Domestically, exclusive of HSB Industrial Risk Insurers, gross earned premiums increased $34.8 million or 9.3 percent in 1999 due to the integration of the Kemper portfolio and growth in our client company business. Gross earned premiums representing coverage outside the U.S., exclusive of HSB Industrial Risk Insurers, decreased 12.5 percent to $116.8 from $133.5 million in 1998 due to price erosion and maintenance of strict underwriting standards.
The expense ratio increased to 51.0 percent in 1999 from 45.4 percent in 1998 and 47.3 percent in 1997. A portion of the 1999 increase in the expense ratio was attributable to increases in policy acquisition costs. Increases in commission rates that reflect changes in the mix of business, primarily in the commercial segment, increased the expense ratio approximately 1.9 percentage points. In 1999, the Company's results were negatively impacted by increased information systems costs of $8 million (including Year 2000 remediation costs) and $5 million of charges related to a change in management at HSB and consolidation and relocation of certain businesses. Approximately $11 million of these amounts were allocated to the insurance operations, thereby increasing the expense ratio by 2.9 percentage points.
The following analysis illustrates the sensitivity of the market value of the Company's financial instruments to selected changes in market rates and prices. The range of changes selected reflects the Company's view of reasonably possible market movements over a one-year period. The range of values selected should not be interpreted as the Company's prediction of future market events, but rather an illustration of the impact of such events.
Consolidated Statements of Comprehensive Income For the years ended December 31, (in millions)
The accompanying financial statements present the consolidated accounts of HSB Group, Inc. and its subsidiaries (collectively, HSB or the Company) and are prepared in accordance with Generally Accepted Accounting Principles (GAAP) within the U.S. Significant intercompany transactions and balances have been eliminated in consolidation. The preparation of financial statements in accordance with GAAP requires the use of estimates in reporting certain assets and liabilities. Actual results could differ from those estimates. Certain amounts for 1998 and 1997 have been reclassified to conform with the 1999 presentation.
Liabilities for claims and adjustment expenses for boiler and machinery, property and other coverages represent estimated reserves on claims and adjustment expenses reported but not yet settled and the cost of claims and adjustment expenses incurred but not yet reported. Reserves for claims and adjustment expenses are undiscounted and are gross of amounts recoverable from reinsurers. Reserves are reduced for estimated amounts of salvage and subrogation and deductibles from customers. HSB records subrogation when recoverability is probable, such as when a judgment is returned, liability is admitted or settlement is reached. The length of time that reserves for claims and adjustment expenses are carried on the Consolidated Statements of Financial Position is a function of the pay-out patterns associated with the types of coverages involved. Estimates for these reserves reflect such variables as past loss experience, changes in judicial interpretation of legal liability, policy coverage and inflation. The establishment of such reserves frequently requires complex engineering judgements. Due to the nature of the variables involved in the reserving process, subjective judgments are an integral component. Previously estimated reserves are regularly adjusted as loss experience develops and new information becomes available. Since reserves are based on estimates, the ultimate liability may be more or less than such reserves. The effects of changes in estimated reserves are included in the results of operations in the period in which the estimates change (see note 11).
Deferred tax assets and liabilities are generally determined based on the difference between financial statement and tax basis for certain assets and liabilities using tax rates in effect for the year in which the differences are expected to reverse. Deferred tax assets are allowed if future realization is more likely than not. Deferred income taxes are provided for unrealized appreciation/depreciation on fixed maturities and equity securities available for sale, prepaid acquisition costs, loss reserve discounting, unearned premiums, certain employee benefit costs and other items which are the result of temporary differences in the treatment of such items for tax and financial statement purposes (see note 12).
On January 6, 1998, HSBIIC sold its interest in IRI to ERC in accordance with a previously announced purchase and sale agreement between ERC and IRI's twenty-three member insurers. HSBIIC received gross proceeds of $49.1 million, prior to transaction costs, for its 23.5 percent share in IRI. The gain on the sale of IRI was $36.6 million pre-tax and $23.8 million after-tax. Because the sale was structured in part as a reinsurance transaction, a portion of HSBIIC's gross proceeds was utilized to reinsure in-force policies with ERC.
On January 2, 1998, HSBIIC exercised its option to put its 40 percent share in Radian International LLC (Radian LLC) to The Dow Chemical Company (Dow), for approximately $129 million, net of expenses. Radian LLC was formed in January 1996 as a joint venture with Dow to provide environmental, engineering, information technology, remediation and strategic chemical management services to industries and governments worldwide. In connection with the formation of the new company, HSBIIC contributed substantially all of the assets and liabilities of its wholly owned subsidiary, Radian Corporation to Radian LLC. The results of Radian LLC were classified as discontinued operations following ratification on July 28, 1997 by HSB's Board of Directors of management's decision to exercise its put. HSBIIC's share of Radian LLC's losses incurred subsequent to such decision of approximately $6.6 million after-tax was deferred and recognized at the time the gain was recognized in 1998. This transaction resulted in an after-tax gain of approximately $36.9 million, which was recorded in the
1999, 1998 and 1997 net claims and adjustment expenses incurred have been reduced by subrogation recoveries of approximately $2.0, $5.0 and $3.3 million, respectively.
As of December 31, 1999, no other reinsurance asset of the Company from any single reinsurer exceeded 3.0 percent of shareholders' equity. Certain Lloyd's syndicates participate in the excess of loss reinsurance program, primarily in the excess layers. The highest aggregate percentage participation of such syndicates, at 32.4 percent,
Income taxes consisted of the following: 1999 1998 1997 - ------------------------------------------------------------------------ Current provision (benefit): U.S. $ 31.1 $ 45.3 $ 16.8 Foreign 4.0 (0.3) 7.0 ----------------------------- Total current provision 35.1 45.0 23.8 Deferred provision (benefit): U.S. (0.4) 6.2 1.1 Foreign 1.0 0.2 0.2 ----------------------------- Total deferred provision 0.6 6.4 1.3 ----------------------------- Total income taxes $ 35.7 $ 51.4 $ 25.1 - ------------------------------------------------------------------------
1999 1998 - ------------------------------------------------------------------------ Short-term borrowings $ 41.5 $ 21.0 Long-term borrowings * $ 25.1 $ 25.1 Company obligated mandatorily redeemable capital securities of subsidiary Trust I holding solely junior subordinated deferrable interest debentures of the Company, net of unamortized discount of $1.0; $1.1 $ 109.0 $108.9 Company obligated mandatorily redeemable convertible capital securities of subsidiary Trust II holding solely junior subordinated deferrable interest debentures of the Company $ 300.0 $300.0 Common shareholders' equity $ 376.5 $419.3 - ------------------------------------------------------------------------ * Excludes capital lease (see note 9).
The estimated fair value of the Capital Securities issued by Trust I is equal to their carrying value. The estimated fair value of the Convertible Capital Securities issued by Trust II is $272.2 million and is calculated without giving any effect to the relationship of the conversion price to the current market price of HSB Group, Inc. common stock.
HSB has a Stock Option Plan under which key employees may be granted restricted stock and stock options.