The Hartford Steam Boiler Inspection and Insurance Company leases approximately 233,145 square feet for its home office at One State Street, Hartford, Connecticut under a long-term capital lease with One State Street Limited Partnership. In addition to its home office facility, the Company leases facilities for its branch offices and subsidiaries throughout the United States, and in a small number of foreign locations. The Company considers the office facilities to be suitable and adequate for its current and anticipated level of operations.
(1) All per share data has been restated to reflect stock splits.
Net income in 1994 showed significant improvement from the prior two years. The current year's results were driven by higher margins in insurance operations resulting, in part, from the Company's program of reunderwriting its book of business and focusing on more profitable contracts. Engineering services also showed improvement as expense reduction initiatives, begun in 1993, were realized. Overall results in 1993 were negatively impacted by a $20 million restructuring charge, significant strengthening of claims reserves and increased costs of reinsurance.
On December 30, 1994, the Company acquired the remaining 50 percent interest in Engineering Insurance Group (EIG) from General Reinsurance Corporation (Gen Re). EIG is the parent of Engineering Insurance Company Limited, a London based insurer which offers machinery breakdown coverage to business and industry outside the United States and Canada. Concurrent with the acquisition, EIG was incorporated and the Company received all the common shares outstanding of EIG, Co. (the newly formed company) while Gen Re acquired preferred shares with a value of $20 million. The acquisition was accounted for as a purchase and accordingly, the results of operations for all periods presented do not include those of EIG other than for the equity in earnings related to the 50 percent interest previously owned.
Insurance operations include the insurance results of The Hartford Steam Boiler Inspection and Insurance Company (HSB) and The Boiler Inspection and Insurance Company of Canada (BI&I).
The marginal growth in gross insurance premiums was largely attributable to the Company's major reunderwriting program, which began in early 1993. The goal of that program was to significantly improve insurance profitability through application of aggressive, sound underwriting principles to both the existing book of business and new business opportunities. The Company's focus on improved risk selectivity and the insistence upon appropriate terms, conditions and pricing, had the anticipated effect of slowing the growth in gross insurance premiums, especially in what continued to be a soft property/casualty market. Overall volume growth was impacted negatively by the reunderwriting effort and only partially offset by price increases. In addition, many customers responded to economic and competitive pressures by selecting programs with higher deductibles to offset the effective price increases. Higher deductibles have contributed to slower premium growth over the past few years.
New business growth over the past several years has been largely attributable to growth in the reinsurance assumed book of business. In 1994, 41 percent of the Company's net written premium was derived from assumed reinsurance, up from 38 percent in 1993 and 36 percent in 1992. HSB assumes business from a number of insurance companies and associations with no one ceding entity providing more than 16 percent of the total assumed premium.
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. Unprecedented levels of catastrophic losses in the last few years (such as Hurricane Andrew, two California earthquakes and Midwest floods) have led to a dramatically tightened world-wide reinsurance market. Combined with HSB's own loss experience in prior years, this situation has led to much higher reinsurance ceded premiums, which has negatively impacted net insurance premiums. In 1994, the Company's reinsurance ceded costs increased 54 percent while gross premiums rose by 1 percent resulting in net insurance premiums decreasing 3.6 percent from 1993. In addition, in order to mitigate the cost of existing excess of loss treaties, in 1994, HSB accepted a higher retention which could affect future claim levels. Facultative reinsurance costs were also higher for the year.
Claims and adjustment expenses decreased $55.9 million in 1994 compared with an increase of $26.7 million in 1993. Claim costs in 1994 include $4.8 million of losses relating to the California earthquake. The 1993 claims and adjustment expense includes catastrophic losses of $5.3 million for winter storms and $6.8 million for Midwest floods as well as the previously noted reserve strengthening. In 1992, $15 million of claims and adjustment
The 1994 loss ratio was 42.5 percent compared to 57.1 percent and 50.3 percent for 1993 and 1992, respectively. The improvement in 1994 is largely attributable to the reunderwriting efforts which began in 1993. In 1993 and 1992, adverse development of prior year reserves was attributable to the settlement of certain large losses for which the Company initially determined it would not have liability; the settlement of some outstanding claims for more than was originally anticipated; unusually late notice of loss provided by the insured for several large losses; and reserves established for losses on which the coverage was being contested. At December 31, 1994, the amount recoverable from reinsurers on paid and unpaid claims and adjustment expenses was $44.9 million compared to $44.5 million in 1993 and $39.9 million in 1992.
The insurance industry, in general, is undergoing a significant shake-out and consolidation. Significant merger and acquisition activity has occurred, more has been announced, and still more is anticipated in the future. HSB is positioned to benefit from these changes over the long term due to its strong market position and reinsurance relationships with more than 100 multi-line carriers; while over the shorter term there is both opportunity and challenge. 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.
Engineering services operations include the results of HSB's and BI&I's engineering services, Radian Corporation, HSB Reliability Technologies, HSB Professional Loss Control and HSB International.
Consolidated engineering services operating gain was $18.2 million, a 54.2 percent increase over the 1993 gain of $11.8 million. This also compares favorably to the 1992 gain of $14.7 million. The 1994 gain, a record profit for the Company, was achieved as a result of the cost reduction program which began in 1993, the sales of certain unprofitable business operations and more focus on higher margin business. Net revenues for 1994 were level with 1993 and 1992 while margins increased over the three-year period. Both price and volume remained relatively constant from the prior year.
Radian Corporation, the Company's environmental services subsidiary, accounted for the majority of the change in engineering services results. In 1994, Radian's results improved as they undertook cost control measures and improved staff utilization. Radian also reduced expenses through consolidation of international offices.
The Company's investment strategy continues to be to maximize total return on the investment portfolio over the long term through investment income and capital appreciation. Net investment income declined 11 percent in 1994 and 8 percent in 1993. The decreases in both years resulted from a lower average investment portfolio as equity holdings were liquidated to meet cash flow requirements. Cash was used to pay dividends, repay debt and to purchase fixed assets and treasury stock. With the addition of EIG, Co.'s investments and reductions in equity securities holdings, the mix of the portfolio has shifted to a more even distribution between fixed maturities and equity securities.
In 1993, the Company adopted SFAS 115 and determined that all fixed maturities and equity securities are available for sale and, consequently, they are carried at estimated fair value. Prior to 1993, fixed maturities were carried at amortized cost and classified as held to maturity. The Company's investment portfolio continues to consist of high grade investments. At December 31, 1994, the Company's fixed maturities portfolio comprised 41 percent of total invested assets. The credit quality of the Company's bond investments at December 31, 1994, averaged a AA rating. Excluding the bonds held by EIG, Co., 85 percent of the bond portfolio was investment grade (BBB or better). EIG, Co.'s bond holdings consisted of Euro notes and bank bonds with 60 percent of the portfolio rated A or better and the remainder nonrated. The Company's portfolio does not include any bonds in default as to either principal or interest. Bonds held at December 31, 1994, had an average yield of 7.8 percent and fair value of $135.0 million. Redeemable preferred stocks averaged a BBB rating and had a yield of 8.7 percent. The fair value of these investments was $63.9 million at year end.
The carrying value of the equity securities portfolio represented 42 percent of total investments at December 31, 1994. The Company recorded $11.8 million of dividends and $6.7 million of net realized gains from this portfolio in 1994. Also included in realized losses in 1994 is $1.5 million in losses on common stocks arising from declines in the realizable value of investments considered to be other than temporary. The Company's largest single holding accounted for less than 1.0 percent of total assets.
Cash provided from operations was $40.3 million in 1994 compared to $53.3 million in 1993 and $63.3 million in 1992. The decline in cash provided from operations in 1994 is due to lower premiums received, higher paid claims (which relate primarily to claims incurred in prior years), and higher expenses paid. Cash outflows include payments for restructuring initiatives begun late in 1993.
Dividends paid by the Company are limited by state insurance regulations. The current restriction is the greater of 10 percent of statutory surplus or prior year's net income as reported to the regulatory agencies. Currently the Company can pay $37.9 million in dividends in 1995 without requesting regulatory approval. Due to the Company's strong financial position, regulatory approval was received for the payment of 1994 dividends.
In December 1993, the National Association of Insurance Commissioners (NAIC) adopted the property and casualty risk based capital (RBC) formula. RBC will be used by regulators as an early warning tool to identify insurers with weak or deteriorating financial positions requiring further regulatory attention or the initiation of regulatory action. The RBC formula monitors elements of risk defined as underwriting risk, invested asset risk, credit risk and off-balance sheet risk. Property and casualty insurers are required to report the results of the formula for the first time in their 1994 statutory filings. The Company expects to meet RBC requirements.
Regulator concerns about the consistency and comparability of statutory accounting practices (SAP) has prompted the NAIC to undertake a codification project which will replace prescribed or permitted SAP as the regulatory basis of accounting for insurance companies. Conversion to new statutory accounting standards is expected to be required for years beginning after 1995.
Schedule I - Summary of Investments - 	 Other than Investments in Related Parties
We conducted our audits in accordance with generally accepted auditing standards. Those standards 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 2 to the consolidated financial statements, the Company changed its method of accounting for postemployment benefits, accounting for investments in debt and equity securities, and accounting and reporting for reinsurance during 1993 and its method of accounting for postretirement benefits other than pensions in 1992.
CONSOLIDATION. The accompanying financial statements present the consolidated accounts of The Hartford Steam Boiler Inspection and Insurance Company and its subsidiaries (collectively, the Company) and are prepared in accordance with generally accepted accounting principles (GAAP). Significant intercompany transactions and balances have been eliminated in consolidation. Certain amounts from prior years have been reclassified to conform to the 1994 presentation.
INSURANCE. Insurance premiums are net of reinsurance ceded and are 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. Unearned ceded premiums are recorded as prepaid premiums and included in Other assets on the Consolidated Statements of Financial Position.
Prepaid acquisition costs, consisting of commissions and premium taxes, are amortized as the related insurance premiums are earned. All other acquisition costs are charged to operations as incurred.
INVESTMENTS. Short-term investments have a maturity of one year or less and are carried at cost which approximates fair value. Fixed maturities include bonds, notes and redeemable preferred stocks. Equity securities include common and non-redeemable preferred stocks. At December 31, 1993, the Company adopted Statement of Financial Accounting Standards No. 115 (SFAS 115), "Accounting for Certain Investments in Debt and Equity Securities." The Company determined that all fixed maturities and equity securities should be 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. The adoption of this statement resulted in an increase in the carrying value of fixed maturity investments of $8.2 million and an increase in Shareholders' equity of $5.3 million, net of related deferred taxes at December 31, 1993.
GOODWILL AND OTHER INTANGIBLE ASSETS. Goodwill is generally amortized over 15 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 $22.9 and $3.9 million at December 31, 1994 and 1993, respectively. See Note 3. The Company evaluates the realizability of goodwill based upon projections of non-discounted cash flows of the related subsidiary.
In 1993, the Company also adopted Statement of Financial Accounting Standards No. 113 (SFAS 113), "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts." All amounts on the Consolidated Statements of Financial Position were reclassified accordingly. The adoption of SFAS 113 had no impact on net income.
These unaudited pro forma results are not necessarily indicative of the results of operations that would have occurred had the acquisition taken place at the beginning of each period, or of future operations of the combined companies.
The cost, estimated fair values (based principally upon quoted market prices) and gross unrealized gains and losses of equity securities at December 31 were as follows:
The Company writes direct business through agencies and brokerage firms. In addition, the Company assumes boiler and machinery exposures from over 100 insurance companies and several insurance pools. A significant amount of this assumed book is underwritten by the Company. 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. 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 113. The Company recorded $31.0 and $43.3 million of reinsurance recoveries as a reduction of its claims and adjustment expenses during the years of 1994 and 1993, respectively. Reinsurance recoverable on paid claims and adjustment expenses was $6.8 and $1.4 million at December 31, 1994 and 1993, respectively.
The 1993 and 1992 claims and adjustment expenses included adverse development of prior years' reserves. The adverse development of the 1992 and 1991 year-end reserves was attributable to the settlement of certain large losses for which the Company initially determined it would not have liability, the settlement of some outstanding claims for more than was originally anticipated, unusually late notice of loss provided by the insured for several large losses, and reserves established for losses on which the coverage is being contested. The adverse development of the 1991 year-end reserve was also impacted by two large December losses.
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, 1994 and 1993 are as follows:
The Company owns the One State Street land and leases it to the One State Street Limited Partnership. The Company receives a base rental for the land and a participation in the cash flow of the Partnership. The Company has a right of first refusal should the Partnership decide to sell the facility. If the Company does not exercise its right of first refusal, it will receive 65 percent of the net sale proceeds.
At December 31, 1994, minimum rental commitments under noncancelable leases accounted for as operating leases with initial or remaining terms of more than one year were as follows:
The benefits payable under the Company's pension plans are based on a combination of years of service and compensation level. Generally, vesting occurs if a plan participant has at least five years of service or meets other criteria. Assets available for plan benefits include approximately $13.4 million of Company stock at December 31, 1994.
The Company made contributions to the plans in 1994 as claims were incurred. Contributions totaled $2.3, $1.8 and $1.4 million for the years ended December 31, 1994, 1993 and 1992, respectively. At December 31, 1994, 1993 and 1992 these plans were unfunded. Retirees' 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.
The health care cost trend rate assumption has a significant effect on the amount reported. To illustrate, increasing the assumed health care cost trend rates by 1 percent each year would increase the accumulated postretirement benefit obligation as of January 1, 1994 of $29.4 million by approximately $1.9 million and the aggregate of the service and interest cost for the year ended December 31, 1994 by $.1 million.
The Company's restricted stock is an award of common shares that may not be sold or transferred during the restriction period, usually three years, 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 plan in 1994, 1993 and 1992 was $2.2, $3.3 and $4.0 million, respectively. The unamortized compensation expense related to this plan is included in Benefit plans as a component of Shareholders' equity. These amounts were $1.4 and $3.0 million in 1994 and 1993, respectively.
A stock option award under the Company's stock option plan allows for the purchase of the Company's 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 seven years from the date of grant. Information with respect to restricted stock and stock options follows:
The loan is reported as a liability, and the cost of unallocated shares related to the ESOP is included under Benefit plans as a component of Shareholders' equity. At December 31, 1994 and 1993, respectively, the ESOP loan was $1.7 and $3.7 million, respectively. The cost of unallocated shares was $1.1, $2.6 and $4.1 million in 1994, 1993 and 1992, respectively.
The rights will separate from the common stock and become exercisable if a person or group acquires ownership of 20 percent or more of the outstanding common stock of the Company, commences a tender or exchange offer to acquire 20 percent or more of the outstanding shares, or if any person or group has become the beneficial owner of an amount of common stock which the Board determines to be substantial and not in the best interest of the shareholders.