See Notes 8 and 9 to Consolidated Financial Statements located in Item 8 of Part II herein for additional information.
(1) Excludes revenues from investments accounted for under the equity method. (2) Includes gain on sale of IRI and Radian LLC. (3) Reflects the repurchase of approximately 0.1, 1.2, 1.5, 0.4 and 0.2 million shares in 1999, 1998, 1997, 1996 and 1995, respectively.
Income from continuing operations (excluding the gain on sale of IRI) $ 72.8 $ 80.3 $ 66.3
Income from continuing operations for 1999, excluding the 1998 gain on sale of Industrial Risk Insurers (IRI) discussed below, decreased $7.5 million or 9.3 percent from 1998. The decline in after-tax earnings was primarily due to reduced underwriting profits as well as a decline in the engineering services operating gain. The impact of these items was partially offset by higher income from investment operations, virtually all of which resulted from increased net realized gains in 1999. Excluding the gain on sale of IRI, income from continuing operations per common share on a diluted basis decreased 6.4 percent in 1999 as compared to 1998.
In comparison to 1998, the major contributors to the reduction in pre-tax earnings (exclusive of realized gains) were: increased information systems costs (including Year 2000 remediation costs) of $8 million; reduced profits from HSB Industrial Risk Insurers of $7 million; change in management and other expenses related to consolidation and relocation of certain businesses of $5 million; and $3 million of reduced margins in certain engineering businesses.
Total revenues grew 4.7 percent in 1999 as compared to a decline of 4.0 percent in 1998. The increase in 1999 was attributable to growth in engineering services as well as strong realized investment gains offset by a reduction in net earned premiums. Gross earned premiums grew 6.9 percent in 1999 and 26.5 percent in 1998. In 1999, much of this increase was attributable to the continued growth in our commercial book of business as well as a full year's earnings related to the 1998 acquisition of the Kemper book noted in the Other Developments section of this Management's Discussion and Analysis (MD&A).
The combined ratio for the Company increased to 94.4 percent in 1999 from 89.6 percent in 1998. In 1997, the combined ratio was 91.7 percent. The 1999 ratio was adversely impacted by the increase in the expense ratio from 45.4 percent in 1998 to 51.0 percent in 1999.
Income from investment operations increased 16.9 percent in 1999 primarily as a result of increased realized investment gains from 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 Generally Accepted Accounting Principles (GAAP) capital. Net investment income grew 74.5 percent in 1998 from the investment of proceeds from the sales of IRI and Radian LLC and the issuance of capital securities in the second half of 1997.
Contemporaneous with the close of the 1998 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 was renamed HSB Industrial Risk Insurers. In 1999 and 1998, HSBIIC wrote the business for HSB Industrial Risk Insurers using its insurance licenses and provided certain other 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 in 1998 and retained 85 percent of the equipment breakdown insurance and 15 percent of the property insurance of the combined insurance portfolio. This agreement was the largest contributing factor in the growth of both gross earned premium and ceded premium. As a result, in both 1999 and 1998 transactions arising from this agreement comprise a significant
portion of the reinsurance asset, unearned insurance premiums and ceded reinsurance payables reflected in the Consolidated Statements of Financial Position.
In June 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities" subsequently amended by SFAS No. 137. This statement establishes 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 the Company for the first quarter of 2001. Based on the Company's current investment policies and practices, the Company anticipates that the adoption of the provisions of SFAS No. 133 will not have a significant effect on results of operations, financial condition or cash flows.
In July 1999, 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.
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 written as part of Kemper's commercial package policies.
For the years ended December 31, 1999 1998 1997 - ------------------------------------------------------------------------ Gross earned premiums $ 823.8 $ 770.5 $609.3 Ceded premiums 441.9 374.4 118.1 ------------------------------------ Insurance premiums $ 381.9 $ 396.1 $491.2
Claims and adjustment expenses 165.8 174.9 217.9 Underwriting, acquisition and other expenses 194.8 180.0 233.5 ------------------------------------ Underwriting gain $ 21.3 $ 41.2 $ 39.8
Gross earned premiums in 1999 increased 6.9 percent over 1998. Much of this growth was attributable to the integration of certain commercial books of business acquired in mid-1998; growth in our client company business and a full year of writing HSB Industrial Risk Insurers policies utilizing the Company's licenses. In 1998, a portion of HSB Industrial Risk Insurers policies in-force were written/renewed utilizing the licenses of other insurers. The increases in gross premiums were offset by premium declines in certain operations within Global Special Risks. In some areas of the Company's direct businesses, the market continued to experience price erosion in 1999 as the number of insurers offering capacity expanded. HSB
The increase in ceded premiums of 18.0 and 217.0 percent in 1999 and 1998, respectively, was primarily due to the HSB Industrial Risk Insurers arrangement and related reinsurance with ERC, as well as the increasing effect of the Company's reinsurance programs which over the past three years have utilized significantly more quota share reinsurance on certain of our books of business. Due to changing reinsurance market conditions and the impact of the new IRI agreement effective January 1, 2000, the Company is in the process of evaluating and redesigning its current reinsurance programs that will place less reliance on quota share reinsurance. The Company anticipates this will lead to a reduced level of ceded premiums.
Due to the new agreement with IRI, coupled with a decline in our Global Special Risks segment, gross earned premiums are expected to decline in 2000. However, anticipated changes in the utilization of reinsurance may cause ceded premiums to decline at a higher rate than gross earned premiums for 2000.
Claims and adjustment expense reserves comprise one of the largest liabilities on the Company's Consolidated Statements of Financial Position. Reserves are established to record 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.
Although reported claim activity has been negligible at this time, quantification of the Company's exposure to Year 2000 losses and loss adjustment expenses are not reasonably estimable as applicable policy and reinsurance contract wordings have not been legally tested in the context of such losses.
For the years ended December 31, 1999 1998 1997 - ------------------------------------------------------------------------ Commercial: Net earned premiums $ 335.2 $ 306.3 $ 269.0 Net income 12.8 14.8 13.4 Income taxes 7.2 4.6 6.1
The Commercial business has shown strong revenue growth year over year despite significant price competition as HSB continues to focus on its client company strategy. Net earned premiums in the Commercial segment rose $28.9 and $37.3 million in 1999 and 1998, respectively, due primarily to the integration of the Kemper portfolio and growth in our client company business, offset by declines in direct writings. In 1999, domestic operations posted an underwriting gain at a lower margin than 1998 due to the increased expense ratio. International operations posted an improved underwriting gain as 1998 was more severely impacted by weather-related claims. In 1998, 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 to decline from 1997.
Global Special Risks net earned premiums declined $38.0 million in 1999. This decrease relates primarily to increased ceded premiums related to the HSB Industrial Risk Insurers business. In addition, price erosion and maintenance of strict underwriting standards, coupled with changes in reinsurance programs, contributed to the decline in 1999. In 1998, net earned premiums decreased $133.5 million primarily due to the increased use of reinsurance and the arrangement with HSB Industrial Risk Insurers. Global Special Risks net income decreased in 1999 primarily as a result of the declining book. In 1998, the international businesses were impacted by adverse claims experience as compared to 1997. In 1998, income taxes as a percentage of net income increased as a result of a decreased use of foreign tax credits.
For the years ended December 31, 1999 1998 1997 - ------------------------------------------------------------------------ Engineering services Revenues $119.6 $ 93.5 $ 61.3 Engineering services Expenses 116.6 86.2 57.0 ----------------------------------- Operating gain $ 3.0 $ 7.3 $ 4.3 Operating margin 2.5% 7.8% 7.0% - ------------------------------------------------------------------------
Engineering services operations include the results of HSBIIC's, EIL's and BI&I's engineering services, HSB Reliability Technologies (HSBRT), HSB Professional Loss Control, HSB International, SAI, Structural and the Company's interest in Integrated Process Technologies, LLC (IPT).
In July 1999, HSBIIC acquired Structural based in San Jose, California. Structural is an engineering consulting firm that specializes in prevention, control and repair of structural and mechanical failures. The Company continues to focus on identifying and evaluating acquisition candidates in the niche engineering management consulting service business, primarily in process industries, in order to expand or complement its engineering service capabilities.
For the years ended December 31, 1999 1998 1997 - --------------------------------------------------------------------------- Net investment income $ 64.1 $ 64.2 $ 36.8 Realized investment gains 40.6 25.4 14.1 ---------------------------------- Income from investment operations $ 104.7 $ 89.6 $ 50.9 Total cash and invested assets, at fair value $ 998.1 $1,094.8 $ 996.7 Unrealized gains, pre-tax $ 4.7 $ 113.1 $ 95.3 - ---------------------------------------------------------------------------
The Company's investment strategy is 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, servicing requirements of capital securities and market conditions. The
Net investment income for 1999 remained flat compared to 1998 and increased $27.4 million in 1998 as 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 sale of HSB's interests in IRI and Radian LLC significantly increased investable funds. 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. Net investment income has also been impacted by calls of high yielding preferred stocks.
Through its U.K. subsidiary, EIL, the Company writes business in Malaysia and is required to maintain ringgit denominated investments based on the level of premiums written in Malaysia. At December 31, 1999, 1998 and 1997, the Company's deposits were 20, 29 and 50 million ringgits, respectively. This equated to $5.1, $7.1 and $12.8 million at December 31, 1999, 1998 and 1997, respectively. In 1997, due to currency fluctuation in Southeast Asia, realized investment gains were negatively impacted by $7.4 million.
securities. At the end of 1999, HSB's fixed maturities portfolio comprised 52.9 percent of the value of the invested assets. The credit quality of HSB's bond investments at December 31, 1999, 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, 1999 had a fair value of $299.8 million. Redeemable preferred stocks averaged a BBB rating. During 1999 bond yields continued to move up, the impact of which has caused a reduction in the Company's unrealized gains with respect to fixed income securities by approximately $64.5 million pre-tax.
For purposes of this disclosure market risk sensitive instruments are 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.
to the overall market. The Company attempts to reduce this risk through diversification and a focus on high quality, blue chip investments.
Foreign exchange risk arises from the possibility that changes in foreign currency exchange rates will adversely impact the value of financial instruments. The Company has foreign exchange exposure when it buys or sells foreign currencies or financial instruments denominated in a foreign currency. The Company's foreign transactions are primarily denominated in Canadian 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 in 1999 and 1998 and $0.5 million in 1999 and 1998. The effect of 100 and 150 basis point increases in interest rates on the $300 million convertible capital securities would result in an estimated market value of $247.6 and $296.4 million in 1999 and 1998, and $237.0 and $289.4 million in 1999 and 1998, respectively, 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 in 1999 and 1998 and $1.6 million in 1999 and 1998, respectively, per year. A 100 and 150 basis point decrease in interest rates would increase pre-tax income by $1.1 million in 1999 and 1998 and $1.6 million in 1999 and 1998, respectively, per year.
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 100 basis points, a 10 percent decline in the S&P 500 Index and a decline of 10 percent in foreign currency exchange rates.
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.
Market Interest Currency Equity At December 31, 1999 Value Rate Risk Risk Risk - ------------------------------------------------------------------------- Fixed maturity securities $ 489.8 $ (49.1) $ (5.2) $ -- Equity securities 381.8 (17.2) (4.1) (53.4) Short-term investments 53.5 (1.1) (2.9) -- --------------------------------------------- Total all securities $ 925.1 $ (67.4) $ (12.2) $ (53.4) - --------------------------------------------------------------------------
Market Interest Currency Equity At December 31, 1998 Value Rate Risk Risk Risk - ------------------------------------------------------------------------- Fixed maturity securities $ 577.1 $ (39.4) $ (4.2) $ -- Equity securities 437.1 (14.4) (3.7) (62.4) Short-term investments 62.3 (1.3) (4.5) -- -------------------------------------------- Total all securities $1,076.5 $ (55.1) $ (12.4) $ (62.4) - --------------------------------------------------------------------------
At December 31, 1999 1998 - ------------------------------------------------------------------------ Total assets $2,263.2 $2,138.6 Short-term investments 53.5 62.3 Cash and cash equivalents 73.0 18.3 Short-term borrowings 41.5 21.0 Long-term borrowings 25.1 25.1 Capital securities of subsidiary Trust I 109.0 108.9 Capital securities of subsidiary Trust II 300.0 300.0 Common shareholders' equity $ 376.5 $ 419.3 - ------------------------------------------------------------------------
The Debt Securities represent all of the assets of the trust. The proceeds from the issuance of the Debt Securities were used by the Company for general corporate purposes. The Debt Securities and related income statement effects are eliminated in the Company's consolidated financial statements. The $113.4 million principal amount of Debt Securities accrue and pay cash distributions quarterly in arrears at a variable rate equal to the 90 day LIBOR plus 0.91 percent of the stated liquidation amount of $1,000 per Debt Security and are scheduled to mature on July 15, 2027.
The Capital Securities accrue and pay cash distributions quarterly in arrears at a variable rate equal to the 90 day LIBOR plus 0.91 percent of the stated liquidation amount of $1,000 per Capital Security. The current coupon is 7.1 percent. HSB has the right to defer payment of distributions on the securities at any time or from time to time for a period not exceeding 20 consecutive quarterly 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 Capital Securities are entitled will accumulate, and the Company will be prohibited from paying any cash dividends on its common stock.
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 per share, 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. If ERC were to exercise its conversion rights in total, it would hold at December 31, 1999, on a fully diluted basis, approximately 15.4 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 increased $29.5 million in 1998 as compared to 1997. Insurance operations cash flows, excluding HSB Industrial Risk Insurers, were impacted by a decline in net claims paid of 2.9 percent while premiums collected increased 6.5 percent. Payments to reinsurers for ceded premiums increased 70.5 percent from 1997. HSBIIC's participation in HSB Industrial Risk Insurers positively impacted cash flow from operations $35.3 million.
Capital resources consist of shareholders' equity, capital securities and debt outstanding and represent those funds deployed, or available to be deployed, to support business operations. Common shareholders' equity of $376.5 million at December 31, 1999 decreased $42.8 million since December 31, 1998. The decrease primarily reflects net income of $72.8 million and net stock issuance of $7.7 million, offset by a decrease in unrealized investment gains, net of tax, of $69.8 million and dividends of $49.9 million. The decrease in unrealized investment gains of $69.8 million results principally from realized gains of $26.4 million and unrealized depreciation of fixed maturities and non-redeemable preferreds of $63.2 million, the sum of which is offset by net unrealized appreciation of common stocks and convertible preferreds of $18.0 million.
On January 24, 2000, the Board renewed the authorization to repurchase up to 3 million shares of common stock. HSB repurchased approximately 0.1, 1.2 and 1.5 million shares at a cost of $4.4, $47.7 and $54.0 million during 1999, 1998 and 1997, respectively.
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 did not result in a substantial change in the business or a significant increase in costs. In part, this is due to the fact that much of EIL's business is U.S. dollar denominated. Also, the U.K. is not a
first wave euro country. The Company will continue to monitor developments and assess impacts on markets, pricing and reporting.
The Company has completed all stages of its Year 2000 Program: (i) assessment and analysis; (ii) development, renovation and replacement; (iii) implementation; (iv) testing and validation; (v) contingency planning; and (vi) audit and review.
The Company continues to monitor information systems and transaction processing with the objective of identifying and correcting any undetected errors of omission or commission which may have occurred in the execution of its Year 2000 Program.
The Company continues to evaluate the potential coverage exposures arising out of the Year 2000 event and its impact on insured equipment. The Company had filed with the various jurisdictions an endorsement to its equipment breakdown forms which reiterated that coverage was 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 was included in policies in all states that approved the endorsement. In the four jurisdictions that did not approve the endorsement, a notice reiterating the Company's coverage intent with respect to Year 2000 exposures was sent to policyholders. The Company filed a similar endorsement for use with its all-risk policy. Many of the insurers that the Company reinsures for equipment breakdown coverage issued similar endorsements to their policies.
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, in particular the passage of financial services reform legislation; 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 new agreement with IRI; 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, 1999, 1998 and 1997. 47
Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998 and 1997. 49
Schedule I - Summary of investments- other than investments in related parties 77
Schedule II - Condensed Financial Information of HSB Group, Inc. 78
Consolidated Statements of Financial Position At December 31, (in millions, except per share amounts)
Consolidated Statements of Changes in Shareholders' Equity For the years ended December 31, (in millions)
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.
Goodwill represents the cost of acquiring a business which is in excess of the fair value of its net assets. Goodwill is generally amortized over 3 to 20 years and other intangible assets over their estimated useful lives. These assets are included in other assets on the Consolidated Statements of Financial Position and amounted to $56.7 and $57.7 million (net of accumulated amortization of $12.5 and $5.5 million) at December 31, 1999 and 1998, respectively. HSB evaluates the realizability of goodwill based upon projections of undiscounted 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 SOP became effective for financial statements for fiscal years beginning after June 15, 1999. Currently the Company is not party to any contracts that 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 SOP 98-7 will have a material impact on results of operations, financial condition or cash flows.
The reinsurance agreements effective January 1, 1998 between HSBIIC, Employers Reinsurance Corporation (ERC) and Industrial Risk Insurers (IRI), as discussed below, were terminated with respect to loss or liabilities arising out of occurrences taking place on or after January 1, 2000. As a result, HSBIIC will no longer retain 85 percent of the equipment breakdown insurance and 15 percent of the property insurance of the combined insurance portfolio for risks arising on or after January 1, 2000. The joint underwriting association that was known as HSB Industrial Risk Insurers will, from January 1, 2000, be known as Industrial Risk Insurers (IRI).
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 had been renamed HSB Industrial Risk Insurers. In 1999 and 1998, HSBIIC wrote the business for HSB Industrial Risk Insurers using its insurance licenses and provided 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 retained 85 percent of the equipment breakdown insurance and 15 percent of the property insurance of the combined insurance portfolio.
As of December 31, 1997, Radian LLC had assets of $159.7 million, liabilities of $88.4 million, revenues of $288.0 million and expenses of $314.0 million. As of December 31, 1997, HSBIIC's interest in Radian LLC was 40 percent.
(1) See note 13. (2) Weighted-average shares reflect the repurchase of approximately 0.1, 1.2 and 1.5 million shares in 1999, 1998 and 1997, respectively. (3) Includes the dilutive effect of stock options computed using the treasury stock method and shares issuable under deferred stock awards (see note 15). (4) Represents income applicable to common stock divided by weighted-average common shares outstanding.
For the years ended December 31, 1999 1998 1997 - -------------------------------------------------------------------------------- Revenues from continuing operations: Insurance premiums: Commercial $ 335.2 $ 306.3 $ 269.0 Global Special Risks 45.6 83.6 217.1 Engineering services 119.6 93.5 61.3 Net investment income and realized investment gains 104.7 89.6 50.9 ------------------------------- Total revenues from reportable segments 605.1 573.0 598.3 Other segments 1.1 6.2 5.1 ------------------------------- Total revenues $ 606.2 $ 579.2 $ 603.4 -------------------------------
Specified items included in the measure of net income for reportable segments are as follows:
For the years ended December 31, 1999 1998 1997 - ------------------------------------------------------------------------------ Depreciation and amortization expense: Commercial $ 9.9 $ 7.3 $ 3.4 Global Special Risks 2.1 2.2 3.2 Engineering services 8.1 5.9 2.7 Investments 0.4 0.3 --
Income tax expense: Commercial 7.2 4.6 6.1 Global Special Risks 2.3 7.7 6.2 Engineering services 0.4 1.6 0.1 Investments 27.6 22.5 10.3 - ------------------------------------------------------------------------------
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 adopted by the Connecticut Insurance Department.
Fixed Maturities 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:
- -------------------------------------------------------------------------------- Gross Gross Estimated Unrealized Unrealized Cost Fair Value Gains Losses - -------------------------------------------------------------------------------- Common stocks $128.6 $221.2 $100.5 $ 7.9 Non-redeemable preferred stocks 187.9 160.6 3.2 30.5 ----------------------------------------------- Total equity securities $316.5 $381.8 $103.7 $38.4 - --------------------------------------------------------------------------------
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). 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 included price appreciation of approximately $54 million) and had a price movement correlation with the S&P 500 Index well in excess of 80 percent.
The collar subjected the Company to market and counterparty credit risk. The Company managed this exposure by frequently modeling the effects of potential future price movements on the value of the collar and HSB's portfolio and by entering into contracts with internationally recognized financial institutions, which were expected to perform under the terms of the contract, and by evaluating the credit worthiness of such institutions by taking into account credit ratings and other factors.
At December 31, 1999 1998 - ------------------------------------------------------------------------------ Land and buildings $ 4.9 $ 5.1 Furniture, equipment, leasehold improvements and other 72.8 68.0 Systems development costs 32.5 23.9 --------------------- 110.2 97.0 Less accumulated depreciation and amortization (52.0) (42.1) --------------------- Total fixed assets $ 58.2 $ 54.9 - ------------------------------------------------------------------------------
Property and equipment are stated at cost. Depreciation expense is computed using straight-line and accelerated methods over the estimated useful lives of 31.5 years for buildings and 3 to 10 years for equipment and furniture. Leasehold improvements are amortized over the shorter of the assets' useful lives or their remaining contractual lease terms.
The Company has a policy of capitalizing certain systems development costs. Systems development costs are amortized over estimated useful lives of 3 to 10 years. In 1998, approximately $6.5 million of systems development costs related to the allocation of purchase price for SAI.
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. 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 amounts, and are being capitalized in accordance with the Company's existing capitalization policy.
For the years ended December 31, 1999 1998 1997 - ------------------------------------------------------------------------- Written premiums: Direct $ 416.6 $ 478.2 $ 361.4 Assumed 363.3 318.5 257.1 Ceded (413.2) (444.1) (120.0) ----------------------------------- Net written premiums $ 366.7 $ 352.6 $ 498.5 Earned premiums: Direct $ 452.8 $ 408.8 $ 370.1 Assumed 371.0 361.7 239.2 Ceded (441.9) (374.4) (118.1) ----------------------------------- Insurance premiums $ 381.9 $ 396.1 $ 491.2 - -------------------------------------------------------------------------
In 1999 and 1998, HSBIIC was the direct writer of business written on behalf of HSB Industrial Risk Insurers. This business was ceded to that entity and HSBIIC's share of the equipment breakdown and property business was 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 and 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.
For 1999 approximately 26 percent of the Company's gross written premium, which includes HSB Industrial Risk Insurers, was produced by J&H Marsh & McLennan and Sedgwick Group.
As a property insurer, the Company is subject to losses that may arise from catastrophic events. The Company participates in various facultative, quota share and excess of loss reinsurance agreements to limit its exposure, particularly to catastrophic losses, and to provide additional capacity to write business. In the unlikely event that ceded reinsurers are unable to meet their obligations, the Company would continue to have primary liability to policyholders for losses incurred. Reinsurance recoverable on unpaid claims and the unearned portion of ceded reinsurance premiums are reported as assets, rather than netted against the related liability accounts. 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." The Company recorded $503.4, $444.7 and $45.2 million of reinsurance recoveries as a reduction of its claims and adjustment expenses for the years ended December 31, 1999, 1998 and 1997, respectively. Reinsurance recoverable on paid claims and adjustment expenses was $22.9 and $14.6 million at December 31, 1999 and 1998, respectively.
At December 31, 1999 1998 1997 - -------------------------------------------------------------------------- Net liability for claims and adjustment expenses $ 156.1 $ 169.7 $ 190.8 Reinsurance recoverable on unpaid claims and adjustment expenses 626.2 388.5 85.9 ------------------------------- Gross liability for claims and adjustment expenses $ 782.3 $ 558.2 $ 276.7 - --------------------------------------------------------------------------
The following table displays information concerning the primary participants in the Company's current reinsurance program as of December 31, 1999:
Reinsurer Ceded Written Reinsurance 1999 A.M. Best's Premium Asset Rating - -------------------------------------------------------------------------------- Employers Reinsurance Corporation* $ 141.5 $ 292.6 A++ (Superior) General Reinsurance Corporation 39.7 83.5 A++ (Superior) Scottsdale Insurance Company 5.3 29.1 A+ (Superior) Gerling-Konzern Globale 10.9 22.4 n/a Hartford Fire Insurance Company 10.6 21.8 A+ (Superior) Terra Nova Insurance Company LTD 7.7 18.4 n/a Mid Ocean Reinsurance Company 7.8 17.3 n/a NAC Reinsurance Corporation 7.0 16.5 A+ (Superior) Frankona Ruckversicherungs AG 6.4 15.7 n/a Lloyds 376 JHV 9.9 15.6 n/a - ----------------------------------------------------------------------------- * Net of business assumed by HSB from ERC
is in the $50 million excess of $100 million layer. No individual syndicate has more than 7.2 percent participation in any of the excess layers. In addition, certain syndicates participate in three of our quota share treaties, aggregating 10.6, 12.7 and 82.9 percent in each of the three treaties. Lloyd's participation in our catastrophe cover is 71.4 percent with no individual syndicate retaining more than 6.7 percent. The Company's reinsurance asset in the aggregate from over 100 Lloyd's syndicates, excluding the syndicate disclosed above, is 12 percent of shareholders' equity at December 31, 1999. Lloyd's has historically participated more heavily in the higher treaty layers.
The Company is involved in various 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.
U.S. federal tax return examinations have been completed for years through 1995. The Company believes adequate provisions for income tax have been recorded for all years.
On July 15, 1997, a trust sponsored and wholly owned by the Company issued $110 million aggregate liquidation amount of capital securities in a private placement and 3,403 shares of common securities to the Company, the proceeds of which were invested by the trust in $113.4 million aggregate principal amount of the Company's debt securities. On November 5, 1997, an exchange offer was commenced, pursuant to which the capital securities originally issued in the private placement were exchanged for capital securities that were registered with the Securities and Exchange Commission (the Capital Securities) and the debt securities were exchanged for debt securities that were registered with the Securities and Exchange Commission (the Debt Securities).
The terms of the Debt Securities, the guarantee of the Company with respect to the Capital Securities, the Indenture and the Trust Agreement together provide a full guarantee of amounts due on the Capital Securities. The Capital Securities are currently rated BBB- by Standard & Poor's and BBB+ by Duff & Phelps credit rating agencies.
On December 31, 1997, HSB Group, Inc. 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 HSB 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 HSB 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 HSB common stock at a conversion price of $56.67 per share, 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. If ERC were to exercise its conversion rights in total, it would hold at December 31, 1999, on a fully diluted basis, approximately 15.4 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.
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 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.
The components of accumulated other comprehensive income (net of income taxes) are as follows:
Total Accumulated Unrealized Minimum Other Gains Pension Foreign Comprehensive on Liability Exchange Income Securities Adjustment Losses - -------------------------------------------------------------------------------- Balances at December 31, 1997 $ 55.9 $ 62.4 $ (3.9) $(2.6) Current period change 10.9 12.1 (0.1) (1.1) - ------------------------------------------------------------------------------- Balances at December 31, 1998 $ 66.8 $ 74.5 $ (4.0) $(3.7) Current period change (68.7) (71.6) 1.1 1.8 - ------------------------------------------------------------------------------- Balances at December 31, 1999 $ (1.9) $ 2.9 $ (2.9) $(1.9) - -------------------------------------------------------------------------------
contributions to these plans vary, based upon retiree's age, years of service and coverage elected. The Company periodically amends the plan changing the contribution rate of retirees and amounts of coverage.
Assumed health care cost trend rates have an 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 restricted stock is an award of common shares that may not be sold or transferred during the restriction period, usually three years under the Stock Option Plan and five years under the Long-Term Incentive Plan, from the date on which the award is granted. During the restriction period, the employee is the registered owner, receives dividends and may vote the restricted shares. Compensation expense is based on the market value of the Company's common stock at the date of grant and is recognized over the period of the restriction. Compensation expense for this benefit was $3.7, $1.0 and $0.6 million in 1999, 1998 and 1997, respectively. The unamortized compensation expense related to this plan is included in benefit plans as a component of shareholders' equity. These amounts were $6.9 and $2.2 million in 1999 and 1998, respectively.
1999 1998 1997 - --------------------------------------------------------------------------- Restricted shares awarded 222,227 54,434 30,594 Weighted-average fair value of shares on grant date $ 36.08 $ 39.86 $ 31.93 - ---------------------------------------------------------------------------
1999 1998 1997 - ------------------------------------------------------------- Risk-free interest rate 5.0% 4.9% 6.3% Expected life 6 years 6 years 6 years Expected volatility 22.2% 15.7% 15.8% Expected dividend yield 4.7% 4.7% 5.0% - -------------------------------------------------------------
Each right entitles a holder to purchase one two-hundredth of a share of Series A Junior Participating Preferred Stock, without par value at an exercise price of $162.00 per share, subject to adjustment. If an acquirer obtains 15 percent or more of the Company's common stock and the Board of Directors determines that such acquisition is not in the best interest of the shareholders, the rights of shareholders other than the acquirer will entitle the holder to purchase common shares of the Company (or, under certain circumstances, of the acquirer) at a 50 percent discount. Under the plan ERC will not be deemed an acquirer in the event of the conversion of the Convertible Capital Securities it holds into common stock of the Company unless it acquires one percent or more additional shares.
The rights expire on November 28, 2008 and may be redeemed by the Company for $.01 per right any time until the tenth business day following public announcement that a 15 percent position has been acquired.
(1) Fourth quarter results reflect pre-tax charges of $5 million related to change in management costs and consolidation and relocation of certain businesses as well as $7 million in losses related to medical equipment insurance contracts.
Schedule I HSB Group, Inc. Summary of investments - other than investments in related parties At December 31, (in millions)
Schedule II HSB Group, Inc. (Registrant) Condensed Financial Information of HSB Group, Inc. Balance Sheet Information At December 31, (in millions)
Distributions on capital securities of subsidiary trusts, net of income taxes of $9.8 and $9.9 18.2 18.4
Schedule II (continued) HSB Group, Inc. (Registrant) Condensed Financial Information of HSB Group, Inc. Condensed Statement of Cash Flows Information For the years ended December 31, (in millions)
* Dividends received from The Hartford Steam Boiler Inspection and Insurance Company were $152.7 million and $56.1 million in 1999 and 1998, respectively.