For the years ended December 31, 1999 1998 1997 - ------------------------------------------------------------------------ Revenues:
Earnings per share: Income from continuing operations (excluding the gain on sale of IRI) Assuming dilution $ 2.50 $ 2.67 $ 2.20
Income from continuing operations: Basic $ 2.51 $ 3.55 $ 2.21 Assuming dilution 2.50 3.35 2.20
Net income: Basic $ 2.51 $ 4.59 $ 2.21 Assuming dilution 2.50 4.21 2.20 - ------------------------------------------------------------------------
Net income for 1998 included after-tax gains on the sale of HSB's interest in 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 21.1 percent in 1998 compared with 1997 due to increased underwriting profits, improved engineering results and higher net realized gains. Income from continuing operations, excluding the gain on sale of IRI, per common share on a diluted basis increased 21.4 percent in 1998 from 1997.
Engineering services revenue increased 27.9 percent in 1999 and 52.5 percent in 1998. The growth in both 1999 and 1998 was led by additional revenues from our recent acquisitions. Operating margins decreased to 2.5 percent from 7.8 percent in 1998. The investment of operating funds to develop new products and establish start-up operations, and the consolidation of certain businesses coupled with reduced volume and profits in certain of our traditional engineering businesses caused margins to contract from 1998.
The effective tax rate on income from continuing operations before distributions on capital securities for 1999 was 28.2 percent compared to 29.6 percent and 26.8 percent for 1998 and 1997, respectively. 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. Various tax credits (primarily foreign tax credits) also impact the effective rate. The Company continues to manage its use of tax advantageous investments in an attempt to maximize after-tax earnings.
In contemplation of HSB's expanded role in HSB Industrial Risk Insurers, 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 (see note 13). 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. $250 million of the proceeds were contributed to HSBIIC and $50 million were retained by HSB.
On January 2, 1998, HSBIIC exercised its option to put its 40 percent share in Radian LLC to Dow, for approximately $129 million, net of expenses. Radian LLC was formed in January 1996 as a joint venture with Dow to provide environmental, engineering, information technology, remediation and strategic chemical management services to industries and governments worldwide. In connection with the formation of the new company, HSBIIC contributed substantially all of the assets and liabilities of its wholly owned subsidiary, Radian Corporation to Radian LLC. The results of Radian LLC were classified as discontinued operations following ratification in July 1997 by HSB's Board of Directors of management's decision to exercise its put. The after-tax gain of $30.3 million recognized in 1998 is net of deferred losses previously noted. Prior to July 1997, HSBIIC's share of the joint venture's results was recorded as equity in Radian.
On April 21, 1998, the Board of Directors approved a three-for-two stock split for shares of record on May 1, 1998. The additional shares were distributed on May 22, 1998. In accordance with SFAS No. 128, "Earnings per Share," all earnings per share presentations have been adjusted to reflect the impact of the stock split, including retroactive restatement of prior periods.
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.
Loss ratio 43.4% 44.2% 44.4% Expense ratio 51.0% 45.4% 47.3% Combined ratio 94.4% 89.6% 91.7% - ------------------------------------------------------------------------
In 1998, domestic gross earned premiums, excluding the impact of HSB Industrial Risk Insurers, remained flat as a result of the combination of growth in written premiums from our client companies offset by reductions in our domestic special risk premiums. Gross earned premiums representing coverage outside the U.S., exclusive of HSB Industrial Risk Insurers, increased 5.4 percent to $133.5 million.
The insurance industry, in general, continues to undergo significant restructuring and consolidation. Considerable merger and acquisition activity has occurred over the last several years and, with the advent of financial services reform, more contraction 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 approximately 200 multi-line carriers; while over the shorter term, there is both opportunity and challenge.
The Company participates in various facultative, quota share and excess of loss reinsurance agreements to limit its exposure, particularly to catastrophic losses and high-risk lines and to provide additional capacity to write business. The Company 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, as well as the design of its program.
For the years ended December 31, 1999 1998 1997 - ------------------------------------------------------------------------ Provision for claims and adjustment expenses occurring in the current year $ 165.4 $ 164.0 $ 209.5 Increase in estimated claims and adjustment expenses arising in prior years 0.4 10.9 8.4 ------------------------------------- Total incurred claims and adjustment expenses* $ 165.8 $ 174.9 $ 217.9 Loss ratio 43.4% 44.2% 44.4% - ------------------------------------------------------------------------ * Includes approximately $2.0, $5.0 and $3.3 million of subrogation recoveries, respectively.
The loss ratio improved 0.8 percentage points in 1999 from 1998. This improvement was primarily attributable to increased use of reinsurance. The 1999 results were impacted by $10 million of domestic weather-related events and the Taiwan earthquake as well as $10 million in losses related to medical equipment insurance contracts. These insurance contracts represented less than 1 percent of the Company's revenues. The loss ratio decreased 0.2 percentage points in 1998 as compared to 1997. Loss results in 1998 were impacted by severe ice storms in Canada, as well as a few significant losses in our other international businesses. Prior year loss development in 1999, 1998 and 1997 added 0.1, 2.8 and 1.7 percentage points to the respective loss ratio. The components of claims and adjustment expenses, net of reinsurance, are displayed above.
Gross claims and adjustment expenses were $684.7 million in 1999 as compared to $619.6 million in 1998 and $263.1 million in 1997. This increase was the result of weather-related events domestically, the Taiwan earthquake and large losses in our Global Special Risks business, all of which were largely reinsured. The significant increases in claim reserves and reinsurance assets since December 31, 1998 largely relate to these events. In 1998, the increase in gross claims was largely due to the Company's role as direct writer of HSB Industrial Risk Insurers' policies and included 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.
The 1998 expense ratio improvement of 1.9 percentage points over 1997 was primarily related to the new quota share reinsurance agreements and the HSB Industrial Risk Insurers arrangement with ERC, both of which resulted in ceding commissions to HSBIIC that positively impacted our expense ratio by 3.9 percentage points. A portion of such ceding commission was intended to reimburse HSBIIC for the additional costs of managing HSB Industrial Risk Insurers and to offset the reduction in net earned premiums.
Global Special Risks: Net earned premiums $ 45.6 $ 83.6 $ 217.1 Net income 6.7 9.8 10.7 Income taxes 2.3 7.7 6.2 - ------------------------------------------------------------------------
As part of the arrangement with HSB Industrial Risk Insurers, HSBIIC wrote all direct policies for HSB Industrial Risk Insurers and then ceded back these risks 100 percent to HSB Industrial Risk Insurers. HSBIIC then reinsured ERC's 99.5 percent share of the business resulting in the assumption of 85 percent of the equipment breakdown business and 15 percent of the property business. As a result of the termination of the ERC reinsurance agreement and the replacement of the IRI agreement effective January 1, 2000, as
previously discussed, the Company anticipates that Global Special Risks' gross earned and ceded premiums, as well as the fees/expense reimbursement generated from managing the IRI business will continue to decline.
Engineering services revenues increased 27.9 percent in comparison to 1998. The growth in revenues is primarily due to significant increases related to IPT, a full year's integration of the SAI acquisition which occurred in April 1998, the Structural acquisition in July 1999 and EIL's engineering services revenues generated through other acquisitions. In 1998, revenue increases of 52.5 percent were generated by HSBRT; EIL's acquisition of Haughton's engineering in the last quarter of 1997; and the addition of SAI in April 1998.
Operating margins decreased to 2.5 percent from 7.8 percent in 1998. The decline in operating margin from the previous year reflects the investment of operating funds to develop new products and establish start-up operations coupled with reduced volume and profits in certain of our traditional engineering businesses, particularly HSBRT. In addition, the Company recorded a charge of $0.7 million related to costs associated with the consolidation of certain engineering activities. Margins increased 0.8 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 certain acquisitions.
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 in an attempt 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 on a segmented basis. Approximately $300 million (cost basis) of the Company's invested assets (comprised of perpetual and redeemable preferred stocks and corporate bonds) are utilized to provide interest coverage and potential principal repayment over the life of the convertible capital securities issued on December 31, 1997. The remainder of the Company's invested assets, exclusive of cash and cash equivalents, short-term securities and common stocks are invested to provide income for the future. There are three portfolio areas with quite different maturity/call characteristics. The portfolio of traditional bonds of approximately $245 million has an average life of 22 years, with over 50 percent of that portfolio callable in less than ten years. The sinking fund preferred portfolio of $43 million, based on expected calls, has an estimated life of three years. The $52 million adjustable rate preferred stock portfolio, based on expected calls, has an estimated life of five years.
The Company believes the expected cash flows from the Company's operations, maturities and calls are adequate to enable the Company to respond to the previously discussed parameters that impact its investment strategy.
Realized investment gains increased $15.2 million in 1999 as a result of repositioning the investment portfolio due to market fluctuations and to keep the absolute amount of common equities from exceeding a certain targeted percentage of the Company's GAAP capital. In 1998, realized gains increased $11.3 million as a result of call premiums on fixed income investments and sales of certain convertible securities and common stocks in response to market conditions.
In 1997, realized gains were reduced by $30.7 million (all of which were offset by and represented portfolio appreciation and returns that were realized) to reflect the estimated fair value of three "zero cost collar contracts" entered into at the end of 1996 to mitigate the effects of market risk on the Company's 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
The carrying value of the equity securities portfolio represented 41.3 percent of the investments at December 31, 1999. This included $65.3 million of pre-tax unrealized investment gains of which $92.6 million related to common equities, offset by $27.3 million of preferred unrealized investment losses. The Company's common equities, which are comprised of primarily Standard & Poor's 500 (S&P 500) "large cap" stocks, essentially modeled the performance of the S&P 500 Index in 1999. HSB also recorded $22.1 million of dividends and $43.5 million of net pre-tax realized gains from this portfolio in 1999. The Company's largest single holding accounted for less than 1 percent of total consolidated assets. Realized investment gains increased in 1999 over 1998 (and in 1998 over 1997 taking into account the $30.7 million loss on the "zero cost collar contracts") as HSB managed its portfolio to respond to changing market conditions and tax planning opportunities.
Interest rate risk is the major price risk facing the Company's fixed income portfolio. Such exposure can subject the Company to economic losses due to changes in the level or volatility of interest rates. Bond prices change inversely with the direction of interest rates. Generally, as interest rates rise, prices for fixed 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.
Equity market risk is defined as the chance that market influences will affect the expected returns of all equities. Returns are influenced not only by the fundamental attributes of investment securities, but by the price movements of the general marketplace. Much of this depends on the sensitivity of the individual issue
The analysis assumes that the composition of the Company's interest rate sensitive assets and liabilities existing at the beginning of the period remains constant over the period being measured and also assumes that a particular change in interest rates is reflected uniformly across the yield curve regardless of the time to maturity. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Accordingly, the analysis may not be indicative of, is not intended to provide and does not provide a precise forecast of the effect of changes of market interest rates on the Company's income or stockholders' equity. Further, the computations do not contemplate any actions the Company would undertake in response to changes in interest rates.
The sensitivity analysis assumes an instantaneous shift in market interest rates, with scenarios of interest rates increasing and decreasing 100 and 150 basis points from their levels at December 31, 1999 and 1998 with all other variables held constant. The analysis assumes the yield to worst methodology. A 100 and 150 basis point increase in the market interest rates would result in a pre-tax decrease in the net financial instrument position of $50.1 and $38.1 million for 1999 and 1998 and $67.4 and $55.1 million for 1999 and 1998, respectively. Similarly, a 100 and 150 basis point decrease in market interest rates would result in a pre-tax increase in the net financial instrument position of $50.1 and $38.1 million for 1999 and 1998 and $67.4 and $55.1 million for 1999 and 1998, respectively.
Portfolio sensitivity to these variables tends to change over time due to changes in portfolio composition and changes in market environment. For the fixed maturity portfolio, sensitivity, as measured by duration, increased from 5.48 at December 31, 1998 to 8.37 at December 31, 1999. This increase in duration is due primarily to changes that occurred in the interest rate environment during the period. The Company uses a yield to worst methodology to calculate duration. This assumes that an issuer, given the current rate environment, will call higher coupon debt if appropriate. As interest rates increased during the year, the call feature on many issues became non-applicable. This change in the environment caused portfolio duration to increase and a corresponding increase in sensitivity to interest rates.
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, 1999 and 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 $21.4 and $24.9 million increase or decrease in 1999 and 1998 and $53.4 and $62.4 million increase or decrease in 1999 and 1998, respectively, in the net financial instrument position. The Company's equity instruments' sensitivity to equity market risk, as measured by portfolio beta, decreased from 1.02 at December 31, 1998 to 0.98 at December 31, 1999. This change is generally attributed to portfolio repositioning during the period.
The sensitivity analysis also assumes an instantaneous 10 percent and 20 percent change in the foreign currency exchange rates versus the U.S. dollar from their levels at December 31, 1999 and 1998 with all other variables held constant. A 10 percent and 20 percent strengthening of the U.S. dollar would result in decreases of $6.1 and $6.4 million in 1999 and 1998 and $12.2 and $12.4 million in 1999 and 1998, respectively, in the net financial instrument position. Weakening of the U.S. dollar versus all other currencies would result in like increases in the net financial instrument position.
Market Interest Currency Equity At December 31, 1999 Value Rate Risk Risk Risk - -------------------------------------------------------------------------- Fixed maturity securities $ 489.8 $ (37.3) $ (2.6) $ -- Equity securities 381.8 (12.1) (2.0) (21.4) Short-term investments 53.5 (0.7) (1.5) -- ---------------------------------------------- Total all securities $ 925.1 $ (50.1) $ (6.1) $ (21.4) - --------------------------------------------------------------------------
Market Interest Currency Equity At December 31, 1998 Value Rate Risk Risk Risk - ------------------------------------------------------------------------- Fixed maturity securities $ 577.1 $ (27.1) $ (2.1) $ -- Equity securities 437.1 (10.1) (1.9) (24.9) Short-term investments 62.3 (0.9) (2.4) -- -------------------------------------------- Total all securities $1,076.5 $ (38.1) $ (6.4) $ (24.9) - --------------------------------------------------------------------------
Liquidity refers to the Company's ability to generate sufficient funds to meet the cash requirements of its business operations and financing obligations. 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 cash equivalents and a highly liquid short-term portfolio to provide for immediate cash needs and to offset a portion of interest rate risk relating to $110 million of Global Floating Rate Capital Securities. During 1999, HSB received $152.7 million in dividends from HSBIIC and at December 31, 1999 the holding company had $143.2 million of cash and invested assets as compared to $92.8 million at December 31, 1998. Current estimates are that HSBIIC has the capacity to dividend to HSB approximately $80 million in 2000 without regulatory approval.
The Capital Securities are generally non-callable for ten years, but may be called earlier by HSB upon the occurrence of certain tax events including loss of deductibility of interest on the securities. The Capital Securities are mandatorily redeemable upon the maturity of the Debt Securities on July 15, 2027, or earlier to the extent of any redemption by the Company of any Debt Securities. The redemption price in either such case will be $1,000 per share plus accrued and unpaid distributions to the date fixed for redemption.
The securities were issued through HSB Capital II (Trust II), a Delaware business trust created by HSB, at a 7 percent coupon, payable semi-annually. The Convertible Capital Securities rank pari passu with the Global Floating Rate Capital Securities issued in July 1997. Holders of the Convertible Capital Securities will be entitled to receive preferential cumulative cash distributions accumulating from the date of original issuance and payable semi-annually in arrears. HSB has the right to defer payment of interest at any time or from time to time for a period not exceeding 10 consecutive semi-annual periods with respect to each deferral period. During an extension period, interest will continue to accrue and the amount of distributions to which holders of the Convertible Capital Securities are entitled will accumulate, and HSB will be prohibited from paying any cash dividends on its common stock. HSB has irrevocably and unconditionally guaranteed all of Trust II's obligations under the Convertible Capital Securities.
At December 31, 1999, HSBIIC had significant short-term borrowing capacity. HSBIIC is currently authorized to issue up to $75 million of commercial paper. Commercial paper outstanding at December 31, 1999 and 1998 was $38.6 and $20.0 million, respectively. The weighted-average interest rate was 6.0 percent and 5.2 percent at December 31, 1999 and 1998, respectively. In 1999, Standard & Poor's and Duff & Phelps credit rating services reaffirmed their highest ratings for the commercial paper.
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. Year 2000 problems could result in system failures, product failures or miscalculations causing disruptions of operations. If the computer systems, software products and devices do not correctly process dates after December 31, 1999, business could be adversely affected.
As a part of this effort, the Company established a Year 2000 Program to address four key areas: (i) applications software, primarily consisting of the Company's policy management, claims, financial recording and reporting, human resource systems and engineering databases and systems; (ii) infrastructures, such as mainframe and corporate servers, workstations and networking components; (iii) embedded technology in facilities in which the Company conducts its operations and in testing equipment used by the Company's engineering staff; and (iv) key business partners and suppliers. In addition, the Company has evaluated and continues to evaluate its potential insurance coverage exposures arising out of the Year 2000 and its impact on insured equipment.
Subsequent to January 1, 2000, HSB has not encountered any disruptions or anomalies that affected any critical internal system nor experienced any material disruption in its business due to the inability of any of its key business partners and suppliers to deliver information and services due to Year 2000 problems.
The Company's aggregate spending in connection with the Year 2000 Program was approximately $28 million. Certain of these costs were expensed as incurred and funded through operating cash flow. The Company has expensed $6.9, $5.1 and $1.5 million in 1999, 1998 and 1997, respectively. The remainder of the $28 million related to systems that the Company anticipated replacing in the normal course of information technology development but the timetable for which was accelerated in contemplation of the Year 2000 event. Costs of replacement of information systems and infrastructure that would have occurred in the normal course of business without the advent of the Year 2000 event are excluded from these expensed amounts.
Consolidated Statements of Operations for the years ended December 31, 1999, 1998 and 1997. 46
Consolidated Statements of Financial Position - December 31, 1999 and 1998. 48
Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 1999, 1998 and 1997. 51
Schedules other than the ones listed above are omitted for the reason that they are not required or are not applicable or the required information is shown in the financial statements or notes thereto.
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of HSB Group, Inc. and its subsidiaries at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules listed in the accompanying index present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
Financial Statements Consolidated Statements of Operations For the years ended December 31, (in millions, except per share amounts)
1999 1998 - -------------------------------------------------------------------------------- Assets: Cash and cash equivalents $ 73.0 $ 18.3 Short-term investments, at cost 53.5 62.3 Fixed maturities, at fair value (cost - $545.7; $568.5) 489.8 577.1 Equity securities, at fair value (cost - $316.5; $326.3) 381.8 437.1 -------------------------- Total cash and invested assets 998.1 1,094.8 Reinsurance assets 850.3 625.0 Insurance premiums receivable 104.4 146.7 Engineering services receivable 39.1 26.1 Fixed assets 58.2 54.9 Prepaid acquisition costs 52.9 46.6 Capital lease 13.8 14.6 Other assets 146.4 129.9 -------------------------- Total assets $ 2,263.2 $ 2,138.6 -------------------------- Liabilities: Unearned insurance premiums $ 420.1 $ 464.6 Claims and adjustment expenses 782.3 558.2 Short-term borrowings 41.5 21.0 Long-term borrowings 25.1 25.1 Capital lease 27.8 27.9 Deferred income taxes 2.8 42.7 Dividends and distributions on capital securities 24.0 23.2 Ceded reinsurance payable 66.3 64.1 Other liabilities 87.8 83.6 -------------------------- Total liabilities 1,477.7 1,310.4 -------------------------- Company obligated mandatorily redeemable capital securities of subsidiary Trust I holding solely junior subordinated deferrable interest debentures of the Company, net of unamortized discount of $1.0; $1.1 109.0 108.9 Company obligated mandatorily redeemable convertible capital securities of subsidiary Trust II holding solely junior subordinated deferrable interest debentures of the Company 300.0 300.0 Shareholders' equity: Common stock (stated value; shares authorized 50.0; shares issued and outstanding 29.1; 28.9) 10.0 10.0 Additional paid-in capital 36.2 33.5 Accumulated other comprehensive income (1.9) 66.8 Retained earnings 339.1 311.2 Benefit plans (6.9) (2.2) -------------------------- Total shareholders' equity 376.5 419.3 -------------------------- Total $ 2,263.2 $ 2,138.6 -------------------------- Common shareholders' equity per common share $ 12.95 $ 14.53 - -------------------------------------------------------------------------------- The accompanying notes are an integral part of the consolidated financial statements.
Consolidated Statements of Cash Flows For the years ended December 31, (in millions)
Non-cash investing and financing activities: Conversion of HSB convertible preferred stock 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). - -------------------------------------------------------------------------------- The accompanying notes are an integral part of the consolidated financial statements.
Insurance premium revenues are net of reinsurance ceded and are generally earned on a pro rata basis over the contract period. The portion of gross insurance premiums not earned at the end of the period is recorded as unearned insurance premiums on the Consolidated Statements of Financial Position.
Prepaid acquisition costs, consisting principally of commissions, premium taxes and certain underwriting expenses are amortized as the related insurance premiums are earned. Unearned ceded commissions arising from certain reinsurance transactions are netted in prepaid acquisition costs. All other acquisition costs are charged to operations as incurred.
HSB recognizes the majority of its engineering services revenues as the service is provided. Costs on such contracts are included in operations as incurred. Provisions are made for losses on contracts at the time such losses become known.
Cash and cash equivalents include cash on hand and short-term highly liquid investments with maturities of three months or less. Short-term investments have a maturity of one year or less and are carried at cost which, together with accrued interest thereon, approximates fair value. Fixed maturities include bonds, notes and redeemable preferred stocks. Equity securities include common and non-redeemable preferred stocks. All fixed maturities and equity securities are classified as available for sale. Accordingly, these investments are carried at estimated fair value. Estimated fair values of securities classified as available for sale are based principally upon quoted market prices. Unrealized gains and losses on investments classified as available for sale and foreign exchange gains and losses on certain investments in foreign operations where the U.S. dollar is not the functional currency are included net of income tax in shareholders' equity.
The Accounting Standards Executive Committee of the American Institute of Certified Public Accountants (AcSEC) issued three Statements of Position (SOPs) that became effective for fiscal years beginning after December 15, 1998: SOP 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments," SOP 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" and SOP 98-5, "Reporting on the Costs of Start-Up Activities." Because the Company's accounting policies were already in compliance with these SOPs, the implementation of these statements had no impact upon the results of operations, financial condition or cash flows.
In July 1999, The Hartford Steam Boiler Inspection and Insurance Company (HSBIIC) acquired Structural Integrity Associates, Inc. (Structural) based in San Jose, California. Structural is an engineering consulting and inspection services firm specializing in the analysis, control and prevention of structural and equipment failures. It offers a full array of services, from inspection and condition assessment, to monitoring and remaining life analysis, repair, remediation and total risk management of critical equipment and structures.
Concurrent with the termination of the reinsurance agreements, HSBIIC, ERC and IRI replaced the operating agreement dated January 1, 1998. The new agreement, effective January 1, 2000, calls for HSBIIC to retain 0.5 percent membership share in IRI with the ability to increase its total share up to a maximum of 10 percent, at no cost, at HSBIIC's option. In addition, the agreement also establishes an arrangement for HSB to perform engineering and inspection services for clients of IRI and provides for a fixed fronting fee in the event that IRI continues to use HSBIIC's licenses. HSBIIC received payments of $27 million in December 1999 related to the partial settlement of unearned reinsurance premiums and ceding commissions due to HSBIIC under the agreement. Final settlement is expected to occur in the second half of 2000.
To support HSB's expanded role, on December 31, 1997, a business trust formed by HSB sold $300 million of 20 year, 7 percent Convertible Capital Securities in a private placement to ERC (see note 13). These capital securities are convertible into HSB common stock, at any time, subject to regulatory approval, at a conversion price of $56.67 per share. $250 million of the proceeds were contributed to HSBIIC and $50 million were retained by HSB.
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.
1999 1998 1997 - ------------------------------------------------------------------------ Income from continuing Operations $ 72.8 $ 104.1 $ 66.3 Dividends on preferred shares -- -- (1.1) ----------------------------- Income applicable to common stock 72.8 104.1 65.2 Convertible preferred stock -- -- 1.1 After-tax distributions on convertible capital securities (1) 13.7 13.7 -- ----------------------------- Adjusted for diluted Computation $ 86.5 $ 117.8 $ 66.3 - ------------------------------------------------------------------------ Weighted-average common shares outstanding (2) 29.0 29.3 29.5 Convertible capital securities 5.3 5.3 -- Convertible preferred stock -- -- 0.5 Stock options (3) 0.3 0.6 0.2 ----------------------------- Adjusted for diluted Computation 34.6 35.2 30.2 - ------------------------------------------------------------------------ From continuing operations: Earnings per share - basic (4) $ 2.51 $ 3.55 $ 2.21 Earnings per share - assuming Dilution $ 2.50 $ 3.35 $ 2.20 - ------------------------------------------------------------------------
HSB has four reportable segments - Commercial insurance, Global Special Risks 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 Risks 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 offer 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.
The accounting policies of the segments are the same as those described in "Accounting Policies" (see note 1), except for certain benefit charges which comprise the Corporate Account. HSB evaluates the performance of its
segments and allocates resources to them based on net income (loss). Segment assets are not included in this evaluation process. Interest income and expense are included in the results of Investment operations.
HSB's foreign operations (primarily insurance) are widely dispersed such that no country or logical aggregation of countries in a geographic area comprises 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.
For the years ended December 31, 1999 1998 1997 - -------------------------------------------------------------------------- Revenues from continuing operations: U.S. $ 526.1 $ 491.0 $ 483.1 Non-U.S. 80.1 88.2 120.3 ----------------------------------- Total $ 606.2 $ 579.2 $ 603.4 -----------------------------------
Income from continuing operations before taxes and distributions on capital securities: U.S. $ 114.7 $ 168.2 $ 78.4 Non-U.S. 12.0 5.7 15.3 ---------------------------------- Total $ 126.7 $ 173.9 $ 93.7 - --------------------------------------------------------------------------
At December 31, 1999 1998 1997 - -------------------------------------------------------------------------- Identifiable assets: U.S. $ 1,822.8 $ 1,755.9 $ 1,244.7 Non-U.S. 440.4 382.7 292.5 ---------------------------------------- Total $ 2,263.2 $ 2,138.6 $ 1,537.2 - --------------------------------------------------------------------------
Net income (loss): Commercial $ 12.8 $ 14.8 $ 13.4 Global Special Risks 6.7 9.8 10.7 Engineering services 0.7 4.6 3.0 Investments 73.8 65.1 37.7 ------------------------------- Total net income from reportable segments 94.0 94.3 64.8 Other segments (1) (9.4) (0.3) (1.3) Corporate account 6.4 4.7 5.1 Distributions on capital securities (18.2) (18.4) (2.3) Discontinued operations -- 30.3 -- Gain on sale of IRI, net of income taxes -- 23.8 -- ------------------------------- Net income $ 72.8 $ 134.4 $ 66.3 - --------------------------------------------------------------------------------
(1) In 1999, other segments includes an after-tax charge of $6.5 million for losses related to medical equipment insurance contracts.
HSBIIC and its insurance subsidiaries are currently subject to various regulations that limit the maximum amount of dividends available to HSBIIC's parent company without prior approval of insurance regulatory authorities. Under SAP, approximately $80 million of statutory surplus is available for distribution to HSB Group, Inc. in 2000 without prior regulatory approval.
For the years ended December 31, 1999 1998 1997 - ----------------------------------------------------------------------------- Income from Investment Operations: Net investment income: Short-term interest $ 5.0 $ 8.7 $ 6.7 Fixed maturities: Taxable interest 24.7 31.9 9.6 Tax exempt interest 2.0 2.5 2.1 Redeemable preferred dividends 17.3 5.9 7.2 Equity securities: Common dividends 6.5 6.4 4.7 Non-redeemable preferred dividends 15.6 14.0 8.3 Other 2.0 0.2 2.1 ------------------------------ Total investment income 73.1 69.6 40.7 Investment expenses (9.0) (5.4) (3.9) ------------------------------ Net investment income $ 64.1 $ 64.2 $ 36.8
Realized investment gains (losses): Fixed maturities: Bonds: Gains $ 0.3 $ 2.1 $ 0.5 Losses (1.3) (0.2) (0.3) ------------------------------ Net (losses) gains (1.0) 1.9 0.2 Redeemable preferred stocks: Gains 0.7 2.3 0.4 Losses (2.6) (0.1) (0.3) ------------------------------ Net (losses) gains (1.9) 2.2 0.1 Equity securities: Common stocks: Gains 50.7 20.5 48.1 Losses (12.2) (7.0) (5.1) ------------------------------ Net gains 38.5 13.5 43.0 Non-redeemable preferred stocks: Gains 7.8 10.3 7.7 Losses (2.8) (3.1) (0.2) ------------------------------ Net gains 5.0 7.2 7.5 Foreign exchange (losses) gains (0.1) 0.3 (7.4) Collar contracts losses -- -- (30.7) Other gains 0.1 0.3 1.4 ------------------------------ Realized investment gains $ 40.6 $ 25.4 $ 14.1 - ---------------------------------------------------------------------------
There were no material declines in the realizable value of investments considered to be other than temporary for 1999, 1998 and 1997.
At December 31, 1999 1998 1997 - ------------------------------------------------------------------------------- Unrealized Investment Gains, Net of Tax Fixed maturities: Gains $ 2.7 $ 13.0 $ 7.9 Losses (58.6) (4.4) (0.6) ------------------------------- Net (losses) gains (55.9) 8.6 7.3 Equity securities: Gains 103.7 122.9 94.3 Losses (38.4) (12.1) (1.8) ------------------------------- Net gains 65.3 110.8 92.5 Foreign exchange losses (4.7) (6.3) (4.5) ------------------------------- Total unrealized investment gains 4.7 113.1 95.3 Income taxes (3.7) (42.3) (35.5) ------------------------------- Unrealized investment gains, net of tax $ 1.0 $ 70.8 $ 59.8 - -------------------------------------------------------------------------------
- ------------------------------------------------------------------------------ Category Amortized Estimated Gross Gross Cost Fair Unrealized Unrealized Value Gains Losses - ------------------------------------------------------------------------------ Redeemable preferred stocks $214.8 $190.0 $1.6 $26.4 States and municipalities 37.7 36.6 0.6 1.7 Foreign governments 16.5 16.6 0.3 0.2 Corporate and other 276.7 246.6 0.2 30.3 --------------------------------------------- Total fixed maturities $545.7 $489.8 $2.7 $58.6 - ------------------------------------------------------------------------------
- -------------------------------------------------------------------------------- Category Amortized Estimated Gross Gross Cost Fair Unrealized Unrealized Value Gains Losses - ------------------------------------------------------------------------------- Redeemable preferred stocks $215.5 $219.2 $ 5.0 $1.3 States and municipalities 47.4 49.3 2.1 0.2 Foreign governments 21.0 21.3 0.4 0.1 Corporate and other 284.6 287.3 5.5 2.8 ----------------------------------------------- Total fixed maturities $568.5 $577.1 $13.0 $4.4 - -------------------------------------------------------------------------------
- --------------------------------------------------------------------- Maturity Amortized Estimated Cost Fair Value - ---------------------------------------------------------------------- One year or less $ 39.2 $ 38.1 Over one year through five years 51.0 50.5 Over five years through ten years 53.8 52.0 Over ten years 401.7 349.2 -------------------------- Total fixed maturities $ 545.7 $ 489.8 - ---------------------------------------------------------------------
- -------------------------------------------------------------------------------- Gross Gross Estimated Unrealized Unrealized Cost Fair Value Gains Losses - -------------------------------------------------------------------------------- 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 $326.3 $437.1 $122.9 $12.1 - --------------------------------------------------------------------------------
The Company leases its home office facility at One State Street under a long-term capital lease with the One State Street Limited Partnership (Partnership). The lease obligation of $26.1 million was recorded at July 1, 1983 at an interest rate of 15 percent. An asset of $26.1 million was also recorded in 1983. Accumulated amortization on the asset was $12.3 and $11.5 million at December 31, 1999 and 1998, respectively. Terms of the lease require annual minimum lease payments of approximately $4.2 million a year through June 30, 2018. In addition, the Company is required to pay over the lease term a proportional share of the facility's variable operating expenses. This amounted to approximately $2.7, $2.9 and $2.6 million for the years ended 1999, 1998 and 1997, 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 $12.0, $10.2 and $8.4 million in 1999, 1998 and 1997, respectively.
At December 31, 1999, future minimum rental commitments under noncancelable leases accounted for as operating leases with initial or remaining terms of more than one year were as follows:
2000 $ 6.9 2001 6.3 2002 5.7 2003 5.1 2004 3.7 2005 and thereafter 2.1 -------- Total $29.8 --------
The Company writes direct business, which in 1999 and 1998 included HSB Industrial Risk Insurers business, through agencies and brokerage firms. In addition, the Company assumes boiler and machinery exposures from approximately 200 insurance companies and several insurance pools. Under the reinsurance agreements, the Company's reinsured companies may include equipment breakdown exposures in their multi-peril policies, and such risks will be assumed by the Company under the terms of the agreement. These agreements generally provide that the Company will assume 100 percent of each boiler and machinery risk, subject to the capacity specified in the agreement, and will receive the entire equipment breakdown premium except for a ceding commission, which will be retained by the reinsured company for commissions to agents and brokers, premium taxes and handling expenses.
The insurance industry, in general, continues to undergo significant restructuring and consolidation. Considerable merger and acquisition activity has occurred over the last several years and, with the advent of financial services reform, more contraction 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.
The Company utilizes well-capitalized domestic and international reinsurance companies and syndicates for its reinsurance program and monitors their financial condition on an on-going 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.
Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Components of the Company's deferred tax liabilities and assets as of December 31, 1999 and 1998 are as follows: 1999 1998 - ------------------------------------------------------------------------- Deferred tax liabilities: Prepaid acquisition costs $ 19.4 $ 17.1 Depreciation and amortization 9.6 6.2 Pension asset 16.0 14.4 Unrealized investment gains 3.7 42.3 Other 5.1 8.3 ------------------ Total deferred tax liabilities 53.8 88.3 ------------------ Deferred tax assets: Benefit plans 9.0 9.2 Capital lease 4.9 4.7 Unearned insurance premiums 11.8 12.1 Loss reserve discounting and subrogation 7.7 7.0 Other 17.6 12.6 ------------------ Total deferred tax assets 51.0 45.6 ------------------ Net deferred tax liabilities $ 2.8 $ 42.7 - -------------------------------------------------------------------------
HSBIIC has a commercial paper program with a limit of $75 million. Commercial paper outstanding at December 31, 1999 and 1998 was $38.6 and $20.0 million, respectively. The weighted-average interest rate was 6.0 percent and 5.2 percent at December 31, 1999 and 1998, respectively. Commercial paper outstanding at year end 1999
matures on or before March 14, 2000. 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 $25.3 million.
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 $2.4, $2.1 and $1.7 million for 1999, 1998 and 1997, 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'
The following chart summarizes the balance sheet impact, as well as the benefit obligations, assets, funded status and rate assumptions associated with the U.S. pension and postretirement medical benefit plans:
For measurement purposes, the annual rate of increase in the per capita cost of covered health care benefits ranges from 5.0 percent in 1999 decreasing gradually to 4.25 percent by the year 2001 and remaining level thereafter.
Assets available for pension plan benefits include approximately $25.2 and $24.2 million of Company stock at December 31, 1999 and 1998, respectively.
The projected benefit obligation, accumulated benefit obligation and fair value of plan assets for the pension plan with accumulated benefit obligations in excess of plan assets were $37.7, $30.1 and $2.8 million, respectively, as of December 31, 1999 and $36.6, $29.7 and $3.2 million, respectively, as of December 31, 1998.
1% 1% Point Point Increase Decrease - -------------------------------------------------------------------------------- Effect on total of service and interest cost components $ 0.1 $ (0.1) Effect on postretirement benefit obligation 1.2 (1.1) - --------------------------------------------------------------------------------
A stock option award under the HSB's Stock Option Plan allows for the purchase of HSB common stock at no less than the market price on the date of grant. Options granted to date are exercisable no earlier than one year after the
grant date and expire no more than ten years from the date of grant. The number of shares available for delivery under this plan cannot exceed 4.2 million.
A summary of the status of HSB's stock options as of December 31, 1999, 1998 and 1997 and changes during the years ended on those dates is presented below:
The following table summarizes information about stock options outstanding as of December 31, 1999:
SFAS No. 123, "Accounting for Stock Based Compensation" 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 Principals 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:
1999 1998 1997 - ------------------------------------------------------------------------------- Net income As Reported $ 72.8 $ 134.4 $ 66.3 Pro Forma 68.0 131.4 64.5 Earnings per common share - basic As Reported $ 2.51 $ 4.59 $ 2.21 Pro Forma 2.35 4.49 2.15 Earnings per common share - assuming dilution As Reported $ 2.50 $ 4.21 $ 2.20 Pro Forma 2.32 4.12 2.13 - -------------------------------------------------------------------------------
On September 21, 1998, the Board of Directors approved the adoption of a new shareholder rights plan to replace the plan that was set to expire on November 28, 1998. Pursuant to the new plan, which is substantially similar to the old plan, the Board declared a dividend of one right for each outstanding share of common stock to shareholders of record on November 28, 1998.
(2) In the fourth quarter, the assumed conversion of the Company's convertible capital securities is not used in the computation of earnings per share since such inclusion would be antidilutive. Therefore, the quarterly earnings per share will not equal the full year earnings per share.
Schedule II (continued) HSB Group, Inc. (Registrant) Condensed Financial Information of HSB Group, Inc. Condensed Statement of Income Information For the years ended December 31, (in millions)
1999 1998 ------------------------ Revenues: Net investment income $ 9.6 $ 6.4 Realized investment (losses) gains (0.4) 1.0 ------------------------
Income before income taxes and distributions on capital securities 9.2 7.4
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 76).
* Segment assets are not included in management's evaluation and allocation of resources to segments.
** Investment assets are managed by and investment income is allocated to the Company's Investment segment.