Developments
- ------------------------------
In February 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 128, "Earnings per Share". This statement
establishes standards for computing and presenting earnings per share (EPS). It
replaces the presentation of primary EPS with a presentation of basic EPS. It
also requires dual presentation of basic and diluted EPS on the face of the
income statement and a reconciliation of the numerator and denominator of the
basic EPS computation to the numerator and denominator of the diluted EPS
computation. The requirements of this statement will be effective for year end
1997 financial statements. Had this standard been in effect for 1997, basic EPS
would have increased $.01 for the second quarter to $.81.
In June 1997 the FASB issued SFAS 130 " Reporting Comprehensive Income" which
requires items that comprise comprehensive income be reported in a financial
statement display with the same prominence as other financial statements. This
will include a presentation of items such as market value adjustments of
securities, foreign currency translation, and certain adjustments made for
benefit plans. This statement will be effective beginning in 1998 with
retroactive restatement of prior periods required.
Also in June of 1997 the FASB issued SFAS No. 131 "Disclosures about Segments of
an Enterprise and Related Information". This standard requires companies to
report financial and descriptive information about reportable operating
segments. It includes disclosure requirements relating to products and services,
geographic areas and major customers. This statement will be effective beginning
in 1998.
Other Developments
- ------------------
At a special meeting for the Company on June 23, shareholders voted to approve a
proposal which enabled the Company to form a new holding company, HSB Group,
Inc. Shareholders of Hartford Steam Boiler's common stock automatically became
holders of HSB Group's common stock through a share exchange approved by the
shareholders, and certificates representing Hartford Steam Boiler common stock
automatically represent the corresponding shares of HSB Group common stock.
13
Insurance Operations
- --------------------
Insurance operations include the insurance results of The Hartford Steam Boiler
Inspection and Insurance Company(HSB), HSB Engineering Insurance Limited
(HSB-EIL), The Boiler Inspection and Insurance Company of Canada (BI&I) and The
Allen Insurance Company, Ltd.
On December 1, 1996 HSB increased its participation in Industrial Risk Insurers
(IRI) from 14% to 23.5%. IRI is an unincorporated, voluntary property
underwriting association currently comprised of twenty-three property casualty
insurance companies. IRI primarily writes policies on a syndicate basis which
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 essence, the 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 the
Company to the effect of adverse loss development on claims incurred prior to
the effective date of the increase.
Other than a nominal deposit, which is refunded if participation ceases, there
is no cost to becoming a member of the IRI. Members can change or terminate
their participation on an annual basis. Typically participation levels vary
based on a member's expectations of future profits.
IRI has a fiscal year ending November 30, and provides reports to its members on
a quarterly basis. As a result, the Company's increased participation to 23.5
percent has initially been reflected in the first quarter financial results for
1997.
14
Quarter Ended Six Months Ended
June 30 June 30
--------------------------- ------------------------
1997 1996 1997 1996
---- ---- ---- ----
Gross earned premium $ 149.2 $ 137.7 $ 305.0 $ 271.4
Ceded premium 32.0 24.8 65.5 50.1
------ --------- -------- ---------
Insurance premium 117.2 112.9 239.5 221.3
Claims and adjustment expenses 51.4 56.0 102.9 100.9
Underwriting, acquisition
and other expenses 56.4 56.3 115.2 110.6
------ --------- -------- ---------
Underwriting gain $ 9.4 $ 0.6 $ 21.4 $ 9.8
========= ========== ======== =========
Loss ratio 43.9% 49.5% 43.0% 45.6%
Expense ratio 47.9% 49.5% 47.9% 49.5%
---------- ---------- -------- --------
Combined ratio 91.8% 99.0% 90.9% 95.1%
========== ========== ======== ========
Gross earned premiums in the second quarter and year to date increased 8 percent
and 12 percent from the comparable periods in 1996. This increase was primarily
attributable to the increased participation in IRI ($6.4 million and $16.5
million) and to growth in both domestic and global markets. Gross earned
premiums representing coverage outside the U.S. increased 12 percent in the
second quarter and 21 percent year to date from the comparable period in 1996.
In certain areas of the Company's direct domestic and international businesses,
the market is experiencing price erosion. HSB will not write business at rates
which would lessen our ability to maintain underwriting profit. Increases in
ceded premium of 29 percent in the current quarter and 31 percent year to date
were primarily due to the additional participation in IRI and the purchase of
facultative reinsurance at EIL.
The loss ratio decreased from 49.5 percent in the second quarter of 1996 to 43.9
percent in the current quarter and from 45.6 percent in the first six months of
1996 to 43.0 percent in the first six months of 1997. In 1996, high frequency of
claims and unusually severe winter weather impacted the loss ratio.
Approximately $2.6 million of flood related losses were reported during the
first six months of 1997, which impacted the loss ratio by 1.1 percentage
points. Gross claims and adjustment expenses for 1997 and 1996 were $142.5
million and $214.2 million, respectively.
15
The expense ratio improved in both the quarter and year to date from comparable
periods in the previous year as the growth rate in earned premium exceeded the
growth rate in underwriting and inspection expenses. Underwriting, acquisition
and other expenses were flat in the second quarter but increased approximately 4
percent year to date primarily due to increased participation in IRI. In April
HSB was notified that expected obligations to the Florida Insurance Guaranty
Association relating to Hurricane Andrew were canceled. Expenses in the second
quarter benefited from the release $.6 million of reserves that had been
established in prior years for these assessments.
Engineering Services Operations
Quarter Ended Six Months Ended
June 30 June 30
1997 1996 1997 1996
---- ---- ---- ----
Net engineering services revenue $ 15.0 $ 14.1 $ 29.7 $ 26.8
Net engineering services expenses 14.1 12.3 27.7 23.6
------ ------ ------- -------
Operating gain $ 0.9 $ 1.8 $ 2.0 $ 3.2
======= ======= ====== =======
Net margin 6.1% 12.6% 6.6% 12.0%
Engineering services operations include the results of HSB's and BI&I's
engineering services, HSB Reliability Technologies (HSBRT) and the Company's
other engineering services subsidiaries.
Net engineering services revenues increased $.9 million in the second quarter
and $2.9 million year to date compared to the same periods in 1996. The growth
in revenues was primarily due to increases generated by HSBRT. The decline in
operating gain from the previous periods reflects slower growth in the domestic
book and Far East operations, and operating costs incurred to develop new
products and in new start up operations.
16
Investment Operations
Quarter Ended Six Months Ended
June 30 June 30
--------------------------- -------------------
1997 1996 1997 1996
---- ---- ---- ----
Net investment income $ 8.8 $ 7.9 $ 16.7 $ 15.9
Realized investment gains 3.4 5.1 4.0 6.0
--------- --------- -------- ---------
Pretax income from
investment operations $ 12.2 $ 13.0 $ 20.7 $ 21.9
========= ========= ======== =========
Net investment income for the second quarter and year to date increased $.9
million and $.8 million compared to the same periods in 1996. Investable assets
increased in 1997 in comparison to the same period in 1996. Net investment
income was impacted earlier in 1997 by calls of high yielding preferred stocks
and cash collections from reinsurers that were not received until late in March.
In the second quarter net investment income increases reflected more investable
funds and a modest change in the mix of the portfolio from tax preferred
investments to more taxable investments with higher pre-tax yields. Second
quarter net investment income was also impacted by higher interest costs related
to a larger amount of commercial paper outstanding.
The Company's investment 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 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 to maximize after tax investment earnings.
In the fourth quarter of 1996, HSB entered into three zero cost collar contracts
to mitigate the effects of market risk on its domestic common stock portfolio.
The contracts have maturity dates ranging from November 1997 to January 1998.
The contracts, which were entered into when the S&P index was 744.3, allow the
Company to recover from the counterparty if the index is below 695.2 at the time
of maturity and requires the Company to reimburse the counterparty if the index
is above a range of 811.3 to 818.7 at the time of maturity. In addition to
offering downside protection for market declines in excess of approximately 6
percent, the collar permits the Company to receive the dividends on its common
stock investments and retain a certain level of upside appreciation depending on
market movements.
At June 30, 1997 the S&P index was at 885.14 which is outside the bounds of the
collar. Although there would have been a settlement of $14.0 million had these
contracts matured at June 30, 1997, HSB has adjusted its value of the contracts
to an estimated fair value at that date
17
and reduced realized investment gains by $19.4 million on a year to date basis.
The impact on the quarter was $18.0 million.
The Company's U.S. common stock portfolio has experienced a total return of $37
million (which includes price appreciation of approximately $34 million) since
December 31, 1996, and has had a price movement correlation with the S&P 500
Index well in excess of 80%.
Liquidity and Capital Resources
- -------------------------------
Balances at
June 30 December 31
------- -----------
1997 1996
---- ----
Total assets $ 1,181.2 $ 1,116.3
Short-term investments 98.5 97.9
Cash 4.7 4.5
Short-term borrowings 26.4 3.2
Convertible Redeemable Preferred Stock 20.0 20.0
Common shareholder's equity 349.5 345.6
Liquidity refers to the Company's ability to generate sufficient funds to meet
the cash requirements of its business operations. The Company receives a regular
inflow of cash from maturing investments and engineering services and insurance
operations. The mix of the investment portfolio is managed to respond to
expected claim pay-out patterns. The Company also maintains a highly liquid
short-term portfolio to provide for immediate cash needs.
Cash provided from operations was $13.1 million in the first six months of 1997
compared to $36.5 million for the same period in 1996. Insurance operations cash
flow decreased as claims paid increased 54 percent compared to the same period
in 1996, and premiums collected were 5 percent higher year to date. Collections
from reinsurers increased significantly in the current year. The Company's
participation in IRI impacted components of the Consolidated Statement of Cash
Flows for 1997, including a year to date positive impact of $8.3 million and
$9.4 million for 1997 and 1996, respectively, to cash provided from operations.
Capital resources consist of shareholders' equity, convertible redeemable
preferred stock and debt outstanding and represent those funds deployed or
available to be deployed to support business operations. Common shareholders'
equity of $349.5 million at June 30, 1997 increased by $3.9 million since
December 31, 1996. The increase reflects net income of $32.2 million year to
date and an increase in unrealized gains, net of tax, of $10.9 million, offset
by dividends of $23.3 million and share repurchases.
On January 27, 1997 the Board of Directors renewed the Company's authorization
to repurchase up to one million of its common shares. During the second quarter
the Company repurchased 340,400 common shares at a cost of $15.3 million. At its
July meeting, the HSB Board of Directors increased the authorization to
repurchase shares to two million. Treasury stock of
18
$74.8 million was reclassified to retained earnings and additional paid-in
capital during 1997 in accordance with the Connecticut Business Corporation Act
which, effective January 1, 1997, eliminated the concept of treasury shares. For
comparative purposes treasury stock of $59.5 million was likewise reclassified
at December 1996.
At June 30, 1997, the Company had significant short-term and long-term borrowing
capacity. The Company is currently authorized to issue up to $75 million of
commercial paper. Commercial paper outstanding at June 30, 1997 and December 31,
1996 was $26.4 million and $3.2 million, respectively. The Company has
authorized a guaranty of up to 40 percent of Radian International, LLC's $40
million credit facility with The Dow Chemical Company. At June 30, 1997 the
amount guaranteed was $13.7 million.
On July 10, 1997, HSB Group, Inc. announced the sale of $110 million of 30 year
Capital Securities in a private placement. The securities are non-callable for
ten years and may be called earlier upon the occurrence of a tax event. The
securities were issued through HSB Capital I, a Delaware business trust created
by HSB Group, Inc. at a floating rate tied to 90 day LIBOR. The initial coupon
is approximately 6.7 percent. Holders of the Capital Securities will be entitled
to receive preferential cumulative cash distributions accumulating from the date
of original issuance and payable quarterly in arrears. The Company has the right
to defer payment of interest 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 Company has irrevocably and unconditionally guaranteed all
of the Issuer Trust's obligations under the Capital Securities. The Company
expects to use the proceeds for general corporate purposes, which may include
the repurchase of HSB common stock; funding investments in, or extensions of
credit to, subsidiaries; repayment of maturing debt; and financing possible
future acquisitions.
The Company is involved in three arbitration or litigation proceedings regarding
the extent to which certain explosion events are insured under boiler and
machinery policies of the Company or under the all-risk property insurance
policies issued by other companies. Management believes the Company's policies
do not provide coverage for losses resulting from the explosion events that are
the subject of these proceedings. More information pertaining to these legal
proceedings may be found under note 7 of the Notes to Consolidated Financial
Statements herein.
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
19
of reinsurance; changes in domestic and foreign laws, regulations and taxes; 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 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.
20
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
- -------------------------
The Company is involved in three arbitration or litigation proceedings regarding
the extent to which certain explosion events are insured under boiler and
machinery policies of the Company or under the all-risk property insurance
policies issued by other companies. Management believes the Company's policies
do not provide coverage for losses resulting from the explosion events that are
the subject of these proceedings.
A lower court ruling in one of these cases held that an explosion did occur, and
that the Company was not liable for losses of the insured resulting from the
explosion. In a further action, the court denied the Company's motion for
summary judgment on certain issues, thus leaving the Company potentially liable
for certain unquantified losses resulting from events prior to the explosion. In
the first quarter of 1997 the Company and the property insurer jointly settled
the case with the insured. The Company's ultimate share of the settlement will
be determined in an arbitration proceeding with the property insurer. The
Company has incurred gross losses and LAE of $40.7 million and a net loss after
taking into account reinsurance recoverables of $6.4 million, of which $5
million represents claim cost and the remaining $1.4 million represents loss
adjustment expenses. As a result of payments made to date, at June 30, 1997 the
Company carried gross loss and LAE reserves of $2.8 million and recoverables
from reinsurers of $2.9 million.
The Company has accrued $6.5 million with respect to the other two cases for
potential loss adjustment expenses, including legal costs to defend the
Company's position. One case is in the process of pre-trial summary judgment
motions and appeals; the other case is involved in both arbitration and
litigation proceedings. A trial date has not been set for either case. In the
event that the Company is held liable for one or both of the remaining claims,
amounts in excess of the Company's net maximum aggregate retention of $8.5
million is recoverable from the Company's reinsurers. Claim amounts potentially
recoverable from reinsurers in the event of a possible adverse outcome in these
cases could range, in the aggregate, from $40 million to $195 million.
The obligations of the Company's reinsurers with respect to these cases are not
in dispute. Therefore, management believes that any adverse outcomes in these
cases will not, in the aggregate, have a material effect on either the results
of operations or financial condition of the Company. The Company's reinsurance
contracts do not require the Company to reimburse its reinsurers for any losses
such reinsurers might incur should these cases not be decided in the Company's
favor. Nevertheless, reinsurers often quote rates for future coverages based
upon their or other reinsurer's experience on a particular account. Therefore,
in the event the Company's reinsurers pay significant sums pursuant to the
arbitration or litigation proceedings described above, it is likely the
Company's reinsurance rates would increase in future periods. However, given the
insured capacity that exists in reinsurance markets worldwide, coupled with the
Company's ability to negotiate a redesign
21
or restructuring of its reinsurance program, it does not necessarily mean that
such an increase would be material.
The Company is also involved in various other 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 2. Changes in Securities
- ------------------------------
Recent Sales of Unregistered Securities
Effective September 26, 1996, the Company terminated its retirement plan for
current and future non-employee directors and adopted the Directors Stock and
Deferred Compensation Plan (the "Directors Plan"). At that time, the value of
benefits payable to current non-employee directors who were covered under the
terminated retirement plan was converted into stock equivalent units under the
Directors Plan. Under the Directors Plan, non-employee directors will each
receive an annual award of 550 stock equivalent units, and may elect to defer
all or a portion of their cash compensation for payment at a future date.
Deferred accounts will be credited annually with interest or translated into
stock equivalent units, at the election of the director. The number of stock
equivalent units equals the amount of cash compensation divided by the fair
market value of Company common stock on the date such compensation would
otherwise have been paid.
Account balances held under the Directors Plan are paid out in cash or an
equivalent number of shares of Company common stock, at the election of the
director. Dividend equivalents, in an amount equal to the amount of dividends
that would have been payable had each stock equivalent unit constituted a share
of Company common stock, are payable in cash at the end of the plan year on all
stock equivalent units credited under the plan.
33,858.48 stock equivalent units, in the aggregate, were granted to eight of the
Company's non-employee directors on September 26, 1996, based on a price of
$44.625 per share.
Under the Company's Long-Term Incentive Plan (the "Long-Term Incentive Plan"),
senior executives of the Company are eligible for awards based on the
achievement of long-term performance goals. For each performance goal, an award
schedule of performance contingent units is established. The actual award
payable at the conclusion of a three year performance period is based on the
level of attainment of the performance goals established for such period. Any
payments under the plan are made in cash or in shares of Company common stock
(which may be restricted shares) as determined by the committee administering
the plan. Dividend equivalent units may be paid in conjunction with award
payouts made under the plan equal to the amount of cash dividends that would
have been paid if the award had been made in Company common stock at the
committee's discretion.
22
On January 27, 1997, a total of 7,586 shares of restricted stock were awarded to
senior executives under the plan. The fair market value of a share of the
Company's common stock on that date was $45.8125.
To the extent that such grants under the Directors Plan and the Long-Term
Incentive Plan constitute sales of equity securities, the Company issued such
stock equivalent units, performance contingent units and restricted stock in
reliance on the exemption provided by Section 4(2) of the Securities Act of
1933, as amended, taking into account the nature of the Directors Plan and
Long-Term Incentive Plan, the sophistication of the non-employee directors and
senior executives and their access to the kind of information that a
registration statement would provide.
Item 4 - Submission of Matters to a Vote of Security Holders
- ------------------------------------------------------------
(a) The Annual Meeting of Stockholders was held on April 24, 1997
and a Special Meeting of Stockholders was held on June 23,
1997.
(b) Three directors were nominated for election at the Annual
Meeting. Proxies for such meeting were solicited by
Registrant's management pursuant to Regulation 14A under the
Securities Exchange Act of 1934; there was no solicitation in
opposition to management's nominees as listed in the proxy
statement; and all of such nominees were elected for a
three-year term.
(c) The following matters were voted upon at the Annual Meeting
with the voting results indicated.
1. Election of Directors
---------------------
Nominee Votes For Votes Withheld
------- --------- --------------
William B. Ellis 16,371,482 797,462
E. James Ferland 16,817,823 351,121
Wilson Wilde 16,602,165 566,779
2. Proposal to amend and restate 1995 Stock Option Plan
----------------------------------------------------
Votes for Against Abstain
--------- ------- -------
15,302,655 1,536,186 330,103
3. Appointment of Coopers & Lybrand as Independent
------------------------------------------------
Public Accountants
------------------
Votes for Against Abstain
--------- ------- -------
16,863,270 115,596 191,356
23
The following matter was voted upon at the June 27, 1997
Special Meeting with the voting results indicated.
Proposal to approve Agreement and Plan of Share
-----------------------------------------------------
Exchange in connection with the formation of a
-----------------------------------------------------
revised holding company structure.
---------------------------------
Votes for Against Abstain
--------- ------- -------
15,276,070 191,093 161,267
Item 6 - Exhibits and Reports on Form 8-K
- -----------------------------------------
(a) Exhibits -- Exhibit 4. Documents related to HSB Capital I:
Amended and Restated Trust Agreement dated as of
July 15, 1997 among HSB Group, Inc., The First
National Bank of Chicago, First Chicago Delaware
Inc. and the Administrative Trustees.
Junior Subordinated Indenture dated as of July 15,
1997 between HSB Group, Inc. and The First National
Bank of Chicago.
Guarantee Agreement between HSB Group, Inc. and The
First National Bank of Chicago dated as of July 15,
1997.
First Supplemental Indenture between HSB Group, Inc.
and The First National Bank of Chicago dated as of
July 15, 1997.
Exhibit 27. Financial Data Schedule.
(b) Reports on Form 8-K -
Form 8-K/A filed on May 12, 1997 amending Form 8-K
dated January 30, 1996.
Form 8-K filed June 23, 1997 to announce shareholder
approval of a revised holding company structure.
24
SIGNATURES
Pursuant to the requirements 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.
Date: August 13, 1997 By: /s/ Saul L. Basch
Saul L. Basch
Senior Vice President, Treasurer
and Chief Financial Officer
Date: August 13, 1997 By: /s/ Robert C. Walker
Robert C. Walker
Senior Vice President and
General Counsel
25