SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
/x/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1998
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number 001-13135
HSB GROUP, INC.
(Exact name of registrant as specified in its charter)
CONNECTICUT 06-1475343
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
P.O. BOX 5024, ONE STATE STREET,
HARTFORD, CONNECTICUT 06102-5024
(Address of principal executive offices) (Zip Code)
(860) 722-1866
(Registrant's telephone number, including area code)
Not applicable
(Former name, former address and former fiscal year,
if changed since the last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
The number of shares outstanding of the registrant's common stock without par
value, as of September 30, 1998: 29,369,779
HSB GROUP, INC.
INDEX
PART I FINANCIAL INFORMATION PAGE
Item 1 - Financial Statements
Consolidated Statements of Operations for the
Quarters ended September 30, 1998 and 1997 and
the Nine Months ended September 30, 1998 and 1997
(unaudited)....................................................... 3
Consolidated Statement of Comprehensive Income for the Quarters
ended September 30, 1998 and 1997 and the Nine Months
ended September 30, 1998 and 1997 (unaudited)..................... 4
Consolidated Statements of Financial Position as
of September 30, 1998 (unaudited) and December 31, 1997 .......... 5
Consolidated Statements of Cash Flows for the Nine
Months ended September 30, 1998 and 1997 (unaudited).............. 6
Notes to Consolidated Financial Statements (unaudited)............ 7
Item 2 - Management's Discussion and Analysis of Consolidated
Financial Condition and Results of Operations..................... 11
PART II OTHER INFORMATION
Item 1 - Legal Proceedings........................................ 21
Item 6 - Exhibits and Reports on Form 8-K......................... 22
SIGNATURES.............................................................. 23
2
HSB GROUP, INC.
Consolidated Statements of Operations
Unaudited
(in millions, except per share data)
Quarter Nine Months
Ended September 30 Ended September 30
1998 1997 1998 1997
---------- -------- -------- --------
Revenues:
Insurance premiums $ 99.5 $ 121.3 $ 289.3 $ 360.9
Engineering services 25.3 15.5 67.7 45.2
Net investment income 15.5 9.1 46.6 25.8
Realized investment gains 7.9 2.3 18.4 6.2
---------- -------- -------- --------
Total revenues 148.2 148.2 422.0 438.1
---------- -------- -------- --------
Expenses:
Claims and adjustment 44.2 54.1 129.1 157.0
Policy acquisition 18.0 23.5 45.3 67.5
Underwriting and inspection 26.4 34.2 83.5 105.5
Engineering services 23.4 14.5 62.1 42.3
Interest 0.2 0.4 0.5 0.9
---------- -------- -------- --------
Total expenses 112.2 126.7 320.5 373.2
---------- -------- -------- --------
Gain on sale of IRI - - 39.0 -
Income from continuing operations
before income taxes and
distributions on capital securities $ 36.0 $ 21.5 $ 140.5 $ 64.9
Income taxes (benefit):
Current 9.8 14.2 39.1 26.8
Deferred (0.5) (8.9) 2.0 (10.3)
----------- --------- -------- --------
Total income taxes $ 9.3 $ 5.3 $ 41.1 $ 16.5
Distribution on capital securities
of subsidiary trust, net of income
tax benefits of $2.5; $0.4;
$7.4; and $0.4. 4.6 1.0 13.8 1.0
---------- -------- ----- ---
Income from continuing operations $ 22.1 $ 15.2 $ 85.6 $ 47.4
Discontinued operations:
Loss from operations, net of
income tax benefits of $--; $--;
$3.2;-and $--. - - (6.6) -
Gain on disposal, net of income
taxes of $--; $--;$23.7; and $--. - - 36.9 -
---------- -------- -------- --------
Total discontinued operations $ - $ - $ 30.3 $ -
---------- -------- -------- --------
Net income $ 22.1 $ 15.2 $ 115.9 $ 47.4
========= ========= ========= ========
Per share data:
Net income per common share-basic:
Income from continuing operations $ 0.75 $ 0.51 $ 2.91 $ 1.57
Net income $ 0.75 $ 0.51 $ 3.95 $ 1.57
Net income per common share-assuming dilution:
Income from continuing operations $ 0.72 $ 0.51 $ 2.71 $ 1.56
Net income $ 0.72 $ 0.51 $ 3.57 $ 1.56
Dividends declared per share $ 0.42 $ 0.40 $ 1.22 $ 1.16
Average shares outstanding and
common stock equivalents 35.3 29.9 35.3 30.2
See Notes to Consolidated Financial Statements.
3
HSB GROUP, INC.
Consolidated Statements of Comprehensive Income
Unaudited
(in millions)
Quarter Ended Nine Months
Ended September 30 Ended September 30
1998 1997 1998 1997
------------ ------------- ------------- ------------
Net income $ 22.1 $ 15.2 $ 115.9 $ 47.4
Other comprehensive income, net of tax:
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising
during the period (net of taxes (benefits)
of ($11.8); $0.5; $2.9 and $7.7) (21.9) 1.0 5.4 14.4
Add : reclassification adjustments for gains
included in net income (5.1) (1.3) (11.9) (3.6)
------------ ----------- ----------- -----------
(27.0) (0.3) (6.5) 10.8
Foreign currency translation adjustments (1.0) - (1.7) (0.2)
------------ ----------- ----------- -----------
Other comprehensive income (28.0) (0.3) (8.2) 10.6
------------ ----------- ------------ -----------
Comprehensive income $ (5.9) $ 14.9 $ 107.7 $ 58.0
============ =========== =========== ===========
See Notes to Consolidated Financial Statements
4
HSB GROUP, INC.
Consolidated Statements of Financial Position
(In millions, except per share data)
September 30, December 31,
1998 1997
(Unaudited)
------------- --------------
Assets:
Cash $ 11.8 $ 45.3
Short-term investments, at cost 92.4 379.2
Fixed maturities, at fair value
(cost - $546.5; $241.1) 555.9 248.4
Equity securities, at fair value
(cost - $329.2; $231.3 ) 409.4 323.8
------------- --------------
Total cash and invested assets 1,069.5 996.7
Reinsurance assets 595.6 124.5
Insurance premiums receivable 155.1 138.0
Engineering services receivable 26.9 12.2
Fixed assets 42.8 36.4
Prepaid acquisition costs 38.8 42.5
Capital lease 14.7 15.3
Investment in Radian - 83.4
Other assets 165.8 88.2
------------- --------------
Total assets $ 2,109.2 $ 1,537.2
============= ==============
Liabilities:
Unearned insurance premiums $ 473.6 $ 287.3
Claims and adjustment expenses 522.8 276.7
Short-term borrowings 4.4 42.4
Long-term borrowings 25.1 25.1
Capital lease 27.9 27.9
Deferred income taxes 30.7 31.5
Dividends and distributions on capital securities 18.3 13.3
Ceded reinsurance payables 88.1 3.9
Other liabilities 96.1 74.9
------------- --------------
Total liabilities 1,287.0 783.0
------------- --------------
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 and
$1.1 million, respectively 108.9 108.9
Company obligated mandatorily redeemable
convertible capital securities of
subsidiary Trust II holding solely junior
subordinated deferrable interest debentures
of the Company 300.0 300.0
Shareholders' equity:
Common stock (stated value; shares authorized
50.0; shares issued 32.0; shares
outstanding 29.4; 29.4) 10.0 10.0
Additional paid-in capital 34.3 31.6
Accumulated other comprehensive income 51.6 59.8
Retained earnings 323.8 248.8
Benefit plans (6.4) (4.9)
------------- --------------
Total shareholders' equity 413.3 345.3
------------- --------------
Total $ 2,109.2 $ 1,537.2
============= ==============
Shareholders' equity per common share
(restated for stock split) 14.08 11.75
See Notes to Consolidated Financial Statements.
5
HSB Group, Inc.
Consolidated Statements of Cash Flows
Unaudited
(In Millions)
Nine Months Ended
September 30,
----------------------
1998 1997
--------- ----------
Operating Activities:
Net income $ 115.9 $ 47.4
Adjustments to reconcile net income to
net cash provided by operating activities:
Depreciation and amortization 6.3 5.1
Deferred income taxes (benefit) 2.0 (10.0)
Realized investment gains, including market
adjustment for derivative instruments (18.4) (6.2)
Gain from the disposition of Radian (after tax) (30.3) -
Gain from the disposition of IRI (after tax) (25.2) -
Change in balances net of effects from purchases and
sales of subsidiaries:
Insurance premiums receivable (17.1) (20.4)
Engineering services receivable (12.1) (1.2)
Prepaid acquisition costs 3.7 (4.9)
Reinsurance assets (471.1) 16.5
Unearned insurance premiums 186.3 25.2
Claims and adjustment expenses 246.1 (24.1)
Ceded reinsurance payable 84.2 8.1
Investment in Radian - (5.3)
Other (27.3) (12.0)
--------- ----------
Cash provided by operating activities 43.0 18.2
--------- ----------
Investing Activities:
Fixed asset additions, net (12.6) 0.1
Investments:
Sale (purchase) of short-term investments, net 286.8 (35.4)
Purchase of fixed maturities (378.3) (51.4)
Proceeds from sale of fixed maturities 44.1 26.0
Redemption of fixed maturities 29.8 13.1
Purchase of equity securities (275.6) (178.1)
Proceeds from disposition of Radian 128.9 -
Proceeds from disposition of IRI 49.1 -
Proceeds from sale of equity securities 191.4 167.0
Purchase of Solomon Associates, net of cash acquired (2.1) -
Purchase of Kemper books of business (29.5) -
--------- ---------
Cash provided by (used in) investment activities 32.0 (58.7)
--------- ---------
Financing Activities:
Proceeds from Company-obligated mandatorily redeemable
capital securities of subsidiary trust - 108.9
Increase (decrease) in short-term borrowings (38.0) 14.8
Dividends and distributions on capital securities (52.0) (33.4)
Reacquisition of stock (27.8) (51.6)
Exercise of stock options 9.3 4.0
--------- ----------
Cash provided by (used) in financing
activities (108.5) 42.7
--------- ----------
Net increase (decrease) in cash (33.5) 2.2
Cash at beginning of period 45.3 4.5
--------- ----------
Cash at end of period $ 11.8 $ 6.7
========= ==========
Interest paid $ 1.9 $ 2.0
--------- ----------
Federal income tax paid $ 41.7 $ 25.7
--------- ----------
See notes to Consolidated Financial Statements.
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. General
The interim consolidated financial statements in this report include
adjustments based on management's best estimates and judgments,
including estimates of future loss payments, which are necessary to
present a fair statement of the results for the interim periods
reported. These adjustments are of a normal, recurring nature. The
financial statements are prepared on the basis of generally accepted
accounting principles and should be read in conjunction with the
financial statements and related notes in the 1997 Annual Report.
Certain amounts for 1997 have been reclassified or restated to conform
with the 1998 presentation.
2. Discontinued Operations
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 (Dow), for approximately $129 million, net of
expenses. Radian LLC was formed in January 1996 as a joint venture with
Dow to provide environmental, engineering, information technology,
remediation and strategic chemical management services to industries
and governments world-wide. In connection with the formation of the new
company, the Company contributed substantially all of the assets of its
wholly-owned subsidiary, Radian Corporation to Radian LLC. The results
of Radian LLC were classified as discontinued operations following
ratification in July 1997 by the Board of Directors of management's
decision to exercise its put. The Company's share of Radian LLC's
losses incurred subsequent to such decision of approximately $6.6
million after-tax was deferred until the closing of the sale on January
2, 1998. The after-tax gain of $30.3 million recognized in 1998 is net
of deferred losses noted above. In 1996 and prior to June 1997, the
Company's share of the joint venture's results were recorded as equity
in Radian.
3. Industrial Risk Insurers
On January 6, 1998, The Hartford Steam Boiler Inspection and Insurance
Company (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. The gain on the sale of IRI was $39.0
million pre-tax and $25.2 million after-tax. 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. The new association has
been renamed HSB Industrial Risk Insurers. HSBIIC writes the business
for HSB Industrial Risk Insurers using its insurance licenses and
provides certain other management and technical services. In addition,
through various quota share reinsurance agreements with ERC and HSB
Industrial Risk Insurers, HSBIIC transferred its manufacturing book of
business to HSB Industrial Risk Insurers and will retain 85% of the
equipment breakdown insurance and 15% of the property insurance of the
combined insurance portfolio.
7
4. Recent Accounting Developments
In June 1997 the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (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 changes in
shareholders' equity. This statement is effective beginning in 1998
with retroactive restatement of prior periods required.
Also in June of 1997 the FASB issued SFAS No. 131 "Disclosures about
Segments of an Enterprise and Related Information". This standard
requires companies to report financial and descriptive information
about reportable operating segments. It includes disclosure
requirements relating to products and services, geographic areas and
major customers. This statement will be effective beginning year end
1998.
5. Legal Proceedings
HSBIIC is involved in two 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.
HSBIIC has accrued $6.5 million with respect to these cases for
potential loss adjustment expenses, including legal costs, to defend
HSBIIC's position. One case is on appeal; the other case is involved in
both arbitration and litigation proceedings. The final hearing in the
arbitration proceeding has concluded and the Company is currently
awaiting a decision. 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.
8
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.
6. Earnings per share
In February 1997, FASB issued SFAS No. 128, "Earnings per Share". This
statement established standards for computing and presenting earnings
per share (EPS). It replaced the presentation of primary EPS with a
presentation of basic EPS. It also requires dual presentation of basic
and diluted EPS on the face of the income statement and a
reconciliation of the numerator and denominator of the basic EPS
computation to the numerator and denominator of the diluted EPS
computation. The requirements of this statement became effective for
year end 1997 financial statements with prior restatement required.
Accordingly, comparative information presented in the Consolidated
Statements of Operations have been restated in compliance with SFAS No.
128. On April 21, 1998 the Board of Directors approved a three-for-two
stock split for shares held of record on May 1, 1998. Additional shares
resulting from the split were distributed on May 22, 1998. In
accordance with SFAS No. 128, all earnings per share presentations have
been adjusted to reflect the impact of the stock split, including
retroactive restatement of prior periods. Previously, the Company
reported EPS of $ 0.76 and $2.35 per share for the quarter and nine
months ended September 30,1997, respectively .
9
Computation of Earnings per Share
Quarter Ended Nine Months Ended
September 30, 1998 September 30, 1998
---------------------------------------------------------------------------------------------
Income Shares Per Share Income Shares Per Share
Income from continuing operations $ 22.1 $ 85.6
Basic EPS:
Income available to common
shareholders 22.1(A) $ 85.6(E)
Weighted Average Common Shares
Outstanding 29.3(B) 29.3(F)
Income from continuing operations
per common share-basic: $ 0.75(A/B) 2.91(E/F)
Effect of dilutive securities:
After-tax interest on convertible
capital securities $ 3.4 $ 10.2
Convertible capital securities 5.3 5.3
Stock options 0.7 0.7
Diluted EPS:
Income available to common and $ 25.5(C) 35.3 (D) $ 95.8(G) 35.3(H)
assumed conversions:
Income from continuing operations
per common share-assuming
dilution: $ 0.72(C/D) $ 2.71(G/H)
Quarter Ended Nine Months Ended
September 30, 1997 September 30, 1997
---------------------------------------------------------------------------------------------
Income Shares Per Share Income Shares Per Share
Income from continuing operations $ 15.2 $ 47.4
Less: convertible preferred stock
dividends $ 0.3 $ 1.0
Basic EPS:
Income available to common
shareholders 14.9(A) $ 46.4(E)
Weighted Average Common Shares
Outstanding 29.0(B) 29.4(F)
Income from continuing operations
per common share-basic: $ 0.51(A/B) $1.57(E/F)*
Effect of dilutive securities:
Preferred stock dividends $ 0.3 $ 1.0
Convertible preferred stock 0.6 0.6
Stock options 0.3 0.2
Diluted EPS:
Income available to common and
assumed conversions: $ 15.2(C) 29.9(D) $ 47.4(G) 30.2(H)
Income from continuing operations
per common share-assuming
dilution: $ 0.51(C/D) $1.56(G/H)*
* Computation excludes rounding.
10
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF CONSOLIDATED FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
SEPTEMBER 30, 1998
RESULTS OF OPERATIONS
Consolidated Overview
(dollar amounts in millions)
Quarter Ended Nine Months Ended
September 30 September 30
------------------ --------------------
1998 1997 1998 1997
---- ---- ---- ----
Gross earned premium $ 212.5 $ 151.6 $ 567.8 $ 456.6
Ceded premium 113.0 30.3 278.5 95.7
-------- --------- ------- --------
Insurance premium $ 99.5 $ 121.3 $ 289.3 $ 360.9
Engineering services revenue 25.3 15.5 67.7 45.2
Net investment income 15.5 9.1 46.6 25.8
Realized investment gains 7.9 2.3 18.4 6.2
-------- --------- --------- ----------
Total revenues $ 148.2 $ 148.2 $ 422.0 $ 438.1
======== ========= ======== ===========
Pre-tax Income from continuing operations:
Pre-tax income excluding sale of IRI $ 36.0 $ 21.5 $ 101.5 $ 64.9
Pre-tax gain on sale of IRI -- -- 39.0 --
----------- --------- --------- -----------
Pre-tax income 36.0 21.5 140.5 64.9
Income taxes on continuing operations 9.3 5.3 41.1 16.5
Distributions on Capital Securities, net of tax 4.6 1.0 13.8 1.0
----------- ---------- --------- ------------
Income From continuing operations 22.1 15.2 85.6 47.4
After-tax gain on Radian Disposal -- -- 30.3 --
---------- --------- --------- -------------
Net income $ 22.1 $ 15.2 $ 115.9 $ 47.4
======= ======== ======= ==============
Net income per common share:
Basic $ .75 $ .51 $ 3.95 $ 1.57
Diluted $ .72 $ .51 $ 3.57 $ 1.56
Net income for the nine months ended September 30, 1998 included after-tax gains
on the sale of HSB's interests in Industrial Risk Insurers (IRI) of $ 25.2
million and Radian International LLC of $ 30.3 million. The Radian International
LLC gain is net of after-tax operating losses of $ 6.6 million that were
deferred in 1997 when the decision was made to exercise HSB's option to
11
put the Company's interest to The Dow Chemical Company. As a result, HSB's
interest in Radian International LLC was classified as a discontinued operation.
HSB's after-tax earnings increased 45.4 percent from the third quarter of 1997
and, excluding the above sales, increased 26.4 percent in the first nine months
of 1998 compared to 1997 due to improved engineering revenues and margins and
higher net realized gains.
Gross earned premiums grew 40.2 percent in the quarter and 24.4 percent year to
date compared to the prior year. Much of this growth is attributable to HSB
Industrial Risk Insurers. Contemporaneous with the sale of IRI, the IRI
association was reconstituted with Employers Reinsurance Corporation (ERC) (with
a 99.5 percent share) and The Hartford Steam Boiler Inspection and Insurance
Company (HSBIIC) (with a .5 percent share) as sole members. The new association
has been renamed HSB Industrial Risk Insurers. HSBIIC writes the business for
HSB Industrial Risk Insurers using its insurance licenses and provides certain
other services. HSBIIC transferred its highly protected risk (HPR) manufacturing
book of business to HSB Industrial Risk Insurers and through various quota share
reinsurance arrangements with ERC, HSBIIC retains 85 percent of the equipment
breakdown business and 15 percent of the property business of the combined
insurance portfolio. This arrangement is the largest contributing factor in the
growth of both the gross earned premium and the ceded premium. As a result, the
unearned insurance premiums, the reinsurance assets, and the ceded reinsurance
payables reflected in the Consolidated Statements of Financial Position have
increased significantly. The third quarter combined ratio improved to 87.9
percent in 1998 from 92.0 percent in 1997 and the year to date combined ratio
improved to 88.7 percent in 1998 from 91.3 percent in 1997. Engineering services
revenue increased 63.0 percent for the third quarter and 49.6 percent year to
date and margins in this business grew to 7.6 percent from 6.3 percent in the
third quarter of 1997 and to 8.3 percent from 6.5 percent year to date.
The effective tax rate on income from continuing operations for the third
quarter and year to date were 23.5 percent and 28.2 percent for 1998 compared to
24.4 percent and 25.4 percent for 1997. Typically tax rate fluctuations occur as
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. In 1998 the taxes
associated with the sale of IRI contributed to a higher first quarter effective
tax rate. The Company continues to manage its use of tax advantageous
investments to maximize after tax earnings.
Recent Accounting Developments
- ------------------------------
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 standard may redefine our segment
information. However, the Company has not yet determined how SFAS No. 131 will
be applied.
12
Insurance Operations
- --------------------
Insurance operations include the insurance results of HSBIIC, HSB Engineering
Insurance Limited (HSB-EIL), The Boiler Inspection and Insurance Company of
Canada (BI&I) The Allen Insurance Company, Ltd, HSB of Connecticut and HSB of
Texas.
Quarter Ended Nine Months Ended
September 30 September 30
---------------- ------------------
(in millions)
1998 1997 1998 1997
---- ---- ---- ----
Gross earned premium $ 212.5 $ 151.6 $ 567.8 $ 456.6
Ceded premium 113.0 30.3 278.5 95.7
--------- --------- -------- ---------
Insurance premium 99.5 121.3 289.3 360.9
Claims and adjustment expenses 44.2 54.1 129.1 157.0
Underwriting, acquisition
and other expenses 44.4 57.7 128.8 173.0
--------- --------- -------- --------
Underwriting gain $ 10.9 $ 9.5 $ 31.4 $ 30.9
========= ========= ======== ========
Loss ratio 44.4% 44.6% 44.6% 43.5%
Expense ratio (Excluding Goodwill
Amortization) 43.5% 47.4% 44.1% 47.8%
----- ----- ----- -----
Combined ratio 87.9% 92.0% 88.7% 91.3%
===== ===== ========== ========
Gross earned premiums in the third quarter and year to date increased 40.2
percent and 24.4 percent from the comparable periods in 1997. This increase was
primarily attributable to the new arrangement with HSB Industrial Risk Insurers.
Gross earned premiums from IRI increased $ 51.7 million in the third quarter of
1998 and $ 118.4 million year to date 1998 compared to the respective periods in
1997. Gross earned premiums representing coverage outside the U.S. for non HSB
Industrial Risk Insurers business increased 11.3 percent in the third quarter
and 6.2 percent year to date from the comparable periods in 1997. In certain
areas of our direct domestic and foreign business, the market is experiencing
price erosion. HSB will not write business at rates which would lessen our
ability to maintain underwriting profit.
Increases in ceded premium of 272.9 percent in the third quarter and 191.0
percent year to date were the result of both the new HSB Industrial Risk
Insurers arrangement previously discussed and related reinsurance with ERC, and
changes in the Company's reinsurance programs which now utilize more quota share
reinsurance on certain of our books of business. We anticipate
13
these new reinsurance contracts and the HSB Industrial Risk Insurers arrangement
will continue to result in high growth in gross earned premium but lower growth
in net earned premium.
The loss ratio declined from 44.6 percent in the third quarter of 1997 to 44.4
percent in the current quarter and increased from 43.5 percent in the first nine
months of 1997 to 44.6 percent in the first nine months of 1998. Year to date
1998 results were impacted by severe ice storms in Canada. In 1997 flood related
losses impacted the loss ratio. Gross claims and adjustment expenses for the
first nine months of 1998 and 1997 were $ 478.5 million and $ 216.6 million,
respectively. Gross claims in 1998 include approximately $ 130 million from
Hurricane Georges on exposures written by HSB Industrial Risk Insurers. On a net
basis the impact on losses for the third quarter and year was $ 1.7 million. The
significant increase in claims reserves, reinsurance assets and unearned
insurance premium reserves from prior years are primarily due to HSBIIC's new
relationship with HSB Industrial Risk Insurers as discussed above.
The expense ratio improved to 43.5 percent in the third quarter of 1998 from
47.4 percent in the third quarter of 1997 and to 44.1 percent year to date 1998
from 47.8 percent year to date 1997. The new quota share reinsurance agreements
and the HSB Industrial Risk Insurers arrangement with ERC, both of which result
in ceding commissions to HSBIIC have positively impacted our expense ratio by
approximately 12 percentage points year to date. A portion of such ceding
commission is intended to reimburse HSB for the additional costs of managing HSB
Industrial Risk Insurers. Ceding commissions should continue to positively
impact the expense ratio throughout 1998.
HSBIIC completed an acquisition of the monoline boiler and machinery business of
Kemper Insurance Companies, effective July 1, 1998. The two companies also
completed an arrangement for HSBIIC to reinsure boiler and machinery coverage
written as part of Kemper's commercial package policies. Kemper's total
estimated boiler and machinery premiums were $ 80 million in 1997.
Engineering Services Operations
- -------------------------------
Quarter Ended Nine Months Ended
September 30 September 30
------------------ --------------------
1998 1997 1998 1997
----- ---- ---- ----
Net engineering services revenue $ 25.3 $ 15.5 $ 67.7 $ 45.2
Net engineering services expenses 23.4 14.5 62.1 42.3
------- ------- ------- -------
Operating gain $ 1.9 $ 1.0 $ 5.6 $ 2.9
======= ======== ======= =======
Net margin 7.6% 6.3% 8.3% 6.5%
Engineering services operations include the results of HSBIIC's, BI&I's, and
HSB-EIL's engineering services, HSB Reliability Technologies (HSBRT), Solomon
Associates, Inc (SAI) and the Company's other engineering services subsidiaries.
14
In April 1998 HSB acquired SAI based in Dallas, Texas. SAI is an engineering
management consulting firm that provides comparative performance benchmarking
consulting to the refining, petro-chemical and power generation industries. In
1997, SAI had gross sales of $13 million. SAI establishes efficiency and
productivity benchmarks for 80 percent of the worldwide petroleum refining
industry. This acquisition expands HSB's engineering management consulting
services and benchmarking capability.
Engineering services revenues increased $ 9.8 million in the third quarter and
$22.5 million year to date compared to the same periods in 1997. The growth in
revenues year to date was primarily due to increases generated by HSBRT as their
revenues increased 20.2 percent, HSB-EIL's revenues of $ 7.8 million generated
through recent acquisitions, SAI revenues of $ 3.7 million, as well as revenues
generated by some recent small acquisitions. The improvement in operating gain
from the prior year reflects efforts to improve staff utilization and a refocus
in certain areas on pricing strategies. We are still incurring costs to develop
new products which have the objective of increasing growth rates.
On July 1, 1998, HSB purchased Kemper's ASME inspection services business that
certifies boiler and pressure vessel compliance with the codes and standards of
the American Society of Mechanical Engineers. Total estimated 1997 revenues were
approximately $ 7.5 million.
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 service segment of the business.
Investment Operations
- ---------------------
Quarter Ended Nine Months Ended
September 30 September 30
--------------- --------------------
1998 1997 1998 1997
-------- -------- ---- ----
Net investment income $ 15.5 $ 9.1 $ 46.6 $ 25.8
Realized investment gains 7.9 2.3 18.4 6.2
----------- --------- ---------- --------
Pretax income from
investment operations $ 23.4 $ 11.4 $ 65.0 $ 32.0
============= ======== ========== =========
15
Net investment income for the third quarter and year to date increased
significantly compared to the same periods in 1997 due to the investment of
proceeds from capital securities issued during the second half of 1997. In
addition, proceeds from the January sales of HSB's interests in IRI and Radian
International LLC significantly increased investable funds. Realized investment
gains were significantly impacted in 1998 by call premiums on fixed income
investments. In the third quarter of 1997 realized gains were reduced by $ 10.1
million and year to date 1997 by $ 29.5 million to reflect the estimated fair
value of three "zero cost" collar contracts entered into at the end of 1996
which were used to mitigate the effects of market risk on the U.S. common stock
portfolio. These collars were closed out by year end 1997.
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 shareholders and market conditions. The investment
portfolio includes a wide variety of high quality equity securities and both
domestic and foreign fixed maturities. The Company continues to manage its use
of tax advantageous investments to maximize after tax investment earnings.
Statement of Comprehensive Income
- ---------------------------------
In addition to the impact of HSB's results of operations, the Statement of
Comprehensive Income displays the effects of price movements on HSB's invested
assets. During the third quarter of 1998 the stock market went through a
correction, resulting in HSB's cumulative holding gains decreasing by $21.9
million as compared to a gain of $1.0 million in 1997. Year to date change in
cumulative holding gains in 1998 was an increase of $5.4 million as compared to
an increase of $14.4 million in 1997.
Liquidity and Capital Resources
- -------------------------------
Balances at
September 30 December 31
1998 1997
------------ ----------
Total assets $ 2,109.2 $ 1,537.2
Short-term investments 92.4 379.2
Cash 11.8 45.3
All other invested assets 965.3 572.2
Short-term borrowing 4.4 42.4
Common shareholder's equity 413.3 345.3
Liquidity refers to the Company's ability to generate sufficient funds to meet
the cash requirements of its business operations. The Company receives a regular
inflow of cash from maturing investments and engineering services and insurance
operations. The mix of the investment portfolio is managed to respond to
expected claim pay-out patterns and other cash requirements. The Company also
maintains a highly liquid short-term portfolio to provide for immediate cash
needs and to offset a portion of interest rate risk relating to certain capital
securities.
16
Cash provided from operations was $ 43.0 million in the first nine months of
1998 compared to $18.2 million for the same period in 1997. Premiums collected
increased in the first nine months of 1998 compared to the first nine months of
1997 while claims paid declined.
Capital resources consist of shareholders' equity, capital securities and debt
outstanding and represent those funds deployed or available to be deployed to
support business operations and investment activities. Common shareholders'
equity of $ 413.3 million at September 30, 1998 increased by $ 68.0 million
since December 31, 1997. The increase primarily reflects net income of $ 115.9
million year to date; offset by common dividends of $ 35.7 million and common
stock repurchases of $ 27.9 million offset by issuances of $ 23.4 million.
At September 30, 1998, the Company had significant short-term and long-term
borrowing capacity. The Company is currently authorized to issue up to $ 75
million of commercial paper. Commercial paper outstanding at September 30, 1998
was $ 3 million.
The Company is involved in two 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 the Company's policies do not
provide coverage for losses resulting from the explosion events that are the
subject of these proceedings. In the opinion of management 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. More information
pertaining to these legal proceedings may be found under note 5 of the Notes to
Consolidated Financial Statements herein.
The Company writes business in European markets primarily through its U.K.
subsidiary, HSB Engineering Insurance Limited. The adoption of a common currency
(the euro) by eleven of the fifteen member countries of the European Union on
January 1, 1999 is not expected to result in a substantial change in the
business or a significant increase in costs in the short term. In part, this is
due to the fact that much of the business is U.S. dollar denominated. The UK is
not a first wave euro country and as such the primary impact will be in Spain
and the Irish Republic. Over time, as and if the U.K. adopts the euro as its
currency there may be more of an impact, however the number of affected
transactions are such that a manual backup system is practicable. The Company
will continue to monitor developments and assess impacts on markets, pricing,
etc.
Year 2000
- ---------
Year 2000 Plan and State of Readiness
In 1996 the Company began a comprehensive effort to assess and address issues
affecting the Company which related to the inability of computer equipment and
embedded computer chips to distinguish between the year 1900 and the year 2000.
As has been well publicized, many computer systems and date controlled equipment
may cease to function or may function in a different manner when the year 2000
arrives because they are programmed to recognize only the last two digits of the
year.
As a part of this effort, the Company established a Year 2000 Program to address
four key areas: (i) applications software, primarily consisting of the Company's
policy management, claims, financial recording and reporting, human resource
systems, and engineering databases and systems; (ii) infrastructures, such as
mainframe and corporate servers, workstations and
17
networking components; (iii) embedded technology in facilities in which the
Company conducts its operations and in testing equipment used by the Company's
engineering staff ; and (iv) key business partners and suppliers. In addition,
the Company is evaluating potential coverage exposures arising out of the Year
2000 and its impact on insured equipment. The Company's Year 2000 Program
consists of six partially overlapping stages for the key areas listed above :
(i) assessment and analysis; (ii) development, renovation and replacement; (iii)
implementation; (iv) testing and certification; (v) contingency planning; and
(vi) audit and review. The Company is using members of its internal IT staff as
well as external consultants and programmers to complete various tasks in
connection with its Year 2000 Program and is currently on schedule.
The Company has completed the assessment and analysis phase for its policy
management, claims, and financial recording and reporting, and human resource
systems and engineering databases and systems. The Company expects to have
largely completed the development, renovation, replacement and implementation
phases for all of these applications by year-end 1998 with the exception of
human resource and certain non-critical financial reporting and engineering
systems which are expected to be compliant by mid-1999.
The Company has completed the assessment and analysis phase with respect to
infrastructure items. The mainframe is Year 2000 compliant and the Company
expects to complete the migration to Year 2000 compliant servers and supporting
hardware and software by September 1999. Replacement of the various components
of non-compliant workstations and peripheral equipment also is expected to be
completed by September 1999. Many of the third-party software applications
utilized by the Company in its desktop environment are already Year 2000
compliant. The Company expects to complete the installation of such compliant
programs on virtually all of its workstations during the first half of 1999.
In the area of embedded chip technology, the Company's principal exposure
relates to the prevalence of such technology in office buildings in which the
Company leases space for conducting its business operations. The Company has
sent questionnaires to the leasing vendors for all of its principal facilities
with respect to Year 2000 readiness and has received assurances of readiness
from most of its vendors.
The Company is currently in the process of identifying and contacting key
suppliers of services and business partners, such as client companies, agents
and brokers, with whom the company has significant business relations and who
may either electronically provide to, or receive from, the Company certain
financial and other information. The Company expects to compile the assessment
of the potential impact on the Company of such parties' Year 2000 state of
readiness and remediation plans by the end of the first quarter of 1999 and
conduct renovation and/or replacement and compliance testing, as appropriate.
The Company is relying upon Year 2000 readiness statements of other entities and
has not independently verified the accuracy of such statements.
Costs
It is currently estimated that the Company's aggregate spending in connection
with the Year 2000 Program will be in the range of $26 million of which
approximately $14.9 million has been expended through September 30, 1998.
Certain of these costs are being expensed as they are
18
incurred and are being funded through operating cash flow. The Company has
expensed $.2 million for 1996, $1.5 million for 1997, and $3.6 million for the
first nine months of 1998. It is estimated that expenditures of $1.4 million for
the fourth quarter of 1998 and $4.8 million for 1999 will be expensed as
incurred. The remainder of the $26 million estimate relates to systems that the
Company anticipated replacing in the normal course of information technology
development but the timetable for which was accelerated in contemplation of the
Year 2000 event. Costs of replacement and renovation of information systems and
infrastructure which would have occurred in the normal course of business
without the advent of Year 2000 are excluded from these amounts. The current
estimate also does not include any costs associated with the implementation of
contingency plans which are in the process of being developed.
The Company does not expect the costs relating to its Year 2000 program to have
a material effect on its results of operations, liquidity or financial
condition. However, the Year 2000 Program is an ongoing process and the
estimated costs, as well as the estimated completion dates for various phases of
the program, are subject to change.
Risks
The failure of one or more critical software applications or components of the
Company's infrastructure to be Year 2000 compliant could cause a material
disruption in the normal business operations of the Company. Such disruptions
could include the inability to process policies, register and collect premiums
and engineering receivables, process claims or schedule inspections and
engineering services. Due to the difficulty in estimating the scope and duration
of such failures, the Company is unable to determine at this time whether the
consequences of such failures will have a material impact on the Company's
results of operations, liquidity, or financial condition. Moreover, the
Company's operations are interdependent with systems of business partners and
service providers, such as financial institutions, communication service
providers and utilities, over which the Company has no control. The failure of
one or more of such business partners or service providers to be Year 2000
compliant could have a material adverse impact on the Company. However, the
Company believes that with the implementation of its Year 2000 Program as
scheduled, including the contingency plans discussed below, the risk of material
disruptions to its normal business operations should be significantly reduced.
As an insurance company, the Company maintains a significant portfolio of
investments in cash, short-term fixed income, and equity securities. Inasmuch as
the advent of the Year 2000 may cause events, business interruptions and altered
economic facts and circumstances, the value of the Company's investments may be
affected favorably or unfavorably. The Company is selectively monitoring the
Year 2000 compliant status of the corporate issuers of the securities in its
investment portfolio primarily through reviewing public disclosure documents.
State government and municipal bonds held by the Company are general obligations
and/or are credit-enhanced and therefore the Company does not perceive there to
be a significant credit risk with these securities in the absence of a severe
Year 2000 disruption affecting governments and businesses generally. An
immaterial portion of the Company's portfolio is invested in non-public issuers
where public disclosure documents are unavailable. Due to the difficulty in
estimating the scope and duration of such events, the Company is unable to
determine at this time whether the consequences of such developments will have a
material impact on the Company's investment portfolio and therefore, on the
Company's results of operations, liquidity or financial condition.
19
Contingency Plans
As a component of the Year 2000 Program, the Company is concurrently developing
contingency plans intended to mitigate the possible disruption of business
operations arising out of the Year 2000 event. These plans will be continuously
refined during 1999 as the Company completes compliance testing on its internal
applications software and infrastructure and further assesses the Year 2000
readiness status of its business partners. Contingency plans may include
securing back-up power for the Company's data center, manual processing,
short-term fixes to non-compliant programs or business partner interfaces and
modifying the Company's asset selection criteria for its investment activities.
Insurance Coverage Issues
The Company continues to evaluate the potential coverage exposures arising out
of the Year 2000 event and its impact on insured equipment. The Company has
filed with the various jurisdictions an endorsement to its equipment breakdown
forms which reiterates that coverage is not provided for the inherent inability
of computers and computerized equipment to properly recognize a particular date
or time, such as the Year 2000. The endorsement is being included in policies in
all states which have approved the endorsement. In the four jurisdictions which
have not approved the endorsement, a notice reiterating the Company's coverage
intent with respect to Year 2000 exposures is being sent to policyholders. The
Company has recently filed a similar endorsement for use with its all-risk
policy and expects to receive approvals consistent with those received for its
equipment breakdown endorsement. Many of the insurers that the Company reinsures
for equipment breakdown coverage are issuing similar endorsements to their
policies. The Company is conducting an on-going communications program with its
client company insurers and agents to disseminate to the ultimate policyholders
its Year 2000 loss control suggestions and policy coverage position.
Quantification of the Company's exposure to Year 2000 losses and loss adjustment
expenses are not reasonably estimable at this time as applicable policy and
reinsurance contract wordings have not been legally tested in the context of
such losses.
Forward-Looking Statements
Certain statements contained in this report are forward-looking and are based on
management's current expectations. Actual results may differ materially from
such expectations depending on the outcome of certain factors described with
such forward-looking statements and other factors including: significant natural
disasters and severe weather conditions; changes in interest rates and the
performance of the financial markets; changes in the availability, cost and
collectibility of reinsurance; changes in domestic and foreign laws, regulations
and taxes; 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; adverse development on losses and
loss adjustment expenses related to claims arising in prior periods; new
insurance and reinsurance contract interpretations, including coverage issues
related to Year 2000 events; changes in asset valuations; consolidation and
restructuring in the financial services 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
20
Company, whether resulting from changes in the law or otherwise; the ability of
the Company and key suppliers and business partners to adequately and timely
address issues relating to the Year 2000 event; and other general market
conditions.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
- --------------------------
HSBIIC is involved in two 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.
HSBIIC has accrued $6.5 million with respect to these cases for
potential loss adjustment expenses, including legal costs to defend
HSBIIC's position. One case is on appeal; the other case is involved in
both arbitration and litigation proceedings. The final hearing in the
arbitration proceeding has been concluded and the Company is currently
awaiting a decision. 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.
21
Item 6 - Exhibits and Reports on Form 8-K
- -----------------------------------------
(a) Exhibits
Exhibit 10(ii) - Limited Liability Company Agreement of HSB Industrial Risk
Insurers, L.L.C.
Exhibit 10(iii)(a) - HSB Group, Inc. 1985 Stock Option Plan, amended and
restated as of September 21, 1998
Exhibit 10(iii)(b) - HSB Group, Inc. Directors Stock and Deferred
Compensation Plan, amended and restated effective September 21, 1998
Exhibit 10(iii)(c) - HSB Group, Inc. Long-Term Incentive Plan, as amended
and restated effective September 21, 1998
Exhibit 10(iii)(d) - HSB Group, Inc. 1995 Stock Option Plan, as amended and
restated effective September 21, 1998
Exhibit 27.1 - Financial Data Schedule
Exhibit 27.2 - Financial Data Schedule
(b) Reports on Form 8-K
(i) Form 8-K dated July 13, 1998 announcing the completion of the Company's
acquisition of the monoline boiler and machinery business of Kemper
Insurance Companies, effective July 1, 1998.
(ii) Form 8-K dated July 20, 1998 reporting the second quarter earnings and
announcing the declaration of a dividend of 42 cents per share payable on
October 29, 1998.
(iii) Form 8-K dated July 23, 1998 announcing the election of a new
director.
(iv) Form 8-K dated September 24, 1998 announcing the election of Gordon W.
Kreh to the position of chairman of the board of directors of the Company.
22
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HSB GROUP, INC.
Date: November 13, 1998 By: /s/ Saul L. Basch
Saul L. Basch
Senior Vice President,
Treasurer and
Chief Financial Officer
Date: November 13, 1998 By: /s/ Robert C. Walker
Robert C. Walker
Senior Vice President and
General Counsel
23