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, 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)
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.....X.......
The aggregate market value of the voting stock held by non-affiliates of the
registrant as of February 17, 1998 was $1,179,041,668.
Number of shares of common stock outstanding as of February 17, 1998:
19,409,870.
Documents Incorporated by Reference:
Portions of the Proxy Statement dated March 6, 1998 for the Annual Meeting of
Shareholders to be held April 21, 1998 are incorporated by reference in Parts
III and IV herein.
1
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 three industry segments -
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 services aimed at loss
prevention. Earned premiums for the Company's insurance products were $491.2
million for 1997, which accounted for approximately 81.4 percent of the
Company's revenues. See Note 9 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). In December 1994, the Company purchased
the remaining 50% interest in HSB EIL's parent company, Engineering Insurance
Group (EIG) from General Reinsurance Corporation.
On January 6, 1998, HSBIIC sold its 23.5 percent share in Industrial Risk
Insurers (IRI) to Employers Reinsurance Corporation (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
which 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. HSBIIC will write the business for the reconstituted IRI using its
insurance licenses and will provide certain other management and technical
services. In addition, through various reinsurance agreements with ERC and IRI,
HSBIIC will transfer its manufacturing book of business to IRI and will retain
85% of the equipment breakdown insurance and 15% of the property insurance of
the HSB/IRI combined portfolio. See "Participation in Industrial Risk Insurers"
on page 12 for additional information.
To support the Company's expanded role with IRI, 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, of which $250 million was
contributed by the Company to HSBIIC.
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The capital securities are convertible into HSB common stock, at any time,
subject to regulatory approval. See Note 12 to the Consolidated Financial
Statements located in Item 8 of Part II herein for more information on this
transaction.
The Company also offers professional scientific and technical consulting
services for industry and government on a world-wide basis through its
Engineering Department and its engineering subsidiaries. In 1997 net engineering
services revenues were $61.3 million, which accounted for approximately 10.2
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 $144 million. 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 by the Board of
Directors of management's decision to exercise its put in July 1997 and the
Company's share of Radian LLC's losses incurred subsequent to such decision of
approximately $10 million was deferred until the closing of the sale on January
2, 1998, at which time an estimated after-tax gain of $30 million 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 industries, in order to grow the engineering services
segment of its business. 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. 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, which
markets computerized facilities maintenance vendor management systems and
services.
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 1997 the revenues and pre-tax income associated with operations outside of
the United States were approximately 18.5 percent and 20.9 percent,
respectively. Identifiable assets associated with operations outside of the
United States are approximately 19.0 percent of the consolidated amount. See
Note 1 and Note 4 to the Consolidated Financial Statements located in Item 8 of
Part II herein for more financial data based on geographic location and business
segments.
3
B. PRODUCTS AND SERVICES
Insurance
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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 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
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Separate divisions of the Company's Engineering Department provide quality
assurance services, training for nondestructive testing, inspections to code
standards of the American Society of Mechanical Engineers (ASME), ISO
certification services and other specialized consulting 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
their customers. HSBIIC is the largest Authorized Inspection Agency for ASME
codes in the world. In addition, the Company's Engineering Department focuses on
researching and developing potential new products and services, and new markets
for current services.
4
The Company's engineering subsidiaries include HSB Reliability Technologies
Corp. (HSB RT), and HSB Professional Loss Control, Inc. (HSB PLC). 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, 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. HSB Haughton and Integrated Process Technologies LLC, which became
affiliated with the Company during 1997, are described above under "A. General
Development of Business".
C. COMPETITION
Insurance
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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 gross earned premium, the Company's
U.S. market share, at approximately 37 percent, has remained fairly stable over
the past ten years. Based on net premiums written reported in the 1997 edition
of Best's Aggregates and Averages, no other single company has more than a 10
percent market share. Members of the Factory Mutual System, an affiliated group
of insurers, have a market share of approximately 20 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 has grown as new insurers enter the property casualty market. 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.
5
Engineering Services
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The Company provides a wide range of engineering, consulting and inspection
services as described on page 4. 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 ensure that the Company's inspectors,
engineers, and technicians are kept up-to-date on the latest engineering and
technical developments.
D. MARKETING
Insurance
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The Company's various functional operations are aligned to focus on its two
principal customer groups, commercial risks and 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 1997, 77.1 percent of its net written premiums (exclusive of
IRI) related to risks located in the United States. Of the direct premiums
written in the United States in 1997 (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 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
6
Insurance Limited, based in London, with additional offices in Hong Kong,
Malaysia, Australia, Miami, New York, Spain, Korea and South Africa.
Additionally, the Company markets its insurance products through the
distribution channels of the companies which it reinsures.
IRI markets its products primarily through a small number of large
international brokerage firms. A portion of the Company's special risk business
is also produced through these brokers.
Recently there has been significant consolidation in the international
brokerage business, including the merger of Marsh & McLennan and Johnson &
Higgins during 1997. For 1997, approximately 18.5 percent of the Company's gross
written premium generated by its special risk business and by its 23.5 percent
participation in IRI was produced by J&H Marsh & McLennan after giving effect to
the merger. Based on writings for 1997 it is anticipated that as a result of the
agreements with Employers Reinsurance Corporation relating to IRI as described
under "Participation in Industrial Risk Insurers" which went into effect on
January 1, 1998, J&H Marsh & McLennan will be responsible for producing
approximately 25.2 percent of the Company's gross written premium in 1998.
No other insured or broker accounts for more than 10 percent of the
consolidated total revenues of the Company.
Engineering Services
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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 and the Pacific Rim 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.
7
E. REGULATION
Insurance
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The Company's 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.
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 December 1993, the National Association of Insurance Commissioners
(NAIC) 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
1997.
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 1997 with the
exception of the change in surplus ratio. This ratio exceeded the normal range
for surplus growth because of the $250 million contribution to surplus made by
the Company with the proceeds from the $300 million convertible capital
securities which were sold to Employers Reinsurance Corporation on December 31,
1997.
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 year ended December 31,
1994 by the Connecticut Insurance Department, the HSBIIC's domestic regulator.
No material findings were included in the final report of the examination.
Similar regulatory procedures govern the Company's U.S. and foreign insurance
subsidiaries.
8
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 5 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 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
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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.
Other
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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
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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.
9
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.
The Company's policy with respect to the business it underwrites (exclusive
of its participation in IRI) 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 $3 million,
with potentially higher per risk retentions dependent on aggregate losses
experienced by the Company during the reinsurance period. See "Participation in
Industrial Risk Insurers" below for information on the underwriting policy of
IRI.
Reinsurance Assumed
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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 over 100 multi-line insurance
companies to reach the small to mid-size 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 5 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 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
10
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 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 a significant
shakeout and consolidation. A significant amount of merger and acquisition
activity has occurred recently and may continue 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.
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 $257.1
million in 1997, representing approximately 41.6 percent of the Company's gross
written premium.
Reinsurance Ceded
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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. Under the Company's current treaty
reinsurance program (and not taking into account its participation in IRI), its
retention on any one risk is generally limited to $3 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.
As a result of the Company's growth and global expansion, combined with
loss experience in prior years, the Company has been incurring higher ceded
reinsurance costs in recent years. In 1995 the Company centralized and
consolidated its global ceded reinsurance operations to more closely manage its
reinsurance costs. In 1994 and continuing through 1996 the Company increased its
non-IRI retentions by adding a $5 million aggregate deductible to its
reinsurance program to lessen the impact of higher reinsurance costs. Of the
four losses in the 1994 -1995 treaty year that exceeded $3 million, the Company
retained an additional $1.4 million in 1994 and $1.2 million in 1995 due to the
inclusion of the $5 million annual aggregate deductible. Reinsurance costs were
reduced approximately $2.9 million for both 1994 and 1995. In 1996 the Company's
reinsurance ceded costs increased $42 million over 1995 which was almost
entirely attributable to its increased participation in IRI. Reinsurance ceded
costs for 1997 increased by $10 million over 1996 because of the Company's
increase in participation in IRI in 1997 and the purchase of facultative
insurance at HSB EIL, the Company's U.K. insurance subsidiary.
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The Company anticipates a greater use of quota share reinsurance in the
1998-1999 treaty year because of the favorable pricing in the international
reinsurance market and recent favorable underwriting experience in certain
classes of the Company's business. This increased use of reinsurance will likely
result in a reduction in net earned premiums for 1998 at the same time as gross
premiums are expected to increase as a result of the agreements with Employers
Reinsurance Corporation relating to the IRI business. See "Participation in
Industrial Risk Insurers" below.
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 generally 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 9 and 10 to the
Consolidated Financial Statements located in Item 8 of Part II herein.
Pools and Joint Underwriting Associations
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With the exception of 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. 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.
Participation in Industrial Risk Insurers
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Industrial Risk Insurers is an unincorporated, voluntary joint underwriting
association which 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. 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
12
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 doesn't release HSBIIC from the effects of adverse
development.
On January 6, 1998, HSBIIC and the other IRI members sold their membership
shares to Employers Reinsurance Corporation. 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. HSBIIC entered into an operating
agreement with ERC pursuant to which HSBIIC will write the business for the
reconstituted IRI using its insurance licenses and will provide certain other
technical and management services. HSBIIC, ERC and IRI also entered into
reinsurance agreements pursuant to which HSBIIC transferred its HPR
manufacturing book of business to IRI and agreed to retain 85 percent of the
equipment breakdown business and 15 percent of the property business of the
combined insurance portfolio.
From December 1, 1996 until the close of the sale of its interest in IRI to
ERC, HSBIIC's membership interest was 23.5 percent. In 1996 and 1995 its
membership share was 14 percent and .5 percent, respectively. The Company
increased its share significantly over this two year period because it believed
that participation in the IRI represented an opportunity to apply the Company's
underwriting, engineering and reinsurance skill sets to a large block of
business and to potentially provide a quick turnaround of IRI's underwriting
results with only a limited capital outlay of Company funds. The Company's
increased share enabled the Company to have a more significant role in helping
IRI be an effective and profitable provider of essential property insurance and
loss prevention services to larger risks. The new agreements with ERC and IRI
continue this opportunity to utilize the Company's skills while at the same time
reducing its exposure to the more volatile property business.
The agreements with ERC are of indefinite duration and are terminable in
the event of the insolvency or loss of accredited reinsurer or licensed insurer
status of ERC or HSB, or a material breach which has not been cured within the
time frame specified in the agreements, or by mutual consent of the parties. ERC
and the Company are in discussions which may result in ERC having the option to
buy out the Company's rights under the agreements in the event of a change in
control of the Company. Net earned premium attributable to the agreements with
ERC and IRI, prior to the placement of reinsurance by the Company for its own
account, could approximate 17 percent of the Company's total consolidated
revenues for 1998. Ceding commissions, which are netted out of expenses, are
estimated to be 13 percent of consolidated revenues for 1998.
Pursuant to the agreements with ERC, HSB has the ability to opt out of
IRI's reinsurance programs going forward. The Company anticipates incorporating
the IRI business into its reinsurance program after a brief transitional period
during which the Company will participate in IRI's program.
13
IRI's underwriting policy is to manage its risks to probable maximum losses
(PML) not to exceed $150 million and maximum foreseeable losses (MFL) not to
exceed $400 million. Based on HSB's 1997 participation in IRI at 23.5 percent,
had an MFL event take place, the Company's proportionate share, net of IRI and
HSB reinsurance, would have been $ 26.6 million. The Company maintains other
reinsurance programs for its own account which could absorb up to 50 percent of
this amount. The equipment breakdown PMLs and MFLs within the overall property
coverage underwritten by IRI do not generally exceed $50 million and $100
million, respectively. HSB's primary participation effective January 1, 1998 as
described above will be attributable to the 85 percent share of the equipment
breakdown insurance written through IRI. Based on HSB's 1998 participation in
IRI's business, were an equipment breakdown MFL to take place, the Company's
proportionate share, net of IRI and HSB reinsurance, would be no more than $5
million.
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. Policies underwritten by the
Company pursuant to the agreements with Employers Reinsurance Corporation
relating to the business of IRI described under "Participation in Industrial
Risk Insurers" above will be adjusted by Company and IRI staff claims handlers
as determined by the Company in accordance with such agreements.
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 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 18 - 19) 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". The Company's
claims expenses are based on estimates of the current costs of
14
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, 1997, 1996 and 1995.
RECONCILIATION OF NET LIABILITY FOR
CLAIMS AND CLAIM ADJUSTMENT EXPENSES
------------------------------------
1997 1996 1995
---- ---- ----
(In millions)
Net liability for claims and
adjustment expenses at January 1 $ 177.8 $ 145.5 $ 161.3
------ ------ ------
Plus:
Provision for claims and adjustment
expenses occurring in the current year 209.5 214.2 152.2
Increase (decrease) in estimated claims
and adjustment expenses arising
in prior years 8.4 (9.8) 2.7
------ ------ ------
Total incurred claims and
adjustment expenses 217.9 204.4 154.9
------ ------ ------
Less:
Payment for claims arising in:
Current year 82.3 91.4 58.9
Prior years 122.6 80.7 111.8
------ ------ ------
Total payments 204.9 172.1 170.7
------ ------ ------
Net liability for claims and
adjustment expenses at December 31 $ 190.8 $ 177.8 $ 145.5
====== ====== ======
15
The 1997 loss ratio was 44.4 percent compared to 45.6 percent and 39.8
percent for 1996 and 1995, respectively. The 1.2 percent decrease in loss ratio
in 1997 is primarily the result of fewer weather-related losses. The 1996
increase of 5.8 percentage points as compared to 1995, was primarily the result
of the high frequency of claims and unusually severe winter weather. Adverse
development in 1997 added 1.7 percentage points to the loss ratio, while
positive development in 1996 benefited the loss ratio by 2.2 percentage points.
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
----------------------------------------
1997 1996 1995
---- ---- ----
(In millions)
Net liability for claims and
adjustment expenses at December 31 $ 190.8 $ 177.8 $ 145.5
Reinsurance recoverable on unpaid claims
and adjustment expenses 85.9 125.1 45.4
------ ------ ------
Gross liability for claims and
adjustment expenses at December 31 $ 276.7 $ 302.9 $ 190.9
====== ====== ======
16
RECONCILIATION OF GROSS LIABILITY FOR CLAIMS AND CLAIM ADJUSTMENT EXPENSES
- - --------------------------------------------------------------------------
1997 1996 1995
---- ---- ----
(In millions)
Gross liability for claims and claim adjustment
expenses at January 1 $ 302.9 $ 190.9 $ 199.4
Plus:
Provision for claims and claim adjustment expenses
occurring in the current year 263.3 313.3 183.3
Increase in estimated claims and claim adjustment
expenses arising in prior years (0.2) 16.1 12.6
------ ------ ------
Total incurred claims and claim adjustment
expenses $ 263.1 $ 329.4 $ 195.9
------ ------ ------
Less:
Payment for claims arising in:
Current year $ 90.6 $ 103.3 $ 65.1
Prior years 198.7 114.1 139.3
------ ------ ------
Total payments $ 289.3 $ 217.4 $ 204.4
------ ------ ------
Gross liability for claims and claim adjustment
expenses at December 31 $ 276.7 $ 302.9 $ 190.9
====== ====== ======
The claim and claim expense reserve runoff table on the following pages
shows the amounts of the net liability for 1987 through 1997 and the amounts of
the gross liability for 1993 through 1997. 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.
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.
17
The redundancies shown for 1987 and 1988 were attributed to the difficulty
in estimating claims due to inflationary impacts and business interruption,
which became a larger component of claims. The claim reserves established in
those years have been favorably settled, adjusted or closed based on the results
of claim audits, technical loss analysis, subrogation, settlement with property
carriers and the latest available information. The net impact of those favorable
settlements was to decrease claims expenses as reported by $10.2 million in 1990
and $28.0 million in 1989.
RECONCILIATION OF BEGINNING AND ENDING CLAIMS RESERVES
AND EXHIBIT OF REDUNDANCIES (DEFICIENCIES)
(In Millions)
Net Reserves
YEAR ENDED 1987 1988 1989 1990 1991 1992 1993 1994 1995* 1996* 1997*
- - ---------- ---- ---- ---- ---- ---- ---- ---- ---- ----- ----- -----
Net Liability for Unpaid
Claims and Claim $147.5 $157.4 $139.6 $115.7 $111.4 $132.8 $171.3 $161.3 $145.5 $177.8 $190.8
Adjustment Expenses
Cumulative Amount Paid as of:
End of Year - - - - - - - - - - -
One Year Later 57.4 78.8 85.6 86.7 91.2 99.7 108.8 111.7 80.6 122.6 -
Two Years Later 75.9 92.1 104.2 109.7 115.5 134.0 152.1 126.9 99.8 - -
Three Years Later 74.5 95.5 110.3 120.6 127.0 154.4 153.4 134.5 - - -
Four Years Later 75.4 95.4 112.5 127.6 137.7 151.1 157.8 - - - -
Five Years Later 74.5 93.6 118.9 132.7 135.7 151.6 - - - - -
Six Years Later 74.2 100.5 123.0 131.4 135.7 - - - - - -
Seven Years Later 80.4 101.5 121.4 130.9 - - - - - - -
Eight Years Later 80.4 100.1 120.8 - - - - - - - -
Nine Years Later 79.6 100.2 - - - - - - - - -
Ten Years Later 79.7 - - - - - - - - - -
Net Liability Reestimated as of:
End of Year 147.5 157.4 139.6 115.7 111.4 132.8 171.3 161.3 145.5 177.8 190.8
One Year Later 131.9 129.4 129.4 135.4 137.5 159.7 172.7 163.9 135.7 186.2 -
Two Years Later 100.4 108.7 127.4 138.0 139.7 166.6 173.9 157.3 128.8 - -
Three Years Later 86.0 106.8 127.8 136.9 141.1 165.2 170.6 154.2 - - -
Four Years Later 83.7 103.0 125.0 137.9 142.0 163.0 169.2 - - - -
Five Years Later 80.8 102.3 125.8 135.7 141.4 161.5 - - - - -
Six Years Later 82.0 104.0 125.5 136.0 141.3 - - - - - -
Seven Years Later 82.9 103.8 125.8 135.8 - - - - - - -
Eight Years Later 82.6 104.2 125.5 - - - - - - - -
Nine Years Later 83.6 104.7 - - - - - - - - -
Ten Years Later 84.1 - - - - - - - - - -
Cumulative Redundancy
(Deficiency) 63.4 52.7 14.1 (20.1) (29.9) (28.7) 2.1 7.1 16.7 (8.4) 0.00
The above table includes information related to the Company's participation in
the IRI.
*For 1997, incurred claims and claims adjustment expenses include $31.6 million
related to the Company's 23.5 percent participation in IRI effective December 1,
1996 plus development of ($1.3 million) relating to prior accident years. For
1996, incurred clams and claims adjustment expenses include $23.2 million
related to the Company's 14 percent participation in IRI effective December 1,
1995, plus development of ($.4 million) relating to prior accident years. The
Company carried net reserves in the amounts of $22.2, $11.6 and $3.2 million
related to its participation in IRI at December 31, 1997, 1996, and 1995 (at a
.5 percent participation), respectively.
18
Gross Reserves
YEAR ENDED 1993 1994 1995 1996 1997
- - ---------- ---- ---- ---- ---- ----
Gross Liability for
Unpaid Claims and Claim
Adjustment Expenses $214.4 $199.4 $190.9 $302.9 $276.7
Cumulative Amount Paid as of:
End of Year - - - - -
One Year Later 144.2 135.2 108.9 198.8 -
Two Years Later 189.9 164.1 158.0 - -
Three Years Later 200.2 201.1 - - -
Four Years Later 229.8 - - - -
Gross Liability Reestimated as of:
End of year 214.4 199.4 190.9 302.9 276.7
One Year Later 224.3 212.0 205.5 302.7 -
Two Years Later 227.0 228.3 194.6 - -
Three Years Later 243.4 226.8 - - -
Four Years Later 245.0 - - - -
Cumulative Redundancy
(Deficiency) (30.6) (27.4) (3.7) .2 -
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, and the purchase and sale of equity securities.
(in millions)
1997 1996 1995 1994 1993
------- ------ ------ ------ -----
Net Investment Income $ 36.8 $ 32.3 $ 28.9 $ 26.2 $ 29.3
Realized Investment Gains 14.1 12.1 2.8 8.7 26.1
------ ------ ------ ------ ------
Income from Investment Operations $ 50.9 $ 44.4 $ 31.7 $ 34.9 $ 55.4
Net Unrealized Gains $ 95.3 $ 81.4 $ 65.4 $ 16.5 $ 59.2
Statutory Surplus (HSBIIC) $550.8 $292.4 $280.6 $238.0 $259.2
The fluctuations in income from investment operations is largely driven by
the amount of realized gains generated in any given year. 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. In 1994 the stock market experienced a significant
decline which impacted both the Company's realized and unrealized gains. 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
19
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.
Net investment income reached its lowest level during 1994 as a result of a
lower average investment portfolio as holdings were liquidated to pay dividends,
repay debt, and purchase fixed assets and treasury stock. The increase in 1995
resulted from the full consolidation of EIG, Co. offset by a lower interest rate
environment. 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 offerings.
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 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. Investment
strategies for any given year are developed based on many factors including
operational results, tax implications, regulatory requirements, interest rates,
dividends to shareholders and market conditions.
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 purposes included certain convertible preferreds). In the fourth
quarter of 1997, HSBIIC settled all of its outstanding contracts which required
HSBIIC to pay its counterparty $30.7 million in foregone appreciation on its
portfolio. The Company's U.S. common stock portfolio has experienced a total
return of $57 million (which includes price appreciation of approximately $54
million) since December 31, 1996, and has had a price movement correlation with
the S&P 500 Index well in excess of 80 percent.
At December 31, 1997 the Company had approximately 38.1 percent of its
invested assets (exclusive of the short-term investments made with the proceeds
from its sale of $300 million in convertible capital securities on December 31,
1997) in fixed maturities as compared to 40 percent at year-end 1996. 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 1997 the
carrying value of the equity securities portfolio represented 49.7 percent of
invested assets compared to 44 percent at year-end 1996. The 5.7 percent
increase is primarily attributable to market appreciation relative to the
overall portfolio.
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
20
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 by laddering its maturities such that the average
maturity is generally maintained between 5-10 years. This technique provides the
Company with a predictable cash flow each year and enables it 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 6 to Consolidated Financial Statements in Item 8 of Part II herein for
additional information.
The following table summarizes the investment results of the Company's
investment portfolio:
Annualized Rate Investment
Net Invest- of Return (2) Investment
Cash and ment Income --------------- Gains (Losses) (3)
Invested Less Before After --------------------
Assets, Less Interest Income Income Change in
Borrowed Money Expense (1) Taxes Taxes Realized Unrealized
---------------------------- ----- ----- ----------------------
(In Millions) (In Millions)
1997 $ 629.2* $ 35.5 6.1% 5.1% $ 14.1 $ 13.9
1996 572.6 31.7 6.0 5.4 12.1 16.0
1995 514.8 28.5 6.2 5.2 2.8 48.9
* Does not include $300 million in proceeds from the sale of convertible capital
securities on December 31, 1997.
(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.
21
H. EMPLOYEES
At year-end 1997, the Company, including its wholly-owned subsidiaries, had
1,932 full and part-time employees. Management believes that its relations with
its employees are satisfactory.
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 227,288 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 7 and 8 to Consolidated Financial Statements located in Item 8 of
Part II herein for additional information.
Item 3. Legal Proceedings.
- - ------- ------------------
HSBIIC is involved in three arbitration or litigation proceedings regarding
the extent to which certain explosion events are insured under boiler and
machinery policies of HSBIIC or under the all-risk property insurance policies
issued by other companies. Management believes HSBIIC'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 HSBIIC was not liable for losses of the insured resulting from the
explosion. In a further action, the court denied HSBIIC's motion for summary
judgment on certain issues, thus leaving HSBIIC potentially liable for certain
unquantified losses resulting from events prior to the explosion. In the first
quarter of 1997, HSBIIC and the property insurer jointly settled the case with
the insured. HSBIIC's ultimate share of the settlement will be determined in an
arbitration proceeding with the property carrier. HSBIIC has incurred gross loss
and loss adjustment expenses (LAE) of $40.7 million and a net loss, after taking
into account reinsurance recoverables, of $6.5 million, of which $5 million
represents claim costs and the remaining $1.5 million represents LAE. As a
result of payments made to date, as of December 31, 1997, HSBIIC carried gross
loss and LAE reserves of $2.8 million and recoverables from reinsurers of $2.8
million.
22
HSBIIC has accrued $6.5 million with respect to the other two cases for
potential LAE, including legal costs to defend HSBIIC'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 HSBIIC is held liable for one or
both of the remaining claims, amounts in excess of HSBIIC's net maximum
aggregate retention of $8.5 million is recoverable from 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 HSBIIC'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. HSBIIC's reinsurance
contracts do not require HSBIIC to reimburse its reinsurers for any losses such
reinsurers might incur should these cases not be decided in HSBIIC's favor.
Nevertheless, reinsurers often quote rates for future coverages based upon their
or other reinsurers' experience on a particular account. Therefore, in the event
HSBIIC's reinsurers pay significant sums pursuant to the arbitration or
litigation proceedings described above, it is likely HSBIIC's reinsurance rates
would increase in future periods. However, given the insured capacity that
exists in reinsurance markets worldwide, coupled with HSBIIC'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.
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.
On June 24, 1997 all of the outstanding shares of common stock of The
Hartford Steam Boiler Inspection and Insurance Company were exchanged for shares
of common stock of the Company. The service listed for each executive officer
listed below includes their service with Hartford Steam Boiler.
23
Gordon W. Kreh, 50, Chief Executive Officer, President and Director since 4/94;
President and Director 9/93 - 4/94; Senior Vice President - Marketing 4/92 -
9/93; President - Engineering Insurance Group 10/89 - 4/92; Vice President 11/84
- - - 10/89; Assistant Vice President 4/81 - 11/84.
Saul L. Basch, 51, 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, 48, Senior Vice President - Special Risks 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, 52, Senior Vice President - Commercial Risks 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, 60, 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; Vice President of Development
Operations and Materials Engineering, Pratt & Whitney 1989-4/92.
R. Kevin Price, 51, 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, 52, Senior Vice President since 9/95; Managing Director and
Chief Executive Officer of HSB Engineering Insurance Ltd., London, since 9/94;
Director of Engineering, Engineering Insurance Co., Ltd. 9/92-9/94; Managing
Director Scottish Power PLC, Glasgow, Scotland 1/89 - 8/92.
Robert C. Walker, 54, Senior Vice President-Claims and General Counsel since
1/95; Senior Vice President - Claims 3/94 - 1/95; Associate General Counsel and
head of Corporate Litigation Department of United Technologies Corporation
5/89-3/94.
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 17, 1998, the Company had 5,152 holders of
record.
24
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
required for the payment of 1997 dividends but is not anticipated to be
necessary for 1998 dividends since approximately $55.1 million of HSBIIC's
statutory surplus is available for distribution to HSB Group, Inc. without prior
regulatory approval.
Quarterly dividends declared for the 1997 and 1996 fiscal years were as
follows:
First Second Third Fourth Year
----- ------ ----- ------ ----
1997 $.57 $.57 $.60 $.60 $2.34
1996 $.57 $.57 $.57 $.57 $2.28
Quarterly market prices for the Company's common stock were as follows for
the two most recent years:
First Second Third Fourth Year
----- ------ ----- ------ ----
1997 High $47 5/8 $53 7/8 $56 11/16 $55 3/4 $56 11/16
1997 Low $44 5/8 $44 $52 7/16 $49 13/16 $44
1996 High $52 1/2 $50 3/4 $49 $47 1/8 $52 1/2
1996 Low $48 $46 $43 1/4 $42 3/4 $42 3/4
25
Item 6. Selected Financial Data.
- - ------- ------------------------
The following selected consolidated financial data should be read in
conjunction with the consolidated financial statements and notes included
elsewhere herein.
(in millions, except per share amounts) (1)(2)
1997 1996 1995 1994 1993
- - --------------------------------------------------------------------------------------------------------------------------
Summary of Consolidated Statements of Operations
Revenues:
Insurance premiums $ 491.2 $ 448.6 $ 389.1 $ 336.6 $ 349.2
Engineering services 61.3 55.8 49.9 48.0 46.0
Income from investment operations 50.9 44.4 31.7 34.9 55.4
------- ------- ------- ------- -------
Total revenues (3) $ 603.4 $ 548.8 $ 470.7 $ 419.5 $ 450.6
------- ------- ------- ------- -------
Income from continuing operations $ 66.3 $ 54.6 $ 52.7 $ 44.5 $ 11.1
Income from continuing operations
per common share - basic $ 3.32 $ 2.71 $ 2.58 $ 2.17 $ 0.54
Income from continuing operations
per common share - diluted $ 3.29 $ 2.71 $ 2.58 $ 2.17 $ 0.54
Dividends paid per common share $ 2.31 $ 2.28 $ 2.22 $ 2.14 $ 2.12
- - ---------------------------------------------------------------------------------------------------------------------------
Summary of Consolidated Statements of Financial Position
Total assets $ 1,540.2 $ 1,116.3 $ 954.1 $ 877.8 $ 857.6
Long-term borrowings and capital lease obligations $ 53.0 $ 53.0 $ 53.4 $ 28.4 $ 28.4
Convertible redeemable preferred stock -- $ 20.0 -- -- --
Company obligated mandatorily redeemable
capital securities $ 408.9 -- -- -- --
Shareholders' equity:
Common $ 345.3 $ 345.6 $ 341.1 $ 299.5 $ 324.7
Per common share $ 17.63 $ 17.25 $ 16.81 $ 14.67 $ 15.80
Return on average equity before accounting 19.1% 15.6% 19.5% 16.9% 3.7%
changes
Stock price per share:
High $ 56.69 $ 52.50 $ 50.38 $ 53.38 $ 59.50
Low $ 44.00 $ 42.75 $ 39.25 $ 36.13 $ 43.25
Close $ 55.19 $ 46.38 $ 50.00 $ 39.88 $ 44.50
Common shares outstanding at end of year (4) 19.6 20.0 20.3 20.4 20.5
- - ---------------------------------------------------------------------------------------------------------------------------
Insurance
Operating gain (loss) $ 39.8 $ 21.8 $ 34.2 $ 20.7 $ (26.4)
Loss ratio 44.4% 45.6% 39.8% 42.5% 57.1%
Expense ratio 47.3% 49.1% 50.9% 50.5% 50.5%
------- ------- ------- ------- -------
Combined ratio 91.7% 94.7% 90.7% 93.0%(5) 107.6%
- - ---------------------------------------------------------------------------------------------------------------------------
Engineering Services (3)
Operating gain $ 4.3 $ 7.3 $ 6.7 $ 4.3 $ 4.0
Engineering services margin 7.1% 13.2% 13.3% 9.0% 8.7%
Investments
Net investment income $ 36.8 $ 32.3 $ 28.9 $ 26.2 $ 29.3
Realized investment gains 14.1 12.1 2.8 8.7 26.1
Income from investment operations $ 50.9 $ 44.4 $ 31.7 $ 34.9 $ 55.4
- - ----------------------------------------------------------------------------------------------------------------------------
(1) Prior year information has been restated to reflect Radian International LLC
as a discontinued operation.
(2) All per share data has been restated to reflect stock splits.
(3) Excludes revenues from investments accounted for under the equity method.
(4) Reflects the repurchase of approximately 1.0 in 1997, 0.3 in 1996, 0.1 in
1995, 0.1 in 1994, 0.2 in 1993.
(5) Excludes charge for Proposition 103.
26
Item 7. Management's Discussion and Analysis of 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, 1997 1996 1995
- - ------------------------------------------------------------------------------
Revenues:
Insurance premiums $ 491.2 $ 448.6 $ 389.1
Engineering services 61.3 55.8 49.9
Net investment income 36.8 32.3 28.9
Realized investment gains 14.1 12.1 2.8
------- --------- --------
Total Revenues $ 603.4 $ 548.8 $ 470.7
Income from continuing operations $ 66.3 $ 54.6 $ 52.7
Net income $ 66.3 $ 53.4 $ 62.6
Earnings Per Share:
Income from continuing operations:
Basic $ 3.32 $ 2.71 $ 2.58
Diluted 3.29 2.71 2.58
Net income:
Basic $ 3.32 $ 2.65 $ 3.07
Diluted 3.29 2.65 3.07
------- ---------- ---------
The table above presents consolidated results of HSB Group, Inc. (HSB or the
Company).
Net income and income from continuing operations per common share on a diluted
basis increased 24.2 percent and 21.4 percent, respectively, in 1997 from 1996
due to significantly higher underwriting gains in the Company's insurance
operations. On July 28, 1997 the HSB Board ratified management's decision to
exercise its option to put its share of Radian International LLC (Radian) to The
Dow Chemical Company (Dow) on or about January 1, 1998 for approximately $144
million. Due to this decision, the results of Radian have been classified as
discontinued operations and HSB's share of losses incurred subsequent to this
decision of approximately $10 million pre-tax have been deferred until HSB's
share of Radian has been transferred to Dow. On January 2, 1998 the Radian
transaction closed resulting in an estimated after-tax gain of approximately $30
million, which includes absorption of the deferred loss. (See note 3). Income
from continuing operations in 1996 increased 3.6 percent from 1995 as
catastrophe losses from
27
unusually severe weather conditions in our domestic insurance operations, which
caused our underwriting gain to drop by $12.4 million, were largely offset by
increased income from investment operations of $12.7 million. Net income in 1996
declined 14.7 percent from 1995 as Radian's contribution to pre-tax earnings
declined by approximately $15.7 million during 1996. Revenue shortfalls caused
the venture to reduce its workforce during the year by about 10 percent,
resulting in a charge of $3.5 million.
Consolidated revenues grew 9.9 percent in 1997 and 16.6 percent in 1996.
Insurance premiums grew 9.5 percent in 1997, with the increased participation in
Industrial Risk Insurers (IRI) a contributing factor as well as growth in both
the domestic and international books of business. Effective December 1, 1996,
The Hartford Steam Boiler Inspection and Insurance Company (HSBIIC) increased
its participation in IRI from 14 to 23.5 percent. The combined ratio for the
Company improved to 91.7 percent in 1997 from 94.7 percent in 1996. In 1995 the
combined ratio was 90.7 percent.
Engineering services revenue increased 9.9 percent in 1997 and 11.8 percent in
1996.
The effective tax rates on income from continuing operations before
distributions on capital securities for 1997 was 26.8 percent compared to 25.1
percent and 27.0 percent for 1996 and 1995. 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 that can be obtained by investing in certain instruments.
Various tax credits (primarily foreign tax credits) also impact the effective
rate. 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 (FASB) issued
Statement of Financial Accounting Standards (SFAS) 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 Consolidated Statements of Operations and a
reconciliation of the numerator and denominator of the basic EPS computation to
the numerator and denominator of the diluted EPS computation. This statement was
implemented at year end 1997. (See note 2).
In June 1997 the FASB issued SFAS No. 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 accounting standard will be effective beginning in
1998 with presentation of prior periods required.
28
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 with
calendar year 1998, however application is not required for interim financial
statements in the initial year. It is possible that this disclosure may redefine
our segment information. However, the Company has not yet determined how SFAS
No. 131 will be applied.
Other Developments
At a special meeting of HSBIIC on June 23, 1997, shareholders voted to approve a
proposal which enabled the formation of a new holding company, HSB Group, Inc.
Shareholders of HSBIIC's common and convertible redeemable preferred stock
became holders of HSB common and convertible redeemable preferred stock,
respectively, through a share exchange approved by the shareholders.
Certificates representing HSBIIC's common and convertible redeemable preferred
stock automatically represent the corresponding shares of HSB common and
convertible redeemable preferred stock. The holding company was formed in order
to achieve greater operating and financial flexibility in connection with
certain investments, business operations and financing activities.
On December 1, 1996, HSBIIC increased its participation in IRI from 14 percent
to 23.5 percent. 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
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 1995
and prior, HSBIIC's membership share was .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 doesn't
release HSBIIC from the effects of adverse development.
On January 6, 1998, HSBIIC sold its interest in IRI to Employers Reinsurance
Corporation (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 approximately $50 million, prior to transaction costs, for its
23.5 percent
29
share in IRI. Because the sale was structured in part as a reinsurance
transaction, a portion of HSBIIC's gross proceeds will be utilized to reinsure
in-force policies with ERC.
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.
Initially HSBIIC will write the business for the reconstituted IRI using its
insurance licenses and will provide certain other services. HSBIIC will transfer
its HPR manufacturing book of business to IRI and through various reinsurance
arrangements with IRI/ERC will retain 85 percent of the equipment breakdown
business and 15 percent of the property business 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. The Convertible Capital Securities are convertible
into HSB common stock, at any time, subject to regulatory approval, at a
conversion price of $85. $250 million of the proceeds were contributed to HSBIIC
and $50 million was retained by HSB. (See note 12).
Insurance Operations
For the years ended December 31, 1997 1996 1995
- - -------------------------------------------------------------------
Gross earned premiums $ 609.3 $ 556.5 $ 455.0
Ceded premiums 118.1 107.9 65.9
--------------------------------
Insurance premiums $ 491.2 $ 448.6 $ 389.1
Claims and adjustment
expenses 217.9 204.4 154.9
Underwriting, acquisition
and other expenses 233.5 222.4 200.0
----------------------------------
Underwriting gain $ 39.8 $ 21.8 $ 34.2
Loss ratio 44.4% 45.6% 39.8%
Expense ratio 47.3% 49.1% 50.9%
Combined ratio 91.7% 94.7% 90.7%
- - --------------------------------------------------------------------
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., HSB of Connecticut, HSB of Texas and
HSBIIC's participation in IRI and various other pools.
Insurance premiums in 1997 increased 9.5 percent from 1996. This growth is
primarily attributable to the increased participation in IRI ($22.4 million) and
to growth in both the domestic and global markets. The increase in 1996 was a
result of the increased participation in IRI ($22.6 million) as well as growth
in the global markets. It is possible
30
that the reduction in HSBIIC's interest in IRI, as a result of the sale on
January 6, 1998, may dampen growth in net insurance premiums.
Insurance premiums representing coverage outside the U.S. increased 7.1 percent
to $93.3 million from $87.1 million in 1996 and $73.3 million from 1995. In
certain areas of the Company's direct domestic and international businesses, the
market is experiencing price erosion. The Company will not write business at
rates which would lessen its ability to maintain underwriting profit. Increases
in ceded premium of 9.5 percent in 1997 were primarily due to the additional
participation in IRI and the purchase of facultative reinsurance at EIL. The
Company continues to see opportunities for growth, particularly in those
countries where the infrastructure development is moving to the private sector.
At the same time, softening of the pricing in this market has occurred globally
as the number of insurers offering capacity has expanded.
Domestically, exclusive of IRI, premiums increased approximately $16.3 million,
or 5.0 percent in 1997 and 3.9 percent in 1996. These increases were a
combination of growth in written premiums from our client companies in 1997 and
1996 respectively, and reflects the addition of new client companies, offset by
a loss of business as a result of industry consolidation. The insurance
industry, in general, continues to undergo significant restructuring and
consolidation. Considerable merger and acquisition activity has occurred
recently and more 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 more than 100 multi-line carriers;
while over the shorter term, there is both opportunity and challenge.
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 re-evaluates its exposures and reinsurance needs annually
to implement a program which corresponds with the level of exposure the Company
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. The Company's reinsurance costs continue to be
impacted by its prior loss experience and business growth.
31
For the years ended December 31, 1997 1996 1995
- - --------------------------------------------------------------------------------
Provision for claims and
adjustment expenses
occurring in the current year $ 209.5 $ 214.2 $ 152.2
Increase (decrease) in
estimated claims and adjustment
expenses arising in prior years* 8.4 (9.8) 2.7
-----------------------------
Total incurred claims and adjustment expenses $ 217.9 $ 204.4 $ 154.9
Loss ratio 44.4% 45.6% 39.8%
- - -------------------------------------------------------------------------------
* Includes approximately $3.3, $4.9 and $1.1 million subrogation recoveries,
respectively.
The loss ratio decreased 1.2 percentage points in 1997 as compared to 1996
primarily as a result of fewer weather-related losses. The 1996 increase of 5.8
percentage points as compared to 1995, was primarily the result of the high
frequency of claims and unusually severe winter weather. Adverse development in
1997 added 1.7 percentage points to the loss ratio, while positive development
in 1996 benefited the loss ratio by 2.2 percentage points. The components of
claims and adjustment expenses, net of reinsurance, are displayed above.
Claims and adjustment expense reserves comprise one of the largest liabilities
on the Company's Consolidated Statements of Financial Position. Reserves are
established to reflect 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 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 coverages 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 coverages, 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 doesn't discount its loss reserves.
HSBIIC is involved in three arbitration or litigation proceedings regarding the
extent to which certain explosion events are insured under boiler and machinery
policies of HSBIIC or under the all-risk property insurance policies issued by
other companies. Management believes HSBIIC's policies do not provide coverage
for losses resulting from explosion events that are the subject of these
proceedings.
32
A lower court ruling in one of these cases held that an explosion did occur, and
that HSBIIC was not liable for losses of the insured resulting from the
explosion. In a further action, the court denied HSBIIC's motion for summary
judgment on certain issues, thus leaving HSBIIC potentially liable for certain
unquantified losses resulting from events prior to the explosion. In the first
quarter of 1997 HSBIIC and the property insurer jointly settled the case with
the insured. HSBIIC's ultimate share of the settlement will be determined in an
arbitration proceeding with the property insurer. HSBIIC has incurred gross
losses and loss adjustment expenses (LAE) of $40.7 million and a net loss, after
taking into account reinsurance recoverables, of $6.5 million, of which $5
million represents claim costs and the remaining $1.5 million represents LAE. As
a result of payments made to date, at December 31, 1997, HSBIIC carried gross
loss and LAE reserves of $2.8 million and recoverables from reinsurers of $2.8
million.
HSBIIC has accrued $6.5 million with respect to the other two cases for
potential LAE, including legal costs to defend HSBIIC'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 HSBIIC is held liable for one or
both of the remaining claims, amounts in excess of HSBIIC's net maximum
aggregate retention of $8.5 million is recoverable from 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 HSBIIC'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. HSBIIC's reinsurance contracts
do not require HSBIIC to reimburse its reinsurers for any losses such reinsurers
might incur should these cases not be decided in HSBIIC's favor. Nevertheless,
reinsurers often quote rates for future coverages based upon their or other
reinsurers' experience on a particular account. Therefore, in the event HSBIIC's
reinsurers pay significant sums pursuant to the arbitration or litigation
proceedings described above, it is likely HSBIIC's reinsurance rates would
increase in future periods. However, given the insured capacity that exists in
reinsurance markets worldwide, coupled with HSBIIC'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.
33
Engineering Services Operations*
For the years ended December 31, 1997 1996 1995
- - ------------------------------------------------------------------------------
Engineering services revenues $ 61.3 $ 55.8 $ 49.9
Engineering services expenses 57.0 48.5 43.2
Operating gain $ 4.3 $ 7.3 $ 6.7
--------------------------------
Engineering services margin 7.1% 13.2% 13.3%
- - ------------------------------------------------------------------------------
* Excludes Radian.
Engineering services operations include the results of HSBIIC's and BI&I's
engineering services, HSB Reliability Technologies (HSBRT), HSB Professional
Loss Control, HSB International, and the Company's interest in Integrated
Process Technologies, LLC.
Engineering services revenue increased 9.8 percent in comparison to 1996. This
was primarily attributable to increased sales of $3.2 million at HSBRT and a
modest increase in revenues from our engineering operations based in Asia.
Engineering services revenues in 1996 increased 11.8 percent in comparison to
1995. The growth in revenues was primarily due to increases generated by HSBRT
as their revenues were $4.8 million (35 percent) higher in 1996 compared to
1995, almost entirely attributable to increases in volume. Margins declined in
1997 as the Company decreased the staff utilization domestically in order to
develop new growth opportunities. The Company is also maintaining staff levels
in Asia during the current economic downturn at somewhat lower productivity
levels as the Company continues to have confidence in its long-term growth
prospects in the region.
Investment Operations
For the years ended December 31, 1997 1996 1995
- - -------------------------------------------------------------------------------
Net investment income $ 36.8 $ 32.3 $ 28.9
Realized investment gains 14.1 12.1 2.8
-------------------------------------------
Income from investment
operations $ 50.9 $ 44.4 $ 31.7
Total cash and invested
assets, at fair value $ 996.7 $ 600.9 $ 550.5
Unrealized gains, pre-tax $ 95.3 $ 81.4 $ 65.4
- - --------------------------------------------------------------------------------
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
34
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, the Company manages its portfolio by laddering its maturities
such that the average maturity is generally maintained between 5-10 years. This
technique provides the Company with a predictable cash flow each year that
enables it to respond to the previously discussed parameters that impact its
investment strategy.
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). 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 meant they only
settled upon maturity. The contracts, which were entered into when the 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.
In the fourth quarter of 1997, HSBIIC settled all of its outstanding contracts
which required HSBIIC to pay its counterparty $30.7 million in foregone
appreciation on its portfolio. The Company's U.S. common stock portfolio has
experienced a total return of $57 million (which includes price appreciation of
approximately $54 million) since December 31, 1996, and has had a price movement
correlation with the S&P 500 Index well in excess of 80 percent.
Net investment income for 1997 increased $4.5 million compared to 1996.
Investable assets increased in 1997 in comparison to 1996 as the Company
invested the proceeds from its capital securities offerings. Net investment
income was impacted earlier in 1997 by calls of high yielding preferred stocks.
Net investment income increases also reflected more investable funds, which were
invested during a period of declining rates in comparison to our portfolio
averages, and a modest change in the mix of the portfolio from tax preferred
investments to more taxable investments with higher pre-tax yields. Higher
interest costs relate to a larger amount of commercial paper outstanding.
Through its U.K. subsidiary, EIL, the Company writes business in Malaysia and is
required to maintain approximately 50 million ringgit denominated investments on
deposit in that country. The Company intends to maintain its current level of
deposits in that currency, which equated to $12.8 million at December 31, 1997.
Due to the recent fluctuations of currencies in southeast Asia, realized
investment gains were reduced by approximately $7.4 million during 1997.
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. Invested assets growth was due to
significant cash flow from
35
operations during 1995 as well as the portfolio transfer arising from the
increased participation in IRI during 1996. Investment income in the global
market also increased as these operations have shown significant growth over the
past year.
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 securities. At the end of
1997, HSB's fixed maturities portfolio comprised 26.1 percent of the value of
the invested assets. The credit quality of HSB's bond investments at December
31, 1997, averaged a AA rating. HSB's portfolio does not include any bonds in
default as to either principal or interest. Bonds held at December 31, 1997, had
a fair value of $113 million. Redeemable preferred stocks averaged a BBB rating.
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.
The carrying value of the equity securities portfolio represented 34 percent of
the investments at December 31, 1997. This included $92.5 million of unrealized
investment gains, which had a net increase of $12.7 million from 1996 on a sharp
upturn in the stock market in 1997. HSB also recorded $13 million of dividends
and $43 million of net pre-tax realized gains from this portfolio in 1997. The
Company's largest single holding accounted for less than 1 percent of total
consolidated assets. Realized investment gains increased in 1997 over 1996 (and
in 1996 in comparison to 1995) as HSB managed its portfolio to respond to
changing market conditions and tax planning opportunities.
Liquidity and Capital Resources
At December 31, 1997 1996
- - -------------------------------------------------------------------------------
Total assets $ 1,540.2 $ 1,116.3
Short-term investments 379.2 97.9
Cash 45.3 4.5
Short-term borrowings 42.4 3.2
Capital securities of subsidiary
Trust I 108.8 --
Capital securities of subsidiary
Trust II 300.0 --
Convertible redeemable preferred
stock -- 20.0
Common shareholders' equity 345.3 345.6
- - --------------------------------------------------------------------------------
Liquidity refers to the Company's ability to generate sufficient funds to meet
the cash requirements of its business operations. HSB is a holding company whose
principal
36
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 and
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 equivalent of the Company's capital securities. HSB also
maintains a highly liquid short-term portfolio to provide for immediate cash
needs and since the issuance of the $110 million of Global Floating Rate Capital
Securities in July 1997, which are discussed below, to offset a portion of
interest rate risk relating to such securities. The Company's short-term
portfolio at December 31, 1997 reflects the temporary investment of the proceeds
from the $300 million Convertible Capital Securities discussed below. It is
unlikely that HSB will maintain such high levels of short-term investments;
however, given the current interest rate environment, HSB is proceeding
carefully to structure an appropriate investment portfolio.
On July 15, 1997, HSB sold $110 million of 30 year Global Floating Rate Capital
Securities (Capital Securities), in a private placement. The 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 securities were issued through HSB Capital I (Trust I), a
Delaware business trust created by HSB, at a floating rate equal to 90 day LIBOR
plus .91 percent. The current coupon at December 31, 1997 is 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. 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 Company has irrevocably and unconditionally
guaranteed all of Trust I's obligations under the Capital Securities. The
Company has used or may use the proceeds for general corporate purposes,
including the repurchase of HSB common stock; funding investments in, or
extensions of credit to, subsidiaries; repayment of maturing debt; and financing
possible future acquisitions. HSB subsequently filed a registration statement
covering securities with terms identical in all material respects and offered to
exchange registered securities for the original Capital Securities. The exchange
was completed on December 11, 1997. The floating rate Capital Securities are
currently rated BBB by Standard & Poor's and BBB+ by Duff & Phelps credit rating
agency.
On December 31, 1997, HSB sold $300 million of 20 year Convertible Capital
Securities in a private placement to ERC. The Convertible Capital Securities are
callable by HSB 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
37
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 $85, 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. Were ERC to exercise its
conversion rights in total, it would hold, on a fully diluted basis,
approximately 15.3 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 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.
Cash provided from operations was $26.1 million in 1997 compared to $92.9
million for 1996. Insurance operations cash flow (excluding IRI) decreased as
net claims paid increased 21.8 percent compared to the same period in 1996, and
premiums collected were 1.9 percent higher than last year. Payments to
reinsurers for ceded premium increased approximately 17 percent in the current
year. HSBIIC's participation in IRI impacted components of the Consolidated
Statements of Cash Flows for 1997, including a positive impact of $1.5 million
and $2.2 million for 1997 and 1996, respectively, to cash provided from
operations.
Capital resources consist of shareholders' equity, convertible redeemable
preferred stock, capital securities and debt outstanding, and represent those
funds deployed or available to be deployed to support business operations.
Common shareholders' equity of $345.3 million at December 31, 1997 decreased
$0.3 million since December 31, 1996. The decrease reflects net income of $66.3
million year to date and an increase in unrealized
38
investment gains, net of tax, of $7.0 million, offset by dividends of $47
million and $54 million of share repurchases. Also, on October 30, 1997, the
sole holder of convertible redeemable preferred stock converted into 398,406
shares of common stock, adding $20 million to common shareholders' equity.
On January 27, 1997 the Board of Directors renewed HSBIIC's authorization to
repurchase up to one million of its common shares. At its July meeting, the HSB
Board of Directors increased the authorization to repurchase shares to two
million. Through December 31, 1997, HSB has purchased approximately one million
shares at a cost of $54 million. On January 26, 1998 the Board of Directors
renewed HSB's authorization to repurchase up to two million shares of its common
stock. At December 31, 1997 treasury stock of $85.9 million was reclassified to
retained earnings and additional paid-in capital to reflect the elimination of
the concept of treasury shares in accordance with the Connecticut Business
Corporation Act which became effective January 1, 1997. For comparative
purposes, treasury stock of $59.5 million was likewise reclassified at December
1996.
At December 31, 1997, 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, 1997 and December 31, 1996 was
$42.4 million and $3.2 million, respectively. In early January, Standard &
Poor's and Duff & Phelps credit rating services reaffirmed their highest ratings
for the commercial paper. HSBIIC had authorized a guaranty of up to 40 percent
of Radian's $40 million credit facility with Dow. At December 31, 1997 the
amount guaranteed was $14.3 million. Such guaranty terminated upon the sale of
HSBIIC's interest in Radian to Dow on January 2, 1998.
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. The analysis
indicated roughly 30 percent of existing code is compliant, roughly 60 percent
is represented by legacy systems, which were scheduled to be replaced before the
end of 1998 due to current business needs, and the remainder will be addressed
through modification to compliant code or discontinuation. The impact of year
2000 expenditures on a stand alone basis is not clearly evident as the Company
is replacing legacy applications due to changing business needs and such
replacement applications will be year 2000 compliant. However, the overall cost
of modification efforts and application replacement, which include substantial
enhancements to business functionality, has been estimated at $13-$20 million
over a three year period. Certain of the costs related to the replacement of
legacy applications due to changing business needs will be capitalized
consistent with the Company's existing capitalization policy.
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
39
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; 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 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 8. Financial Statements and Supplementary Data.
- - ------- --------------------------------------------
INDEX TO FINANCIAL STATEMENTS
AND FINANCIAL STATEMENT SCHEDULES
Page No.
Report of Independent Accountants 42
Financial Statements
Consolidated Statements of Operations
for the years ended December 31, 1997,
1996 and 1995. 43
Consolidated Statements of Financial
Position - December 31, 1997 and 1996. 44
Consolidated Statements of Cash Flows
for the years ended December 31, 1997,
1996 and 1995. 45
Consolidated Statements of Changes in
Shareholders' Equity for the years ended
December 31, 1997, 1996 and 1995. 46
Notes to Consolidated Financial Statements 47
Schedule I - Summary of Investments-
Other than Investments in Related Parties 79
40
Schedule II - Condensed Financial Information of
HSB Group, Inc. 80
Schedule IV - Reinsurance 83
Schedule V - Valuation and Qualifying Accounts 84
Schedule VI - Supplemental Information Concerning
Property-Casualty Insurance Operations 85
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.
41
REPORT OF INDEPENDENT ACCOUNTANTS
To the Shareholders and Board of Directors of
HSB Group, Inc., the newly formed parent of The Hartford Steam Boiler Inspection
and Insurance Company:
We have audited the consolidated financial statements and the financial
statement schedules of HSB Group, Inc. and its subsidiaries listed in Item 8 of
this Form 10-K. 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 in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall consolidated financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of HSB Group, Inc.
and its subsidiaries as of December 31, 1997 and 1996, and the consolidated
results of their operations and their cash flows for each of the three years in
the period ended December 31, 1997, in conformity with generally accepted
accounting principles. In addition, in our opinion, the financial statement
schedules referred to above, when considered in relation to the basic financial
statements taken as a whole, present fairly, in all material respects, the
information required to be included therein.
Coopers & Lybrand L.L.P.
Hartford, Connecticut
January 26, 1998
42
Financial Statements
Consolidated Statements of Operations
- - -------------------------------------
For the years then ended December 31, (in millions, except per share amounts)
1997 1996 1995
- - --------------------------------------------------------------------------------------------
Revenues:
Insurance premiums $ 491.2 $ 448.6 $ 389.1
Engineering services 61.3 55.8 49.9
Net investment income 36.8 32.3 28.9
Realized investment gains 14.1 12.1 2.8
----------------------------------
Total revenues 603.4 548.8 470.7
----------------------------------
Expenses:
Claims and adjustment 217.9 204.4 154.9
Policy acquisition 90.7 86.0 78.1
Underwriting and inspection 142.8 136.4 121.9
Engineering services 57.0 48.5 43.2
Interest 1.3 0.6 0.4
----------------------------------
Total expenses 509.7 475.9 398.5
----------------------------------
Income from continuing operations before
income taxes and distributions on capital securities 93.7 72.9 72.2
Income taxes (benefit):
Current 23.8 24.7 20.5
Deferred 1.3 (6.4) (1.0)
----------------------------------
Total income taxes 25.1 18.3 19.5
----------------------------------
Distributions on capital securities of subsidiary
trusts, net of income taxes of $1.2; $--; and $-- 2.3 -- --
----------------------------------
Income from continuing operations 66.3 54.6 52.7
----------------------------------
Discontinued operations:
Income (loss) from operations of Radian International
LLC, net of income taxes (benefit) of
($.1); ($.4); and $4.2 -- (1.2) 9.9
-----------------------------------
Net income $ 66.3 $ 53.4 $ 62.6
-----------------------------------
Earnings (loss) per common share - basic:
Income from continuing operations $ 3.32 $ 2.71 $ 2.58
Discontinued operations -- (0.06) 0.49
-----------------------------------
Net income $ 3.32 $ 2.65 $ 3.07
-----------------------------------
Average common shares outstanding 19.7 20.2 20.4
Earnings (loss) per common share - diluted:
Income from continuing operations $ 3.29 $ 2.71 $ 2.58
Discontinued operations -- (0.06) 0.49
-----------------------------------
Net income $ 3.29 $ 2.65 $ 3.07
-----------------------------------
Average common shares outstanding
and common stock equivalents 20.1 20.2 20.4
-----------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
43
Consolidated Statements of Financial Position
- - ---------------------------------------------
At December 31, (in millions, except per share amounts)
1997 1996
- - ----------------------------------------------------------------------------------------------------------------
Assets:
Cash $ 45.3 $ 4.5
Short-term investments, at cost 379.2 97.9
Fixed maturities, at fair value
(cost - $241.1; $231.3) 248.4 235.8
Equity securities, at fair value
(cost - $231.3; $182.9) 323.8 262.7
--------------------------
Total cash and invested assets 996.7 600.9
Insurance premiums receivable 138.0 106.4
Engineering services receivable 12.2 11.7
Fixed assets 36.4 32.3
Prepaid acquisition costs 45.5 40.6
Capital lease 15.3 16.1
Investment in Radian 83.4 79.7
Reinsurance assets 124.5 162.9
Other assets 88.2 65.7
-------------------------
Total assets $ 1,540.2 $ 1,116.3
-------------------------
Liabilities:
Unearned insurance premiums $ 290.3 $ 270.6
Claims and adjustment expenses 276.7 302.9
Short-term borrowings 42.4 3.2
Long-term borrowings 25.1 25.1
Capital lease 27.9 27.9
Deferred income taxes 31.5 23.7
Dividends payable 13.3 11.4
Other liabilities 78.8 85.9
-------------------------
Total liabilities 786.0 750.7
-------------------------
Convertible redeemable preferred stock - Series B (stated and
redemption value; shares authorized, issued and outstanding .002) -- 20.0
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 $1.1 108.9 --
Company obligated mandatorily redeemable convertible capital securities of
subsidiary Trust II holding solely junior
subordinated deferrable interest debentures of the Company 300.0 --
Shareholders' equity:
Common stock (stated value; shares authorized 50.0;
shares issued 21.3; shares outstanding 19.6; 20.0) 10.0 10.0
Additional paid-in capital 31.6 32.0
Unrealized investment gains, net of tax 59.8 52.8
Retained earnings 248.8 255.1
Benefit plans (4.9) (4.3)
---------------------------
Total shareholders' equity 345.3 345.6
---------------------------
Total $ 1,540.2 $ 1,116.3
---------------------------
Common shareholders' equity per share $ 17.63 $ 17.25
- - ----------------------------------------------------------------------------------------------------------------
- - ----------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
44
Consolidated Statements of Cash Flows
- - -------------------------------------
for the years ended December 31, (in millions)
1997 1996 1995
- - -----------------------------------------------------------------------------------------
Operating activities:
Net income $ 66.3 $ 53.4 $ 62.6
Adjustments to reconcile net income to
cash provided by operating activities:
Depreciation and amortization 8.3 9.8 19.4
Deferred income taxes (benefit) 1.3 (10.0) (0.6)
Realized investment gains (14.1) (12.1) (2.8)
Change in:
Insurance premiums receivable (31.6) (19.2) (4.1)
Engineering services receivable (.5) (2.7) 3.3
Prepaid acquisition costs (4.9) (6.5) 1.4
Investment in Radian (3.7) 12.9 --
Reinsurance assets 38.4 (103.4) (.8)
Unearned insurance premiums 19.7 54.4 14.9
Claims and adjustment expenses (26.2) 112.0 (8.5)
Other (26.9) 4.3 10.7
------------------------------
Cash provided by operating activities 26.1 92.9 95.5
------------------------------
Investing activities:
Fixed asset additions, net (10.4) (1.7) (16.8)
Investments:
Purchase of short-term investments, net (281.4) (24.1) --
Purchase of fixed maturities (60.6) (89.0) (152.1)
Proceeds from sale of fixed maturities 27.9 93.1 91.5
Redemption of fixed maturities 14.4 11.5 17.0
Purchase of equity securities (252.9) (149.3) (95.0)
Proceeds from sale of equity securities 254.1 131.2 122.9
Settlement of collar contracts (30.7) -- --
Cash transferred to investment in Radian -- (0.7) --
-----------------------------
Cash used in investment activities (339.6) (29.0) (32.5)
-----------------------------
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 39.1 (10.2) (37.5)
Repayment of long-term debt -- (0.5) (0.1)
Increase in long-term debt -- -- 25.1
Dividends paid to shareholders (46.7) (46.1) (45.3)
Reacquisition of stock (54.0) (13.0) (6.3)
Repayment of employee stock ownership plan debt -- -- (1.7)
Exercise of stock options 7.0 1.1 --
-----------------------------
Cash provided by (used in) financing activities 354.3 (68.7) (65.8)
-----------------------------
Net increase (decrease) in cash 40.8 (4.8) (2.8)
Cash at beginning of period 4.5 9.3 12.1
-----------------------------
Cash at end of period $ 45.3 $ 4.5 $ 9.3
-----------------------------
Interest paid $ 3.2 $ 2.3 $ 4.1
-----------------------------
Federal income tax paid $ 33.8 $ 25.7 $ 23.4
- - ----------------------------------------------------------------------------------------
Non-cash investing and financing activities:
Issuance of HSB convertible preferred stock in exchange for EIG, Co. preferred
stock in 1996, and conversion into HSB common stock in 1997. (See note 3).
The accompanying notes are an integral part of the consolidated financial
statements.
45
Consolidated Statements of Changes in Shareholders' Equity
- - ----------------------------------------------------------
For the years ended December 31, (in millions)
Net
Total Unrealized
Share- Additional Investment
holders' Common Paid-in Gains Retained Treasury Benefit
Equity Stock Capital (Losses) Earnings Stock Plans
- - --------------------------------------------------------------------------------------------------------
Balances at December 31, 1994 $ 299.5 $ 10.0 $ 34.0 $ 13.9 $ 288.1 ($ 41.9) (4.6)
- - --------------------------------------------------------------------------------------------------------
Net income 62.6 -- -- -- 62.6 -- --
Dividends declared (45.6) -- -- -- (45.6) -- --
Change in unrealized
investment gains, net of tax 30.0 -- -- 30.0 -- -- --
Benefit plans 0.4 -- (0.1) -- -- -- 0.5
Purchase of treasury stock (6.3) -- -- -- -- (6.3) --
Issuance of reacquired stock,
net of forfeitures 0.5 -- -- -- -- 0.5 --
-----------------------------------------------------------------------------------------------------
Balances at December 31, 1995 $ 341.1 $ 10.0 $ 33.9 $ 43.9 $ 305.1 ($ 47.7) ($ 4.1)
- - ------------------------------------------------------------------------------------------------------
Net income 53.4 -- -- -- 53.4 -- --
Dividends declared (45.9) -- -- -- (45.9) -- --
Change in unrealized
investment gains, net of tax 8.9 -- -- 8.9 -- -- --
Benefit plans -- -- -- -- -- 0.2 (0.2)
Purchase of treasury stock (13.0) -- -- -- -- (13.0) --
Exercise of stock options 1.1 -- 0.1 -- -- 1.0 --
Reclassification of treasury
stock -- -- (2.0) -- (57.5) 59.5 --
--------------------------------------------------------------------------------------------------
Balances at December 31, 1996 $ 345.6 $ 10.0 $ 32.0 $ 52.8 $ 255.1 -- ($ 4.3)
- - ------------------------------------------------------------------------------------------------------
Net income 66.3 -- -- -- 66.3 -- --
Dividends declared (47.0) -- -- -- (47.0) -- --
Change in unrealized
investment gains, net of tax 7.0 -- -- 7.0 -- -- --
Benefit plans (0.6) -- -- -- -- -- (0.6)
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 $ 59.8 $ 248.8 -- ($ 4.9)
- - ------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
46
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) (See note 3)
and are prepared in accordance with generally accepted accounting principles
(GAAP). 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 may differ from estimates. Certain amounts for 1996 and 1995 have
been reclassified to conform with the 1997 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 and premium
taxes, are amortized as the related insurance premiums are earned. 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 to 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
require complex engineering judgments. 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 are changed. (See
note 10).
Reinsurance assets represents 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.
47
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.
Investments
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 investments 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 bases 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.
Fixed Assets
Fixed assets are carried at cost less accumulated depreciation. Depreciation 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.
48
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 15 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 $20.7 and $12.1 million at December 31, 1997 and 1996,
respectively. HSB evaluates the reliability of goodwill based upon projections
of undiscounted cash flows.
2. Changes in Accounting Principles
In February 1997, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) 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 Consolidated Statements of Operations 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 are effective for year end 1997 financial statements with
prior period restatement required. The effect of this standard on EPS net income
is as follows:
1997 1996 1995
- - --------------------------------------------------------------
APB No. 15 methodology
(as previously reported) N/A $ 2.65 $ 3.07
SFAS No. 128 methodology
Basic EPS $ 3.32 $ 2.65 $ 3.07
Diluted EPS $ 3.29 $ 2.65 $ 3.07
- - --------------------------------------------------------------
49
The following is a reconciliation of the numerator and denominator of the
calculation of basic and diluted EPS for income from continuing operations for
the years ended 1997, 1996 and 1995:
For the years ended December 31, 1997 1996 1995
- - ---------------------------------------------------------------- --------------------------- ---------------------------
Income Shares Per-Share Income Shares Per-Share Income Shares Per-Share
------ ------ --------- ------ ------ --------- ------ ------ ---------
Income from continuing
operations $66.3 $53.4 $62.6
Less: preferred stock dividends (1.1) -- --
---------------------------- ---------------------------- ---------------------------
Basic EPS:
Income available to
common shareholders 65.2 53.4 62.6
Weighted average shares
outstanding 19.7 20.2 20.4
Basic EPS $3.32* $2.65* $3.07*
Effect of dilutive securities:
Convertible preferred stock 1.1 0.3 -- -- -- --
Stock options 0.1 -- --
--------------------------- ---------------------------- --------------------------
Diluted EPS:
Income available to common
shareholders and
assumed
conversions $66.3 20.1 $53.4 20.2 $62.6 20.4
Diluted EPS $3.29* $2.65* $3.07*
- - ---------------------------------------------------------------- --------------------------- --------------------------
- - -------------------------------------------------------------------------------------------------------------------------------
* Computation is carried out to thousands
On December 31, 1997, HSB sold $300 million of convertible capital securities.
The securities carry a 7 percent coupon and are convertible into 3,529,411
shares. (See note 12). Due to the timing of the issuance, the securities had
minimal impact on the EPS calculation in 1997, but will affect the diluted
calculation in 1998.
In June 1997, FASB issued SFAS No. 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 Consolidated Statements of
Changes in Shareholders' Equity. This statement will be effective beginning in
1998 with retroactive restatement of prior periods required.
Also in June of 1997, FASB issued SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information". This standard requires companies to
report financial
50
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 for 1998, however, application
is not required for interim financial statements in the initial year. It is
possible that this disclosure may redefine our segment information. However, HSB
has not yet determined how SFAS No. 131 will be applied.
3. Corporate Activity
At a special meeting of The Hartford Steam Boiler Inspection and Insurance
Company (HSBIIC) on June 23, 1997, shareholders voted to approve a proposal
which enabled the formation of a new holding company, HSB Group, Inc. (HSB).
Shareholders of HSBIIC's common and convertible redeemable preferred stock
became holders of HSB's common and convertible redeemable preferred stock,
respectively, through a share exchange approved by the shareholders.
Certificates representing HSBIIC's common and convertible redeemable preferred
stock automatically represent the corresponding shares of HSB common and
convertible redeemable preferred stock. HSBIIC remains the principal subsidiary
of HSB.
In December 1994, HSBIIC acquired the remaining 50 percent interest in
Engineering Insurance Group (EIG), a partnership which was jointly formed by
HSBIIC and General Reinsurance Corporation (Gen Re) in 1988. The partnership was
the parent of Engineering Insurance Company Limited, a London based insurer
formed in 1989 principally to offer machinery breakdown coverage to business and
industry outside the United States and Canada. Coincident with the December 1994
acquisition, the partnership was incorporated with HSBIIC acquiring all
outstanding common shares and Gen Re acquiring preferred shares of the new
company, EIG, Co. HSBIIC had the option to request Gen Re to exchange the EIG,
Co. preferred stock for HSBIIC convertible redeemable preferred stock at the end
of 1996. This option was exercised on December 30, 1996 resulting in the
issuance of 2,000 shares of HSBIIC convertible redeemable preferred stock. On
October 30, 1997, these shares were converted into 398,406 shares of common
stock of HSB. (See note 12).
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 sold $300 million
of 20 year fixed rate Convertible Capital Securities to Employers Reinsurance
Corporation (ERC), a subsidiary of GE Capital Services. (See note 12).
Subsequent Events
Radian
In January 1996, HSBIIC and The Dow Chemical Company (Dow) formed a new entity,
Radian International LLC (Radian). According to the terms of the agreement, the
ownership of Radian was initially 60 percent Dow and 40 percent HSBIIC, via the
wholly
51
owned subsidiaries of each company. At the date of the transaction, HSBIIC
transferred virtually all of the assets and liabilities of Radian Corporation at
historical cost to Radian. No gain was recognized on the transfer.
The agreement provided HSBIIC 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 to Dow on or about January 1,
1998. Due to this decision, the results of Radian have been classified as
discontinued operations. HSB's share of Radian's losses generated subsequent to
this decision of approximately $10 million pre-tax have been deferred until
HSB's share of Radian was sold and a gain recognized.
On January 2, 1998 HSB exercised its option to put its share of Radian to Dow
for approximately $144 million. This transaction will result in an after tax
gain of approximately $30 million which will be recorded in the first quarter of
1998.
Summarized financial data for Radian follows:
1997* 1996* 1995
- - ---------------------------------------------------------
Assets $ 159.7 $ 156.3 $ 108.6
Liabilities 88.4 62.1 37.1
Revenues 288.0 229.6 202.2
Expenses 314.0 233.6 188.1
- - ---------------------------------------------------------
*Presented at 100 percent--HSBIIC's interest in Radian during these periods was
40 percent.
Industrial Risk Insurers
On January 6, 1998 HSBIIC sold its interest in Industrial Risk Insurers (IRI) to
ERC in accordance with a previously announced purchase and sale agreement
between ERC and IRI's twenty-three member insurers. IRI is an unincorporated,
voluntary joint underwriting association which underwrites property insurance on
highly protected risks. HSBIIC received gross proceeds of approximately $50
million, prior to transaction costs, for its 23.5 percent share in IRI. Because
the sale was structured in part as a reinsurance transaction, a portion of
HSBIIC's gross proceeds will be utilized to reinsure in-force policies with ERC.
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 its sole members.
Initially HSBIIC will write the business for the reconstituted IRI using its
insurance licenses and will provide certain other services. It is anticipated
that HSBIIC will transfer its domestic highly protected risk manufacturing book
of business to IRI and will retain 85 percent of
52
the equipment breakdown business and 15 percent of the property business 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 Convertible Capital Securities in a private
placement to ERC. These capital securities are convertible into HSB common
stock, at any time, subject to regulatory approval, at a conversion price of
$85. $250 million of the proceeds were contributed by HSB to HSBIIC and $50
million was retained at HSB. (See note 12).
4. Segment Information
HSB is a multi-national company operating primarily in North American, European,
and Asian markets. The Company operates three principal businesses -- insurance,
engineering services and investments. The Company primarily offers coverage for
machinery intensive risks and provides 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 services aimed at
loss prevention. The Company also offers professional scientific and technical
consulting for industry and government on a worldwide basis. While the principal
market for insurance and engineering services is the United States, the Company
continues to see growth opportunities in overseas markets.
The following presents financial data of the Company based on geographic
location:
Revenues from continuing operations
For the years ended December 31, 1997 1996 1995
- - -------------------------------------------------------------------------------
U.S. $ 491.6 $ 444.9 $ 383.4
Non-U.S 111.8 103.9 87.3
-------------------------------------
Total $ 603.4 $ 548.8 $ 470.7
-------------------------------------
- - -------------------------------------------------------------------------------
Income from continuing operations before taxes and distributions on capital
- - ----------------------------------------------------------------------------
securities
- - ----------
For the years ended December 31, 1997 1996 1995
- - -------------------------------------------------------------------------------
U.S. $ 74.1 $ 52.7 $ 53.4
Non-U.S. 19.6 20.2 18.8
----------------------------------------
Total $ 93.7 $ 72.9 $ 72.2
----------------------------------------
- - -------------------------------------------------------------------------------
Identifiable assets
At December 31, 1997 1996 1995
- - -------------------------------------------------------------------------------
U.S. $1,247.7 $ 858.3 $ 743.1
Non-U.S. 292.5 258.0 211.0
--------------------------------------
Total $1,540.2 $1,116.3 $ 954.1
--------------------------------------
- - -------------------------------------------------------------------------------
53
HSB's foreign operations (primarily insurance) are widely dispersed such that no
country or logical aggregation of countries in a geographic area compromise 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 continuing operations of the Company
based on industry segments:
Revenues from continuing operations
- - -----------------------------------
For the years ended December 31, 1997 1996 1995
- - ------------------------------------------------------------------------
Insurance premiums $ 491.2 $ 448.6 $ 389.1
Engineering services 61.3 55.8 49.9
Net investment income
and realized investment
gains 50.9 44.4 31.7
-------------------------------
Total $ 603.4 $ 548.8 $ 470.7
-------------------------------
Income from continuing operations before income taxes and distributions on
- - --------------------------------------------------------------------------
capital securities
- - ------------------
For the years ended December 31, 1997 1996 1995
- - --------------------------------------------------------------------------
Insurance $ 39.8 $ 21.8 $ 34.2
Engineering 4.3 7.3 6.7
Investment 49.6 43.8 31.3
---------------------------------------
Total $ 93.7 $ 72.9 $ 72.2
- - --------------------------------------------------------------------------
Identifiable assets
At December 31, 1997 1996 1995
- - --------------------------------------------------------------------------
Insurance $ 308.0 $ 309.9 $ 180.8
Engineering 95.6 91.4 97.0
Investment 996.7 600.9 553.8
Other 139.9 114.1 122.5
--------------------------------------
Total $1,540.2 $1,116.3 $ 954.1
- - --------------------------------------------------------------------------
5. 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 year-end 1997
and 1996, policyholders' surplus on a statutory basis was $550.8
54
and $292.4 million, respectively. Statutory net income, adjusted to include the
earnings of all HSBIIC domestic insurance subsidiaries for 1997, 1996, and 1995
was $42.9, $32.1, and $66.7 million, respectively.
HSBIIC is currently subject to various regulations that limit the maximum amount
of dividends available to its shareholders without prior approval of insurance
regulatory authorities. Under SAP, approximately $55.1 million of statutory
surplus is available for distribution to HSB Group, Inc. in 1998 without prior
regulatory approval.
55
6. Investments
1997 1996 1995
- - --------------------------------------------------------------------------------
Income from Investment Operations
Net investment income:
Short-term interest $ 6.7 $ 4.8 $ 6.2
Fixed maturities:
Taxable interest 9.6 9.8 9.0
Tax exempt interest 2.1 1.8 1.9
Redeemable preferred
dividends 7.2 7.9 6.3
Equity securities:
Common dividends 4.7 4.6 4.0
Non-redeemable preferred
dividends 8.3 5.9 4.6
Other 2.1 1.0 1.2
------------------------
Total investment income 40.7 35.8 33.2
Investment expenses (3.9) (3.5) (4.3)
------------------------
Net investment
income $ 36.8 $ 32.3 $ 28.9
------------------------
Realized investment gains (losses):
Fixed maturities:
Bonds:
Gains $ 0.5 $ 2.0 $ 0.7
Losses (0.3) (0.2) (1.5)
------------------------
Net gains
(losses) 0.2 1.8 (0.8)
Redeemable
preferred stocks:
Gains 0.4 0.3 0.7
Losses (0.3) (1.5) (0.6)
------------------------
Net gains
(losses) 0.1 (1.2) 0.1
Equity securities:
Common stocks:
Gains 48.1 14.6 11.4
Losses (5.1) (3.3) (7.4)
------------------------
Net gains 43.0 11.3 4.0
Non-redeemable
preferred stocks:
Gains 7.7 4.2 0.2
Losses (0.2) (4.0) (0.7)
------------------------
Net gains
(losses) 7.5 0.2 (0.5)
Foreign Exchange Losses (7.4) -- --
Collar Contracts Losses (30.7) -- --
Other Gains 1.4 -- --
------------------------
Realized investment
gains $ 14.1 $ 12.1 $ 2.8
------------------------
------------------------------------------------------------------------------
There were no material declines in the realizable value of investments
considered to be other than temporary for 1997 or 1995. Realized investment
gains and losses for 1996
56
included $0.8 million of losses on non-redeemable preferred stock arising from
declines in the realizable value of investments considered to be other than
temporary.
1997 1996 1995
- - -------------------------------------------------------------------------------
Unrealized Investment Gains, Net of Tax
Fixed maturities:
Gains $ 7.9 $ 6.1 $ 9.3
Losses (0.6) (1.6) (1.6)
---------------------------
Net gains 7.3 4.5 7.7
Equity securities:
Gains 94.3 82.0 64.2
Losses (1.8) (2.2) (3.8)
---------------------------
Net gains 92.5 79.8 60.4
Foreign exchange losses (4.5) (2.9) (2.7)
---------------------------
Total unrealized
investment gains 95.3 81.4 65.4
Income taxes (35.5) (28.6) (21.5)
---------------------------
Unrealized
investment
gains, net of tax $ 59.8 $ 52.8 $ 43.9
--------------------------
- - ------------------------------------------------------------------------------
57
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:
1997
- - --------------------------------------------------------------------------------
Estimated Gross Gross
Amortized Fair Unrealized Unrealized
Category Cost Value Gains Losses
- - --------------------------------------------------------------------------------
Redeemable preferred
stocks $ 131.2 $ 135.4 $ 4.7 $ 0.5
States and municipalities 37.6 39.7 2.2 0.1
Foreign governments 33.1 33.5 0.4 --
Corporate and other 39.2 39.8 0.6 --
-------------------------------------------
Total fixed maturities $ 241.1 $ 248.4 $ 7.9 $ 0.6
- - --------------------------------------------------------------------------------
1996
- - --------------------------------------------------------------------------------
Estimated Gross Gross
Amortized Fair Unrealized Unrealized
Category Cost Value Gains Losses
- - --------------------------------------------------------------------------------
Redeemable preferred
stocks $ 99.6 $ 101.6 $ 3.1 $ 1.1
States and municipalities 39.4 40.7 1.6 0.3
Foreign governments 30.1 30.5 0.5 0.1
Corporate and other 62.2 63.0 0.9 0.1
-------------------------------------------
Total fixed maturities $ 231.3 $ 235.8 $ 6.1 $ 1.6
- - --------------------------------------------------------------------------------
The amortized cost and estimated fair value of fixed maturities at December 31,
by contractual years-to-maturity follows. Actual maturities may differ from
contractual maturities because borrowers may have the right to prepay
obligations.
1997
- - ----------------------------------------------------------------
Estimated
Amortized Fair
Maturity Cost Value
- - ----------------------------------------------------------------
One year or less $ 13.3 $ 13.7
Over one year through five years 98.6 101.1
Over five years through ten years 32.8 34.1
Over ten years 96.4 99.5
--------------------
Total fixed maturities $ 241.1 $ 248.4
--------------------
- - ----------------------------------------------------------------
58
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:
1997
- - --------------------------------------------------------------------------------
Estimated Gross Gross
Fair Unrealized Unrealized
Cost Value Gains Losses
- - --------------------------------------------------------------------------------
Common stocks $ 97.5 $ 179.0 $ 82.2 $ 0.7
Non-redeemable preferred
stocks 133.8 144.8 12.1 1.1
------------------------------------------
Total equity
securities $ 231.3 $ 323.8 $ 94.3 $ 1.8
------------------------------------------
- - --------------------------------------------------------------------------------
1996
- - -------------------------------------------------------------------------------
Estimated Gross Gross
Fair Unrealized Unrealized
Cost Value Gains Losses
- - -------------------------------------------------------------------------------
Common stocks $ 95.7 $ 168.3 $ 73.6 $ 1.0
Non-redeemable preferred
stocks 87.2 94.4 8.4 1.2
------------------------------------------
Total equity
securities $ 182.9 $ 262.7 $ 82.0 $ 2.2
------------------------------------------
- - -------------------------------------------------------------------------------
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). Each contract
had a notional value of $50 million and maturity dates ranging from November
1997 to January 1998. The contracts, which were entered into when the 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. 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.
The Company's U.S. common stock portfolio has experienced a total return of $57
million (which includes price appreciation of approximately $54 million) since
December 31, 1996, and has 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
59
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.
The Company held no derivative financial instruments in its investment portfolio
at December 31, 1997 and December 31, 1995. The Company sells covered call
options, at times, to protect against adverse changes in market values. Premiums
received on options written are deferred and recognized as a component of gross
realized gains when the option contracts are exercised or expire. During 1995,
aggregate premiums received by the Company on covered call options amounted to
less than $.1 million. Net gains recognized on sales of underlying instruments
amounted to less than $.1 million for 1995. Generally, the duration of covered
call options written by the Company does not exceed thirty days.
7. Fixed Assets
Fixed assets are summarized as follows:
1997 1996
- - --------------------------------------------------------------------------------
Land and buildings $ 5.0 $ 7.3
Furniture, equipment, leasehold improvements,
and other 57.1 65.7
Systems development costs 6.6 0.6
------------------------
$ 68.7 $ 73.6
Less accumulated depreciation and amortization (32.3) (41.3)
------------------------
Fixed assets $ 36.4 $ 32.3
------------------------
- - --------------------------------------------------------------------------------
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' life or the
remaining contractual lease term.
The Company has a policy capitalizing certain systems development costs. Systems
development costs are amortized over estimated useful lives of 3 to 5 years.
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. The analysis
indicated roughly 30 percent of existing code is compliant, roughly 60 percent
is represented by legacy systems, which were scheduled to be replaced before the
end of 1998 due to current business needs, and the remainder will be addressed
through modification to compliant code or discontinuation. The impact of year
2000 expenditures on a stand alone basis is not clearly evident as the Company
is replacing legacy applications due to changing business needs and such
replacement applications will be year 2000 compliant. However, the overall cost
of modification efforts and application replacement, which include substantial
enhancements to business functionality, has been estimated at $13-$20 million
over a three year period. Certain of the costs related to the replacement of
legacy
60
applications due to changing business needs are being capitalized consistent
with the Company's existing capitalization policy.
8. 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 $10.8 and $10.1
million at December 31, 1997 and 1996, respectively. Terms of the lease require
annual payments of approximately $4 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 $2.6, $2.8 and $2.8 million for the years ended 1997, 1996 and
1995, 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.
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 $8.4, $5.7 and $4.7 million in 1997, 1996 and 1995, respectively.
At December 31, 1997, 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:
1998 $ 5.0
1999 4.4
2000 2.9
2001 1.6
2002 0.8
2003 and thereafter 0.3
-------
Total $15.0
-------
61
9. Reinsurance
The components of net written and net earned insurance premiums were as follows:
1997 1996 1995
- - --------------------------------------------------------------------------------
Written premiums:
Direct $ 361.4 $ 338.6 $ 285.3
Assumed 257.1 232.6 182.9
Ceded (120.0) (116.8) (59.9)
----------------------------------
Net written premiums $ 498.5 $ 454.4 $ 408.3
------------------------------------
Earned premiums:
Direct $ 370.1 $ 343.4 $ 279.7
Assumed 239.2 213.1 175.3
Ceded (118.1) (107.9) (65.9)
------------------------------------
Insurance premiums $ 491.2 $ 448.6 $ 389.1
------------------------------------
- - --------------------------------------------------------------------------------
The Company writes direct business through agencies and brokerage firms. In
addition, the Company assumes boiler and machinery exposures from over 100
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 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 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 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, is undergoing a shakeout and consolidation.
A significant amount of merger and acquisition activity has occurred recently
and may continue 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.
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
62
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 $45.2, $113.9 and $28.5 million of reinsurance recoveries as a
reduction of its claims and adjustment expenses for the years ended December 31,
1997, 1996 and 1995, respectively. Reinsurance recoverable on paid claims and
adjustment expenses was $8.0 million at both December 31, 1997 and 1996.
IRI is a voluntary joint underwriting association providing property insurance
for the class of business known as Highly Protected Risks - larger
manufacturing, processing, and industrial businesses which have invested in
protection against loss through the use of sprinklers and other means. Effective
December 1, 1996, HSBIIC increased its participation in IRI to 23.5 percent.
Prior to the December 1, 1996 increase in participation, HSBIIC's interest in
IRI was 14 percent. The 1996 increase resulted in HSBIIC assuming approximately
$15.5 million net unearned premium reserves which have not been reflected in
written premiums. Likewise in 1995, HSBIIC increased its participation from .5
percent to 14 percent resulting in the assumption of $27.9 million in the net
unearned premium reserves which were also not reflected in written premiums. IRI
has a fiscal year ending November 30 and provides quarterly reports to member
companies of the association. As a result, HSBIIC's increases in participation
were initially reflected in the first quarter financial reports for the
subsequent year. Effective January 1, 1998 members of IRI sold their membership
to ERC. (See note 3).
63
10. 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
- - --------------------------------------------------------------------
1997 1996 1995
- - ------------------------------------------------------------------------------------------
Gross liability for claims and adjustment expenses
at January 1, $ 302.9 $ 190.9 $ 199.4
Plus:
Provision for claims and adjustment
expenses occurring in the current year 263.3 313.3 183.3
Increase (decrease) in estimated claims and
adjustment expenses arising in
prior years (0.2) 16.1 12.6
---------------------------------
Total incurred claims and
adjustment expenses $ 263.1 $ 329.4 $ 195.9
---------------------------------
Less:
Payment for claims arising in:
Current year 90.6 103.3 65.1
Prior years 198.7 114.1 139.3
---------------------------------
Total payments $ 289.3 $ 217.4 $ 204.4
---------------------------------
Gross liability for claims and
adjustment expenses at December 31, $ 276.7 $ 302.9 $ 190.9
---------------------------------
64
Reconciliation of Net Liability for Claims and Adjustment Expenses
- - ------------------------------------------------------------------
1997 1996 1995
- - ----------------------------------------------------------------------------------------------
Net liability for claims and adjustment expenses
at January 1, $ 177.8 $ 145.5 $ 161.3
Plus:
Provision for claims and adjustment expenses
occurring in the current year 209.5 214.2 152.2
Increase (decrease) in estimated claims and
adjustment expenses arising in prior
years 8.4 (9.8) 2.7
----------------------------------
Total incurred claims and adjustment
expenses $ 217.9 $ 204.4 $ 154.9
----------------------------------
Less:
Payment for claims arising in:
Current year 82.3 91.4 58.9
Prior years 122.6 80.7 111.8
---------------------------------
Total payments $ 204.9 $ 172.1 $ 170.7
---------------------------------
Net liability for claims and
adjustment expenses at
December 31, $ 190.8 $ 177.8 $ 145.5
---------------------------------
- - ---------------------------------------------------------------------------------------------
1997 and 1996 claims and adjustment expenses incurred have been reduced by
subrogation recoveries of approximately $3.3 million and $4.9 million,
respectively. Subrogation recoveries applied against 1995 claims and adjustment
expenses are immaterial.
A reconciliation of the net liability to the gross liability for claims and
adjustment expenses is as follows:
1997 1996 1995
- - ---------------------------------------------------------------------------------------
Net liability for claims and adjustment expenses
at December 31, $ 190.8 $ 177.8 $ 145.5
Reinsurance recoverable on unpaid claims and
adjustment expenses 85.9 125.1 45.4
---------------------------------
Gross liability for claims and adjustment expenses
at December 31, $ 276.7 $ 302.9 $ 190.9
---------------------------------
- - --------------------------------------------------------------------------------------
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 generally 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.
65
The following table displays information concerning the primary participant in
the Company's current reinsurance program as of December 31, 1997:
Reinsurer Ceded Written Reinsurance Asset 1997 A.M. Best's
Premium Rating
- - --------------------------------------------------------------------------------
General Reinsurance
Corporation $38.6 $50.5 A++(Superior)
As of December 31, 1997 no other reinsurance asset of the Company due from any
single reinsurer exceeded 3 percent of shareholders' equity. Certain Lloyds'
syndicates participate in the excess of loss reinsurance program, primarily in
the excess layers. The highest aggregate percentage participation of such
syndicates, at 44.6 percent, is in the $50 million excess of $100 million layer.
No individual syndicate has more than a 7.7 percent participation in any of the
excess layers. The Company's reinsurance asset in the aggregate from all Lloyds'
syndicates is less than 2 percent of shareholders' equity at December 31, 1997.
Lloyd's has historically participated more heavily in the higher treaty layers,
including those years relating to the arbitration and litigation cases discussed
below.
HSBIIC is involved in three arbitration or litigation proceedings regarding the
extent to which certain explosion events are insured under boiler and machinery
policies of HSBIIC or under the all-risk property insurance policies issued by
other companies. Management believes HSBIIC'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 HSBIIC was not liable for losses of the insured resulting from the
explosion. In a further action, the court denied HSBIIC's motion for summary
judgment on certain issues, thus leaving HSBIIC potentially liable for certain
unqualified losses resulting from events prior to the explosion. In the first
quarter of 1997, HSBIIC and the property insurer jointly settled the case with
the insured. HSBIIC's ultimate share of the settlement will be determined in an
arbitration proceeding with the property insurer. HSBIIC has incurred gross
losses and loss adjustment expenses (LAE) of $40.7 million and a net loss after
taking into account reinsurance recoverables of $6.5 million, of which $5
million represents claim costs and the remaining $1.5 million represents LAE. As
a result of payments made to date, at December 31, 1997, HSBIIC carried gross
loss and LAE reserves of $2.8 million and recoverables from reinsurers of $2.8
million.
HSBIIC has accrued $6.5 million with respect to the other two cases for
potential LAE, including legal costs to defend HSBIIC'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 HSBIIC is held liable for one or
both of the remaining claims, amounts in excess of HSBIIC's net maximum
aggregate retention of $8.5 million is recoverable from 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.
66
The obligations of HSBIIC'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. HSBIIC's reinsurance contracts
do not require HSBIIC to reimburse its reinsurers for any losses such reinsurers
might incur should these cases not be decided in HSBIIC's favor. Nevertheless,
reinsurers often quote rates for future coverages based upon their or other
reinsurers' experience on a particular account. Therefore, in the event HSBIIC's
reinsurers pay significant sums pursuant to the arbitration or litigation
proceedings described above, it is likely HSBIIC's reinsurance rates would
increase in future periods. However, given the insured capacity that exists in
reinsurance markets worldwide, coupled with HSBIIC'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.
11. Income Taxes
Tax Provision
A reconciliation of income taxes (benefit) at U.S. statutory rates to the income taxes (benefit) as reported is as follows:
1997 1996 1995
- - -----------------------------------------------------------------------------------------------------------
% 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 $ 93.7 100% $ 72.9 100% $ 72.2 100%
- - -----------------------------------------------------------------------------------------------------------
Tax at statutory rates $ 32.8 35% $ 25.5 35% $ 25.3 35%
Income taxed at foreign rates 1.0 1 0.5 1 0.2 --
Dividends received deduction (4.9) (5) (4.5) (6) (3.9) (5)
Tax exempt interest (0.8) (1) (0.6) (1) (0.7) (1)
Tax credits and others (3.0) (3) (2.6) (4) (1.4) (2)
Total income taxes and effective
tax rate $ 25.1 27% $ 18.3 25% $ 19.5 27%
---------------------------------------------------------------------
- - ------------------------------------------------------------------------------------------------------------
67
Income taxes (benefit) consisted of the following:
1997 1996 1995
- - --------------------------------------------------------------------------------
Current provision:
U.S $ 16.8 $ 17.3 $ 12.3
Foreign 7.0 7.4 8.2
--------------------------------
Total current provision 23.8 24.7 20.5
--------------------------------
Deferred provision:
U.S 1.1 (6.0) 0.4
Foreign 0.2 (0.4) (1.4)
--------------------------------
Total deferred provision 1.3 (6.4) (1.0)
--------------------------------
Total income taxes $ 25.1 $ 18.3 $ 19.5
--------------------------------
- - --------------------------------------------------------------------------------
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, 1997 and 1996
are as follows:
1997 1996
- - --------------------------------------------------------------------------------
Deferred tax liabilities:
Prepaid acquisition costs $ (13.2) $ (11.8)
Accelerated depreciation (0.3) (2.0)
Pension asset (13.3) (11.9)
Unrealized investment gains (35.4) (28.6)
Other (12.6) (12.7)
---------------------
Total deferred tax liabilities (74.8) (67.0)
---------------------
Deferred tax assets:
Benefit plans 9.0 9.6
Capital lease 4.4 4.1
Unearned insurance premiums 15.0 14.0
Loss reserve discounting 5.9 6.5
Other 9.0 9.1
---------------------
Total deferred tax assets 43.3 43.3
---------------------
Net deferred tax liabilities $ (31.5) $ (23.7)
---------------------
- - --------------------------------------------------------------------------------
Other Information
Federal income tax returns for the years 1995 and 1994 are currently under
examination by the Internal Revenue Service.
68
12. Capital Structure
HSB's capital structure is as follows:
1997 1996
- - ---------------------------------------------------------------------------
Short-term borrowings $ 42.4 $ 3.2
Long-term borrowings * $ 25.1 $ 25.1
Convertible redeemable preferred stock -- $ 20.0
Company obligated mandatorily redeemable
capital securities of subsidiary Trust I
holding solely junior subordinated
deferrable interest debenture of the
Company $ 108.9 --
Company obligated mandatorily redeemable
convertible capital securities of
subsidiary Trust II holding solely
junior subordinated deferrable
interest debenture of the Company $ 300.0 --
Common shareholders' equity $ 345.3 $ 345.6
- - ----------------------------------------------------------------------------
*Excludes capital lease. (See note 8).
Short-term and Long-term Borrowings
HSBIIC has a commercial paper program with a limit of $75 million. Commercial
paper outstanding at December 31, 1997 and 1996 was $42.4 million and $3.2
million, respectively. Commercial paper outstanding at year end 1997 matured on
or before January 6, 1998. Long-term debt consists of $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.
Convertible Redeemable Preferred Stock
On December 30, 1996, HSBIIC exercised its right to exchange 2,000 shares of
EIG, Co. preferred stock, which was issued at the time HSBIIC acquired the
remaining 50 percent interest in EIG, Co. from Gen Re, for 2,000 shares of
HSBIIC's convertible redeemable preferred stock. The stock had no par value, but
had voting rights and carried a quarterly dividend of $162.50. The stock was
converted on October 30, 1997 into 398,406 shares of HSB common stock at a price
of $50.20 per share.
Capital Securities
On July 15, 1997, HSB sold $110 million of 30 year Global Floating Rate Capital
Securities (Capital Securities) in a private placement. The 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 securities were
69
issued through HSB Capital I (Trust I), a Delaware business trust created by
HSB, at a floating rate tied to 90 day LIBOR. The current coupon is 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. 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 HSB will be prohibited from paying any cash dividends on
its common stock. HSB has irrevocably and unconditionally guaranteed all of
Trust I's obligations under the Capital Securities. The Company has used or may
use the proceeds for general corporate purposes, including the repurchase of HSB
common stock; funding investments in, or extensions of credit to, subsidiaries;
repayment of maturing debt; and financing possible future acquisitions. HSB
subsequently filed a registration statement covering securities with terms
identical in all material respects and offered to exchange registered securities
for the original Capital Securities. The exchange was completed on December 11,
1997.
On December 31, 1997, HSB 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 the Company 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
the Company 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 Company
common stock at a conversion price of $85, subject to adjustment. The Company
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. Were ERC to exercise
its conversion rights in total, it would hold, on a fully diluted basis,
approximately 15.3 percent of the Company'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 the Company, other than by
exercise of its conversion rights, and will limit its ability to take certain
other actions with respect to the Company 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 capital securities
issued July 1997. Holders of the Convertible Capital Securities will be entitled
to receive preferential cumulative cash
70
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 and Trust
II is equal to their carrying value.
Common 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 as reductions to additional paid-in
capital and retained earnings. These amounts were $85.9 and $59.5 million as of
December 31, 1997 and 1996, respectively. The reclassifications were distributed
as follows:
At December 31, 1997 1996
- - --------------------------------------------------------------------
Additional paid in capital $ 2.8 $ 2.0
Retained earnings 83.1 57.5
---------------------------------
Total $85.9 $ 59.5
---------------------------------
- - --------------------------------------------------------------------
Financial Guarantees
HSBIIC had guaranteed 40 percent of Radian's loan outstanding with Dow. The
guaranty was terminated on January 2, 1998 in conjunction with the sale of
HSBIIC's interest in Radian to Dow.
13. Pension Plans
HSB maintains various types of pension plans covering employees of certain
subsidiaries. The 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. As a result of the plan's
investment returns, the Company made no contribution to the plan in 1997, 1996
or 1995. Assets available for plan benefits include approximately $20.9 million
of Company stock at December 31, 1997.
71
The pension expense for the U.S. pension plans was a net credit to earnings for
1997, 1996 and 1995 due to the over funded status of the primary plan. The
components of the credit were as follows:
1997 1996 1995
- - -------------------------------------------------------------------
Service costs $ 4.1 $ 3.6 $ 2.9
Interest costs 10.7 10.2 10.2
Return on assets (42.4) (20.1) (30.9)
Net amortization and deferral 24.8 4.0 15.3
--------------------------------
Net pension credit $ (2.8) $ (2.3) $ (2.5)
--------------------------------
- - -------------------------------------------------------------------
The following table represents a reconciliation of the U.S. plans funded status
and the amounts recognized in the Company's Statements of Financial Position at
December 31:
Funded Unfunded
- - -----------------------------------------------------------------------------------------------------
1997 1996 1997 1996
-------------------------------------------------
Actuarial present value of benefit obligations
Vested benefit obligation $ 109.8 $ 99.4 $ 22.5 $ 20.3
----------------------------------------------
Accumulated benefit obligation $ 110.7 $ 100.0 $ 23.8 $ 20.9
----------------------------------------------
Projected benefit obligation $ 128.1 $ 115.7 $ 27.9 $ 24.3
Assets available for plan benefits (equity
securities and fixed income
investments at fair value) 213.0 178.0 -- --
----------------------------------------------
Assets in excess of (less than) projected
benefit obligation 84.9 62.3 (27.9) (24.3)
----------------------------------------------
Unamortized net transition asset
(obligation) 8.4 10.5 (1.9) (2.2)
Unrecognized prior service costs (1.6) (1.9) (1.0) (1.1)
Unrecognized net gain (loss) 21.8 3.9 (8.6) (7.1)
----------------------------------------------
Unrecognized net asset (liability) 28.6 12.5 (11.5) (10.4)
Additional liability -- -- (6.0) (4.6)
----------------------------------------------
Net pension asset (liability) $ 56.3 $ 49.8 $ (22.4) $ (18.5)
----------------------------------------------
- - --------------------------------------------------------------------------------------------------
Assumptions used for the primary U.S. plan at years ended were as follows:
1997 1996 1995
- - -------------------------------------------------------------------------
Discount rate 7.25% 7.5% 7.5%
Long-term rate of return on assets 10.00% 9.5% 9.5%
Rate of increase in future compensation
levels 4.50% 4.5% 5.0%
- - -------------------------------------------------------------------------
72
14. Postretirement Plans
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.
Contributions totaled $1.9, $2.4 and $2.6 million for 1997, 1996 and 1995,
respectively. At December 31, 1997, 1996 and 1995 these plans were unfunded.
Retirees' 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.
Components of net periodic postretirement benefit cost were:
For the years ended December 31, 1997 1996 1995
- - --------------------------------------------------------------------------------
Service cost $ 0.3 $ 0.3 $ 0.3
Interest cost 2.1 2.0 2.3
Amortization of unrecognized obligations 0.1 -- --
Net periodic postretirement
benefit cost $ 2.5 $ 2.3 $ 2.6
- - --------------------------------------------------------------------------------
The following table sets forth the amounts recognized in the Consolidated
Statements of Financial Position at December 31, in accordance with SFAS No.
106, "Employers Accounting for Postretirement Benefits Other Than Pensions".
1997 1996
- - --------------------------------------------------------------------------------
Accumulated postretirement benefit obligations for:
Retirees $ 23.5 $ 22.0
Other fully eligible plan participants 1.5 1.0
Other active plan participants 4.9 3.8
-------------------
Total accumulated postretirement benefit obligation 29.9 26.8
Unrecognized net loss (5.5) (3.0)
-------------------
Accrued postretirement benefit liability $ 24.4 $ 23.8
-------------------
- - --------------------------------------------------------------------------------
The assumptions used to calculate the obligations at December 31, were as
follows:
1997 1996
- - ----------------------------------------------------------------
Weighted average discount rate 7.25% 7.5%
Current year health care cost trend rate 7.00% 8.0%
Ultimate health care cost trend rate 4.50% 4.5%
- - ----------------------------------------------------------------
73
For measurement purposes, the annual rate of increase in the per capita cost of
covered health care benefits ranges from 7 percent in 1997 decreasing gradually
to 4.5 percent by the year 2001 and remaining level thereafter.
The health care cost trend rate assumption has a significant effect on the
amount reported. To illustrate, increasing the assumed health care cost trend
rates by 1 percent each year would increase the accumulated postretirement
benefit obligation as of December 31, 1997 of $29.9 million by approximately
$1.5 million and the aggregate of the service and interest cost for the year
ended December 31, 1997 by $0.1 million.
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
150,000.
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 $0.6 million in 1997 and 1996 and $1.1
million in 1995. The unamortized compensation expense related to this plan is
included in benefit plans as a component of shareholders' equity. These amounts
were $1.2 and $0.7 million in 1997 and 1996, respectively. A summary of grants
follow:
1997 1996 1995
- - --------------------------------------------------------------------------------
Restricted shares awarded 20,396 13,250 9,350
Weighted-average fair value of shares on
grant date $ 47.89 $ 48.85 $ 42.78
- - --------------------------------------------------------------------------------
A stock option award under 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 grant date
and expire no more than ten years from the date of grant.
74
A summary of the status of HSB's stock options as of December 31, 1997, 1996 and
1995 and changes during the years ended on those dates is presented below:
1997 1996 1995
- - ---------------------------------------------------------------------------------------------------------------------------
Weighted- Weighted- Weighted-
Shares Average Shares Average Shares Average
Exercise Price Exercise Price Exercise Price
- - ---------------------------------------------------------------------------------------------------------------------------
Outstanding at
beginning of year 1,319,650 $ 48.67 1,300,000 $ 50.86 1,263,550 $ 54.42
Granted 372,500 48.83 394,000 49.81 303,500 42.54
Exercised (157,000) 46.68 (24,250) 46.26 -- --
Forfeited (50,400) 50.23 (350,100) 58.29 (267,050) 58.39
---------- ---------- ---------- ----------
Outstanding at
end of year 1,484,750 48.86 1,319,650 48.67 1,300,000 50.83
---------- ---------- ----------
Options exercisable
at year-end 1,121,250 $ 48.76 949,650 $ 48.23 1,003,500 $ 53.32
Weighted-average fair
value of options
granted during the year $ 6.36 $ 7.05 $ 7.42
- - ------------------------------------------------------------------------------------------------------------------------
The following table summarizes information about stock options outstanding as of
December 31, 1997:
Options Outstanding Options Exercisable
- - --------------------------------------------------------------------------------------
Weighted-
Range of Average Weighted- Weighted-
Exercise Number Remaining Average Number Average
Prices Outstanding Contractual Life Exercise Price Exercisable Exercise Price
- - -----------------------------------------------------------------------------------------------
$41 - $45.99 587,000 8.43 $ 44.44 226,500 $ 42.27
$46 - $50.99 646,500 6.13 48.63 646,500 48.63
$51 - $55.99 98,800 1.55 51.84 95,800 51.79
$56 - $60.99 152,450 3.33 57.06 152,450 57.06
--------- ---------
1,484,750 1,121,250
--------- ---------
- - -----------------------------------------------------------------------------------------------
SFAS No. 123, "Accounting for Stock Based-Compensation" was issued in October
1995 for implementation by year end 1996. SFAS No. 123 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 APB 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
75
have been measured at date of grant and recognized over the service period. Pro
forma net income and earnings per share would have been reduced as follows for
1997 and 1996:
1997 1996
- - ------------------------------------------------------------------------------
Net Income As Reported $66.3 $53.4
Pro Forma 64.5 51.4
Earnings per common share - basic As Reported $ 3.32 $ 2.65
Pro Forma 3.22 2.55
Earnings per common share - diluted As Reported $ 3.29 $ 2.65
Pro Forma 3.20 2.55
- - ------------------------------------------------------------------------------
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 for 1997 and
1996, respectively: risk-free interest rates of 6.3 percent in 1997 and 6.1
percent in 1996; dividend yield of 5 percent for both years; expected lives of 6
years; and volatility of 15.8 percent in 1997 and 16.8 percent in 1996.
16. Stock Purchase Rights
On November 28, 1988, the Board of Directors created and authorized 250,000
shares of Series A Junior Participating Preferred Stock at no par value and
declared a dividend distribution of one right for each outstanding share of
common stock to shareholders of record on December 8, 1988.
The rights will separate from the common stock and become exercisable if a
person or group acquires ownership of 20 percent or more of the outstanding
common stock of the Company, commences a tender or exchange offer to acquire 20
percent or more of the outstanding shares, or if any person or group has become
the beneficial owner of an amount of common stock which the Board determines to
be substantial and not in the best interest of the shareholders.
The rights entitle holders to purchase preferred shares at an exercise price of
$110 per share. If an acquirer obtains 20 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 will entitle holders to
purchase common shares of the Company at a discount. If the Company is involved
in a merger or other transactions in which shares are exchanged, the rights will
entitle holders to purchase common shares of the acquirer at a discount.
The rights expire on November 28, 1998 and may be redeemed by the Company for
$.01 per right any time until the tenth business day following public
announcement that a 20 percent position has been acquired.
76
17. Consolidated Quarterly Data (unaudited)
First Second Third Fourth
1997 Quarter Quarter Quarter Quarter Year
- - --------------------------------------------------------------------------------------------------------------
Insurance premiums $ 122.3 $ 117.2 $ 121.3 $ 130.4 $ 491.2
Engineering services 14.8 15.0 15.5 16.0 61.3
Net investment income 7.9 8.8 9.1 11.0 36.8
Realized investment gains 0.5 3.4 2.3 7.9 14.1
--------------------------------------------------------------------
Total revenues* $ 145.5 $ 144.4 $ 148.2 $ 165.3 $ 603.4
--------------------------------------------------------------------
Income from continuing
operations before income taxes
and distributions on capital
securities $ 21.3 $ 22.1 $ 21.5 $ 28.8 $ 93.7
Income taxes 5.5 5.7 5.3 8.6 25.1
Distributions on capital
securities of subsidiary trust,
net of income tax -- -- 1.0 1.3 2.3
--------------------------------------------------------------------
Income from continuing
operations $ 15.8 $ 16.4 $ 15.2 $ 18.9 $ 66.3
Discontinued operations:
Income from
operations of
Radian International LLC,
net of income tax -- -- -- -- --
--------------------------------------------------------------------
Net income $ 15.8 $ 16.4 $ 15.2 $ 18.9 $ 66.3
--------------------------------------------------------------------
Earnings per common share - basic:
Income from
continuing operations $ 0.78 $ 0.81 $ 0.77 $ 0.96 $ 3.32
Discontinued operations -- -- -- -- --
--------------------------------------------------------------------
Net income $ 0.78 $ 0.81 $ 0.77 $ 0.96 $ 3.32
--------------------------------------------------------------------
Earnings per common share - diluted:
Income from
continuing operations $ 0.78 $ 0.80 $ 0.76 $ 0.95 $ 3.29
Discontinued operations -- -- -- -- --
--------------------------------------------------------------------
Net income $ 0.78 $ 0.80 $ 0.76 $ 0.95 $ 3.29
--------------------------------------------------------------------
Dividends declared per
common share $ 0.57 $ 0.57 $ 0.60 $ 0.60 $ 2.34
--------------------------------------------------------------------
Common stock price ranges:
High 47 5/8 53 7/8 56 11/16 55 3/4 56 11/16
Low 44 5/8 44 52 7/16 49 13/16 44
Close 44 3/4 53 3/8 55 11/16 55 3/16 55 3/16
Shareholders at December 31, 5,221
- - --------------------------------------------------------------------------------------------------------------
77
First Second Third Fourth
1996 Quarter Quarter Quarter Quarter Year
- - ----------------------------------------------------------------------------------------------------------
Insurance premiums $ 108.4 $ 112.9 $ 113.8 $ 113.5 $ 448.6
Engineering services 12.7 14.1 14.0 15.0 55.8
Net investment income 8.0 7.9 7.6 8.8 32.3
Realized investment gains 0.9 5.1 2.5 3.6 12.1
----------------------------------------------------------------
Total revenues* $ 130.0 $ 140.0 $ 137.9 $ 140.9 $ 548.8
----------------------------------------------------------------
Income from continuing
operations before income
taxes and distributions
on capital securities $ 19.2 $ 15.3 $ 15.4 $ 23.0 $ 72.9
Income taxes 4.9 3.3 3.5 6.6 18.3
Distributions on capital
securities of subsidiary trust,
net of income tax -- -- -- -- --
Income from continuing ----------------------------------------------------------------
operations $ 14.3 $ 12.0 $ 11.9 $ 16.4 $ 54.6
Discontinued operations:
Income from
operations of Radian
International LLC,
net of income tax 2.7 1.4 (0.3) (5.0) (1.2)
----------------------------------------------------------------
Net income $ 17.0 $ 13.4 $ 11.6 $ 11.4 $ 53.4
----------------------------------------------------------------
Income from
continuing operations $ 0.71 $ 0.59 $ 0.59 $ 0.82 $ 2.71
Discontinued operations 0.13 0.07 (0.01) (0.25) (0.06)
----------------------------------------------------------------
Net income $ 0.84 $ 0.66 $ 0.58 $ 0.57 $ 2.65
----------------------------------------------------------------
Earnings per common share - diluted:
Income from
continuing operations $ 0.71 $ 0.59 $ 0.59 $ 0.82 $ 2.71
Discontinued operations 0.13 0.07 (0.01) (0.25) (0.06)
----------------------------------------------------------------
Net income $ 0.84 $ 0.66 $ 0.58 $ 0.57 $ 2.65
----------------------------------------------------------------
Dividends declared per
common share $ 0.57 $ 0.57 $ 0.57 $ 0.57 $ 2.28
----------------------------------------------------------------
Common stock price ranges:
High 52 1/2 50 3/4 49 47 1/8 52 1/2
Low 48 46 43 1/4 42 3/4 42 3/4
Close 50 5/8 49 1/8 44 3/4 46 3/8 46 3/8
Shareholders at December 31, 5,644
- - ----------------------------------------------------------------------------------------------------------
*Total revenues exclude revenues for investments accounted for on the equity
method.
78
Schedule I
HSB Group, Inc.
Summary of Investments - Other Than Investments in Related Parties
(in millions)
Column A Column B Column C Column D Column E Column F Column G
- - -------------------------------------------------------- ----------------------- ----------- ------------ ----------- ---------
1997 1996
------------------------------------- ------------------------------------
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 37.6 39.7 39.7 39.4 40.7 40.7
Foreign Governments 33.1 33.5 33.5 30.1 30.5 30.5
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 Bonds 28.1 28.7 28.7 51.1 51.9 51.9
Certificates of Deposit $0.0 $0.0 $0.0 $0.0 $0.0 $0.0
Mortgage Receivable 11.1 11.1 11.1 11.1 11.1 11.1
Redeemable Preferred Stocks 131.2 135.4 135.4 99.6 101.6 101.6
--------------------------------- ---------------------------------
Total Fixed Maturities $241.1 $248.4 $248.4 $231.3 $235.8 $235.8
Equity Securities:
Common Stocks:
Public Utilities 16.3 19.8 19.8 15.3 16.6 16.6
Banks and Insurance 13.4 23.5 23.5 12.0 20.0 20.0
Industrial and Other 67.8 135.7 135.7 68.4 131.7 131.7
Non-Redeemable Preferred Stocks 133.8 144.8 144.8 87.2 94.4 94.4
--------------------------------- ---------------------------------
Total Equity Securities $231.3 $323.8 $323.8 $182.9 $262.7 $262.7
Short-term Investments and Cash: $424.5 $424.5 $424.5 $102.4 $102.4 $102.4
--------------------------------- ---------------------------------
Total Investments $896.9 $996.7 $996.7 $516.6 $600.9 $600.9
================================= =================================
79
HSB GROUP, INC. (Registrant)
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF HSB GROUP, INC.
CONDENSED STATEMENT OF INCOME INFORMATION
For the period from June 23, 1997 through December 31, 1997
(In millions)
1997
------------
Revenues:
Net investment income $ 1.5
Expenses:
Interest expense 0.1
------------
Income before income taxes and 1.4
distributions on capital securities
Income taxes 0.5
Distributions on capital securities of
subsidiary trusts, net of income taxes
of $1.2 2.3
------------
Net Loss - Parent only (1.4)
Equity in net income of subsidiaries 35.4
------------
Consolidated net income $ 34.0
============
80
HSB GROUP, INC. (Registrant)
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF HSB GROUP, INC.
BALANCE SHEET INFORMATION
December 31, 1997
(In millions)
1997
---------------
Assets
Cash $ 0.7
Short-term investments, at cost 60.5
Investment in subsidiaries 657.0
Fixed maturities 11.8
Equity securities, at fair value 27.2
Other assets 23.9
---------------
Total assets $ 781.1
===============
Liabilities
Dividends payable $ 11.8
Other liabilities 15.1
---------------
Total liabilities 26.9
---------------
Company obligated mandatorily redeemable capital 108.9
securities of subsidiary Trust I holding solely
junior subordinated deferrable interest debentures
of the Company, net of unamortized discount of $1.1
Company obligated mandatorily redeemable convertible 300.0
capital securities of subsidiary Trust II holding solely
junior subordinated deferrable interest debentures
of the Company.
Shareholders' Equity
Common stock 10.0
Paid in capital 31.6
Unrealized investment gains, net of tax 59.8
Retained earnings 248.8
Benefit plans (4.9)
---------------
Total shareholders' equity 345.3
---------------
Total liabilities and shareholders' equity $ 781.1
===============
81
HSB GROUP, INC. (Registrant)
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF HSB GROUP, INC.
CONDENSED STATEMENT OF CASH FLOWS INFORMATION
For the period from June 23, 1997 through December 31, 1997
(In millions)
1997
-------------
Operating Activities:
Net income $ 34.0
Undistributed earnings of subsidiary (21.2)
Increase in other assets (26.2)
Increase in other liabilities 14.3
-------------
Cash provided by operating activities 0.9
-------------
Investing Activities:
Purchase of short-term investments, net (60.5)
Purchase of fixed maturities (11.8)
Purchase of equity securities (27.0)
Contribution to subsidiaries (279.5)
-------------
Cash used in investing activities (378.8)
-------------
Financing Activities:
Dividends paid to shareholders (11.9)
Net proceeds from issuance of company obligated 408.9
manditorily redeemable capital securities
Options Exercised 5.5
Reacquisition of Stock (36.5)
Other 12.6
-------------
Cash provided by financing activities 378.6
-------------
Change in cash 0.7
Cash at beginning of period -
Cash at end of period $ 0.7
=============
82
Schedule IV
HSB Group, Inc.
Reinsurance
(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
- - -------------------------------------------------------------------------------
- - -------------------------------------------------------------------------------
1997
Property and
Liability
Insurance $370.1 $118.1 $239.2 $491.2 48.7%
1996
Property and
Liability
Insurance $343.4 $107.9 $213.1 $448.6 47.5%
1995
Property and
Liability
Insurance $279.7 $65.9 $175.3 $389.1 45.1%
83
SCHEDULE V
HSB Group, Inc.
Valuation and Qualifying Accounts
(in millions)
Column A Column B Column C Column D Column E Column F
- - ---------------------------------- -------- -------- -------- --------- ---------
Description Balance at Charged to Charged to Balance
Beginning of Costs and Other Deductions At End of
Period Expenses Accounts Describe (a) Period
- - -----------------------------------------------------------------------------------------------------
1997
Reserve for Accounts Receivable $3.0 $0.9 $0.0 $0.3 $3.6
1996
Reserve for Accounts Receivable $3.3 $1.4 $0.0 $1.7 $3.0
1995
Reserve for Accounts Receivable $3.0 $2.3 $0.0 $2.0 $3.3
(a) Engineering Services and Insurance Premium Receivables written off as
uncollectible.
84
Schedule VI
HSB Group, Inc.
Supplemental Information Concerning Property-Casualty Insurance Operations
For Years Ended December 31, 1997, 1996, 1995
Column A Column B Column C Column D Column E Column F Column G Column H Column I Column J Column K
- - ------------ ----------- --------- ---------- -------- -------- --------- --------- -------- -------- ---------
Affiliation Prepaid Reserves Discount, if Unearned Earned Net investment Claims and Amortiza- Paid claims Premiums
with Acquisition for unpaid any deducted Premium Premium income Claim tion of and claim written
Registrant Costs claims and in Column C Adjustment prepaid adjustment
(Consolidated claim Expenses policy expenses
property- adjustment incurred acquisi-
casualty expenses related to tion costs
entities)
Current Prior
Year Years
1997 45.5 276.7 -- 290.3 491.2 36.8 209.5 8.4 90.7 204.9 498.5
1996 40.6 302.9 -- 270.6 448.6 32.3 214.2 -9.8 86.0 172.1 454.4
1995 34.1 190.9 -- 216.2 389.1 28.9 152.2 2.7 78.1 170.7 408.3
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 2001" and "Members of the Board of Directors Continuing in Office"
on pages 2-4 of the Company's Proxy Statement dated March 6, 1998 are
incorporated herein by reference. Also see pages 23 - 24 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
15-16, "Compensation Committee Interlocks and Insider Participation" on page 16,
and "Performance Graphs" on page 17 of the Company's Proxy Statement dated March
6, 1998 are incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
---------------------------------------------------------------
"Security Ownership of Certain Beneficial Owners and Management" on page
6-8 of the Company's Proxy Statement dated March 6, 1998 is incorporated herein
by reference.
Item 13. Certain Relationships and Related Transactions.
-----------------------------------------------
"Compensation Committee Interlocks and Insider Participation" on page 16 of
the Company's Proxy Statement dated March 6, 1998 is incorporated herein by
reference.
85
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 40 herein are
filed as part of this report.
(b) Reports on Form 8-K -
(i) Form 8-K dated January 12, 1998 to report sale of interest in
Industrial risk Insurers and $300 million of convertible capital
securities to Employers Reinsurance Corporation; and
(ii) Form 8-K dated January 28, 1998 to report Fourth Quarter 1997
Results of Registrant.
(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/ Gordon W. Kreh
Gordon W. Kreh
President and Chief
Executive Officer
March 30, 1998
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/ Gordon W. Kreh
Gordon W. Kreh President, Chief Executive Officer
March 30, 1998 Director
/s/ Saul L. Basch Senior Vice President, Treasurer
Saul L. Basch and Chief Financial Officer
March 30, 1998 (Principal Financial Officer and
Principal Accounting Officer)
/s/ Robert C. Walker
Robert C. Walker Senior Vice President and General
March 30, 1998 Counsel
(Joel B Alvord)* Director
(Colin G. Campbell)* Director
(Richard G. Dooley)* Director
(William B. Ellis)* Director
(E. James Ferland)* Director
87
(Simon W. Leathes)* Director
(Lois Dickson Rice)* Director
(John M. Washburn, Jr.)* Director
(Wilson Wilde)* Director
*By: /s/ Robert C. Walker
Robert C. Walker
(Attorney-in-Fact)
March 30, 1998
88
INDEX TO EXHIBITS
Exhibit
Number Description
(3)(i) Certificate of Incorporation of HSB Group, Inc.
(3)(ii) By-laws of HSB Group, Inc.
**(4)(i) Rights Agreement dated November 28, 1988 between The Hartford
Steam Boiler Inspection and Insurance Company ("HSBIIC") and The
First National Bank of Boston, as Rights Agent; assumed by
Registrant; incorporated by reference to Exhibit 4(i) to HSBIIC's
Form 10-K for the year ended December 31, 1995, File No.
001-10527.
**(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.
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
89
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) 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) The Hartford Steam Boiler Inspection and Insurance Company
Long-Term Incentive Plan, as amended and restated December
23, 1996, assumed by Registrant; incorporated by reference
to the 1996 10-K.*
**(c) The Hartford Steam Boiler Inspection and Insurance Company
Short-Term Incentive Plan, as amended and restated December
23, 1996, assumed by Registrant; incorporated by reference
to the 1996 10-K.*
**(d) The Hartford Steam Boiler Inspection and Insurance Company
1985 Stock Option Plan, as amended and restated December
23, 1996, assumed by Registrant, incorporated by reference
to the 1996 10-K. *
**(e) The Hartford Steam Boiler Inspection and Insurance Company
1995 Stock Option Plan,
90
as amended and restated effective December 23, 1996, assumed
by Registrant, incorporated by reference to the 1996 10-K. *
**(f) 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. *
**(g) 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. *
**(h) 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.*
**(i) The Hartford Steam Boiler Inspection and Insurance Company
Directors Stock and Deferred Compensation Plan, assumed by
Registrant, incorporated by reference to the 1996 10-K.*
**(j) 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 6, 1998. *
(21) Subsidiaries of the Registrant.
(23) Consent of experts and counsel - consent of Coopers & Lybrand.
(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