Net income for 1998 included after-tax gains on the sale of HSB's interest in Industrial Risk Insurers (IRI) of $23.8 million and Radian International LLC (Radian LLC) of $30.3 million. The Radian LLC gain is net of after-tax operating losses of $6.6 million that were deferred in 1997 when the decision was made to exercise HSB's option to put the Company's interest to The Dow Chemical Company (Dow). As a result, HSB's interest in Radian LLC was classified as a discontinued operation in 1997. The Company's after-tax earnings, excluding the after-tax gains on sales of IRI and Radian LLC, increased 20.9 percent in 1998 compared with 1997 due to increased underwriting profits, improved engineering results and higher net realized gains.
IRI is an unincorporated, voluntary joint underwriting association which provides property insurance for the class of business known as Highly Protected Risks (HPR) for larger manufacturing, processing and industrial businesses, which have invested in protection against loss through the use of sprinklers and other means. IRI primarily writes policies on a syndicate basis that specifies to the insured the percentage share of risk accepted by each member of the association. Each member company, therefore, operates as a direct insurer or reinsurer on such policies and participates in the premiums and losses generated thereunder in proportion to its membership interest. In 1997 and 1996, HSBIIC's membership shares were 23.5 and 14 percent respectively; in 1995 and prior the shares were 0.5 percent.
In contemplation of 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 shares of HSB common stock, at any time, subject to regulatory approval, at a conversion price of $56.67 per share, restated to reflect the May 22, 1998 three-for-two stock split (formerly a conversion price of $85.00 per share). $250 million of the proceeds were contributed to HSBIIC and $50 million was retained by HSB (see note 13).
Total revenues declined 4.0 percent in 1998 and grew 9.9 percent in 1997. Gross earned premiums grew 26.4 percent in 1998. Much of this growth is attributable to HSB Industrial Risk Insurers and growth in our commercial book of business, as well as through the acquisition of the Kemper book noted in the Other Developments section of this MD&A.
Engineering services revenue increased 52.6 percent in 1998 and 9.9 percent in 1997. The growth in 1998 was primarily due to acquisitions made late in 1997 and in 1998 as well as growth in certain core businesses.
Net investment income grew 73.9 percent in 1998 primarily due to the investment of proceeds from the sales of IRI and Radian LLC and the capital securities issued in the second half of 1997.
The effective tax rates on income from continuing operations before distributions on capital securities for 1998 was 29.6 percent compared to 26.8 percent and 25.1 percent for 1997 and 1996. 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.
Also in June of 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." This statement 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 was implemented at year-end 1998 and caused the Company to redefine its reportable segments (see note 5).
In December 1997, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants (AcSEC) issued Statement of Position (SOP) 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments." This statement provides guidance for the recording of a liability for insurance-related assessments. The statement requires that a liability be recorded when all of the following conditions have been met: an assessment has been imposed or it is probable that an assessment will be imposed; the event obligating an entity to pay an imposed or probable assessment has occurred on or before the date of the financial statements; and the amount of the assessment can be reasonably estimated. This statement is effective for fiscal years beginning after December 15, 1998. The Company anticipates that the adoption of the provisions of SOP 97-3 will not have a material impact on results of operations, financial condition or cash flows.
In April 1998, HSB acquired Solomon Associates, Inc. (SAI) based in Dallas, Texas. SAI is an engineering management consulting firm that provides comparative performance benchmarking consulting to the refining, petrochemical and power generation industries. SAI establishes efficiency and productivity
benchmarks for 80 percent of the worldwide petroleum refining industry. This acquisition expands HSB's engineering management consulting services and benchmarking capability.
HSBIIC completed an acquisition of the monoline boiler and machinery business of Kemper Insurance Companies (Kemper), 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.
Claims and adjustment expenses 174.9 217.9 204.4 Underwriting, acquisition and other expenses 180.0 233.5 222.4 ----------------------------------------------
Loss ratio 44.2% 44.4% 45.6% Expense ratio 45.2% 47.3% 49.1% Combined ratio 89.4% 91.7% 94.7% - ------------------------------ ----------------------------------------------
Gross earned premiums in 1998 increased 26.4 percent over 1997. Much of this growth is attributable to HSB Industrial Risk Insurers ($155.4 million) as well as the addition of the Kemper portfolio to our commercial business. In 1997, gross earned premiums increased 9.5 percent as a result of IRI ($23.2 million) and growth in both the domestic and global markets.
Domestically, exclusive of HSB Industrial Risk Insurers, gross earned premiums remained flat in 1998 and increased approximately 3.5 percent in 1997. This performance resulted from the combination of growth in written premiums from our client companies in 1998, 1997 and 1996, and a reduction in our domestic special risk premiums. In addition, the 1998 acquisition of the Kemper direct boiler and machinery book and reinsurance of the boiler and machinery component of their package policies have provided premium growth. Gross earned premiums representing coverage outside the U.S., exclusive of HSB Industrial Risk Insurers, increased 5.4 percent to $133.5 million from $126.7 million in 1997. In 1997, gross earned premiums increased 15.5 percent from 1996.
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 increase in ceded premiums of 217.1 percent in 1998 was primarily due to the quota share reinsurance agreements with ERC and HSB Industrial Risk Insurers, as previously discussed, and changes in the Company's reinsurance programs which now utilize more quota share reinsurance on certain of our books of business. We anticipate these new reinsurance contracts and the HSB Industrial Risk Insurers arrangement will continue to result in growth in gross earned premiums but lower growth in net earned premiums. The Company continues to seek 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. The Company will not write business at rates that would lessen its ability to maintain underwriting profit.
The Company participates in various facultative, quota share and excess of loss reinsurance agreements to limit its exposure, particularly to catastrophic losses and high risk lines, and to provide additional capacity to write business. The Company evaluates its exposures and reinsurance needs annually to implement a program that corresponds with the level of exposure it is willing to retain. Because the Company has primary responsibility to its insureds, a careful evaluation of the financial strength of those reinsurers it cedes business to is performed. HSB's reinsurance costs continue to be impacted by its prior loss experience and business growth.
For the years ended December 31, 1998 1997 1996 - ------------------------------------------------------------------------ Provision for claims and adjustment expenses occurring in the current year $164.0 $209.5 $214.2 Increase (decrease) in estimated claims and adjustment expenses arising in prior years* 10.9 8.4 (9.8) -------------------------------------- Total incurred claims and adjustment expenses $174.9 $217.9 $204.4
* Includes approximately $5.0, $3.3 and $4.9 million of subrogation recoveries, respectively.
Gross claims and adjustment expenses were $611.7 million in 1998 as compared to $263.1 million in 1997. The increase in gross claims was largely due to the Company's role as direct writer of HSB Industrial Risk Insurers' policies and include approximately $154 million from Hurricane Georges on exposures written by HSB Industrial Risk Insurers. On a net basis the impact on HSB from such hurricane losses after cessions to HSB Industrial Risk Insurers and reinsurance recoveries was $1.9 million.
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
yet settled and those that have been incurred but not yet reported to the Company. The length of time that reserves are carried on the Consolidated Statements of Financial Position is a function of the pay-out patterns associated with the types of coverage involved. The majority of claims the Company incurs are short-tailed in nature, relative to the property/casualty industry as a whole, meaning they generally settle shortly after claims are reported. The Company's loss reserve estimates reflect such variables as past loss experience and inflation. In addition, due to the nature of much of the Company's types of coverage, complex engineering judgments are involved. Previously established loss reserves are regularly adjusted as loss experience develops and new information becomes available. Adjustments to previously established reserves are reflected in the financial statements in the period in which the estimates are changed. The Company does not discount its loss reserves.
For the years ended December 31, 1998 1997 1996 - -------------------------------- ------------ ------------- ----------------- Commercial: Net earned premiums $306.3 $269.0 $253.1 Net income 14.8 13.4 11.8 Income taxes 4.6 6.1 6.9 Global Special Risks: Net earned premiums $ 83.6 $217.1 $187.7 Net income (loss) 9.8 10.7 (3.0) Income taxes (benefit) 7.7 6.2 (1.3) - -------------------------------- ------------ ------------- -----------------
The Commercial business has shown strong revenue growth year over year notwithstanding significant price competition as HSB continues to focus on its client company strategy. Net earned premiums in the commercial segment rose $37.3 million in 1998 due primarily to strong growth in client company billings and integration of the Kemper portfolio. Domestic operations posted an underwriting gain that was partially offset by a difficult claims year internationally, particularly due to severe ice storms that affected over 30 percent of Canada. The high tax benefit recognized on Canadian losses caused the effective tax rate decline from 1997.
HSBIIC is currently involved in a claim-related dispute concerning the extent to which a certain explosion event is insured under the boiler and machinery coverage of HSBIIC or under coverages of other insurers. A final decision in an arbitration proceeding on this matter has concluded with a decision requiring HSBIIC to pay $22 million of the amount that was in dispute. The $22 million, less HSBIIC's retention of $3 million, which was reserved for in prior years, is fully reinsured. In response to the ruling, the Company increased both its gross reserves and reinsurance recoverable by $19 million, resulting in no impact to net income.
The obligations of HSBIIC's reinsurers with respect to this litigation are not in dispute. Therefore, management believes that any adverse outcome in this case will not 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 loss such reinsurers might incur should this case 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 litigation 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.
Engineering services revenues increased 52.6 percent in comparison to 1997. The growth in revenues is primarily due to increases generated by HSBRT, EIL's acquisition of Haughton's engineering in the last quarter of 1997, the addition of SAI in April 1998, as well as revenues generated by some recent small acquisitions. Engineering services revenues in 1997 increased 9.8 percent primarily attributable to increased sales of $3.2 million at HSBRT, offset by a modest decline in revenues from our engineering operations based in Asia.
Margins increased 0.7 percentage points in 1998 as a result of improved field service staff utilization and cost efficiencies, which were offset somewhat by the start-up costs of integrating recent acquisitions. Margins declined in 1997 as the Company decreased the staff utilization domestically in order to develop new growth opportunities. The Company continues to maintain staff levels in Asia at somewhat lower than historical productivity levels, as the Company continues to have confidence in its long-term growth prospects in the region.
The Company's investment strategy continues to be to maximize total return on the investment portfolio through investment income and capital appreciation. Investment strategies for any given year are developed based on many factors including operational results, tax implications, regulatory requirements, interest rates, dividends to stockholders and market conditions. The investment portfolio includes a wide variety of high quality equity securities and both domestic and foreign fixed maturities. The Company continues to manage its use of tax advantageous investments to maximize after-tax investment earnings. The Company does not engage in cash flow underwriting; it seeks to have underwriting profit each year.
None of the Company's claim reserves are discounted as most claims settle, on average, within one year. Therefore, the Company does not use duration measurements in managing its interest rate exposure. Instead, HSB manages its portfolio by laddering a portion of its invested assets such that the effective average estimated maturity of these assets 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. In addition, the Company manages a portion of its invested assets on a long-term/segmented basis to provide interest coverage on the servicing requirements of its convertible capital securities.
Net investment income for 1998 increased $27.4 million compared to 1997 due to the investment of proceeds from capital securities issued during the second half of 1997. In addition, proceeds from the January 1998 sales of HSB's interests in IRI and Radian LLC significantly increased investable funds. Realized investment gains were significantly impacted in 1998 by call premiums on fixed income investments and sales of certain convertible securities and common stocks in response to market conditions.
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 means they only settled upon maturity. The contracts, which were entered into when the Standard & Poor's 500 Index (S&P 500 Index) was 744.3, allowed HSBIIC to recover from the counterparty if the index was below 695.2 at the time of maturity, and required HSBIIC to reimburse the counterparty if the index was above a range of 811.3 to 818.7 at the time of maturity.
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 1998, HSB's fixed maturities portfolio comprised 53.6 percent of the value of the invested assets. The credit quality of HSB's bond investments at December 31, 1998, averaged an A rating. HSB's portfolio does not include any bonds in default as to either principal or interest. Bonds held at December 31, 1998, had a fair value of $357.9 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.
For purposes of this disclosure market risk sensitive instruments are to be categorized as instruments entered into for trading purposes and instruments entered into for purposes other than trading. The Company does not hold any financial instruments entered into for trading purposes and, therefore, market risk sensitive instruments are classified as held for purposes other than trading.
income instruments will fall. As rates decline the inverse is true. The Company attempts to mitigate this risk by investing in high quality issues using a buy and hold approach.
The Company's long term debt of $25.1 million as of December 31, 1998 is denominated in U.S. dollars. The Company's long term debt and convertible capital securities have been issued at fixed rates, and as such, interest expense would not be impacted by interest rate shifts. The impact of 100 and 150 basis point increases in interest rates on the fixed rate debt would result in a decrease in the market value of the debt by $0.3 million and $0.5 million, respectively. The effect on the convertible capital securities is estimated to be $14.7 million and $21.7 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. The impact of 100 and 150 basis point increases in interest rates on the variable rate capital securities would result in an additional
charge to pre-tax income of $1.1 million and $1.6 million, respectively, per year. A 100 and 150 basis point decrease in interest rates would increase pre-tax income by $1.1 million and $1.6 million, respectively, per year.
Equity price risk was measured assuming an instantaneous 10 percent and 25 percent change in the S&P 500 Index from its level at December 31, 1998 with all other variables held constant. The Company's equity holdings (comprised of common stocks and non-redeemable preferreds) were assumed to be 100 percent correlated to this index. A 10 percent and 25 percent increase or decrease in the S&P 500 Index would result in a $24.9 million and $62.4 million increase or decrease, respectively in the net financial instrument position.
The following table reflects the estimated effects on the market value of the Company's financial instruments due to an increase in interest rates of 150 basis points, a 25 percent decline in the S&P 500 Index, and a decline of 20 percent in foreign currency exchange rates.
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 subsidiary is HSBIIC. HSB relies on investment income, primarily in the form of dividends from HSBIIC, in order to meet its short and long-term liquidity requirements including the service requirements for its capital securities. The Company receives a regular inflow of cash from maturing investments, engineering services and insurance operations. The mix of the investment portfolio is managed to respond to expected claim pay-out patterns and the service requirements of the Company's capital securities. HSB also maintains 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 cash equivalents and short-term portfolio at December 31, 1997 reflects the temporary investment of the proceeds from the $300 million Convertible Capital Securities discussed below.
The Convertible Capital Securities are convertible, in whole or in part, at ERC's option at any time, subject to regulatory approval, into shares of HSB common stock at a conversion price of $56.67, 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 at December 31, 1998, on a fully diluted basis, approximately 15.5 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.
Cash provided from operations was $55.6 million in 1998 compared to $26.1 million for 1997. Insurance operations cash flows (excluding HSB Industrial Risk Insurers) were impacted by a decline in net claims paid of 2.9 percent compared to the same period in 1997 while premiums collected were 6.2 percent higher in 1998. Payments to reinsurers for ceded premiums increased approximately 72 percent in the current year. HSBIIC's participation in HSB Industrial Risk Insurers impacted components of the Consolidated Statements of Cash Flows, including a positive impact of $35.3 million and $1.5 million for 1998 and 1997, respectively, to cash provided from operations.
of convertible redeemable preferred stock converted those shares into 597,609 shares of common stock, restated to reflect the May 22, 1998 three-for-two stock split (formerly 398,406 shares) adding $20 million to common shareholders' equity.
Pursuant to the share repurchase authorization approved by the Board, during 1998, HSB repurchased approximately 1.2 million shares at a cost of $47.7 million. 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. On January 25, 1999, the Board renewed the authorization to repurchase up to 3 million shares of common stock.
The Company writes business in European markets primarily through its U.K. subsidiary, EIL. The adoption of a common currency (the euro) by eleven of the fifteen member countries of the European Union on January 1, 1999 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 U.K. is not a first wave euro country and as such the primary impact will be in Spain and the Irish Republic. Over time, 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 and reporting.
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.
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 has largely completed the development, renovation, replacement and implementation phases for
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.
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.
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 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.
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 that have approved the endorsement. In the four jurisdictions that 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.
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; the adequacy of loss reserves; changes in asset valuations; consolidation and restructuring in the insurance industry; changes in the Company's participation in joint underwriting associations, and in particular its arrangement with HSB Industrial Risk Insurers; 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.
Consolidated Statements of Comprehensive Income for the years ended December 31, 1998, 1997 and 1996. 47
Consolidated Statements of Cash Flows for the years ended December 31, 1998, 1997 and 1996. 49
Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 1998, 1997 and 1996. 50
For the years ended December 31, (in millions, except per share amounts)
Expenses: Claims and adjustment 174.9 217.9 204.4 Policy acquisition 66.3 90.7 86.0 Underwriting and inspection 113.7 142.8 136.4 Engineering services 86.2 57.0 48.5 Interest 0.8 1.3 0.6 ------------------------------------ Total expenses 441.9 509.7 475.9 ------------------------------------ Gain on sale of IRI 36.6 -- --
Income from continuing operations before income taxes and distributions on capital securities 173.9 93.7 72.9
Income taxes (benefit): Current 45.0 23.8 24.7 Deferred 6.4 1.3 (6.4) ------------------------------------ Total income taxes 51.4 25.1 18.3 ------------------------------------
Liabilities: Unearned insurance premiums $ 477.9 $ 287.3 Claims and adjustment expenses 550.3 276.7 Short-term borrowings 21.0 42.4 Long-term borrowings 25.1 25.1 Capital lease 27.9 27.9 Deferred income taxes 42.7 31.5 Dividends and distributions on capital securities 23.2 13.3 Ceded reinsurance payable 64.1 3.9 Other liabilities 83.6 74.9 --------------------------------- Total liabilities 1,315.8 783.0 --------------------------------- 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 in 1998 and 1997 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 and outstanding 28.9; 29.4) 10.0 10.0 Additional paid-in capital 33.5 31.6 Accumulated other comprehensive income 66.8 55.9 Retained earnings 311.2 248.8 Benefit plans (2.2) (1.0) --------------------------------- Total shareholders' equity 419.3 345.3 --------------------------------- Total $2,144.0 $1,537.2 --------------------------------- Common shareholders' equity per common share $ 14.53 $ 11.75
Non-cash investing and financing activities: Issuance of HSB convertible preferred stock in exchange for EIG, Co. preferred stock in 1996; conversion into HSB common stock in 1997; and issuance of HSB common stock in connection with the acquisition of Solomon Associates, Inc. in 1998 (see note 3).
Reinsurance assets represent amounts due from reinsurers for paid and unpaid claims, paid and unpaid loss adjustment expenses and the unearned portion of premiums ceded through reinsurance agreements.
Financial instruments which qualify for hedge accounting are recorded at market with gains and losses reflected in shareholders' equity. To the extent such instruments do not qualify for hedge accounting, related gains and losses are reflected in results of operations.
Fixed assets include real and personal property and certain eligible capitalized system development costs. Fixed assets are carried at cost less accumulated depreciation and amortization. Depreciation and amortization is calculated on the basis of estimated useful lives using straight-line and accelerated methods. Upon retirement or replacement, any gain or loss is included in results of operations.
accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that all derivatives be recognized as either assets or liabilities in the statement of financial position and that such instruments be measured at fair value. In addition, all hedging relationships must be designated, reassessed and documented pursuant to the provisions of SFAS No. 133. This statement is effective for fiscal years beginning after June 15, 1999. The Company anticipates that the adoption of the provisions of SFAS No. 133 will not have a material impact on results of operations, financial condition or cash flows.
In December 1997, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants (AcSEC) issued Statement of Position (SOP) 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments." This statement provides guidance for the recording of a liability for insurance related assessments. The statement requires that a liability be recorded when all of the following conditions have been met: an assessment has been imposed or it is probable that an assessment will be imposed; the event obligating an entity to pay an imposed or probable assessment has occurred on or before the date of the financial statements; and the amount of the assessment can be reasonably estimated. This statement is effective for fiscal years beginning after December 15, 1998. The Company anticipates that the adoption of the provisions of SOP 97-3 will not have a material impact on results of operations, financial condition or cash flows.
In March 1998, AcSEC issued SOP 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." This statement specifies the types of costs that must be capitalized and amortized over the software's expected useful life and the types of costs which must be immediately recognized as expense. For purposes of this SOP, internal-use software is software acquired, internally developed or modified solely to meet the entity's internal needs for which no substantive plan exists or is being developed to market the software externally during the software's development or modification. Certain internal and external costs incurred to develop internal-use computer software that relate to system design, software configuration and interfaces, coding, testing and installation to hardware should generally be capitalized. This statement is effective for fiscal years beginning after December 15, 1998. The Company's current policy is to capitalize such costs and therefore anticipates that the adoption of the provisions of SOP 98-1 will not have a material impact on results of operations, financial condition or cash flows.
In April 1998, AcSEC issued SOP 98-5, "Reporting on the Costs of Start-Up Activities." This statement requires the costs of start-up activities and organization costs to be expensed as incurred. Start-up costs are defined broadly as those one-time activities related to opening a new facility, introducing a new product or service, conducting business in a new territory, conducting business with a new class of customer, initiating a new process in an existing facility, or commencing some new operation. Start-up costs include activities related to organizing a new entity (commonly referred to as organization costs). This SOP applies to development stage entities as well as established entities. This statement is effective for fiscal years beginning after December 15, 1998 and initial application should be reported as a cumulative effect of a change in accounting principle. The Company does not expect the application of SOP 98-5 will have a material impact on results of operations, financial condition or cash flows.
In October 1998, AcSEC issued SOP 98-7, "Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk." The SOP identifies several methods of deposit accounting and provides guidance on the application of each method. This statement classifies insurance and reinsurance contracts for which the deposit method is appropriate as contracts that (i) transfer only significant timing risk; (ii) transfer only significant underwriting risk; (iii) transfer neither significant timing nor underwriting risk; and (iv) have an indeterminate risk. This SOP is effective for financial statements for fiscal years beginning after June 15, 1999. Restatement of previously issued financial statements is not permitted. The effect of initially adopting SOP 98-7 should be reported as a cumulative effect of a change in accounting principle. Currently 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," and, therefore, does not anticipate the adoption of this statement will have a material impact on results of operations, financial condition or cash flows.
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 $36.6 million pre-tax and $23.8 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. HSBIIC received gross proceeds of $49.1 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 was 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 0.5 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 retains 85 percent of the equipment breakdown insurance and 15 percent of the property insurance of the combined insurance portfolio.
To support HSB's expanded role, on December 31, 1997, a business trust formed by HSB sold $300 million of 20 year 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 $56.67, restated to reflect the May 22,1998 three-for-two stock split. $250 million of the proceeds were contributed by HSB to HSBIIC and $50 million was retained at HSB (see note 13).
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 at historical cost to Radian LLC. No gain was recognized on the transfer. 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. The Company'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 first quarter of 1998. In 1996 and prior to June 1997, the Company's share of the joint venture's results were recorded as equity in Radian.
HSBIIC completed an acquisition of the monoline boiler and machinery business of Kemper Insurance Companies (Kemper) and Kemper's ASME inspection services business that certifies boiler and pressure vessel compliance with the codes and standards of the American Society of Mechanical Engineers, effective July 1, 1998. The two companies also completed an agreement for HSBIIC to reinsure boiler and machinery coverage as part of Kemper's commercial package policies.
On July 15, 1997, HSB sold $110 million of 30 year Global Floating Rate Capital Securities in a private placement. On December 31, 1997, HSB issued $300 million of 20 year fixed rate Convertible Capital Securities to ERC, a subsidiary of GE Capital Services (see note 13).
1998 1997 1996 - -------------------------------------------------------------------------------- Income from continuing operations $104.1 $66.3 $54.6 Dividends on preferred shares -- (1.1) -- ------------------------------------------- Income applicable to common stock 104.1 65.2 54.6 Convertible preferred stock -- 1.1 -- After-tax distributions on convertible capital securities(1) 13.7 -- -- ------------------------------------------- Adjusted for diluted computation $117.8 $66.3 $54.6 - -------------------------------------------------------------------------------- Weighted average common shares outstanding(2) 29.3 29.5 30.3 Convertible capital securities 5.3 -- -- Convertible preferred stock -- 0.5 -- Stock options(3) 0.6 0.2 -- ------------------------------------------- Adjusted for diluted computation 35.2 30.2 30.3 - -------------------------------------------------------------------------------- From continuing operations: Earnings per share-basic (4) $ 3.55 $2.21 $1.81 Earnings per share-assuming dilution $ 3.35 $2.20 $1.81 - --------------------------------------------------------------------------------
In 1998, HSB implemented the provisions of 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 utilizing the management approach to defining operating segments. It includes disclosure requirements relating to products and services, geographic areas and major customers. The adoption of SFAS No. 131 did not affect consolidated results of operations, financial position or cash flows but did affect the disclosure of segment information.
The prior year's segment information has been restated to present HSB's four reportable segments - Commercial insurance, Global Special Risk insurance, Engineering services and Investments. HSB is a multi-national company operating primarily in North American, European and Asian markets. Through its Commercial segment operations, HSB provides risk modification services, equipment breakdown insurance and loss recovery services to commercial businesses. The Global Special Risk operating segment focuses on the needs of equipment-intensive industries by offering all-risk coverage with customized engineering consulting and risk management. HSB's Engineering services operations offers professional scientific and technical consulting for industry and government on a worldwide basis. The Company's investment assets are managed by its Investment operating segment.
HSB's foreign operations (primarily insurance) are widely dispersed such that no country or logical aggregation of countries in a geographic area comprise a significant concentration with respect to either revenues or identifiable assets. Export sales from HSB's domestic operations are minimal due to the existence of the Company's foreign subsidiaries which are responsible for virtually all of the Company's foreign sales.
The following presents financial data of the Company based on geographic location:
Income from continuing operations before taxes and distributions on capital securities: U.S. $ 168.2 $ 78.4 $ 52.9 Non-U.S. 5.7 15.3 20.0 ---------------------------------------- Total $ 173.9 $ 93.7 $ 72.9 - --------------------------------------------------------------------------------
The following presents revenue and net income from the Company's reportable segments and reconciles these amounts to the corresponding consolidated totals:
For the years ended December 31, 1998 1997 1996 - -------------------------------------------------------------------------------- Depreciation and amortization expense: Commercial $ 7.3 $ 3.4 $ 5.2 Global Special Risks 2.2 3.2 2.3 Engineering services 5.9 2.7 3.0 Investments 0.3 -- -- Income tax expense (benefit): Commercial 4.6 6.1 6.9 Global Special Risks 7.7 6.2 (1.3) Engineering services 1.6 0.1 2.0 Investments 22.5 10.3 7.0 - --------------------------------------------------------------------------------
HSBIIC and its insurance subsidiaries are currently subject to various regulations that limit the maximum amount of dividends ultimately available to HSBIIC's parent company without prior approval of insurance regulatory authorities. Under SAP, approximately $200.2 million of statutory surplus is available for distribution to HSB Group, Inc. in 1999 without prior regulatory approval.
In 1998, the National Association of Insurance Commissioners (NAIC) adopted the Codification of Statutory Accounting Principles guidance, which will replace the current Accounting Practices and Procedures manual as the NAIC's primary guidance on statutory accounting. The NAIC is now considering amendments to the Codification guidance that would be effective upon implementation. The NAIC has recommended an effective date of January 1, 2001. The Company has not estimated the potential effect of the Codification guidance if adopted by the Connecticut Insurance Department.
For the years ended December 31, 1998 1997 1996 - -------------------------------------------------------------------------------- Income from Investment Operations: Net investment income: Short-term interest $ 8.7 $ 6.7 $ 4.8 Fixed maturities: Taxable interest 31.9 9.6 9.8 Tax exempt interest 2.5 2.1 1.8 Redeemable preferred dividends 5.9 7.2 7.9 Equity securities: Common dividends 6.4 4.7 4.6 Non-redeemable preferred dividends 14.0 8.3 5.9 Other 0.2 2.1 1.0 ------------------------------------ Total investment income 69.6 40.7 35.8 Investment expenses (5.4) (3.9) (3.5) ------------------------------------ Net investment income $64.2 $36.8 $32.3 Realized investment gains (losses): Fixed maturities: Bonds: Gains $ 2.1 $ 0.5 $ 2.0 Losses (0.2) (0.3) (0.2) ------------------------------------ Net gains 1.9 0.2 1.8 Redeemable preferred stocks: Gains 2.3 0.4 0.3 Losses (0.1) (0.3) (1.5) ------------------------------------ Net gains (losses) 2.2 0.1 (1.2) Equity securities: Common stocks: Gains 20.5 48.1 14.6 Losses (7.0) (5.1) (3.3) ------------------------------------ Net gains 13.5 43.0 11.3 Non-redeemable preferred stocks: Gains 10.3 7.7 4.2 Losses (3.1) (0.2) (4.0) ------------------------------------ Net gains 7.2 7.5 0.2 Foreign exchange gains (losses) 0.3 (7.4) -- Collar contracts losses -- (30.7) -- Other gains 0.3 1.4 -- ------------------------------------ Realized investment gains $25.4 $14.1 $12.1 - --------------------------------------------------------------------------------
There were no material declines in the realizable value of investments considered to be other than temporary for 1998 and 1997. Realized investment gains and losses for 1996 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.
Unrealized Investment Gains, Net of Tax Fixed maturities: Gains $13.0 $ 7.9 $ 6.1 Losses (4.4) (0.6) (1.6) --------------- ----------------- --------------- Net gains 8.6 7.3 4.5 Equity securities: Gains 122.9 94.3 82.0 Losses (12.1) (1.8) (2.2) --------------- ----------------- --------------- Net gains 110.8 92.5 79.8 Foreign exchange losses (6.3) (4.5) (2.9) --------------- ----------------- --------------- Total unrealized investment gains 113.1 95.3 81.4 Income taxes (42.3) (35.5) (28.6) --------------- ----------------- --------------- Unrealized investment gains, net of tax $70.8 $59.8 $52.8 - ---------------------------------------------- ----------------- ---------------
The amortized cost and estimated fair value of fixed maturities at December 31, by contractual years-to-maturity is as follows (actual maturities may differ from contractual maturities because borrowers may have the right to prepay obligations):
Common stocks $141.3 $249.3 $112.3 $ 4.3 Non-redeemable preferred stocks 185.0 187.8 10.6 7.8 --------------------------------------- -----------
Total equity securities $231.3 $323.8 $ 94.3 $ 1.8 - --------------------------------------------------------------------------------
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. During the year ended December 31, 1997, the Company's U.S. common stock portfolio had experienced a total return of $57 million (which includes price appreciation of approximately $54 million) and had a price movement correlation with the S&P 500 Index well in excess of 80 percent.
In 1996, the Company began a comprehensive effort to assess and address issues relating to the ability of its policy processing and other operational systems to properly recognize calendar dates beginning in the year 2000. As part of this effort, the Company established a Year 2000 Program to address the areas of applications software, infrastructures, embedded technology and key business partners and suppliers. 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. Certain of these costs are being expensed as incurred. The Company has expensed $5.1 million for 1998, $1.5 million for 1997 and $0.2 million for 1996. It is estimated that expenditures of $5.2 million for 1999 will be expensed as incurred. The remainder of the $26 million estimate is related to systems that the Company anticipated replacing in the normal course of information technology development, however, the timetable was accelerated in contemplation of the Year 2000 event. The costs associated with replacement of such systems are being capitalized in accordance with the Company's existing capitalization policy.
term a proportional share of the facility's variable operating expenses. This amounted to approximately $2.9, $2.6 and $2.8 million for the years ended 1998, 1997 and 1996, respectively.
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 $10.2, $8.4 and $5.7 million in 1998, 1997 and 1996, respectively.
The components of net written and net earned insurance premiums were as follows:
In 1998 HSBIIC became the direct writer for business written on behalf of HSB Industrial Risk Insurers. This business is ceded to that entity and HSBIIC's share of the equipment breakdown and property business is assumed back in accordance with the reinsurance agreements in place with ERC (see note 3). This has resulted in growth in gross and ceded premiums, claims and adjustment 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 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:
Total incurred claims and adjustment expenses $611.7 $263.1 $329.4 ----------------------------------------- Less: Payment for claims arising in: Current year 141.0 90.6 103.3 Prior years 197.1 198.7 114.1 ----------------------------------------- Total payments $338.1 $289.3 $217.4 ----------------------------------------- Gross liability for claims and adjustment expenses at December 31, $550.3 $276.7 $302.9 - --------------------------------------------------------------------------------
1998 1997 1996 - -------------------------------------------------------------------------------- Net liability for claims and adjustment expenses at January 1, $190.8 $177.8 $145.5 Plus: Provision for claims and adjustment expenses occurring in the current year 164.0 209.5 214.2 Increase (decrease) in estimated claims and adjustment expenses arising in prior years 10.9 8.4 (9.8) ----------------------------------------- Total incurred claims and adjustment expenses $174.9 $217.9 $204.4 ----------------------------------------- Less: Payment for claims arising in: Current year 84.2 82.3 91.4 Prior years 111.8 122.6 80.7 ----------------------------------------- Total payments $196.0 $204.9 $172.1 ----------------------------------------- Net liability for claims and adjustment expenses at December 31, $169.7 $190.8 $177.8 - --------------------------------------------------------------------------------
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 requires collateral for reinsurance recoverable from such carriers. Uncollectible reinsurance recoverables have not had, and are not expected by management to have in the future, a material adverse effect on the consolidated results of operations or financial position of the Company.
The following table displays information concerning the primary participants in the Company's current reinsurance program as of December 31, 1998.
Employers Reinsurance Corporation* $167.7 $ 248.6 A++(Superior) General Reinsurance Corporation $ 44.7 $ 66.0 A++(Superior) Gerling-Konzern Globale $ 9.6 $ 13.3 n/a Hartford Fire Insurance Company $ 9.3 $ 13.4 A+ (Superior) American Re-Insurance Company $ 8.7 $ 13.2 A++(Superior) NAC Reinsurance Corporation $ 8.3 $ 12.8 A+ (Superior)
As of December 31, 1998 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 31.9 percent, is in the $50 million excess of $100 million layer. No individual syndicate has more than 6.8 percent participation in any of the excess layers. In addition, certain syndicates participate in two of our quota share treaties, aggregating 7.9 percent participation in one and 13.5 percent participation in another. Lloyd's participation in our catastrophe cover is 77.3 percent with no individual syndicate retaining more than 5.3 percent. The Company's reinsurance asset in the aggregate from all Lloyd's syndicates is less than 8.0 percent of shareholders' equity at December 31, 1998. Lloyd's has historically participated more heavily in the higher treaty layers, including those years relating to the arbitration and litigation cases discussed below.
arbitration proceeding on this matter has concluded with a decision requiring HSBIIC to pay $22 million of the amount that was in dispute. The $22 million, less HSBIIC's retention of $3 million, which was reserved for in prior years, is fully reinsured. In response to the ruling, the Company increased both its gross reserves and reinsurance recoverable by $19 million, resulting in no impact to net income. HSBIIC has filed a motion in Connecticut Superior Court to confirm the arbitration award. The other insurers have contested the award. In the event the award is not confirmed, subsequent proceedings could result in additional amounts on the order of $100 million potentially becoming recoverable from HSBIIC's reinsurers.
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.
1998 1997 1996 - -------------------------------------------------------------------------------- Current provision: U.S. $45.3 $16.8 $17.3 Foreign (0.3) 7.0 7.4 ------------------------------------------------ Total current provision 45.0 23.8 24.7 ------------------------------------------------ Deferred provision: U.S. 6.2 1.1 (6.0) Foreign 0.2 0.2 (0.4) ------------------------------------------------ Total deferred provision 6.4 1.3 (6.4) ------------------------------------------------ Total income taxes $51.4 $25.1 $18.3 - --------------------------------------------------------------------------------
Deferred tax liabilities: Prepaid acquisition costs $(17.1) $(13.2) Accelerated depreciation (0.5) (0.3) Pension asset (14.4) (13.3) Unrealized investment gains (42.3) (35.5) Other (14.0) (12.5) -------------------- ----------------------
Deferred tax assets: Benefit plans 9.2 9.0 Capital lease 4.7 4.4 Unearned insurance premiums 12.1 15.0 Loss reserve discounting 3.3 5.9 Other 16.3 9.0 -------------------- ----------------------
Short-term borrowings $ 21.0 $ 42.4 Long-term borrowings * $ 25.1 $ 25.1 Company obligated mandatorily redeemable capital securities of subsidiary Trust I holding solely junior subordinated deferrable interest debenture of the Company $108.9 $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 $300.0 Common shareholders' equity $419.3 $345.3 - --------------------------------------------------------------------------------
HSBIIC has a commercial paper program with a limit of $75 million. Commercial paper outstanding at December 31, 1998 and 1997 was $20.0 and $42.3 million, respectively. Commercial paper outstanding at year end 1998 matures on or before April 20, 1999. Long-term debt includes $25.1 million of senior notes due May 15, 2000 at an interest rate of 6.83 percent. Current market value is estimated to be $26.2 million.
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 $56.67 per share, restated to reflect the May 22,1998 three-for-two stock split (formerly a conversion price of $85.00 per share) (see note 3), 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 15.5 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.
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 to additional paid-in capital and retained earnings. These amounts were $112.8 and $85.9 million as of December 31, 1998 and 1997, respectively. The reclassifications were distributed as follows:
The components of accumulated other comprehensive income (net of taxes) are as follows:
HSB maintains various types of pension and postretirement medical plans covering employees of the Company and certain subsidiaries. The pension plans are non-contributory and benefits are based upon an employee's years of service and final average pay based upon the highest three out of five years. Vesting occurs after five years of service in compliance with the provisions of the Tax Reform Act of 1986.
Under the terms of the HSB Group, Inc. Thrift Incentive Plan, a defined contribution plan, covered employees are allowed to contribute up to 15 percent of their pay, on a pre-tax basis, limited by the maximum allowed under Internal Revenue Service regulations. The Company makes a matching contribution of 50 percent of employee contributions up to 6 percent of compensation. Total expense for the plan was $2.1, $1.7 and $1.8 million for 1998, 1997 and 1996, respectively.
The Company makes available health care and life insurance benefits for retired employees of the Company and certain subsidiaries. The Company makes contributions to the plans as claims are incurred. Retirees' contributions to these plans vary, based upon retiree's age, years of service and coverage elected. The Company periodically amends the plans changing the contribution rate of retirees and amounts of coverage.
Assets available for pension plan benefits include approximately $24.2 and $20.9 million of Company stock at December 31, 1998 and 1997, respectively.
Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plan. A one percentage-point change in the assumed health care cost trend rates would have the following effects:
HSB's Long-Term Incentive Plan grants senior management awards contingent upon achievement of specified performance objectives over a three year period, which may be paid out in cash or shares of common stock (which may be restricted shares). The number of shares subject to issuance under this plan cannot exceed 375,000.
A summary of the status of HSB's stock options as of December 31, 1998, 1997 and 1996 and changes during the years ended on those dates is presented below (1997 and 1996 numbers have been adjusted to reflect the April 1998 stock split - see note 3):
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 Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" with pro forma disclosures of net income and earnings per share as if the fair value based method of accounting had been applied. The Company has elected to continue using the intrinsic value based method. Had the Company elected to recognize compensation cost using the fair value based method, compensation would have been measured at date of grant and recognized over the service period. Pro forma net income and earnings per share would have been imputed as follows for 1998 and 1997:
The rights will separate from the common stock and become exercisable if a person or group acquires ownership of 15 percent or more of the outstanding common stock of the Company or commences a tender or exchange offer to acquire 15 percent or more of the outstanding shares.
The rights expire on November 28, 2008 and may be redeemed by the Company for $0.01 per right any time until the tenth business day following public announcement that a 15 percent position has been acquired.
Shareholders' Equity Common stock 10.0 10.0 Paid in capital 33.5 31.6 Accumulated other comprehensive income 66.8 55.9 Retained earnings 311.2 248.8 Benefit plans (2.2) (1.0) -----------------------------------
HSB GROUP, INC. (Registrant) SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF HSB GROUP, INC. CONDENSED STATEMENTS OF INCOME INFORMATION For the periods ended December 31, (In millions)
Revenues: Net investment income $ 6.4 $ 1.4 Realized investment gains 1.0 - --------------------------------
Financing Activities: Dividends and distribution on capital securities (66.2) (11.9) Net proceeds from issuance of company obligated mandatorily redeemable capital securities - 408.9 Options exercised 9.3 5.5 Reacquisition of stock (47.7) (36.5) Other - 12.6
These condensed financial statements should be read in conjunction with the consolidated financial statements and accompanying footnotes of HSB Group, Inc. (see pages 46 through 78).