See Notes 9 and 13 to Consolidated Financial Statements located in Item 8 of Part II herein for additional information.
The following selected consolidated financial data should be read in conjunction with the consolidated financial statements and notes included elsewhere herein.
Consolidated revenues in 1994 were down 5.1 percent from 1993. Marginal growth in gross premiums, due to selective underwriting, was offset by higher reinsurance costs. Lower net investment income is principally due to a decline in the level of invested assets. In 1994, the Company modified the mix of its investment portfolio to increase its holdings in fixed maturities. Realized gains declined 67 percent from the prior year. Revenues in 1993 were essentially unchanged from 1992.
In November 1988, California voters passed Proposition 103 requiring premium rollbacks on certain policies then in effect to 20 percent below the rates that were in effect in November 1987. Upon challenge in the courts, the California Supreme Court, in 1989, held that insurers could not be deprived of a fair and reasonable return and subsequently, in 1991, emergency regulations were issued by the regulators which, among other things, defined a "fair and reasonable rate of return." The Company and a number of other insurers successfully challenged the regulations in Los Angeles Superior Court and, in February 1993, the Court issued a decision enjoining the enforcement of the emergency regulations. The decision was appealed to the California Supreme Court, which in August 1994, ruled in favor of the California Insurance Department and upheld the regulations. The Company continues to maintain its position that the rollback formula is constitutionally defective and that a fair rate of return cannot be arbitrarily capped; however, based upon this most recent ruling, the Company established a reserve in the third quarter of $2.9 million. It should be noted that the California Supreme Court decision is the subject of a petition for certiorari presently pending before the United States Supreme Court.
The effective tax rate for 1994 was 29 percent compared to 22 and 23 percent for 1993 and 1992, respectively. The difference is primarily due to the change in the mix between fully taxable earnings and tax preferred investment income.
expenses related to Hurricane Andrew. The components of claims and adjustment expenses, net of reinsurance, were as follows:
Claims and adjustment expense reserves comprise one of the largest liabilities on the Company's Statements of Financial Position. Reserves are established to reflect the Company's estimates of total losses and loss adjustment expenses that will ultimately be paid under direct and assumed insurance contracts. Loss reserves include claims and adjustment expenses on claims that have been reported but not settled and those that have been incurred but not yet reported to the Company. The length of time that reserves are carried on the Statements of Financial Position is a function of the pay-out patterns associated with the types of coverages involved. The majority of risks the Company insures are short-tailed in nature, relative to the property/casualty industry as a whole, meaning they are generally settled shortly after claims are reported. The Company's loss reserve estimates reflect such variables as past loss experience and inflation. In addition, due to the nature of much of the Company's coverages, complex engineering judgments are involved. Subjective judgments are an integral component of the loss reserving process, due to the nature of the variables involved. Previously established loss reserves are regularly adjusted as loss experience develops and new information becomes available. Adjustments to previously established reserves are reflected in the financial statements in the period in which the estimates are changed.
Failures of some insurance companies in recent years have caused increased interest and concern on the part of both the public and regulators. Various state laws require the Company to participate in guaranty associations, which pay policyholders' claims in the event of an insurer's insolvency, and certain joint underwriting associations, which provide insurance for particular classes of insureds when insurance in the voluntary market is unavailable. The increase in insurer insolvencies and the unprecedented level of catastrophes in recent years have resulted in higher assessments against the Company from the associations in which it participates.
*Includes $63.1 million resulting from the consolidation of EIG, Co. **At December 31, 1992, prior to the adoption of SFAS 115, fixed maturities were carried at amortized cost.
*Includes $100.9 million resulting from consolidation of EIG, Co. **Includes $22.6 million resulting from the consolidation of EIG, Co. ***Includes $24.1 million resulting from consolidation of EIG, Co.
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 its insurance and engineering operations, and maintains a highly liquid investment portfolio. The Company manages its cash and short- term investment position to meet its operating expense and claim payment needs. In addition, the Company has capacity to generate liquidity through its short-term commercial paper program. This program has a limit of $75 million. At December 31, 1994, $26.7 million was outstanding. Commercial paper outstanding is primarily used to fund engineering services operations. The Company currently has no significant capital commitments planned for 1995.
Cash provided by operating and investing activities was used to pay dividends, repay short-term borrowings, and repurchase Company stock. The Company repurchased 147,486; 229,992 and 350,354 shares of its common stock in 1994, 1993 and 1992, respectively.
As part of HSB's strategic planning process the Company will assess its capital structure to ensure that appropriate capital is available to grow its core business.
The NAIC is currently working on a model investment law which would provide guidelines for insurers in structuring their investment portfolios. These guidelines are intended to preserve principal, assure diversification as to investment, issuer and credit quality, and promote prudent investment management strategies to ensure companies are positioned to cover reasonably foreseeable contingencies. The guidelines are expected to be effective sometime after 1995.
Consolidated Statements of Operations for the years ended December 31, 1994, 1993 and 1992.
Consolidated Statements of Financial Position - December 31, 1994 and 1993.
Consolidated Statements of Cash Flows for the years ended December 31, 1994, 1993 and 1992.
Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 1994, 1993 and 1992.
We have audited the consolidated statements of financial position of The Hartford Steam Boiler Inspection and Insurance Company and its subsidiaries as of December 31, 1994 and 1993, and the related consolidated statements of operations, cash flows and changes in shareholders' equity for each of the three years in the period ended December 31, 1994, which financial statements are listed in the Index to Financial Statements and Financial Statement Schedules (Index) of this Form 10-K. We have also audited the financial statement schedules listed in the Index of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of The Hartford Steam Boiler Inspection and Insurance Company and its subsidiaries as of December 31, 1994 and 1993, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1994, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein.
Acquisition of EIG through issuance of EIG, Co. preferred stock of $20 million in 1994.
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 gross of amounts recoverable from reinsurers and are reduced for estimated amounts of salvage and subrogation, and deductibles recoverable from customers. 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 and inflation, and require complex engineering judgments. Due to the nature of the variables involved in the reserving process, subjective judgments are an integral component. Previously estimated reserves are regularly adjusted as loss experience develops and new information becomes available. Since reserves are based on estimates, the ultimate liability may be more or less than such reserves. The effects of changes in such estimated reserves are included in the results of operations in the period in which the estimates are changed. See Note 11. The Company records subrogation when recoverability is probable, such as when a judgment is returned, liability is admitted to or settlement is reached. In previous years, the Company had exposure to environmental loss through participation in certain insurance pools. Those liabilities were settled in early 1994.
Reinsurance recoverable represents amounts due from reinsurers for paid and unpaid claims and adjustment expenses through ceded reinsurance agreements.
ENGINEERING SERVICES. The Company recognizes the majority of its engineering services revenues as the service is provided, net of related subcontract costs of $21.5, $24.6 and $33.7 million in 1994, 1993 and 1992, respectively. Revenues from contracts are recognized on the percentage-of-completion method; costs on such contracts are included in operations as incurred. Provisions are made for losses on contracts at the time such losses become known.
The carrying values of short-term investments, investment income accrued and securities transactions in the course of settlement approximate their fair value because of the relatively short period of time between origination of the instruments and their expected realization.
INCOME TAXES. Deferred income taxes are provided for unrealized appreciation on fixed maturities and equity securities available for sale, prepaid acquisition costs, certain employee benefit obligations, and other items which are the result of temporary differences in the treatment of such items for tax and financial statement purposes. Deferred tax assets and liabilities are generally determined based on the difference between financial statement and tax bases for certain assets and liabilities using tax rates in effect for the year in which the differences are expected to reverse. Deferred tax assets are allowed if future realization is more likely than not.
FIXED ASSETS. Fixed assets are carried at cost less accumulated depreciation. Depreciation is calculated on the basis of estimated useful lives using straight-line and accelerated methods. Upon retirement or replacement, any gain or loss is included in operations.
As discussed in Note 1, the Company adopted SFAS 115 in 1993.
In 1993, the Company adopted Statement of Financial Accounting Standards No. 112 (SFAS 112), "Employers Accounting for Postemployment Benefits" with retroactive application to January 1, 1993. The adoption of SFAS 112 resulted in a non-cash, after-tax charge of $3.6 million or $0.17 per share. This charge was recognized as the cumulative effect of a change in accounting in the Consolidated Statements of Operations.
In 1992, the Company adopted Statement of Financial Accounting Standards No. 106 (SFAS 106), "Employers Accounting for Postretirement Benefits Other Than Pensions" with retroactive application to January 1, 1992. Under SFAS 106 the expense for these benefits was $2.7, $2.3 and $2.0 million for 1994, 1993 and 1992, respectively. Prior to 1992 these costs were expensed as claims were paid. See Note 16.
In December 1994, the Company acquired the remaining 50% interest in Engineering Insurance Group (EIG), a partnership which was jointly formed by the Company and General Reinsurance Corporation (Gen Re) in 1988. The partnership is the parent of Engineering Insurance Company Limited, a London-based insurer formed in 1989 principally to offer machinery breakdown coverage to business and industry outside the United States and Canada. Coincident with the December 1994 acquisition, the partnership was incorporated with the Company acquiring all outstanding common shares and Gen Re acquiring preferred shares of the new company, EIG, Co. The Company has accounted for this transaction as a purchase resulting in the recording of assets and liabilities acquired at fair value, and goodwill of $15.9 million, which will be amortized over 15 years. The Company's interest in EIG, Co. has been fully consolidated in the Consolidated Statements of Financial Position at December 31, 1994. Prior to this acquisition, the Company's 50% ownership in EIG had been accounted for under the equity method. Accordingly, the results of operations for all periods presented have been reflected under the caption, "Equity in operations of insurance association," in the Consolidated Statements of Operations.
In September of 1993, the Company recorded a $20 million charge for the cost of restructuring its insurance and engineering services businesses. Restructuring costs include severance and other costs related to planned staff reductions and charges related to a realignment of the Company's operations. At December 31, 1994, $1.5 million of restructuring liability remains on the books requiring payments through 1996.
The Company operates three principal businesses -- insurance, engineering services and investments. Revenues, expenses and receivables are shown for these segments in the Company's financial statements. The Company does not allocate assets between business segments because the allocations would be immaterial.
The Company derives approximately 10 percent of its revenues from contracts with various agencies and departments of the U.S. government.
The following presents financial data of the Company based on geographic location:
* Includes $100.9 million resulting from consolidation of EIG, Co. See Note 3.
Annual statements for state insurance regulatory authorities are currently prepared using an accounting method prescribed or permitted by such authorities (statutory basis). Statutory accounting practices (SAP) differ in certain respects from GAAP. With respect to the Company's financial statements, these differences consist primarily of the accounting for prepaid acquisition costs, deferred income taxes, certain non-insurance affiliates and employee benefit plans. At year-end 1994 and 1993, policyholders' surplus on a statutory basis was $238.0 and $259.2 million, respectively. Consolidated statutory net income for 1994, 1993 and 1992 was $38.6, $19.7 and $41.8 million, respectively.
The Company is currently subject to various regulations that limit the maximum amount of dividends available to shareholders without prior approval of insurance regulatory authorities. Under SAP, $37.9 million of statutory surplus is available for distribution to shareholders in 1995 without prior regulatory approval.
In December 1993, the NAIC adopted the property and casualty risk based capital (RBC) formula that will allow regulators to more closely monitor insurers with weak or deteriorating financial positions and take regulatory action under certain conditions. The RBC formula for property and casualty companies monitors elements of risk defined as underwriting risk, invested assets risk, credit risk and off-balance sheet risk. Property and casualty insurers are required to report the results of the formula for the first time in their l994 statutory filings. The Company expects to meet RBC requirements.
Realized investment gains and losses for 1994 included $1.5 million of losses on common stocks arising from declines in the realizable value of investments considered to be other than temporary.
*The Company adopted SFAS 115 at December 31, 1993. See Notes 1 and 2.
The amortized cost, estimated fair values (based principally upon quoted market prices) and gross unrealized gains and losses of fixed maturities at December 31 were as follows:
The Company held no derivative financial instruments in its investment portfolio at December 31, 1994 and 1993. The Company sells covered call options, at times, to protect against adverse changes in market values. Premiums received on options written are deferred and recognized as a component of gross realized gains when the option contracts are exercised or expire. During 1994 and 1993, aggregate premiums received by the Company on covered call options amounted to $.5 and $.6 million, respectively. Net gains recognized on sales of underlying instruments amounted to $1.0 and $2.5 million for 1994 and 1993, respectively. Generally the duration of covered call options written by the Company does not exceed thirty days.
The following table provides a reconciliation of the beginning and ending reserves for claims and adjustment expenses, net of reinsurance recoverables.
A reconciliation of the net liability to the gross liability for claims and adjustment expenses is as follows:
At December 31, 1994, no valuation allowance was established as realization of deferred tax assets was determined to be more likely than not through taxable income from prior years available for carryback.
Deferred income taxes on the Consolidated Statements of Financial Position include a provision for taxes on net unrealized investment gains. Federal income tax returns for the years 1993, 1992 and 1991 are open to examination by the Internal Revenue Service. If examined, no significant tax adjustments are anticipated.
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 $15.1, $14.7 and $14.5 million in 1994, 1993 and 1992, respectively.
During 1994, the Company borrowed on a short-term basis through its commercial paper program which has a limit of $75 million. Commercial paper outstanding at December 31, 1994 and 1993 was $26.7 and $42.6 million, respectively. Current maturities of long-term debt at December 31, 1994 included $24.1 million recorded as a result of the Company's acquisition of the remaining interest in EIG. See Note 3. This debt matures in 1995 and bears interest at an average rate of 9.4%. Long-term borrowings mature on or before December 31, 2001.
The pension expense for the U.S. pension plans was a net credit to earnings for 1994, 1993 and 1992 due to the over-funded status of the primary plan. The components of the credit were as follows:
The following table represents a reconciliation of the U.S. plans funded status and the amounts recognized in the Company's statements of financial position at December 31:
The following table sets forth the amounts recognized in the Consolidated Statements of Financial Position at December 31, in accordance with SFAS 106:
In 1989, the Company established a Restricted Stock Plan for non- employee Directors of the Company. Stock awards are made on the date of the annual meeting to each Director elected or continuing in office. The maximum number of restricted shares which may be granted under the Plan is 20,000 shares of common stock. Under this plan, 1,935, 1,413 and 1,740 shares of restricted stock were granted in 1994, 1993 and 1992, respectively.
The Company has an Employee Stock Ownership Plan (ESOP) which is administered through the Hartford Steam Boiler Inspection and Insurance Company Leveraged Employee Stock Ownership Plan Trust (the Trust). In 1985, the Trust borrowed $15 million from commercial lenders at 9.57 percent and purchased 1,142,856 newly issued shares of the Company's common stock (adjusted to reflect stock splits since that date). The loan matures in 1995. The Company guaranteed the loan, and the shares held in the Trust are pledged as collateral. At December 31, 1994, the Trust held approximately 200,000 shares of stock not allocated to employees.
Contributions made by the Company, plus the dividends on the unallocated shares held by the Trust, are used to make principal and interest payments of approximately $2.4 million per year over the 10-year term. Shares are allocated to the account of each participant with one or more years of service, based on salary, and become fully vested after five years of service.
*Certain amounts have been reclassified to reflect treatment of commissions on reinsurance treaties.
(a) Engineering Services Receivable written off as uncollectible. Allowance for Assumed Reinsurance Accounts Receivable