SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
/x/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1997
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number 001-13135
HSB GROUP, INC.
(Exact name of registrant as specified in its charter)
CONNECTICUT 06-1475343
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
P.O. BOX 5024, ONE STATE STREET,
HARTFORD, CONNECTICUT 06102-5024
(Address of principal executive offices) (Zip Code)
(860) 722-1866
(Registrant's telephone number, including area code)
Not applicable
(Former name, former address and former
fiscal year, if
changed since the last report.)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
The number of shares outstanding of the registrant's common stock without par
value, as of September 30, 1997: 19,151,742
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HSB GROUP, INC.
INDEX
PART I FINANCIAL INFORMATION PAGE
Consolidated Statements of Operations for the
Quarters Ended September 30, 1997 and 1996 (unaudited)................. 3
Consolidated Statements of Financial Position as
of September 30, 1997 (unaudited) and December 31, 1996................ 4
Consolidated Statements of Cash Flows for the
Nine Months Ended September 30, 1997 and 1996
(unaudited)............................................................ 5
Notes to Consolidated Financial Statements (unaudited)................. 6
Management's Discussion and Analysis of
Consolidated Financial Condition and Results
of Operations......................................................... 12
PART II OTHER INFORMATION
Item 1 - Legal Proceedings............................................... 20
Item 6 - Exhibits and Reports on Form 8-K................................ 22
SIGNATURES............................................................... 23
2
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<TABLE>
HSB GROUP, INC.
Consolidated Statements of Operations
Unaudited
(in millions, except per share data)
Quarter Nine Months
Ended September 30 Ended September 30
Revenues: 1997 1996 1997 1996
---------- ---------- --------- --------
<CAPTION>
<S> <C> <C> <C> <C>
Insurance premiums $ 121.3 $ 113.8 $ 360.9 $ 335.1
Net engineering services 15.5 14.0 45.2 40.8
Net investment income 9.1 7.6 25.8 23.5
Realized investment gains 2.3 2.5 6.2 8.5
----------- ---------- --------- --------
Total revenues 148.2 137.9 438.1 407.9
----------- ---------- --------- --------
Expenses:
Claims and adjustment 54.1 54.5 157.0 155.4
Policy acquisition 23.5 21.4 67.5 63.9
Underwriting and inspection 34.2 34.2 105.5 102.3
Net engineering services 14.5 12.4 42.3 36.0
Interest 0.4 - 0.9 0.4
----------- ---------- ---------- ---------
Total expenses 126.7 122.5 373.2 358.0
----------- ---------- ---------- ---------
Income from continuing
operations before income
taxes and distributions
on capital securities $ 21.5 $ 15.4 $ 64.9 $ 49.9
Income taxes:
Current 14.2 3.2 26.8 13.6
Deferred (8.9) 0.3 (10.3) (1.9)
----------- ---------- ---------- ---------
Total income taxes $ 5.3 $ 3.5 $ 16.5 $ 11.7
Distribution on capital
securities of subsidiary trust,
net of taxes 1.0 - 1.0 -
----------- ---------- ---------- ---------
Income from continuing operations $ 15.2 $ 11.9 $ 47.4 $ 38.2
Discontinued operations:
Income from operations of Radian
International LLC net of income
taxes of $0.0; ($0.1); $0.0; and $2.8 - (0.3) - 3.8
----------- ---------- ---------- ---------
Net income $ 15.2 $ 11.6 $ 47.4 $ 42.0
=========== ========== ========== =========
Net income per common share:
Income from continuing operations $ 0.76 $ 0.59 $ 2.35 $ 1.88
Discontinued operations - (0.01) - 0.19
------------ ---------- ---------- ---------
Net income $ 0.76 $ 0.58 $ 2.35 $ 2.07
============ ========== ======== =========
Dividends declared per common share $ 0.60 $ 0.57 $ 1.74 $ 1.71
Average common shares outstanding
and common stock equivalents 19.9 20.1 20.1 20.2
See Notes to Consolidated Financial Statements.
</TABLE>
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HSB GROUP, INC.
Consolidated Statements of Financial Position
(In millions, except per share data)
September 30, December 31,
1997 1996
(Unaudited)
--------- --------
Assets:
Cash $ 6.6 $ 4.5
Short-term investments, at cost 133.3 97.9
Fixed maturities, at fair value
(cost -$239.3; $231.3) 247.6 235.8
Equity securities, at fair value
(cost - $231.5 $182.9 ) 325.8 262.7
---------- --------
Total cash and invested assets 713.3 600.9
Insurance premiums receivable 126.8 106.4
Engineering services receivable 12.9 11.7
Fixed assets 28.4 31.7
Prepaid acquisition costs 45.5 40.6
Capital lease 15.5 16.1
Investment in Radian 85.0 79.7
Reinsurance assets 146.4 162.9
Other assets 82.9 66.3
---------- --------
Total assets $ 1,256.7 $ 1,116.3
========== ========
Liabilities:
Unearned insurance premiums $ 295.8 $ 270.6
Claims and adjustment expenses 278.8 302.9
Short-term borrowings 18.0 3.2
Long-term borrowings 25.1 25.1
Capital lease 27.9 27.9
Deferred income taxes 21.1 23.7
Dividends payable 13.3 11.4
Other liabilities 127.3 85.9
---------- --------
Total liabilities 807.3 750.7
---------- --------
Convertible redeemable preferred stock-
Series B (stated and redemption
value; shares authorized, issued
and outstanding .002) 20.0 20.0
Company obligated mandatorily redeemable
capital securities of subsidiary
trust holding solely junior
subordinated deferrable interest
debenture of the Company, net of
discount of $1.1 million 108.9 -
Shareholders' equity:
Common stock (stated value; shares
authorized 50.0; shares issued
21.3; shares outstanding 19.2; 20.0) 10.0 10.0
Additional paid-in capital 30.7 32.0
Unrealized investment gains, net of tax 63.4 52.8
Retained earnings 221.2 255.1
Benefit plans (4.8) (4.3)
---------- ---------
Total shareholders' equity 320.5 345.6
---------- ---------
Total $ 1,256.7 $ 1,116.3
========== =========
Shareholders' equity per common share 16.73 17.25
See Notes to Consolidated Financial Statements.
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HSB Group, Inc.
Consolidated Statements of Cash Flows
(in millions)
Nine Months Ended
September 30
--------------------------
1997 1996
----------- -----------
Operating activities:
Net income $ 47.4 $ 42.0
Adjustments to reconcile net income to
cash provided by operating activities:
Depreciation and amortization 5.1 7.8
Deferred income taxes (10.0) (1.9)
Realized investment gains including
market adjustment for derivative
investments (6.2) (8.5)
Change in:
Insurance premiums receivable (20.4) (19.3)
Engineering services receivable (1.2) (2.2)
Prepaid acquisition costs (4.9) (8.8)
Reinsurance assets 16.5 (67.5)
Unearned insurance premiums 25.2 54.2
Claims and adjustment expenses (24.1) 65.8
Distributions on capital securities 1.6 0.0
Investment in Radian (5.3) 9.3
Other (3.9) (2.0)
-------- --------
Cash provided by operating
activities 19.8 68.9
-------- --------
Investing activities:
Fixed asset additions, net 0.1 0.2
Investments:
Purchase of short-term investments, net (35.4) (4.9)
Purchase of fixed maturities (51.4) (65.3)
Proceeds from sale of fixed maturities 26.0 74.7
Redemption of fixed maturities 13.1 5.5
Purchase of equity securities (178.1) (113.7)
Proceeds from sale of equity securities 167.0 91.2
Cash transferred to investment in Radian - (0.8)
-------- --------
Cash used in investment activities (58.7) (13.1)
-------- --------
Financing activities:
Proceeds from Company-obligated mandatorily
redeemable capital securities of
subsidiary trust 108.9
Increase (decrease) in short-term borrowings 14.8 (9.8)
Increase (decrease) in long-term debt - (0.5)
Dividends paid to shareholders (35.0) (34.7)
Reacquisition of stock (51.6) (13.0)
Exercise of stock options 4.0 1.0
-------- --------
Cash provided by (used in)
financing activities 41.1 (57.0)
-------- --------
Net increase in cash 2.2 (1.2)
Cash at beginning of period 4.5 8.6
-------- --------
Cash at end of period $ 6.7 $ 7.4
======== ========
Interest paid $ 2.0 $ 1.7
-------- --------
Federal income tax paid $ 25.7 $ 16.7
-------- --------
See Notes to Consolidated Financial Statements.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. General
The interim consolidated financial statements in this report include
adjustments based on management's best estimates and judgments,
including estimates of future loss payments, which are necessary to
present a fair statement of the results for the interim periods
reported. These adjustments are of a normal, recurring nature. The
financial statements are prepared on the basis of generally accepted
accounting principles and should be read in conjunction with the
financial statements and related notes in the 1996 Annual Report.
Certain amounts for 1996 have been reclassified to conform with the
1997 presentation.
2. Discontinued Operations
In 1996, the Company entered into a joint venture agreement with The
Dow Chemical Company (Dow) to form a new company, Radian International
LLC (Radian LLC). The terms of the agreement provided that HSB
contribute the net assets of its Radian Corp. subsidiary into this
joint venture for a 40% ownership. Income was subject to a preference
return to HSB in the first two years. The agreement provided HSB the
option to put its share of the venture to Dow any time during the
period from December 31, 1997 to December 31, 1998 upon giving
appropriate notice. On July 28, 1997 the HSB Board of Directors
ratified management's decision to put its share of Radian LLC to Dow on
or about January 1, 1998 for approximately $143 million. This amount is
not subject to any material adjustment due to the future operating
results of Radian LLC; therefore this will result in a pre-tax gain of
approximately $57 million. Due to this decision, the results of Radian
LLC have been classified as discontinued operations. HSB's share of
Radian LLC's losses generated in the third quarter of approximately
$1.2 million pre-tax have been deferred until HSB's share of Radian LLC
has been transferred to Dow.
3. Industrial Risk Insurers
On December 1, 1996 HSB increased its participation in Industrial Risk
Insurers (IRI) from 14% to 23.5%. IRI is an unincorporated, voluntary
property underwriting association currently comprised of twenty-three
property casualty insurance companies. IRI primarily writes policies on
a syndicate basis which specifies to the insured the percentage share
of risk accepted by each member of the association. Each member
company, therefore, operates as a direct insurer or reinsurer on such
policies and participates in the premiums and losses generated
thereunder in proportion to its membership interest.
In essence, the IRI facilitates the proportional sharing of risk under
one policy where each member is essentially considered to be the direct
writer for reporting, premium tax and other regulatory purposes.
Liability on such policies is several and not joint, and therefore,
members are not responsible for policy liabilities of the other
members. An
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increased participation does not expose the Company to the effect of
adverse loss development on claims incurred prior to the effective
date of the increase.
Other than a nominal deposit, which is refunded if participation
ceases, there is no cost to becoming a member of the IRI. Members can
change or terminate their participation on an annual basis. Typically
participation levels vary based on a member's expectations of future
profits. Therefore, the form and extent of HSB's participation in IRI
may vary in the future.
4. Shareholders' Equity
The Connecticut Business Corporation Act, which became effective on
January 1, 1997, eliminated the concept of treasury shares. Therefore,
shares reacquired by the Company constitute authorized but unissued
shares. As a result of this change in law, the Company eliminated the
caption Treasury Stock from its balance sheet and reclassified the
amounts to additional paid-in capital and retained earnings. These
amounts were $107.2 million as of September 30, 1997 and $59.5 million
as of December 31, 1996. The reclassifications were distributed as
follows:
September 30, 1997 December 31, 1996
------------------ -----------------
Additional Paid In $ 3.5 $ 2.0
Retained Earnings 103.7 57.5
----- -----
Total $ 107.2 $ 59.5
On December 30, 1996, the Company issued Convertible Redeemable
Preferred Stock. The stock is convertible into 398,406 shares of HSB
common stock at a price of $50.20 per share and may be redeemed at the
option of the Company on or after the fifth anniversary of issuance and
by the holder after the eighth anniversary. As a result of the stock's
redemption features, it has been included in the "mezzanine" section of
the balance sheet located between liabilities and shareholders' equity.
On October 29, 1997, the holder converted its convertible redeemable
preferred stock into common stock.
5. Derivative Instruments
On December 19, 1996, the Company entered into three "zero cost collar
contracts" to mitigate the effects of market risk on its U. S. common
stock portfolio (which, for management purposes, included certain
convertible preferreds). Each contract had a notional value of $50
million and maturity dates ranging from November 1997 to January 1998.
The contracts are European style, which means they only settle upon
maturity. The contracts, which were entered into when the S&P 500 Index
was 744.3, allow the Company to recover from the counterparty if the
index is below 695.2 at the time of maturity, and requires the Company
to reimburse the counterparty if the index is above a range of 811.3 to
818.7 at the time of maturity.
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The Company entered into these contracts with the intent to hold such
contracts until maturity. However, based upon price movements in the
S&P 500 Index since December 31, 1996, the contracts do have a current
estimated market value of $(29.5) million, which represents the cost
the Company would incur if it had canceled the contracts at September
30, 1997. As of September 30, 1997, the Company recorded the mark to
market valuation of $29.5 million as a reduction of realized investment
gains. At present such contracts are included in other liabilities in
the Statement of Financial Position.
At September 30, 1997, the S&P 500 Index was 947.28, which is outside
the bounds of the collar. If the contracts had reached their expiration
dates at the end of the quarter, HSB would have been required to pay
approximately $26.5 million to its counterparty and an additional $3.0
million of realized gains would have been recognized in the statement
of income.
The Company's U.S. common stock portfolio has experienced a total
return of $46 million (which includes price appreciation of
approximately $41 million) since December 31, 1996, and has had a price
movement correlation with the S&P 500 Index well in excess of 80%.
The collar subjects the Company to market and counterparty credit risk.
The Company manages 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 are 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.
6. Recent Accounting Developments
In February 1997, the Financial Accounting Standards Board (FASB)
issued Statement of Financial Accounting Standards (SFAS) No. 128,
"Earnings per Share". This statement establishes standards for
computing and presenting earnings per share (EPS). It replaces the
presentation of primary EPS with a presentation of basic EPS. It also
requires dual presentation of basic and diluted EPS on the face of the
income statement and a reconciliation of the numerator and denominator
of the basic EPS computation to the numerator and denominator of the
diluted EPS computation. The requirements of this statement will be
effective for year end 1997 financial statements. Had this standard
been in effect as of the first quarter 1996, EPS would have been as
follows:
September 30, 1997 September 30, 1996
------------------ ------------------
Quarter YTD Quarter YTD
------- ---- ------- -----
Basic $ .77 $2.37 $ .58 $2.08
Diluted $ .76 $2.35 $ .58 $2.07
As Reported $ .76 $2.35 $ .58 $2.07
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In June 1997 the FASB issued SFAS 130 " Reporting Comprehensive Income"
which requires items that comprise comprehensive income be reported in
a financial statement display with the same prominence as other
financial statements. This presentation will include such items as
market value adjustments of securities, foreign currency translation,
and certain adjustments made for benefit plans, which are currently
reported as components of the changes in shareholders' equity. This
statement will be effective beginning in 1998 with retroactive
restatement of prior periods required.
Also in June of 1997 the FASB issued SFAS No. 131 "Disclosures about
Segments of an Enterprise and Related Information". This standard
requires companies to report financial and descriptive information
about reportable operating segments. It includes disclosure
requirements relating to products and services, geographic areas and
major customers. This statement will be effective beginning in 1998.
7. Legal Proceedings
The Company is involved in three arbitration or litigation proceedings
regarding the extent to which certain explosion events are insured
under boiler and machinery policies of the Company or under the
all-risk property insurance policies issued by other companies.
Management believes the Company's policies do not provide coverage for
losses resulting from the explosion events that are the subject of
these proceedings.
A lower court ruling in one of these cases held that an explosion did
occur, and that the Company was not liable for losses of the insured
resulting from the explosion. In a further action, the court denied the
Company's motion for summary judgment on certain issues, thus leaving
the Company potentially liable for certain unquantified losses
resulting from events prior to the explosion. In the first quarter of
1997 the Company and the property insurer jointly settled the case with
the insured. The Company's ultimate share of the settlement will be
determined in an arbitration proceeding with the property insurer. The
Company has incurred gross losses and LAE of $40.7 million and a net
loss after taking into account reinsurance recoverables of $6.5
million, of which $5 million represents claim cost and the remaining
$1.5 million represents loss adjustment expenses. As a result of
payments made to date, at September 30, 1997 the Company carried gross
loss and LAE reserves of $2.8 million and recoverables from reinsurers
of $2.9 million.
The Company has accrued $6.5 million with respect to the other two
cases for potential loss adjustment expenses, including legal costs to
defend the Company's position. One case is in the process of pre-trial
summary judgment motions and appeals; the other case is involved in
both arbitration and litigation proceedings. A trial date has not been
set for either case. In the event that the Company is held liable for
one or both of the remaining claims, amounts in excess of the Company's
9
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net maximum aggregate retention of $8.5 million is recoverable from the
Company's reinsurers. Claim amounts potentially recoverable from
reinsurers in the event of a possible adverse outcome in these cases
could range, in the aggregate, from $40 million to $195 million.
The obligations of the Company's reinsurers with respect to these cases
are not in dispute. Therefore, management believes that any adverse
outcomes in these cases will not, in the aggregate, have a material
effect on either the results of operations or financial condition of
the Company. The Company's reinsurance contracts do not require the
Company to reimburse its reinsurers for any losses such reinsurers
might incur should these cases not be decided in the Company's favor.
Nevertheless, reinsurers often quote rates for future coverages based
upon their or other reinsurer's experience on a particular account.
Therefore, in the event the Company's reinsurers pay significant sums
pursuant to the arbitration or litigation proceedings described above,
it is likely the Company's reinsurance rates would increase in future
periods. However, given the insured capacity that exists in reinsurance
markets worldwide, coupled with the Company's ability to negotiate a
redesign or restructuring of its reinsurance program, it does not
necessarily mean that such an increase would be material.
The Company is also involved in various other legal proceedings as
defendant or co-defendant that have arisen in the normal course of its
business. In the judgment of management, after consultation with
counsel, it is improbable that any liabilities which may arise from
such litigation will have a material adverse impact on the results of
operations or the financial position of the Company.
8. Holding Company Formation
At a special meeting of the Company on June 23, 1997, shareholders
voted to approve a proposal which enabled the Company to form a new
holding company, HSB Group, Inc. Shareholders of Hartford Steam
Boiler's common stock automatically became holders of HSB Group's
common stock through a share exchange approved by the shareholders, and
certificates representing Hartford Steam Boiler common stock
automatically represent the corresponding shares of HSB Group common
stock.
9. Capital Securities
On July 10, 1997, HSB Group, Inc. announced the sale of $110 million of
30 year Capital Securities in a private placement. The securities are
non-callable for ten years and may be called earlier upon the
occurrence of a Tax Event. The securities were issued through HSB
Capital I, a Delaware business trust created by HSB Group, Inc. at a
floating rate tied to 90 day LIBOR. The initial coupon is 6.7 percent.
Holders of the Capital Securities will be entitled to receive
preferential
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cumulative cash distributions accumulating from the date
of original issuance and payable quarterly in arrears. The Company has
the right to defer payment of interest 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 Company has irrevocably and unconditionally guaranteed all
of the Issuer Trust's obligations under the Capital Securities. The
Company expects to use the proceeds for general corporate purposes,
which may include the repurchase of HSB common stock; funding
investments in, or extensions of credit to, subsidiaries; repayment of
maturing debt; and financing possible future acquisitions. Pursuant to
certain registration rights contained in the agreement with the initial
purchasers of the Capital Securities, the Company has filed a
registration statement for capital securities with virtually identical
terms which holders can receive in exchange for the original
securities.
10. Computation of Earnings Per Share
Quarter Ended Year to Date
September 30, 1997 September 30, 1997
------------------ ------------------
Net Income $15.2 (A) $ 47.4 (A)
===== =======
Weighted Average Common
Shares Outstanding 19.3 19.6
Common Stock Equivalents
Preferred Stock - assuming
conversion .4 .4
Options .2 .1
------ -------
19.9 (B) 20.1 (B)
====== =======
EPS - (A)/(B) $0.76 $2.35*
* Computation excludes rounding.
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MANAGEMENT'S DISCUSSION AND ANALYSIS
OF CONSOLIDATED FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
SEPTEMBER 30, 1997
RESULTS OF OPERATIONS
(dollar amounts in millions)
Consolidated Overview
- ---------------------
Quarter Ended Nine Months Ended
September 30 September 30
----------------- ---------------
1997 1996 1997 1996
---- ---- ---- ----
Insurance premium $121.3 $113.8 $360.9 $335.1
Net engineering services revenue 15.5 14.0 45.2 40.8
Net investment income 9.1 7.6 25.8 23.5
Realized investment gains 2.3 2.5 6.2 8.5
-------- ------- -------- -------
Total revenues $148.2 $ 137.9 $ 438.1 $407.9
====== ======= ====== ======
Income from continuing operations $ 15.2 $ 11.9 $ 47.4 $ 38.2
-------- ------- -------- -------
Net income $ 15.2 $ 11.6 $ 47.4 $ 42.0
======== ======= ======== =======
Income from continuing operations
per common share $ 0.76 $ 0.59 $ 2.35 $ 1.88
--------- ------- -------- -------
Net income per common share $ 0.76 $ 0.58 $ 2.35 $ 2.07
========= ======= ======== =======
Net income per common share for the third quarter of 1997 increased 31 percent
from the third quarter of 1996 and increased 14 percent in the first nine months
of 1997 compared to 1996 due to significantly higher underwriting gains in the
Company's insurance operations. On July 28, 1997 the HSB Board ratified
management's decision to exercise its option to put its share of Radian
International LLC to Dow on or about January 1, 1998 for approximately $143
million. Due to this decision, the results of Radian International LLC have been
classified as discontinued operations and losses generated in the third quarter
of approximately $1.2 million pre-tax have been deferred until HSB's share of
Radian LLC has been transferred to Dow. In comparison to 1996 results, income
per share from continuing operations increased 29 percent and 25 percent for the
third quarter and year to date respectively.
Insurance premiums grew 7 percent in the quarter and 8 percent year to date,
with the increased participation in IRI a contributing factor as well as growth
in both the domestic and international books of business. The third quarter
combined ratio improved from 96.3 percent in 1996 to 92.0
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percent in 1997. Net engineering services revenue increased 11 percent for the
third quarter and 11 percent year to date compared to comparable periods last
year.
The effective tax rates on continuing operations for the third quarter and year
to date were 25 percent compared to 23 percent for the comparable prior periods.
Tax rate fluctuations occur as underwriting and engineering services results
change the mix of pre-tax income between fully taxable earnings and tax
preferred earnings that can be obtained by investing in certain instruments. The
Company continues to manage its use of tax advantageous investments to maximize
after tax earnings.
Recent Accounting Developments
- ------------------------------
In February 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 128, "Earnings per Share". This statement
establishes standards for computing and presenting earnings per share (EPS). It
replaces the presentation of primary EPS with a presentation of basic EPS. It
also requires dual presentation of basic and diluted EPS on the face of the
income statement and a reconciliation of the numerator and denominator of the
basic EPS computation to the numerator and denominator of the diluted EPS
computation. The requirements of this statement will be effective for year end
1997 financial statements. Had this standard been in effect for 1997, basic EPS
would have increased $.01 for the third quarter to $.77 and increased $.02 year
to date to $2.37.
In June 1997 the FASB issued SFAS 130 " Reporting Comprehensive Income" which
requires items that comprise comprehensive income be reported in a financial
statement display with the same prominence as other financial statements. This
will include a presentation of items such
as market value adjustments of securities, foreign currency translation, and
certain adjustments made for benefit plans. This statement will be effective
beginning in 1998 with retroactive restatement of prior periods required.
Also in June of 1997 the FASB issued SFAS No. 131 "Disclosures about Segments of
an Enterprise and Related Information". This standard requires companies to
report financial and descriptive information about reportable operating
segments. It includes disclosure requirements relating to products and services,
geographic areas and major customers. This statement will be effective beginning
in 1998.
Other Developments
- ------------------
At a special meeting for the Company on June 23, 1997 shareholders voted to
approve a proposal which enabled the Company to form a new holding company, HSB
Group, Inc. Shareholders of Hartford Steam Boiler's common stock automatically
became holders of HSB Group's common stock through a share exchange approved by
the shareholders, and certificates representing Hartford Steam Boiler common
stock automatically represent the corresponding shares of HSB Group common
stock.
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<PAGE>
Insurance Operations
- --------------------
Insurance operations include the insurance results of The Hartford Steam Boiler
Inspection and Insurance Company(HSB), HSB Engineering Insurance Limited
(HSB-EIL), The Boiler Inspection and Insurance Company of Canada (BI&I) and The
Allen Insurance Company, Ltd.
On December 1, 1996 HSB increased its participation in Industrial Risk Insurers
(IRI) from 14% to 23.5%. IRI is an unincorporated, voluntary property
underwriting association currently comprised of twenty-three property casualty
insurance companies. IRI primarily writes policies on a syndicate basis which
specifies to the insured the percentage share of risk accepted by each member of
the association. Each member company, therefore, operates as a direct insurer or
reinsurer on such policies and participates in the premiums and losses generated
thereunder in proportion to its membership interest.
In essence, the IRI facilitates the proportional sharing of risk under one
policy where each member is essentially considered to be the direct writer for
reporting, premium tax and other regulatory purposes. Liability on such policies
is several and not joint, and therefore, members are not responsible for policy
liabilities of the other members. An increased participation does not expose the
Company to the effect of adverse loss development on claims incurred prior to
the effective date of the increase.
Other than a nominal deposit, which is refunded if participation ceases, there
is no cost to becoming a member of the IRI. Members can change or terminate
their participation on an annual basis. Typically participation levels vary
based on a member's expectations of future profits. Therefore, the form and
extent of HSB's participation in IRI may vary in the future.
IRI has a fiscal year ending November 30, and provides reports to its members on
a quarterly basis. As a result, the Company's increased participation to 23.5
percent has initially been reflected in the first quarter financial results for
1997.
14
<PAGE>
Quarter Ended Nine Months Ended
September 30 September 30
--------------------- --------------------
1997 1996 1997 1996
---- ---- ---- ----
Gross earned premium $151.6 $ 143.1 $ 456.6 $ 414.5
Ceded premium 30.3 29.3 95.7 79.4
--------- --------- -------- ---------
Insurance premium 121.3 113.8 360.9 335.1
Claims and adjustment expenses 54.1 54.5 157.0 155.4
Underwriting, acquisition
and other expenses 57.7 55.6 173.0 166.2
--------- --------- -------- ---------
Underwriting gain $ 9.5 $ 3.7 $ 30.9 $ 13.5
========== ========= ======== =========
Loss ratio 44.6% 47.9% 43.5% 46.4%
Expense ratio 47.4% 48.4% 47.8% 49.1%
---------- ---------- -------- ---------
Combined ratio 92.0% 96.3% 91.3% 95.5%
========== ========== ======== =========
Gross earned premiums in the third quarter and year to date increased 6 percent
and 10 percent from the comparable periods in 1996. This increase was primarily
attributable to the increased participation in IRI ($3.1 million and $19.6
million) and to growth in both domestic and global markets. Gross earned
premiums representing coverage outside the U.S. increased 9 percent in the third
quarter and 17 percent year to date from the comparable period in 1996. In
certain areas of the Company's direct domestic and international businesses, the
market is experiencing price erosion. HSB will not write business at rates which
would lessen our ability to maintain underwriting profit. Increases in ceded
premium of 3 percent in the current quarter and 21 percent year to date were
primarily due to the additional participation in IRI and the purchase of
facultative reinsurance at EIL.
The loss ratio decreased from 47.9 percent in the third quarter of 1996 to 44.6
percent in the current quarter and from 46.4 percent in the first nine months of
1996 to 43.5 percent in the first nine months of 1997. In 1996, high frequency
of claims and unusually severe winter weather impacted the loss ratio. Gross
claims and adjustment expenses for the first nine months of 1997 and 1996 were
$217.9 million and $214.2 million, respectively.
The expense ratio improved in both the quarter and year to date from comparable
periods in the previous year as the growth rate in earned premium exceeded the
growth rate in underwriting and
15
<PAGE>
inspection expenses. Underwriting, acquisition and other expenses increased
approximately 4 percent in the third quarter and year to date primarily due to
increased participation in IRI.
Through its UK subsidiary, HSB-EIL, the Company writes business in Malaysia and
is required to maintain approximately 50 million ringgit denominated investments
on deposit in that country. The Company intends to maintain its current level of
deposits in that currency, which equates to $16 million. Due to the recent
fluctuations of currencies in southeast Asia, realized investment gains were
reduced by approximately $4 million during the quarter and year to date,
although there have been no sales out of such investments.
Engineering Services Operations
- -------------------------------
Quarter Ended Nine Months Ended
September 30 September 30
------------------ ------------------
1997 1996 1997 1996
---- ---- ---- ----
Net engineering services revenue $ 15.5 $ 14.0 $ 45.2 $ 40.8
Net engineering services expenses 14.5 12.4 42.3 36.0
----- ---- ---- ----
Operating gain $ 1.0 $ 1.6 $ 2.9 $ 4.8
===== ==== ==== ====
Net margin 6.3% 11.4% 6.5% 11.8%
Engineering services operations include the results of HSB's and BI&I's
engineering services, HSB Reliability Technologies (HSBRT) and the Company's
other engineering services subsidiaries.
Net engineering services revenues increased $1.5 million in the third quarter
and $4.4 million year to date compared to the same periods in 1996. The growth
in revenues was primarily due to increases generated by HSBRT. The decline in
operating gain from the previous periods reflects slower growth in the domestic
book and Far East operations, and operating costs incurred to develop new
products and in new start up operations.
16
<PAGE>
Investment Operations
- ---------------------
Quarter Ended Nine Months Ended
September 30 September 30
------------- ----------------
1997 1996 1997 1996
---- ---- ---- ----
Net investment income $ 9.1 $ 7.6 $ 25.8 $ 23.5
Realized investment gains 2.3 2.5 6.2 8.5
---- ---- ---- -----
Pretax income from
investment operations $11.4 $10.1 $ 32.0 $ 32.0
==== ==== ==== =====
Net investment income for the third quarter and year to date increased $1.5
million and $2.3 million compared to the same periods in 1996. Investable assets
increased in 1997 in comparison to the same period in 1996, and in particular
during the third quarter, as the Company invested the proceeds from its Capital
Securities offering. Net investment income was impacted earlier in 1997 by calls
of high yielding preferred stocks and cash collections from reinsurers that were
not received until late in March. Net investment income increases also reflected
more investable funds and a modest change in the mix of the portfolio from tax
preferred investments to more taxable investments with higher pre-tax yields.
Higher interest costs related to a larger amount of commercial paper
outstanding.
The Company's investment strategy continues to be to maximize total return on
the investment portfolio through investment income and capital appreciation.
Investment strategies for any given year are developed based on many factors
including operational results, tax implications, regulatory requirements,
interest rates, dividends to stockholders and market conditions. The investment
portfolio includes a wide variety of high quality equity securities and both
domestic and foreign fixed maturities. The Company continues to manage its use
of tax advantageous investments to maximize after tax investment earnings.
In the fourth quarter of 1996, HSB entered into three zero cost collar contracts
to mitigate the effects of market risk on its domestic common stock portfolio.
The contracts have maturity dates ranging from November 1997 to January 1998.
The contracts, which were entered into when the S&P index was 744.3, allow the
Company to recover from the counterparty if the index is below 695.2 at the time
of maturity and requires the Company to reimburse the counterparty if the index
is above a range of 811.3 to 818.7 at the time of maturity. In addition to
offering downside protection for market declines in excess of approximately 6
percent, the collar permits the Company to receive the dividends on its common
stock investments and retain a certain level of upside appreciation depending on
market movements.
At September 30, 1997 the S&P index was at 947.28 which is outside the bounds of
the collar. Although there would have been a settlement of $26.5 million had
these contracts matured at September 30, 1997, HSB has adjusted its value of the
contracts to an estimated fair value at that
17
<PAGE>
date and reduced realized investment gains by $29.5 million on a year to date
basis. The impact on the quarter was $10.1 million.
The Company's U.S. common stock portfolio has experienced a total return of $46
million (which includes price appreciation of approximately $41 million) since
December 31, 1996, and has had a price movement correlation with the S&P 500
Index well in excess of 80%.
As previously discussed, due to the recent fluctuations of currencies in
southeast Asia, realized investment gains were reduced by approximately $4
million during the quarter and year to date, although there have been no sales
of investments in Malaysian currencies.
Liquidity and Capital Resources
- -------------------------------
Balances at
September 30 December 31
------------ -----------
1997 1996
---- ----
Total assets $ 1,256.7 $ 1,116.3
Short-term investments 133.3 97.9
Cash 6.6 4.5
Short-term borrowings 18.0 3.2
Capital securities 108.9 -
Convertible Redeemable Preferred Stock 20.0 20.0
Common shareholder's equity 320.5 345.6
Liquidity refers to the Company's ability to generate sufficient funds to meet
the cash requirements of its business operations. The Company receives a regular
inflow of cash from maturing investments and engineering services and insurance
operations. The mix of the investment portfolio is managed to respond to
expected claim pay-out patterns. The Company also maintains a highly liquid
short-term portfolio to provide for immediate cash needs and, since the issuance
of the Capital Securities which are discussed below, to offset a portion of
interest rate risk relating to such securities.
On July 10, 1997, HSB Group, Inc. announced the sale of $110 million of 30 year
Capital Securities in a private placement. The securities are non-callable for
ten years and may be called earlier upon the occurrence of a tax event. The
securities were issued through HSB Capital I, a Delaware business trust created
by HSB Group, Inc. at a floating rate tied to 90 day LIBOR. The initial coupon
is 6.7 percent. Holders of the Capital Securities will be entitled to receive
preferential cumulative cash distributions accumulating from the date of
original issuance and payable quarterly in arrears. The Company has the right to
defer payment of interest 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 Company has irrevocably and unconditionally guaranteed all
of the Issuer Trust's obligations
18
<PAGE>
under the Capital Securities. The Company is using the proceeds for general
corporate purposes, which include the repurchase of HSB common stock; funding
investments in, or extensions of credit to, subsidiaries; repayment of maturing
debt; and financing possible future acquisitions. Pursuant to certain
registration rights contained in the agreement with the initial purchasers of
the Capital Securities, the Company has filed a registration statement for
capital securities with virtually identical terms which holders can receive in
exchange for the original securities.
Cash provided from operations was $19.8 million in the first nine months of 1997
compared to $68.9 million for the same period in 1996. Insurance operations cash
flow (excluding IRI) decreased as claims paid increased 41 percent compared to
the same period in 1996, and premiums collected were 2 percent higher year to
date. Collections from reinsurers increased significantly in the current year.
The Company's participation in IRI impacted components of the Consolidated
Statement of Cash Flows for 1997, including a year to date positive impact of
$3.7 million and $4.1 million for 1997 and 1996, respectively, to cash provided
from operations.
Capital resources consist of shareholders' equity, convertible redeemable
preferred stock, capital securities and debt outstanding and represent those
funds deployed or available to be deployed to support business operations.
Common shareholders' equity of $320.5 million at September 30, 1997 decreased by
$25.1 million since December 31, 1996. The decrease reflects net income of $47.4
million year to date and an increase in unrealized gains, net of tax, of $10.6
million, offset by dividends of $35.1 million and share repurchases. On October
29, 1997, the sole holder of convertible redeemable preferred stock converted
into 398,406 shares of common stock.
On January 27, 1997 the Board of Directors renewed the Company's authorization
to repurchase up to one million of its common shares. At its July meeting, the
HSB Board of Directors increased the authorization to repurchase shares to two
million. Through September 30, 1997, the Company has purchased approximately one
million shares at a cost of $52.4 million. Treasury stock of $107.2 million was
reclassified to retained earnings and additional paid-in capital during 1997 to
reflect the elimination of the concept of treasury shares in accordance with the
Connecticut Business Corporation Act which became effective January 1, 1997. For
comparative purposes treasury stock of $59.5 million was likewise reclassified
at December 1996.
At September 30, 1997, the Company had significant short-term and long-term
borrowing capacity. The Company is currently authorized to issue up to $75
million of commercial paper. Commercial paper outstanding at September 30, 1997
and December 31, 1996 was $18.0 million and $3.2 million, respectively. The
Company has authorized a guaranty of up to 40 percent of Radian International,
LLC's $40 million credit facility with The Dow Chemical Company. At September
30, 1997 the amount guaranteed was $12.8 million. Such guaranty will terminate
upon the sale of the Company's interest in Radian International LLC to Dow.
The Company is involved in three arbitration or litigation proceedings regarding
the extent to which certain explosion events are insured under boiler and
machinery policies of the Company or under the all-risk property insurance
policies issued by other companies. Management
19
<PAGE>
believes the Company's policies do not provide coverage for losses resulting
from the explosion events that are the subject of these proceedings. More
information pertaining to these legal proceedings may be found under note 7 of
the Notes to Consolidated Financial Statements herein.
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. The analysis
indicated roughly 30% of existing code is compliant, roughly 60% is represented
by aging legacy systems which are scheduled to be replaced before the end of
1998 due to current business needs, and the remainder will be addressed through
modification to compliant code or discontinuation. The impact of year 2000
expenditures on a stand alone basis is not clearly evident as the Company is
replacing legacy applications due to changing business needs and such
replacement applications will be year 2000 compliant. However, the overall cost
of modification efforts and application replacement which include substantial
enhancements to business functionality, has been estimated at $13-$20 million
over a three year period. Certain of the application replacement costs will be
capitalized consistent with the Company's existing capitalization policy.
Forward-Looking Statements
Certain statements contained in this report are forward-looking and are based on
management's current expectations. Actual results may differ materially from
such expectations depending on the outcome of certain factors described with
such forward-looking statements and other factors including: significant natural
disasters and severe weather conditions; changes in interest rates and the
performance of the financial markets; changes in the availability, cost and
collectibility of reinsurance; changes in domestic and foreign laws, regulations
and taxes; the entry of new or stronger competitors and the intensification of
pricing competition; the loss of current customers or the inability to obtain
new customers; changes in the coverage terms selected by insurance customers,
including higher deductibles and lower limits; the adequacy of loss reserves;
changes in asset valuations; consolidation and restructuring in the insurance
industry; changes in the Company's participation in joint underwriting
associations, and in particular 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.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
- --------------------------
The Company is involved in three arbitration or litigation proceedings regarding
the extent to which certain explosion events are insured under boiler and
machinery policies of the Company or under the all-risk property insurance
policies issued by other companies. Management believes the Company's policies
do not provide coverage for losses resulting from the explosion events that are
the subject of these proceedings.
20
<PAGE>
A lower court ruling in one of these cases held that an explosion did occur, and
that the Company was not liable for losses of the insured resulting from the
explosion. In a further action, the court denied the Company's motion for
summary judgment on certain issues, thus leaving the Company potentially liable
for certain unquantified losses resulting from events prior to the explosion. In
the first quarter of 1997 the Company and the property insurer jointly settled
the case with the insured. The Company's ultimate share of the settlement will
be determined in an arbitration proceeding with the property insurer. The
Company has incurred gross losses and LAE of $40.7 million and a net loss after
taking into account reinsurance recoverables of $6.5 million, of which $5
million represents claim cost and the remaining $1.5 million represents loss
adjustment expenses. As a result of payments made to date, at September 30, 1997
the Company carried gross loss and LAE reserves of $2.8 million and recoverables
from reinsurers of $2.9 million.
The Company has accrued $6.5 million with respect to the other two cases for
potential loss adjustment expenses, including legal costs to defend the
Company's position. One case is in the process of pre-trial summary judgment
motions and appeals; the other case is involved in both arbitration and
litigation proceedings. A trial date has not been set for either case. In the
event that the Company is held liable for one or both of the remaining claims,
amounts in excess of the Company's net maximum aggregate retention of $8.5
million is recoverable from the Company's reinsurers. Claim amounts potentially
recoverable from reinsurers in the event of a possible adverse outcome in these
cases could range, in the aggregate, from $40 million to $195 million.
The obligations of the Company's reinsurers with respect to these cases are not
in dispute. Therefore, management believes that any adverse outcomes in these
cases will not, in the aggregate, have a material effect on either the results
of operations or financial condition of the Company. The Company's reinsurance
contracts do not require the Company to reimburse its reinsurers for any losses
such reinsurers might incur should these cases not be decided in the Company's
favor. Nevertheless, reinsurers often quote rates for future coverages based
upon their or other reinsurer's experience on a particular account. Therefore,
in the event the Company's reinsurers pay significant sums pursuant to the
arbitration or litigation proceedings described above, it is likely the
Company's reinsurance rates would increase in future periods. However, given the
insured capacity that exists in reinsurance markets worldwide, coupled with the
Company's ability to negotiate a redesign or restructuring of its reinsurance
program, it does not necessarily mean that such an increase would be material.
The Company is also involved in various other legal proceedings as defendant or
co-defendant that have arisen in the normal course of its business. In the
judgment of management, after consultation with counsel, it is improbable that
any liabilities which may arise from such litigation will have a material
adverse impact on the results of operations or the financial position of the
Company.
21
<PAGE>
Item 6 - Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit 27. Financial Data Schedule.
(b) Reports on Form 8-K -
Form 8-K filed on July 10, 1997 announcing the sale of $110
million of 30-year Floating Rate Capital Securities issued by
HSB Capital I, a Delaware statutory business trust created by
HSB Group, Inc.
Form 8-K filed July 28, 1997 announcing second quarter
results, an increase in the share repurchase authorization and
the October dividend.
22
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HSB GROUP, INC.
Date: November 7, 1997 By: /s/ Saul L. Basch
Saul L. Basch
Senior Vice President, Treasurer
and Chief Financial Officer
Date: November 7, 1997 By: /s/ Robert C. Walker
Robert C. Walker
Senior Vice President and
General Counsel
23
<PAGE>
<TABLE> <S> <C>
<ARTICLE> 7
<LEGEND>
This schedule contains summary financial information extracted from the
financial statements filed herewith and is qualified in its entirety by
reference to such financial statements.
</LEGEND>
<MULTIPLIER> 1,000,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-END> SEP-30-1997
<DEBT-HELD-FOR-SALE> 248
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 326
<MORTGAGE> 11
<REAL-ESTATE> 0
<TOTAL-INVEST> 585
<CASH> 140<F1>
<RECOVER-REINSURE> 146
<DEFERRED-ACQUISITION> 46
<TOTAL-ASSETS> 1257
<POLICY-LOSSES> 279
<UNEARNED-PREMIUMS> 296
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 43
0
20<F2>
<COMMON> 10
<OTHER-SE> 311<F3>
<TOTAL-LIABILITY-AND-EQUITY> 1257
121
<INVESTMENT-INCOME> 9
<INVESTMENT-GAINS> 2
<OTHER-INCOME> 16
<BENEFITS> 54
<UNDERWRITING-AMORTIZATION> 24
<UNDERWRITING-OTHER> 49
<INCOME-PRETAX> 22
<INCOME-TAX> 5
<INCOME-CONTINUING> 15
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 15
<EPS-PRIMARY> .76<F4>
<EPS-DILUTED> 0
<RESERVE-OPEN> 0
<PROVISION-CURRENT> 0
<PROVISION-PRIOR> 0
<PAYMENTS-CURRENT> 0
<PAYMENTS-PRIOR> 0
<RESERVE-CLOSE> 0
<CUMULATIVE-DEFICIENCY> 0
<FN>
<F1>Cash includes short-term investments.
<F2>Convertible redeemable preferred stock classified at mezzanine level on
Consolidated Statements of Financial Position.
<F3>Excludes $108.9 million company obligated mandatorily redeemable capital
subsidiary trust, net of discount.
<F4>Per common share.
</FN>
</TABLE>
