SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1998
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)
Registrant's telephone number, including area code: (860) 722-1866
Securities registered pursuant to Section 12(b) of the Act:
Name of each exchange
Title of each class on which registered
- ------------------- --------------------
Common stock, without par value New York Stock Exchange, Inc.
Rights to Purchase Depositary Receipts New York Stock Exchange, Inc.
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports 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.......
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.....X.......
The aggregate market value of the voting stock held by non-affiliates of the
registrant as of February 16, 1999 was $1,005,363,488.
Number of shares of common stock outstanding as of February 16, 1999:
28,948,775.
Documents Incorporated by Reference:
Portions of the Proxy Statement dated March 5, 1999 for the Annual Meeting of
Shareholders to be held April 20, 1999 are incorporated by reference in Parts
III and IV herein.
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PART I
Item 1. Business.
A. GENERAL DEVELOPMENT OF BUSINESS
HSB Group, Inc. (together with its subsidiaries referred to as the
"Company" or "HSB" hereinafter) was formed under the laws of the State of
Connecticut in 1997 to serve as the holding company for The Hartford Steam
Boiler Inspection and Insurance Company (HSBIIC) and its subsidiaries. The
Hartford Steam Boiler Inspection and Insurance Company was chartered as an
insurance company by the Connecticut legislature in 1866.
The Company's operations are divided into four reportable operating segments
- - Commercial insurance, Global Special Risk insurance, Engineering Services and
Investments. The most significant business of the Company is providing insurance
against losses from accidents to boilers, pressure vessels, and a wide variety
of mechanical and electrical machinery and equipment along with a high level of
inspection and engineering services aimed at loss prevention. Earned premiums
for the Company's insurance segments in the aggregate were $396.1 million for
1998, which accounted for approximately 68.4 percent of the Company's revenues.
See Note 10 to the Consolidated Financial Statements located in Item 8 of Part
II herein for information on the Company's net written and net earned premiums
over the last three years.
The Company conducts its business in Canada through its subsidiary, The
Boiler Inspection and Insurance Company of Canada. Insurance for risks located
in countries other than the United States and Canada is written by HSB
Engineering Insurance Limited (HSB EIL). In December 1994, the Company purchased
the remaining 50% interest in HSB EIL's parent company, Engineering Insurance
Group (EIG) from General Reinsurance Corporation.
Effective July 1, 1998, HSBIIC completed an acquisition of the monoline
boiler and machinery business and the ASME inspection services, which certify
boiler and pressure vessel compliance with the codes and standards of the
American Society of Mechanical Engineers, of the Kemper Insurance Companies.
Kemper and HSBIIC also completed an agreement for HSBIIC to reinsure boiler and
machinery coverage included as part of Kemper's commercial package policies.
On January 6, 1998, HSBIIC sold its 23.5 percent share in Industrial Risk
Insurers (IRI) to Employers Reinsurance Corporation (ERC), one of the world's
largest reinsurance companies, in accordance with a previously announced
purchase and sale agreement between ERC and IRI's twenty-three member insurers.
IRI is a voluntary, unincorporated joint underwriting association which provides
property insurance for the class of business known as "highly protected risks"
(HPR) -- larger manufacturing, processing, and industrial businesses that have
invested in protection against loss through the use of sprinklers and other
means. Contemporaneous with the close of the sale, IRI was reconstituted with
ERC (with a 99.5 percent share) and HSBIIC (with a .5 percent share) as the sole
members. HSBIIC writes the business for the reconstituted IRI
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(which has been renamed HSB Industrial Risk Insurers) using its insurance
licenses and provides certain other management and technical services. In
addition, through various reinsurance agreements with ERC and IRI, HSBIIC
transferred its manufacturing book of business to IRI and retains 85% of the
equipment breakdown insurance and 15% of the property insurance of the HSB/IRI
combined portfolio. See "Participation in HSB Industrial Risk Insurers" on page
xx for additional information.
To support the Company's expanded role with HSB IRI, on December 31, 1997,
a business trust formed by HSB sold $300 million of 20-year, 7 percent
Convertible Capital Securities in a private placement to ERC, of which $250
million was contributed by the Company to HSBIIC. The capital securities are
convertible into HSB common stock, at any time, subject to regulatory approval.
See Note 13 to the Consolidated Financial Statements located in Item 8 of Part
II herein for more information on this transaction.
The Company also offers professional scientific and technical consulting
services for industry and government on a world-wide basis through its
Engineering Department and its engineering subsidiaries. In 1998 net engineering
services revenues were $93.5 million, which accounted for approximately 16.1
percent of the Company's revenues.
On January 2, 1998, the Company exercised its option to put its 40 percent
share in Radian International LLC (Radian LLC) to The Dow Chemical Company for
approximately $129 million, net of expenses. Radian LLC was formed in January
1996 as a joint venture with Dow to provide environmental, engineering,
information technology, remediation and strategic chemical management services
to industries and governments world-wide. In connection with the formation of
the new company, the Company contributed substantially all of the assets of its
wholly-owned subsidiary, Radian Corporation to Radian LLC. The results of Radian
LLC were classified as discontinued operations following ratification in July
1997 by the Board of Directors of management's decision to exercise its put. The
Company's share of Radian LLC's losses incurred subsequent to such decision of
approximately $6.6 million after-tax was deferred until the closing of the sale
on January 2, 1998, at which time an estimated after-tax gain of $30.3 million,
net of deferred losses, was realized. In 1996 and prior to July 1997, the
Company's share of the joint venture's results were recorded as equity in
Radian.
Recently the Company has been focusing on identifying acquisition
candidates in the niche engineering management consulting service business,
primarily in process industries, in order to grow the engineering services
segment of its business. The Company does not currently anticipate that any
single acquisition within the next twelve months will be material to the
operations or financial position of the Company. In April 1998, HSB acquired
Solomon Associates, Inc. (SAI) based in Dallas, Texas. SAI is an engineering
management consulting firm that provides comparative performance benchmarking
consulting to the refining, petro-chemical and power generation industries. SAI
establishes efficiency and productivity benchmarks for 80 percent of the
world-wide petroleum refining industry. During 1997 the Company completed the
acquisition of Haughton Engineering Services Limited of England. Haughton offers
a wide range of inspection services in the United Kingdom to help ensure
compliance with regulatory codes. During 1997 the
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Company also acquired a 51 percent interest in Integrated Process Technologies
LLC, a provider of cost control strategies and management services for
businesses with geographically distributed locations.
The Company is a multi-national company operating primarily in North
American, European, and Asian markets. Currently, the Company's principal market
for its insurance and engineering services is the United States. However, the
Company does desire to become a stronger competitor in the international
machinery breakdown insurance and related engineering services markets as it
believes that there is significant opportunity for profitable growth overseas.
In 1998 the revenues and pre-tax income associated with operations outside of
the United States were approximately 15.2 percent and 3.3 percent, respectively.
Identifiable assets associated with operations outside of the United States are
approximately 17.5 percent of the consolidated amount. See Note 1 and Note 5 to
the Consolidated Financial Statements located in Item 8 of Part II herein for
more financial data based on geographic location and business segments.
B. PRODUCTS AND SERVICES
Insurance
Equipment breakdown insurance provides for the indemnification of the
policyholder for financial loss resulting from destruction or damage to an
insured boiler, pressure vessel, or other item of machinery or equipment caused
by an accident. This financial loss can include the cost to repair or replace
the damaged equipment (property damage), and product spoilage, lost profits and
expenses to avert lost profits (business interruption) stemming from an
accident.
The Company distinguishes itself from other insurance suppliers by
providing a high level of loss prevention, failure analysis and other
engineering services with the insurance product. This heavy emphasis on loss
prevention historically has had the dual effect of increasing underwriting and
inspection expenses, while reducing loss and loss adjustment expenses.
An important ancillary benefit for the policyholder is that the inspection
performed by the Company's inspector on a boiler, pressure vessel, or other
piece of equipment, as part of the insurance process, is normally accepted by
state and other regulatory jurisdictions for their certification purposes.
Without a certificate of inspection by the insurance carrier or another
inspection agency, policyholders cannot legally operate many types of equipment.
The Company also writes all risk property insurance for risks with
significant machinery and equipment exposures, in addition to its more
traditional boiler and machinery products. The all risk line is marketed to
customers with equipment and machinery exposures, such as electric utilities,
where sophisticated engineering services are important to loss prevention and
control. These customers are offered technical services such as computerized
evaluations of fire protection systems in addition to fire inspections and
boiler and
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machinery inspections. The Company also writes all risk coverage specifically
tailored for data processing systems.
Engineering Services
HSBIIC's Engineering Services division provides quality assurance services,
training for nondestructive testing, inspections to code standards of the
American Society of Mechanical Engineers (ASME) and other organizations, ISO
certification and registration services and other specialized consulting,
condition monitoring, benchmarking and inspection services related to the design
and applications of boilers, pressure vessels, and many other types of equipment
for domestic and foreign equipment manufacturers and their customers. HSBIIC is
the largest Authorized Inspection Agency for ASME codes in the world. The
Engineering Services division also offers a wide array of training and
educational services related to these areas, and in addition focuses on
researching and developing potential new products and services, and new markets
for current services.
Aside from HSBIIC, the Company's engineering subsidiaries include HSB
Reliability Technologies Corp. (HSB RT), HSB Professional Loss Control, Inc.
(HSB PLC), Solomon Associates, Inc. (SAI) and HSB Haughton Engineering Services
Limited (Haughton). HSB RT maintains an extensive database on equipment
maintenance and reliability and provides preventive maintenance consulting
services and programs to a wide range of businesses and industries. Such
services and programs are designed to increase production, reduce maintenance,
energy and spare parts inventory costs, and extend equipment life. HSB PLC is a
fire protection consulting and engineering firm. Its services include
inspections, hazards analysis and risk assessment, engineering design, code
consulting, research and testing, and training. SAI, Haughton, and Integrated
Process Technologies, in which the Company holds a majority interest, are
described on pages 3-4.
C. COMPETITION
Insurance
The Company is the largest writer of equipment breakdown insurance in North
America and is establishing a significant presence in the engineering insurance
market outside of North America. Based on net premiums written reported in the
1998 edition of Best's Aggregates and Averages, the Company has approximately a
40 percent market share and no other single company has more than a 10 percent
market share of the domestic equipment breakdown market. Members of the Factory
Mutual System, an affiliated group of insurers which are in the process of
completing a merger, have a market share of approximately 18 percent.
In general, the insurance market is influenced by the total insurance
capacity available based on policyholder surplus. Over the last few years,
global capacity to accept risk has grown as new insurers enter the property
casualty market and new financial products have been designed to securitize
catastrophe risks. In addition to available capacity, competition
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in the equipment breakdown insurance market is based on price and service to the
insured. Service includes maintaining customer relationships, engineering and
loss prevention activities, and claims settlement. The Company prices its
product competitively in the marketplace, but primarily competes by offering a
high level of service, not by offering the lowest-priced product.
Competition in the equipment breakdown insurance market, as well as the
property/casualty market in general, has intensified in recent years as a result
of continuing restructuring and consolidation in the insurance industry.
However, because the Company primarily underwrites risks which require unique
engineering expertise and jurisdictionally mandated inspections, the Company
believes that its products and services will continue to be competitive.
Engineering Services
The Company provides a wide range of engineering, consulting and inspection
services as described on page 5. For most of these services it has numerous
competitors, some of whom are much larger and have greater financial resources
than the Company.
Competition in these areas is based on price and on the qualifications,
experience and availability of the individuals who perform the work. The
Company's force of inspectors, engineers, and technicians is spread throughout
the world. Ongoing training programs ensure that the Company's inspectors,
engineers, and technicians are kept up-to-date on the latest engineering and
technical developments.
D. MARKETING
Insurance
The Company's various functional operations are aligned to focus on its two
principal customer groups, commercial risks and global special risks. The
Company believes that this organizational structure allows it to service its
customers more effectively and efficiently and at the same time to be a more
aggressive and flexible competitor.
Currently, the Company's principal market for its insurance business is the
United States. In 1998, 87.4 percent of its net written premiums related to
risks located in the United States. Of the direct premiums written in the United
States in 1998 (gross premiums less return premiums and cancellations, excluding
reinsurance assumed and before deducting reinsurance ceded), less than 10
percent was written in any one state. With the exception of California, Florida,
New York, Pennsylvania and Texas, no state accounted for more than 5 percent of
such premiums.
The Company has contracts with independent insurance agencies in all fifty
states, the District of Columbia, Puerto Rico and Canada. These agencies market
the Company's direct insurance to its small and medium commercial accounts.
Personal contact with these
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independent insurance agents is accomplished through the Company's field sales
force which operates out of various branch offices across the country and in
Canada. It is the Company's policy in appointing agents to be selective, seeking
to maintain and strengthen its existing relationships and to develop
relationships with new agents whom the Company believes will become a continuing
source of profitable business. The Company periodically reviews its agency
contracts and selectively reduces them in order to retain only those agents who
consistently produce certain minimum levels of business for the Company.
Large, engineering-intensive U.S. and international accounts, most of which
comprise the Global Special Risk segment, are primarily marketed and serviced by
account teams comprised of underwriting, marketing, engineering and claims staff
who have specialized knowledge of particular customer industries. U.S. customers
are serviced primarily by HSBIIC and HSB Industrial Risk Insurers. Canadian
customers are serviced by The Boiler Inspection and Insurance Company of Canada.
Overseas customers are serviced by HSB Engineering Insurance Limited, based in
London, with additional offices in Hong Kong, Malaysia, Australia, Miami, New
York, Spain, Korea and South Africa.
Additionally, the Company markets its insurance products through the
distribution channels of the companies which it reinsures.
HSB Industrial Risk Insurers markets its products primarily through a small
number of large international brokerage firms. A portion of the Company's Global
Special Risk business is also produced through these brokers.
Recently there has been significant consolidation in the international
brokerage business, including the merger of Marsh & McLennan and Johnson &
Higgins during 1997, and the subsequent merger with Sedgwick Group. For 1998,
approximately 35 percent of the Company's gross written premium generated by its
Global Special Risk business which includes HSB Industrial Risk Insurers was
produced by J&H Marsh & McLennan and Sedgwick Group and 11.35 percent was
produced by Aon Corporation.
No other insured or broker accounts for more than 10 percent of the
consolidated total revenues of the Company.
Engineering Services
The Company's engineering services are marketed in a variety of ways.
Customized services related to loss prevention, failure analysis, and equipment
testing are generally sold in conjunction with the insurance contract but are
also available separately. Most other engineering services are marketed on a bid
or proposal basis. While such business is usually price sensitive, the exacting
standards and requirements set by industry and government for most of the
services offered by the Company tend to diminish that effect.
Engineering services are marketed and serviced primarily by personnel
located in the Company's various domestic and international offices.
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While the primary market for engineering services continues to be the U.S.,
the Company has been focusing on expanding its international business, primarily
in Europe, the Pacific Rim and certain countries in South America as demand for
engineering services is expected to grow at a faster rate in these developing
regions than in the U.S.
No engineering services customer accounts for more than 10 percent of the
Company's consolidated total revenues.
E. REGULATION
Insurance
The Company's domestic insurance subsidiaries' operations are subject to
regulation throughout the United States. Various aspects of the insurance
operations are regulated, including the type and amount of business that can be
written, the price that can be charged for particular forms of coverage, policy
forms, trade and claim settlement practices, reserve requirements and agency
appointments. Regulations also extend to the form and content of financial
statements filed with such regulatory authorities, the type and concentration of
permitted investments for insurers, and the extent and nature of transactions
between members of a holding company system, including dividends involving
insurers. In general, such transactions must be on fair and reasonable terms,
and in some cases, prior regulatory approval is required.
The nature and extent of regulations pertaining to the business the Company
writes outside of the U.S. varies considerably. Regulations cover various
financial and operational areas, including such matters as amount and type of
reserves, currency, policy language, repatriation of assets and compulsory
cessions of reinsurance.
The National Association of Insurance Commissioners (NAIC) has adopted
risk-based capital (RBC) requirements applicable to property and casualty
insurers. The RBC formula establishes a required statutory surplus level for an
insurer based on the risks inherent in its overall operations which are
identified as underwriting risk, invested asset risk, credit risk and
off-balance sheet risk. The law provides for regulatory responses ranging from
requiring a plan of corrective action to placing the insurer under regulatory
control for insurers whose surplus is below the prescribed RBC target. HSBIIC's
adjusted capital significantly exceeded the authorized control level RBC for
1998.
NAIC Insurance Regulatory Information System (IRIS) ratios are part of the
solvency impairment early warning system of the NAIC. They consist of twelve
categories of financial data with defined acceptable ranges for each. Companies
with ratios outside of the acceptable ranges are selected for closer review by
regulators. HSBIIC's IRIS ratios were within acceptable ranges for 1998.
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The Company's insurance subsidiaries' operations are subject to examination
by insurance regulators at regular intervals. The most recently concluded
insurance examination for HSBIIC was conducted for the year ended December 31,
1994 by the Connecticut Insurance Department, the HSBIIC's domestic regulator.
No material findings were included in the final report of the examination. The
years 1995-1998 are currently under examination by the Connecticut Insurance
Department. Similar regulatory procedures govern the Company's other U.S. and
foreign insurance subsidiaries.
Insurance guaranty fund laws exist in all states which subject insurers to
assessments up to prescribed limits for certain obligations of insolvent
insurers to their policyholders and claimants. The Company is permitted to
recover a portion of these assessments through premium tax offsets and policy
surcharges.
See Note 6 to the Consolidated Financial Statements located in Item 8 of
Part II herein for additional information on statutory reporting.
As discussed earlier, the Company's insureds receive, in addition to the
insurance product, inspections which meet state, county or municipally mandated
requirements. In order for the Company's inspectors to perform these mandated
inspections, they must be commissioned. Commissioning is conducted by the
National Board of Boiler and Pressure Vessel Inspectors and the various state
jurisdictional authorities. The majority of the Company's inspectors are
commissioned, and the Company believes that it has an adequate number of
commissioned inspectors to conduct its business affairs.
Engineering Services
A portion of the Company's engineering services revenue comes from
certifying that boilers and pressure vessels are being constructed according to
standards adopted by the American Society of Mechanical Engineers (ASME). The
commission that authorizes inspectors to conduct insurance inspections also
authorizes them to perform ASME Code inspections. The Company performs other
certification and inspection services which are governed by established
standards, such as ISO 9000.
Other
The Company and members of its professional and technical staff are subject
to a variety of other state, local and foreign licensing and permit requirements
and other laws generally applicable to corporations and businesses.
F. INSURANCE OPERATIONS
Policies
Pricing for the Company's insurance policies is based upon the rates the
Company has developed for use with its various products. In many jurisdictions
in which the Company
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does business, such rates, as well as the policy forms themselves, must be
approved by the jurisdiction's insurance regulator. Rates for the Company's
products are developed based upon estimated claim costs, expenses related to the
acquisition and servicing of the business, engineering expenses and a profit
component.
Coverages for unique risks are judgment-rated, taking into account
deductibles, the condition of the insured's equipment, loss prevention and
maintenance programs of the insured, and other factors.
Policies are normally written for a term of one year. Most of the Company's
policies provide coverage for property damage and business interruption to
insured property (including buildings and structures under the Company's all
risk policy) resulting from covered perils. Property insured under the Company's
equipment breakdown policies includes such equipment as steam boilers, hot water
boilers, pressure vessels, refrigerating and air conditioning systems, motors,
generators, compressors, pumps, engines, fans, blowers, gear sets, turbines,
transformers, electrical switch gear, data processing and business equipment and
a wide variety of production and processing equipment.
The Company's policy with respect to the business it underwrites (exclusive
of its participation in HSB Industrial Risk Insurers) is to generally manage its
risks to probable maximum losses (PMLs) not in excess of $50 million and maximum
foreseeable losses (MFLs) not in excess of $100 million. The Company's current
reinsurance program generally limits the Company's retention on any one loss to
$3 million, with potentially higher per risk retentions dependent on aggregate
losses experienced by the Company during the reinsurance period. See
"Participation in HSB Industrial Risk Insurers" on page 12 below for information
on the underwriting policy of HSB Industrial Risk Insurers.
Reinsurance Assumed
The predominant practice in the insurance industry is to combine several
types of insurance coverages into one policy referred to as a package policy.
The Company has reinsurance agreements with over 100 multi-line insurance
companies to reach the small to mid-sized customers that purchase such package
policies. This business primarily focuses on small and mid-sized commercial
customers and it offers a significant opportunity for growth by the Company
because, based on Company estimates, equipment breakdown coverage is only
provided currently to less than 10 percent of the over 10 million insured
companies and institutions in the United States.
Under the reinsurance agreements, the Company's reinsured companies may
include equipment breakdown exposures in their multi-peril policies, and such
risks will be assumed by the Company under the terms of the agreements. These
plans generally provide that the Company will assume 100 percent of each boiler
and machinery risk, subject to the capacity specified in the agreement, and will
receive the entire equipment breakdown premium except for a ceding commission
which will be retained by the reinsured company for commissions to agents and
brokers, premium taxes and handling expenses.
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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 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 a portfolio of accounts meeting
specific underwriting guidelines and occupancy parameters, which the Company
agrees to reinsure for equipment breakdown losses.
The insurance industry, in general, continues to undergo a significant
shakeout and consolidation. A significant amount of merger and acquisition
activity has occurred recently and may continue in the future. Depending on the
specific companies involved in these activities and other market factors, the
level of reinsured business the Company assumes in the future under the
arrangements described above could be impacted.
The Company also assumes reinsurance, primarily on a facultative basis, for
certain large risks and several insurance pools.
The written premium generated through reinsurance assumed totaled $318.5
million in 1998, representing approximately 40.0 percent of the Company's gross
written premium.
Reinsurance Ceded
As a property carrier, 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 high risk lines, and to provide
additional capacity to write business. The Company evaluates its exposures and
reinsurance needs annually to implement a program that corresponds with the
level of exposure it is willing to retain. Under the Company's current treaty
reinsurance program, its maximum retention on any one risk is limited to $3
million, with potentially higher per risk retentions depending on aggregate
losses experienced by the Company during the reinsurance program period. In
addition, the Company uses facultative reinsurance on certain high exposure
risks and has catastrophe reinsurance for aggregate net losses greater than $15
million.
The Company's reinsurance costs continue to be impacted by its prior loss
experience and business growth. In 1998 the Company's ceded premiums increased
by 217.1 percent primarily due to the quota share reinsurance agreements with
Employers Reinsurance Corporation and HSB Industrial Risk Insurers (see
"Participation in HSB Industrial
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Risk Insurers" below) and changes in the Company's reinsurance programs which
now utilize more quota share reinsurance on certain of its books of business.
The Company utilizes well-capitalized domestic and international
reinsurance companies and syndicates for its reinsurance program and monitors
their financial condition on an ongoing basis. For reinsurers that are not
accredited in their state of domicile, the Company requires collateral for
reinsurance recoverable from such carriers. In the unlikely event that the
Company's reinsurers are unable to meet their obligations, the Company would
continue to have primary liability to policyholders for losses incurred.
Uncollectible reinsurance recoverables have not had, and are not expected by
management to have in the future, a material adverse effect on the consolidated
results of operations or financial position of the Company. The Company is not
party to any contracts that do not comply with the risk transfer provisions of
SFAS 113 "Accounting and Reporting for Reinsurance of Short-Duration and
Long-Duration Contracts".
For additional information on reinsurance, see Notes 10 and 11 to the
Consolidated Financial Statements located in Item 8 of Part II herein.
Pools and Joint Underwriting Associations
With the exception of HSB Industrial Risk Insurers as described on page 2
and discussed below, the Company does not participate to any significant degree
in voluntary reinsurance pools of other insurance companies because the Company
generally chooses to insure only those risks which it has inspected or has the
right to inspect. The Company is required to participate in certain joint
underwriting associations which provide insurance for particular classes of
insureds when insurance in the voluntary market is unavailable.
Participation in HSB Industrial Risk Insurers
HSB Industrial Risk Insurers (HSB IRI) is an unincorporated, voluntary
joint underwriting association that provides property insurance for the class of
business known as "highly protected risks" for larger manufacturing, processing
and industrial businesses which have invested in protection against loss through
the use of sprinklers and other means. As a result of the reconstitution of HSB
IRI effective January 1, 1998 (see "A. GENERAL DEVELOPMENT OF BUSINESS" above),
HSBIIC writes the insurance for HSB IRI using its insurance licenses and
provides certain other services. In addition, through various quota share
reinsurance agreements with Employers Reinsurance Corporation and HSB IRI,
HSBIIC transferred its manufacturing book of business to HSB IRI and retains 85
percent of the equipment breakdown insurance and 15 percent of the property
insurance of the combined insurance portfolio.
From December 1, 1996 until the close of the sale of its interest in
Industrial Risk Insurers to ERC, HSBIIC's membership interest was 23.5 percent.
In 1996 and 1995 its membership share was 14 percent and .5 percent,
respectively. The Company increased its share significantly over this two-year
period because it believed that participation in the IRI represented an
opportunity to
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apply the Company's underwriting, engineering and reinsurance skill sets to a
large block of business and to potentially provide a quick turnaround of IRI's
underwriting results with only a limited capital outlay of Company funds. The
Company's increased share enabled the Company to have a more significant role in
helping IRI be an effective and profitable provider of essential property
insurance and loss prevention services to larger risks. The new agreements with
ERC and HSB IRI continue this opportunity to utilize the Company's skills while
at the same time reducing its exposure to the more volatile property business.
The agreements with ERC are of indefinite duration and are terminable in
the event of the insolvency or loss of accredited reinsurer or licensed insurer
status of ERC or HSBIIC, or a material breach which has not been cured within
the time frame specified in the agreements, or by mutual consent of the parties.
In addition, ERC has an option to purchase HSBIIC's interest in the business in
the event of a 50 percent or more change in control of HSB. Net earned premium
attributable to the agreements with ERC and HSB IRI, prior to the placement of
reinsurance by the Company for its own account, was 15 percent of the Company's
total consolidated revenues for 1998. Ceding commissions, which are netted out
of expenses, were 10 percent of consolidated revenues for 1998.
HSB IRI's underwriting policy is to manage its risks to probable
maximum losses (PML) not to exceed $150 million and maximum foreseeable losses
(MFL) not to exceed $400 million. The equipment breakdown PMLs and MFLs within
the overall property coverage underwritten by HSB IRI do not generally exceed
$50 million and $100 million, respectively. HSBIIC's primary participation
effective January 1, 1998 as described above is attributable to the 85 percent
share of the equipment breakdown insurance written through HSB IRI. Based on
HSBIIC's current participation in HSB IRI's business, were an equipment
breakdown MFL to take place, the Company's proportionate share, net of HSB IRI
and HSBIIC reinsurance, would be no more than $3 million.
Claims and Claim Adjustment
Essentially all claims under the Company's policies of insurance are
handled by the Company's own claims handlers. Management believes that the
Company's handlers are better able to make the connection between loss
prevention and loss control. The Company employs claims handlers in its various
offices throughout the country, Canada and the U.K. Claims handlers, in many
cases, are assigned to particular customer groups in order to apply specialized
industry knowledge to the adjustment of claims. Policies underwritten by the
Company pursuant to the agreements with Employers Reinsurance Corporation
relating to the business of HSB IRI described under "Participation in HSB
Industrial Risk Insurers" on page 12 are adjusted by Company and HSB IRI staff
claims handlers as determined by the Company in accordance with such agreements.
Claims and adjustment expense reserves comprise one of the largest
liabilities of the Company. Reserves are established to reflect 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
13
<PAGE>
settled and those that have been incurred but not yet reported. Loss reserve
estimates reflect such variables as past loss experience and inflation. In
addition, due to the nature of much of the coverages, complex engineering
judgments are involved. Subjective judgments are an integral component of the
loss reserving process, due to the nature of the variables involved. Previously
established loss reserves are regularly adjusted as loss experience develops and
new information becomes available. Adjustments to previously established
reserves are reflected in the financial statements in the period in which the
estimates are changed.
The normal turnaround time in paying small claims is less than six months.
The vast majority of claims are settled within one year and very few remain
unsettled two years after the loss occurs. This pattern is somewhat skewed in
terms of claim dollars (as noted in the schedule on pages 17 - 18) as it is the
larger claims that often take longer to adjust. Compared to the
property/casualty industry as a whole, the Company has a very "short-tail". The
Company's claims expenses are based on estimates of the current costs of
replacing productive capacity. The Company does not employ discounting
techniques in establishing liabilities for claims and claim adjustment expenses.
For those relatively few claims involving litigation, the Company uses both
its in-house law department and outside counsel, depending on the issues, costs,
and staffing requirements.
The following table provides a reconciliation of the beginning and ending
reserves for net claims and claim adjustment expenses for the years ended
December 31, 1998, 1997 and 1996.
RECONCILIATION OF NET LIABILITY FOR
CLAIMS AND CLAIM ADJUSTMENT EXPENSES
1998 1997 1996
---------- ---------- ----------
(in millions)
Net liability for claims and
adjustment expenses at January 1, $190.8 $177.8 $145.5
Plus:
Provision for claims and adjustment
expenses occurring in the current year 164.0 209.5 214.2
Increase (decrease) in estimated claims and
adjustment expenses arising in prior years 10.9 8.4 (9.8)
--------------------------------
Total incurred claims and adjustment expenses 174.9 217.9 204.4
--------------------------------
Less:
Payment for claims arising in:
Current year 84.2 82.3 91.4
Prior years 111.8 122.6 80.7
--------------------------------
Total payments 196.0 204.9 172.1
--------------------------------
Net liability for claims and adjustment
expenses at December 31, $169.7 $190.8 $177.8
--------------------------------
14
<PAGE>
The 1998 loss ratio was 44.2 percent compared to 44.4 percent and 45.6
percent for 1997 and 1996, respectively. Results for the 1998 year were impacted
by severe ice storms that affected 30 percent of Canada in January, as well as a
few significant losses in the Company's international business. The 1.2 percent
decrease in loss ratio in 1997 was primarily the result of fewer weather-related
losses. Adverse development in 1998 and 1997 added 2.8 and 1.7 percentage points
to the respective loss ratio. Positive development in 1996 reduced the loss
ratio by 2.2 percentage points.
The following table shows a reconciliation of the net liability to the
gross liability for claims and claim adjustment expenses based on reinsurance
recoverable on unpaid losses.
RECONCILIATION OF NET LIABILITY TO GROSS LIABILITY
FOR CLAIMS AND CLAIM ADJUSTMENT EXPENSES
1998 1997 1996
---------------------------------
(in millions)
Net liability for claims and
adjustment expenses at December 31, $169.7 $190.8 $177.8
Reinsurance recoverable on unpaid claims
and adjustment expenses 380.6 85.9 125.1
------------------------------------
Gross liability for claims and
adjustment expenses at December 31, $550.3 $276.7 $302.9
====================================
15
<PAGE>
RECONCILIATION OF GROSS LIABILITY FOR CLAIMS AND
CLAIM ADJUSTMENT EXPENSES
1998 1997 1996
- --------------------------------------------------------------------------------
(in millions)
Gross liability for claims and
claim adjustment expenses at January 1, $276.7 $302.9 $190.9
Plus:
Provision for claims and claim adjustment
expenses occurring in the current year 564.8 263.3 313.3
Increase in estimated claims and claim
adjustment expenses arising in prior years 46.9 (0.2) 16.1
-------------------------------
Total incurred claims and claim
adjustment expenses $611.7 $263.1 $329.4
-------------------------------
Less:
Payment for claims arising in:
Current year 141.0 90.6 103.3
Prior years 197.1 198.7 114.1
-------------------------------
Total payments $338.1 $289.3 $217.4
-------------------------------
Gross liability for claims and claim
adjustment expenses at December 31, $550.3 $276.7 $302.9
- --------------------------------------------------------------------------------
The claim and claim expense reserve runoff table on the following pages
shows the amounts of the net liability for 1988 through 1998 and the amounts of
the gross liability for 1993 through 1998. The ten-year development table for
gross liabilities is being constructed progressively, with 1993 as the base
year. Within the tables for net and gross liabilities, each column shows the
reserve established at each calendar year-end as well as cumulative totals for
claims payments and re-estimated liabilities for both that accident year and all
previous years that combined make up that year-end reserve. The redundancy
(deficiency) shown on a gross and net basis is a cumulative number for that year
and all previous years.
The net deficiencies in 1990, 1991 and 1992 were 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.
The redundancy shown for 1988 was attributed to the difficulty in
estimating claims due to inflationary impacts and business interruption, which
became a larger component of
16
<PAGE>
claims. The claim reserves established in 1988 have been favorably settled,
adjusted or closed based on the results of claim audits, technical loss
analysis, subrogation, settlement with property carriers and the latest
available information. The net impact of those favorable settlements was to
decrease claims expenses as reported by $10.2 million in 1990 and $28.0 million
in 1989.
<PAGE>
RECONCILIATION OF BEGINNING AND ENDING CLAIMS RESERVES
AND EXHIBIT OF REDUNDANCIES (DEFICIENCIES)
(in millions)
Net Reserves
<TABLE>
<CAPTION>
YEAR ENDED 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
- ---------- ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Net Liability for
Unpaid Claims and
Claim Adjustment
Expenses $157.4 $139.6 $115.7 $111.4 $132.8 $171.3 $161.3 $145.5 $177.8 $190.8 $169.7
Cumulative Amount Paid
as of:
End of Year - - - - - - - - - - -
One Year Later 78.8 85.6 86.7 91.2 99.7 108.8 111.7 80.6 122.6 111.8 -
Two Years Later 92.1 104.2 109.7 115.5 134.0 152.1 126.9 99.8 146.3 - -
Three Years Later 95.5 110.3 120.6 127.0 154.4 153.4 134.5 112.1 - - -
Four Years Later 95.4 112.5 127.6 137.7 151.1 157.8 144.1 - - - -
Five Years Later 93.6 118.9 132.7 135.7 151.6 166.1 - - - - -
Six Years Later 100.5 123.0 131.4 135.7 160.0 - - - - - -
Seven Years Later 101.5 121.4 130.9 136.7 - - - - - - -
Eight Years Later 100.1 120.8 131.6 - - - - - - - -
Nine Years Later 100.2 121.5 - - - - - - - - -
Ten Years Later 100.4 - - - - - - - - - -
Net Liability
Reestimated as of:
End of Year 157.4 139.6 115.7 111.4 132.8 171.3 161.3 145.5 177.8 190.8 169.7
One Year Later 129.4 129.4 135.4 137.5 159.7 172.7 163.9 135.7 186.2 201.7 -
Two Years Later 108.7 127.4 138.0 139.7 166.6 173.9 157.3 128.8 187.5 - -
Three Years Later 106.8 127.8 136.9 141.1 165.2 170.6 154.2 131.2 - - -
Four Years Later 103.0 125.0 137.9 142.0 163.0 169.2 155.3 - - - -
Five Years Later 102.3 125.8 135.7 141.4 161.5 168.0 - - - -
Six Years Later 104.0 125.5 136.0 141.3 163.4 - - - - - -
Seven Years Later 103.8 125.8 135.8 139.6 - - - - - - -
Eight Years Later 104.2 125.5 134.5 - - - - - - - -
Nine Years Later 104.7 124.2 - - - - - - - - -
Ten Years Later 103.0 - - - - - - - - - -
Cumulative Redundancy
(Deficiency) 54.3 15.4 (18.7) (28.3) (30.6) 3.4 6.1 14.3 (9.6) (10.9) -
</TABLE>
The above table and the following table include information related to the
Company's participation in HSB IRI. For 1998, incurred claims and claims
adjustment expenses include $14.4 million related to the Company's participation
in HSB IRI effective January 1, 1998 plus development of $.4 relating to 1997
and prior accident years. For 1997, incurred claims and claims adjustment
expenses include $31.6 million related to the Company's 23.5 percent
participation in IRI effective December 1, 1996 plus development of ($1.3
million) relating to prior accident years. For 1996, incurred claims and claims
adjustment expenses include $23.2 million related to the Company's 14 percent
participation in IRI effective December 1, 1995, plus development of ($.4
million) relating to prior accident years. The Company carried net reserves in
the amounts of $20.6, $22.2, and $11.6 million related to its participation in
HSB IRI at December 31, 1998 and in IRI at December 31, 1997 and 1996,
respectively.
17
<PAGE>
Gross Reserves
<TABLE>
<CAPTION>
YEAR ENDED 1993 1994 1995 1996 1997 1998
- ---------- ---- ---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C> <C>
Gross Liability for
Unpaid Claims and Claim
Adjustment Expenses $214.4 $199.4 $190.9 $302.9 $276.7 $550.3
Cumulative Amount Paid as of:
End of Year - - - - - -
One Year Later 144.2 135.2 108.9 198.8 197.1 -
Two Years Later 189.9 164.1 158.0 284.2 - -
Three Years Later 200.2 201.1 212.4 - - -
Four Years Later 229.8 251.7 - - - -
Five Years Later 277.0 - - - - -
Gross Liability Reestimated as of:
End of year 214.4 199.4 190.9 302.9 276.7 550.3
One Year Later 224.3 212.0 205.5 302.7 323.5 -
Two Years Later 227.0 228.3 194.6 339.8 - -
Three Years Later 243.4 226.8 234.6 - - -
Four Years Later 245.0 264.8 - - - -
Five Years Later 281.4 - - - - -
Cumulative Redundancy
(Deficiency) (67.0) (65.3) (43.7) (36.9) (46.9) -
</TABLE>
The adverse development primarily resulted from the decision rendered under an
arbitration proceeding for a claim occurring in 1992 and from adverse claims
experience in international operations primarily occurring in accident year
1997.
G. INVESTMENTS
Income from the Company's investment portfolio contributes significantly to
earnings. Each year there is a significant net inflow of cash from insurance,
engineering services and investment operations into the Company's investment
portfolio. In addition, cash flow is affected by the normal maturity of fixed
income investments, financing activities and the purchase and sale of equity
securities.
<TABLE>
<CAPTION>
(in millions)
1998 1997 1996 1995 1994
-------- -----------------------------------------
<S> <C> <C> <C> <C> <C>
Net Investment Income $ 64.2 $ 36.8 $ 32.3 $ 28.9 $ 26.2
Realized Investment Gains 25.4 14.1 12.1 2.8 8.7
-------- --------- -------------------------------
Income from Investment Operations $ 89.6 $ 50.9 $ 44.4 $ 31.7 $ 34.9
Net Unrealized Gains $113.1 $ 95.3 $ 81.4 $ 65.4 $ 16.5
Statutory Surplus (HSBIIC) $612.6 $550.8 $292.4 $280.6 $238.0
</TABLE>
The Company's 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
fluctuations in income from investment operations from 1994 through 1997 were
largely driven by the amount of realized gains generated in each of such years.
In 1994 the stock market experienced a significant decline which impacted both
the Company's realized and unrealized gains. In 1995 the Company curtailed its
realized gains in order to
18
<PAGE>
take advantage of a strongly performing market and to build statutory surplus.
In 1996 the Company continued to build statutory surplus, however, high
valuations towards the end of the year caused the Company to realize gains.
Realized investment gains increased in 1997 over 1996 as the Company managed its
portfolio to respond to changing market conditions and tax planning
opportunities, and as a result of calls of fixed income and convertible
securities. Realized investment gains in 1998 were significantly impacted by
call premiums on fixed income instruments and sales of certain convertible
securities and common stocks in response to market conditions.
Net investment income reached its lowest level during 1994 as a result of a
lower average investment portfolio as holdings were liquidated to pay dividends,
repay debt, and purchase fixed assets and treasury stock. The increase in 1995
resulted from the full consolidation of EIG, Co. offset by a lower interest rate
environment. Net investment income increased 11.8 percent in 1996 due to an
increased level of investable assets and to a lesser extent by dividend
increases on the Company's common stock investments. Net investment income for
1997 increased 13.9 percent compared to 1996. The increase is attributable to
calls of high yielding preferred stocks early in the year the proceeds of which
were invested in fully taxable securities, and more investable funds as the
Company invested the proceeds from its capital securities issued in the second
half of 1997. In 1998 net investment income increased significantly due to the
investment of the capital securities proceeds and from the January 1998 sales of
the Company's interests in IRI and Radian International LLC.
The significant increase in statutory surplus of HSBIIC for 1997 resulted
from a contribution to capital of $250 million of the $300 million in proceeds
received by the Company from the sale of its convertible capital securities to
Employers Reinsurance Corporation on December 31, 1997. The increase in surplus
for 1998 resulted from the January 1998 sales of HSBIIC's interests in IRI and
Radian International LLC.
The Company's investment portfolio consists of high-grade domestic and
foreign investments. Excluding short-term investments, HSB's investments are
primarily comprised of publicly traded, highly liquid securities. Investment
strategies for any given year are developed based on many factors including
operational results, tax implications, regulatory requirements, interest rates,
dividends to shareholders and market conditions.
In December 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 which required
HSBIIC to pay its counterparty $30.7 million in foregone appreciation on its
portfolio. In 1997, the Company's U.S. common stock portfolio experienced a
total return of $57 million (which included price appreciation of approximately
$54 million) since December 31, 1996, and had a price movement correlation with
the S&P 500 Index well in excess of 80 percent.
19
<PAGE>
At December 31, 1998, the Company had approximately 53.6 percent of its
invested assets in fixed maturities as compared to 38.1 percent at year-end
1997. In the period 1991-1996 the Company gradually reduced its investments in
common stocks as part of its overall capital management strategy. At year-end
1998, the carrying value of the equity securities portfolio represented 40.6
percent of invested assets compared to 49.7 percent at year-end 1997. The 9.1
percent decrease is primarily attributable to a substantial increase in fixed
income assets as total equity securities actually increased by over $100
million.
The Company does not engage in cash-flow underwriting; it seeks to have
underwriting profit each year. None of the Company's claim reserves are
discounted as most claims settle, on average, within one year. Therefore, the
Company does not use duration measurements in managing its interest rate
exposure. Instead, the Company manages its portfolio by laddering a portion of
its invested assets such that the average estimated maturity of these assets is
generally maintained between 5-10 years. This technique provides the Company
with a predictable cash flow each year and enables it to respond to the
previously discussed parameters that impact its investment strategy. In
addition, the Company manages a portion of its invested assets on a
long-term/segmented basis to provide interest coverage on the servicing
requirements of its convertible capital securities.
See "Investment Operations" in the Management's Discussion and Analysis of
Consolidated Financial Condition and Results of Operations located in Item 7 and
Note 7 to Consolidated Financial Statements in Item 8 of Part II herein for
additional information.
The following table summarizes the investment results of the Company's
investment portfolio:
Annualized Rate Investment
Net Invest- of Return (2) Gains (Losses) (3)
Cash and ment Income ------------------------------------------
Invested Less Before After
Assets, Less Interest Income Income Change in
Borrowed Money Expense (1) Taxes Taxes Realized Unrealized
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
(in millions) (in millions)
1998 $1,048.7 $63.4 6.6%** 5.1%** $25.4 $17.8
1997 629.2* 35.5 6.1 5.1 14.1 13.9
1996 572.6 31.7 6.0 5.4 12.1 16.0
* Does not include $300 million in proceeds from the sale of convertible capital
securities on December 31, 1997.
**For the calculation of Annualized Rate of Return, "Cash and Invested Assets,
Less Borrowed Money" includes the $300 million in proceeds in the beginning of
the year.
(1) Net investment income excludes realized investment gains and is reduced by
investment expenses, but is before the deduction for income taxes.
20
<PAGE>
(2) The rates of return on investments shown above have been determined in
accordance with rules prescribed by the National Association of Insurance
Commissioners. These rates have been determined by the following formula:
2I
----
A + B - I
I is equal to net investment income, before taxes, earned on investment assets.
A+B is equal to the sum of the beginning and end of the year amounts shown under
"Cash and Invested Assets, Less Borrowed Money". The after tax rates of return
are computed in the same manner, but net investment income is reduced by income
taxes.
(3) Realized and unrealized investment gains (losses) are before income taxes.
H. EMPLOYEES
At year-end 1998, the Company, including its wholly-owned subsidiaries, had
2,447 full and part-time employees. Management believes that its relations with
its employees are satisfactory.
I. FORWARD-LOOKING STATEMENTS
For a summary of factors that may materially affect the Company's future
business, see "Forward-Looking Statements" in Management's Discussion and
Analysis of Consolidated Financial Condition and Results of Operations in Item
7.
Item 2. Properties.
The Hartford Steam Boiler Inspection and Insurance Company leases
approximately 221,516 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 Canada, and in a small number of other foreign locations. The Company
considers the office facilities and other operating resources to be suitable and
adequate for its current and anticipated level of operations.
See Notes 8 and 9 to Consolidated Financial Statements located in Item 8 of
Part II herein for additional information.
21
<PAGE>
Item 3. Legal Proceedings.
HSBIIC is currently involved in a claim-related dispute concerning the
extent to which a certain explosion event is insured under the boiler and
machinery coverage of HSBIIC or under coverages of other insurers. A final
decision in an arbitration proceeding on this matter has concluded with a
decision requiring HSBIIC to pay $22 million of the amount that was in dispute.
The $22 million, less HSBIIC's retention of $3 million, which was reserved for
in prior years, is fully reinsured. In response to the ruling, the Company
increased both its gross reserves and reinsurance recoverable by $19 million,
resulting in no impact to net income. HSBIIC has filed a motion in Connecticut
Superior Court to confirm the arbitration award. The other insurers have
contested the award. In the event the award is not confirmed, subsequent
proceedings could result in additional amounts on the order of $100 million
potentially becoming recoverable from HSBIIC's reinsurers.
The obligations of HSBIIC's reinsurers with respect to this litigation are
not in dispute. Therefore, management believes that any adverse outcome in this
case will not have a material effect on either the results of operations or
financial condition of the Company. HSBIIC's reinsurance contracts do not
require HSBIIC to reimburse its reinsurers for any loss such reinsurers might
incur should this case not be decided in HSBIIC's favor. Nevertheless,
reinsurers often quote rates for future coverages based upon their or other
reinsurers' experience on a particular account. Therefore, in the event HSBIIC's
reinsurers pay significant sums pursuant to the litigation described above, it
is likely HSBIIC's reinsurance rates would increase in future periods. However,
given the insured capacity that exists in reinsurance markets worldwide, coupled
with HSBIIC's ability to negotiate a redesign or restructuring of its
reinsurance program, it does not necessarily mean that such an increase would be
material.
HSBIIC was involved in another litigation regarding an explosion event and
the extent of HSBIIC's coverage in that matter. The 7th Circuit Court of Appeals
recently ruled in HSBIIC's favor and remanded the case for a judgment of no
liability to be entered for HSBIIC.
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.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
22
<PAGE>
Item 4(a). Executive Officers of the Registrant.
All executive officers are elected by the Board of Directors to hold office
until the next Annual Meeting of Shareholders. An officer may be removed at any
time by the Board of Directors.
On June 24, 1997, all of the outstanding shares of common stock of The
Hartford Steam Boiler Inspection and Insurance Company were exchanged for shares
of common stock of the Company. The service listed for each executive officer
listed below includes their service with Hartford Steam Boiler.
Gordon W. Kreh, 51, Chairman since 9/98 and Chief Executive Officer, President
and Director since 4/94; President and Director 9/93 - 4/94; Senior Vice
President - Marketing 4/92 - 9/93; President - Engineering Insurance Group 10/89
- - 4/92; Vice President 11/84 - 10/89; Assistant Vice President 4/81 - 11/84.
Saul L. Basch, 52, Senior Vice President, Treasurer and Chief Financial Officer
since 10/95; Partner, Coopers & Lybrand L.L.P. 9/73 - 10/95, most recently as
Partner-in-Charge of Coopers & Lybrand's New York Insurance Industry Practice.
Michael L. Downs, 49, Senior Vice President - Global Special Risks since 2/94;
Managing Director - Engineering Insurance Co., Ltd. 1/91 - 2/94; Second Vice
President 7/87 - 1/91; Assistant Vice President 2/85 - 7/87; Assistant Secretary
4/80 - 2/85.
John J. Kelley, 53, Senior Vice President - Commercial Risks - Strategic
Development since 2/94; Corporate Secretary and Special Assistant to the
President 5/87 - 2/94; Assistant Vice President and Special Assistant to the
President 9/83 - 5/87; Assistant Vice President 9/79 - 9/83; Assistant Secretary
4/77 - 9/79.
William A. Kerr, 61, Senior Vice President - Engineering since 9/95; Vice
President and General Manager, Pratt & Whitney Turbo Power and Marine Division,
United Technologies Corporation 8/95 - 9/95; Vice President of Aftermarket
Operations, Pratt & Whitney 4/92 - 8/95; Vice President of Development
Operations and Materials Engineering, Pratt & Whitney 1989-4/92.
Normand Mercier, 53, Senior Vice President - Commercial Risks - Operations since
9/98; Senior Vice President, HSBIIC since 4/98; President, The Boiler Inspection
and Insurance Company 1/90-4/98.
R. Kevin Price, 52, Senior Vice President and Corporate Secretary since 2/94;
Second Vice President 4/89 - 2/94; Assistant Vice President 1/84 - 4/89.
William Stockdale, 53, Senior Vice President since 9/95; Managing Director and
Chief Executive Officer of HSB Engineering Insurance Ltd., London, since 9/94;
Director of
23
<PAGE>
Engineering, Engineering Insurance Co., Ltd. 9/92-9/94; Managing Director
Scottish Power PLC, Glasgow, Scotland 1/89 - 8/92.
Robert C. Walker, 55, Senior Vice President-Claims and General Counsel since
1/95; Senior Vice President - Claims 3/94 - 1/95; Associate General Counsel and
head of Corporate Litigation Department of United Technologies Corporation
5/89-3/94.
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.
The Company's common stock is traded on the New York Stock Exchange under
the symbol HSB. As of February 16, 1999, the Company had 5,034 holders of
record.
Dividends paid by The Hartford Steam Boiler Inspection and Insurance
Company, HSB Group's principal subsidiary, are limited by state insurance
regulations. Approval from the Connecticut Insurance Commissioner is required
for dividend distributions within a twelve-month period which would exceed the
greater of (i) 10 percent of an insurer's statutory surplus or (ii) net income
calculated as of the December 31st last preceding. Regulatory approval was
required for the payment of 1998 dividends but is not anticipated to be
necessary for 1999 dividends since approximately $200.2 million of HSBIIC's
statutory surplus is available for distribution to HSB Group, Inc. without prior
regulatory approval.
Quarterly dividends declared for the 1998 and 1997 fiscal years, adjusted
for the May 22, 1998 three-for-two stock split, were as follows:
First Second Third Fourth Year
1998 $.40 $.40 $.42 $.42 $1.64
1997 $.38 $.38 $.40 $.40 $1.56
Quarterly market prices for the Company's common stock, adjusted for the
May 22, 1998 three-for-two stock split, were as follows for the two most recent
years:
First Second Third Fourth Year
1998 High $44.92 $53.50 $57.63 $42.00 $57.63
1998 Low $36.45 $43.17 $40.38 $36.00 $36.00
1997 High $31.50 $35.92 $37.67 $37.08 $37.67
1997 Low $29.83 $29.58 $35.08 $33.67 $29.58
24
<PAGE>
Item 6. Selected Financial Data.
The following selected consolidated financial data should be read in
conjunction with the consolidated financial statements and notes included
elsewhere herein.
(in millions, except per share amounts)(1)(2)
<TABLE>
<CAPTION>
1998 1997 1996 1995 1994
- ------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Summary of Consolidated Statements of
Operations
Revenues:
Gross earned premiums $ 770.5 $ 609.3 $ 556.5 $455.0 $381.7
Ceded premiums 374.4 118.1 107.9 65.9 45.1
-------------- --------------- --------------- ----------------- ----------------
Insurance premiums $ 396.1 $ 491.2 $ 448.6 $389.1 $336.6
Engineering services 93.5 61.3 55.8 49.9 48.0
Income from investment operations 89.6 50.9 44.4 31.7 34.9
-------------- --------------- --------------- ----------------- ----------------
Total revenues(3) $ 579.2 $ 603.4 $ 548.8 $470.7 $419.5
-------------- --------------- --------------- ----------------- ----------------
Income from continuing operations $ 104.1 $ 66.3 $ 54.6 $ 52.7 $ 44.5
Income from continuing operations
per common share-basic $ 3.55 $ 2.21 $ 1.81 $ 1.72 $ 1.45
Income from continuing operations
per common share-assuming dilution $ 3.35 $ 2.20 $ 1.81 $ 1.72 $ 1.45
Dividends paid per common share $ 1.62 $ 1.54 $ 1.52 $ 1.48 $ 1.43
------------------------------------------------------------------------------------------------------------------------
Summary of Consolidated Statements of
Financial Position
Total assets $ 2,144.0 $1,537.2 $ 1,112.3 $951.9 $877.8
Long-term borrowings and capital
lease obligations $ 53.0 $ 53.0 $ 53.0 $ 53.4 $ 28.4
Convertible redeemable preferred
stock $ -- $ -- $ 20.0 $ -- $ --
Company obligated mandatorily
redeemable capital securities $ 408.9 $ 408.9 $ -- $ -- $ --
Shareholders' equity:
Common $ 419.3 $ 345.3 $ 345.6 $341.1 $299.5
Per common share $ 14.53 $ 11.75 $ 11.50 $ 11.21 $ 9.78
Return on average equity 35.2%(5) 19.1% 15.6% 19.5% 16.9%
Stock price per share:
High $ 57.63 $ 37.67 $ 34.83 $ 33.50 $ 35.58
Low $ 36.00 $ 29.58 $ 28.58 $ 26.50 $ 24.08
Close $ 41.06 $ 36.80 $ 30.92 $ 33.33 $ 26.58
Common shares outstanding at end
of year (4) 28.9 29.4 30.0 30.5 30.6
------------------------------------------------------------------------------------------------------------------------
Insurance
Operating gain $ 41.2 $ 39.8 $ 21.8 $ 34.2 $ 20.7
Loss ratio 44.2% 44.4% 45.6% 39.8% 42.5%
Expense ratio 45.2% 47.3% 49.1% 50.9% 50.5%
-------------- --------------- --------------- ----------------- ----------------
Combined ratio 89.4% 91.7% 94.7% 90.7% 93.0%(6)
------------------------------------------------------------------------------------------------------------------------
Engineering Services
Operating gain $ 7.3 $ 4.3 $ 7.3 $ 6.7 $ 4.3
Engineering services margin 7.8% 7.1% 13.2% 13.3% 9.0%
- ------------------------------------------------------------------------------------------------------------------------
Investments
Net investment income $ 64.2 $ 36.8 $ 32.3 $ 28.9 $ 26.2
Realized investment gains 25.4 14.1 12.1 2.8 8.7
-------------- --------------- --------------- ----------------- ----------------
Income from investment operations $ 89.6 $ 50.9 $ 44.4 $ 31.7 $ 34.9
- ------------------------------------------------------------------------------------------------------------------------
</TABLE>
(1)Prior year information has been restated to reflect Radian LLC as a
discontinued operation.
(2)All per share and share data has been restated to reflect stock splits.
(3)Excludes revenues from investments accounted for under the equity method.
(4)Reflects the repurchase of approximately 1.2, 1.5, 0.4, 0.2 and 0.2 million
shares in 1998, 1997, 1996, 1995 and 1994, respectively.
(5)Includes gain on sale of IRI and discontinued operations of Radian.
(6)Excludes charge for Proposition 103.
25
<PAGE>
Item 7. Management's Discussion and Analysis of Consolidated Financial
Condition and Results of Operations.
(dollar amounts in millions, except per share amounts)
Summary of Results of Operations
Consolidated Overview
For the years ended December 31, 1998 1997 1996
- --------------------------------------------------------------------------------
Revenues:
Gross earned premiums $770.5 $609.3 $556.5
Ceded premiums 374.4 118.1 107.9
-----------------------------------------------
Insurance premiums $396.1 $491.2 $448.6
Engineering services 93.5 61.3 55.8
Net investment income 64.2 36.8 32.3
Realized investment gains 25.4 14.1 12.1
-----------------------------------------------
Total revenues $579.2 $603.4 $548.8
Gain on sale of IRI $ 36.6 $ -- $ --
Income from continuing
operations $104.1 $ 66.3 $ 54.6
Discontinued operations 30.3 -- (1.2)
Net income $134.4 $ 66.3 $ 53.4
Earnings per share*:
Income from continuing
operations:
Basic $ 3.55 $ 2.21 $ 1.81
Assuming dilution $ 3.35 $ 2.20 $ 1.81
Net income:
Basic $ 4.59 $ 2.21 $ 1.77
Assuming dilution $ 4.21 $ 2.20 $ 1.77
- --------------------------------------------------------------------------------
* Prior years restated to reflect 1998 stock split.
The table above presents consolidated results of HSB Group, Inc. (HSB or the
Company).
Net income for 1998 included after-tax gains on the sale of HSB's interest
in Industrial Risk Insurers (IRI) of $23.8 million and Radian International LLC
(Radian LLC) of $30.3 million. The Radian LLC gain is net of after-tax operating
losses of $6.6 million that were deferred in 1997 when the decision was made to
exercise HSB's option to put the Company's interest to The Dow Chemical Company
(Dow). As a result, HSB's interest in Radian LLC was classified as a
discontinued operation in 1997. The Company's after-tax earnings, excluding the
after-tax gains on sales of IRI and Radian LLC, increased 20.9 percent in 1998
compared with 1997 due to increased underwriting profits, improved engineering
results and higher net realized gains.
Net income and income from continuing operations per common share on a
diluted basis increased 24.2 percent and 21.4 percent, respectively, in 1997
from 1996 due to significantly higher underwriting gains in the Company's
insurance operations.
On January 2, 1998, the Company exercised its option to put its 40 percent
share in Radian LLC to Dow, for approximately $129 million, net of expenses.
Radian LLC was formed in January 1996 as a joint venture with Dow to provide
environmental, engineering, information technology, remediation and strategic
chemical management services to industries and governments worldwide. In
connection with the formation of the new company, the Company contributed
substantially all of the assets of its wholly owned subsidiary, Radian
Corporation to Radian LLC. The results of Radian LLC were classified as
discontinued operations following ratification in July 1997 by HSB's Board of
Directors of management's decision to exercise its
26
<PAGE>
put. The after-tax gain of $30.3 million recognized in 1998 is net of deferred
losses previously noted. In 1996 and prior to July 1997, the Company's share of
the joint venture's results was recorded as equity in Radian.
On January 6, 1998, the Company sold its interest in IRI to Employers
Reinsurance Corporation (ERC) in accordance with a previously announced purchase
and sale agreement between ERC and IRI's twenty-three member insurers. The
Hartford Steam Boiler Inspection and Insurance Company (HSBIIC) received gross
proceeds of $49.1 million, prior to transaction costs, for its 23.5 percent
share in IRI. The gain on the sale of IRI was $36.6 million pre-tax and $23.8
million after-tax. Because the sale was structured in part as a reinsurance
transaction, a portion of HSBIIC's gross proceeds was utilized to reinsure
in-force policies with ERC.
IRI is an unincorporated, voluntary joint underwriting association which
provides property insurance for the class of business known as Highly Protected
Risks (HPR) for larger manufacturing, processing and industrial businesses,
which have invested in protection against loss through the use of sprinklers and
other means. IRI primarily writes policies on a syndicate basis that 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 1997 and 1996, HSBIIC's
membership shares were 23.5 and 14 percent respectively; in 1995 and prior the
shares were 0.5 percent.
In essence, 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
HSBIIC to the effect of adverse loss development on claims incurred prior to the
effective date of the increase; conversely a decrease in participation does not
release HSBIIC from the effect of adverse development.
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 has been renamed HSB Industrial Risk Insurers.
HSBIIC writes the business for HSB Industrial Risk Insurers using its insurance
licenses and provides 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
and retains 85 percent of the equipment breakdown insurance and 15 percent of
the property insurance of the combined insurance portfolio. This arrangement is
the largest contributing factor in the growth of both gross earned premium and
ceded premium. As a result, the unearned insurance premiums, reinsurance assets
and the ceded reinsurance payables reflected in the Consolidated Statements of
Financial Position have increased significantly. The agreements are of
indefinite duration, but ERC has an option to purchase HSB's interest in the
business in the event of a 50 percent or more change in control of HSB.
In contemplation of HSB's expanded role, on December 31, 1997 a business
trust formed by HSB sold $300 million of 20 year, 7 percent Convertible Capital
Securities in a private placement to ERC. The Convertible Capital Securities are
convertible into shares of HSB common stock, at any time, subject to regulatory
approval, at a conversion price of $56.67 per share, restated to reflect the May
22, 1998 three-for-two stock split (formerly a conversion price of $85.00 per
share). $250 million of the proceeds were contributed to HSBIIC and $50 million
was retained by HSB (see note 13).
Total revenues declined 4.0 percent in 1998 and grew 9.9 percent in 1997.
Gross earned premiums grew 26.4 percent in 1998. Much of this growth is
attributable to HSB Industrial Risk Insurers and growth in our commercial book
of business, as well as through the acquisition of the Kemper book noted in the
Other Developments section of this MD&A.
27
<PAGE>
The combined ratio for the Company improved to 89.4 percent in 1998 from
91.7 percent in 1997. In 1996 the combined ratio was 94.7 percent.
Engineering services revenue increased 52.6 percent in 1998 and 9.9 percent
in 1997. The growth in 1998 was primarily due to acquisitions made late in 1997
and in 1998 as well as growth in certain core businesses.
Net investment income grew 73.9 percent in 1998 primarily due to the
investment of proceeds from the sales of IRI and Radian LLC and the capital
securities issued in the second half of 1997.
The effective tax rates on income from continuing operations before
distributions on capital securities for 1998 was 29.6 percent compared to 26.8
percent and 25.1 percent for 1997 and 1996. Tax rate fluctuations occur as the
levels of underwriting and engineering services results and realized gains
change the mix of pre-tax income between fully taxable earnings and tax
preferred earnings that can be obtained by investing in certain instruments.
Various tax credits (primarily foreign tax credits) also impact the effective
rate. The Company continues to manage its use of tax advantageous investments to
maximize after-tax earnings.
Recent Accounting Developments
In June 1997, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standard (SFAS) No. 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 includes the presentation of items such as market
value adjustments of securities, foreign currency translation and certain
adjustments made for benefit plans. This statement was implemented in the first
quarter of 1998.
Also in June of 1997, the FASB issued SFAS No. 131, "Disclosures about
Segments of an Enterprise and Related Information." This statement 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 was implemented
at year-end 1998 and caused the Company to redefine its reportable segments (see
note 5).
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities." 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 fiscal years beginning after June 15, 1999. The Company
anticipates that the adoption of the provisions of SFAS No. 133 will not have a
material impact on results of operations, financial condition or cash flows.
In December 1997, the Accounting Standards Executive Committee of the
American Institute of Certified Public Accountants (AcSEC) issued Statement of
Position (SOP) 97-3, "Accounting by Insurance and Other Enterprises for
Insurance-Related Assessments." This statement provides guidance for the
recording of a liability for insurance-related assessments. The statement
requires that a liability be recorded when all of the following conditions have
been met: an assessment has been imposed or it is probable that an assessment
will be imposed; the event obligating an entity to pay an imposed or probable
assessment has occurred on or before the date of the financial statements; and
the amount of the assessment can be reasonably estimated. This statement is
effective for fiscal years beginning after December 15, 1998. The Company
anticipates that the adoption of the provisions of SOP 97-3 will not have a
material impact on results of operations, financial condition or cash flows.
In March 1998, AcSEC issued SOP 98-1, "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use." This statement specifies the
types of costs that must be capitalized and amortized over the software's
expected useful life and the types of costs which must be immediately
28
<PAGE>
recognized as expense. For purposes of this SOP, internal-use software is
software acquired, internally developed or modified solely to meet the entity's
internal needs for which no substantive plan exists or is being developed to
market the software externally during the software's development or
modification. Certain internal and external costs incurred to develop
internal-use computer software that relate to system design, software
configuration and interfaces, coding, testing and installation to hardware
should generally be capitalized. This statement is effective for fiscal years
beginning after December 15, 1998. The Company's current policy is to capitalize
such costs and therefore anticipates that the adoption of the provisions of SOP
98-1 will not have a material impact on results of operations, financial
condition or cash flows.
In April 1998, AcSEC issued SOP 98-5, "Reporting on the Costs of Start-Up
Activities." This statement requires the costs of start-up activities and
organization costs be expensed as incurred. Start-up costs are defined broadly
as those one-time activities related to opening a new facility, introducing a
new product or service, conducting business in a new territory, conducting
business with a new class of customer, initiating a new process in an existing
facility, or commencing some new operation. Start-up costs include activities
related to organizing a new entity (commonly referred to as organization costs).
This SOP applies to development stage entities as well as established entities.
This statement is effective for fiscal years beginning after December 15, 1998
and initial application should be reported as a cumulative effect of a change in
accounting principle. The Company does not expect the application of SOP 98-5
will have a material impact on results of operations, financial condition or
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 statement classifies insurance and
reinsurance contracts for which the deposit method is appropriate as contracts
that (i) transfer only significant timing risk, (ii) transfer only significant
underwriting risk, (iii) transfer neither significant timing nor underwriting
risk, and (iv) have an indeterminate risk. This SOP is effective for financial
statements for fiscal years beginning after June 15, 1999. Restatement of
previously issued financial statements is not permitted. The effect of initially
adopting SOP 98-7 should be reported as a cumulative effect of a change in
accounting principle. Currently 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," 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.
Other Developments
At a special meeting of HSBIIC on June 23, 1997, shareholders voted to
approve a proposal which enabled the formation of a new holding company, HSB
Group, Inc. Shareholders of HSBIIC's common and convertible redeemable preferred
stock became holders of HSB Group, Inc. common and convertible redeemable
preferred stock, respectively, through a share exchange approved by the
shareholders. Certificates representing HSBIIC's common and convertible
redeemable preferred stock automatically represent the corresponding shares of
HSB Group, Inc. common and convertible redeemable preferred stock. The holding
company was formed in order to achieve greater operating and financial
flexibility in connection with certain investments, business operations and
financing activities.
On April 21, 1998, the Board of Directors approved a three-for-two stock
split for shares held of record on May 1, 1998. Additional shares resulting from
the split were distributed on May 22, 1998. In accordance with SFAS No. 128,
"Earnings per Share," all earnings per share presentations have been adjusted to
reflect the impact of the stock split, including retroactive restatement of
prior periods.
In April 1998, HSB acquired Solomon Associates, Inc. (SAI) based in Dallas,
Texas. SAI is an engineering management consulting firm that provides
comparative performance benchmarking consulting to the refining, petrochemical
and power generation industries. SAI establishes efficiency and productivity
29
<PAGE>
benchmarks for 80 percent of the worldwide petroleum refining industry. This
acquisition expands HSB's engineering management consulting services and
benchmarking capability.
HSBIIC completed an acquisition of the monoline boiler and machinery
business of Kemper Insurance Companies (Kemper), effective July 1, 1998. The two
companies also completed an arrangement for HSBIIC to reinsure boiler and
machinery coverage written as part of Kemper's commercial package policies.
On July 1, 1998, HSB purchased 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.
Insurance Operations
For the years ended December 31, 1998 1997 1996
- ------------------------------ ----------------------------------------------
Gross earned premiums $770.5 $609.3 $556.5
Ceded premiums 374.4 118.1 107.9
----------------------------------------------
Insurance premiums $396.1 $491.2 $448.6
Claims and adjustment
expenses 174.9 217.9 204.4
Underwriting, acquisition
and other expenses 180.0 233.5 222.4
----------------------------------------------
Underwriting gain $ 41.2 $ 39.8 $ 21.8
Loss ratio 44.2% 44.4% 45.6%
Expense ratio 45.2% 47.3% 49.1%
Combined ratio 89.4% 91.7% 94.7%
- ------------------------------ ----------------------------------------------
Insurance operations include the underwriting results of HSBIIC, HSB
Engineering Insurance Limited (EIL), The Boiler Inspection and Insurance Company
of Canada (BI&I), The Allen Insurance Company, Ltd., The Hartford Steam Boiler
Inspection and Insurance Company of Connecticut, The Hartford Steam Boiler
Inspection and Insurance Company of Texas and HSBIIC's participation in HSB
Industrial Risk Insurers and various other pools.
Gross earned premiums in 1998 increased 26.4 percent over 1997. Much of
this growth is attributable to HSB Industrial Risk Insurers ($155.4 million) as
well as the addition of the Kemper portfolio to our commercial business. In
1997, gross earned premiums increased 9.5 percent as a result of IRI ($23.2
million) and growth in both the domestic and global markets.
Domestically, exclusive of HSB Industrial Risk Insurers, gross earned
premiums remained flat in 1998 and increased approximately 3.5 percent in 1997.
This performance resulted from the combination of growth in written premiums
from our client companies in 1998, 1997 and 1996, and a reduction in our
domestic special risk premiums. In addition, the 1998 acquisition of the Kemper
direct boiler and machinery book and reinsurance of the boiler and machinery
component of their package policies have provided premium growth. Gross earned
premiums representing coverage outside the U.S., exclusive of HSB Industrial
Risk Insurers, increased 5.4 percent to $133.5 million from $126.7 million in
1997. In 1997, gross earned premiums increased 15.5 percent from 1996.
The insurance industry, in general, continues to undergo significant
restructuring and consolidation. Considerable merger and acquisition activity
has occurred recently and more is possible in the future. Depending on the
specific companies involved in these activities and other market factors, the
level of reinsured business the Company assumes in the future could be impacted.
HSB is positioned to benefit from
30
<PAGE>
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.
The increase in ceded premiums of 217.1 percent in 1998 was primarily due
to the quota share reinsurance agreements with ERC and HSB Industrial Risk
Insurers, as previously discussed, and changes in the Company's reinsurance
programs which now utilize more quota share reinsurance on certain of our books
of business. We anticipate these new reinsurance contracts and the HSB
Industrial Risk Insurers arrangement will continue to result in growth in gross
earned premiums but lower growth in net earned premiums. The Company continues
to seek opportunities for growth, particularly in those countries where the
infrastructure development is moving to the private sector. At the same time,
softening of the pricing in this market has occurred globally as the number of
insurers offering capacity has expanded. The Company will not write business at
rates that would lessen its ability to maintain underwriting profit.
The Company participates in various facultative, quota share and excess of
loss reinsurance agreements to limit its exposure, particularly to catastrophic
losses and high risk lines, and to provide additional capacity to write
business. The Company evaluates its exposures and reinsurance needs annually to
implement a program that corresponds with the level of exposure it is willing to
retain. Because the Company has primary responsibility to its insureds, a
careful evaluation of the financial strength of those reinsurers it cedes
business to is performed. HSB's reinsurance costs continue to be impacted by its
prior loss experience and business growth.
For the years ended December 31, 1998 1997 1996
- ------------------------------------------------------------------------
Provision for claims and
adjustment expenses
occurring in the
current year $164.0 $209.5 $214.2
Increase (decrease) in
estimated claims and
adjustment expenses
arising in prior years* 10.9 8.4 (9.8)
--------------------------------------
Total incurred claims and
adjustment expenses $174.9 $217.9 $204.4
Loss ratio 44.2% 44.4% 45.6%
- -------------------------------------------------------------------------
* Includes approximately $5.0, $3.3 and $4.9 million of subrogation recoveries,
respectively.
The loss ratio decreased 0.2 percentage points in 1998 from 1997. Current
year results were impacted by severe ice storms that affected over 30 percent of
Canada in January, as well as a few significant losses in our other
international business. The loss ratio decreased 1.2 percentage points in 1997
as compared to 1996 primarily as a result of fewer weather-related losses.
Adverse development in 1998 and 1997 added 2.8 and 1.7 percentage points to the
respective loss ratio. Positive development in 1996 reduced the loss ratio by
2.2 percentage points. The components of claims and adjustment expenses, net of
reinsurance, are displayed above.
Gross claims and adjustment expenses were $611.7 million in 1998 as
compared to $263.1 million in 1997. The increase in gross claims was largely due
to the Company's role as direct writer of HSB Industrial Risk Insurers' policies
and include approximately $154 million from Hurricane Georges on exposures
written by HSB Industrial Risk Insurers. On a net basis the impact on HSB from
such hurricane losses after cessions to HSB Industrial Risk Insurers and
reinsurance recoveries was $1.9 million.
Claims and adjustment expense reserves comprise one of the largest
liabilities on the Company's Consolidated Statements of Financial Position.
Reserves are established to reflect the Company's estimates of total losses and
loss adjustment expenses that will ultimately be paid under direct and assumed
insurance contracts. Loss reserves include claims and adjustment expenses on
claims that have been reported but not
31
<PAGE>
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.
The expense ratio improved to 45.2 percent in 1998 from 47.3 percent in 1997.
The new quota share reinsurance agreements and the HSB Industrial Risk Insurers
arrangement with ERC, both of which result in ceding commissions to HSBIIC have
positively impacted our expense ratio by approximately 11.0 percentage points. A
portion of such ceding commission is intended to reimburse HSB for the
additional costs of managing HSB Industrial Risk Insurers and offset the
reduction in net earned premiums. The rate of decline in the expense ratio since
1996 may not continue in 1999 and beyond.
The following information summarizes key financial results by reportable
insurance segment:
For the years ended December 31, 1998 1997 1996
- -------------------------------- ------------ ------------- -----------------
Commercial:
Net earned premiums $306.3 $269.0 $253.1
Net income 14.8 13.4 11.8
Income taxes 4.6 6.1 6.9
Global Special Risks:
Net earned premiums $ 83.6 $217.1 $187.7
Net income (loss) 9.8 10.7 (3.0)
Income taxes (benefit) 7.7 6.2 (1.3)
- -------------------------------- ------------ ------------- -----------------
The Commercial business has shown strong revenue growth year over year
notwithstanding significant price competition as HSB continues to focus on its
client company strategy. Net earned premiums in the commercial segment rose
$37.3 million in 1998 due primarily to strong growth in client company billings
and integration of the Kemper portfolio. 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 decline from 1997.
Global Special Risks net earned premiums declined $133.5 million in 1998
primarily due to the increased use of reinsurance and the arrangement with HSB
Industrial Risk Insurers. The business does not set revenue goals as such but
rather continues to seek to increase underwriting profits. As part of the
arrangement with HSB Industrial Risk Insurers, HSB writes all direct policies
for HSB Industrial Risk Insurers and then cedes back these risks 100 percent to
HSB Industrial Risk Insurers. HSB then reinsures ERC's 99.5 percent share of the
business resulting in the assumption of 85 percent of the equipment breakdown
business and 15 percent of the property business. In 1998, the international
businesses have been impacted by adverse claims experience as compared to 1997.
In 1996, claims experience was positive. In 1998, income taxes as a percentage
of net income increased as a result of a decreased use of foreign tax credits.
HSBIIC is currently involved in a claim-related dispute concerning the extent to
which a certain explosion event is insured under the boiler and machinery
coverage of HSBIIC or under coverages of other insurers. A final decision in an
arbitration proceeding on this matter has concluded with a decision requiring
HSBIIC to pay $22 million of the amount that was in dispute. The $22 million,
less HSBIIC's retention of $3 million, which was reserved for in prior years, is
fully reinsured. In response to the ruling, the Company increased both its gross
reserves and reinsurance recoverable by $19 million, resulting in no impact to
net income.
32
<PAGE>
HSBIIC has filed a motion in Connecticut Superior Court to confirm the
arbitration award.The other insurers have contested the award. In the event the
award is not confirmed, subsequent proceedings could result in additional
amounts on the order of $100 million potentially becoming recoverable from
HSBIIC's reinsurers.
The obligations of HSBIIC's reinsurers with respect to this litigation are not
in dispute. Therefore, management believes that any adverse outcome in this case
will not have a material effect on either the results of operations or financial
condition of the Company. HSBIIC's reinsurance contracts do not require HSBIIC
to reimburse its reinsurers for any loss such reinsurers might incur should this
case not be decided in HSBIIC's favor. Nevertheless, reinsurers often quote
rates for future coverages based upon their or other reinsurers' experience on a
particular account. Therefore, in the event HSBIIC's reinsurers pay significant
sums pursuant to the litigation described above, it is likely HSBIIC's
reinsurance rates would increase in future periods. However, given the insured
capacity that exists in reinsurance markets worldwide, coupled with HSBIIC's
ability to negotiate a redesign or restructuring of its reinsurance program, it
does not necessarily mean that such an increase would be material.
HSBIIC was involved in another litigation regarding an explosion event and the
extent of HSBIIC's coverage in that matter. The 7th Circuit Court of Appeals
recently ruled in HSBIIC's favor and remanded the case for a judgment of no
liability to be entered for HSBIIC.
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.
Engineering Services Operations
For the years ended December 31, 1998 1997 1996
- ------------------------------------- ---------- ----------- ------------------
Engineering services revenues $93.5 $61.3 $55.8
Engineering services expenses 86.2 57.0 48.5
---------- ----------- ------------------
Operating gain $ 7.3 $ 4.3 $ 7.3
Operating margin 7.8% 7.1% 13.2%
- ------------------------------------- ---------- ----------- ------------------
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 and the Company's interest in
Integrated Process Technologies, LLC.
Engineering services revenues increased 52.6 percent in comparison to 1997. The
growth in revenues is primarily due to increases generated by HSBRT, EIL's
acquisition of Haughton's engineering in the last quarter of 1997, the addition
of SAI in April 1998, as well as revenues generated by some recent small
acquisitions. Engineering services revenues in 1997 increased 9.8 percent
primarily attributable to increased sales of $3.2 million at HSBRT, offset by a
modest decline in revenues from our engineering operations based in Asia.
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.
Margins increased 0.7 percentage points in 1998 as a result of improved field
service staff utilization and cost efficiencies, which were offset somewhat by
the start-up costs of integrating recent acquisitions. Margins declined in 1997
as the Company decreased the staff utilization domestically in order to develop
new growth opportunities. The Company continues to maintain staff levels in Asia
at somewhat lower than historical productivity levels, as the Company continues
to have confidence in its long-term growth prospects in the region.
33
<PAGE>
Investment Operations
For the years ended December 31, 1998 1997 1996
- --------------------------------------------------------------------------------
Net investment income $ 64.2 $ 36.8 $ 32.3
Realized investment gains 25.4 14.1 12.1
----------------------------------------------
Income from investment
operations $ 89.6 $ 50.9 $ 44.4
Total cash and invested
assets, at fair value $1,094.8 $996.7 $600.9
Unrealized gains, pre-tax $ 113.1 $ 95.3 $ 81.4
- --------------------------------------------------------------------------------
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. The
Company does not engage in cash flow underwriting; it seeks to have underwriting
profit each year.
None of the Company's claim reserves are discounted as most claims settle, on
average, within one year. Therefore, the Company does not use duration
measurements in managing its interest rate exposure. Instead, HSB manages its
portfolio by laddering a portion of its invested assets such that the effective
average estimated maturity of these assets is generally maintained between 5-10
years. This technique provides the Company with a predictable cash flow each
year that enables it to respond to the previously discussed parameters that
impact its investment strategy. In addition, the Company manages a portion of
its invested assets on a long-term/segmented basis to provide interest coverage
on the servicing requirements of its convertible capital securities.
Net investment income for 1998 increased $27.4 million 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 sales of HSB's interests in
IRI and Radian LLC significantly increased investable funds. Realized investment
gains were significantly impacted in 1998 by call premiums on fixed income
investments and sales of certain convertible securities and common stocks in
response to market conditions.
In 1997 realized gains were reduced by $30.7 million to reflect the estimated
fair value of three "zero cost collar contracts" entered into at the end of
1996. These collars were closed out by year-end 1997. Net investment income for
1997 increased $4.5 million in comparison to 1996 as the Company invested the
proceeds from its July 1997 Capital Securities offerings. Net investment income
was impacted early in 1997 by calls of high yielding preferred stocks. Net
investment income increases in 1997 also reflected more investable funds, which
were invested during a period of declining rates in comparison to our portfolio
averages, and a modest change in the mix of the portfolio from tax preferred
investments to more taxable investments with higher pre-tax yields. In 1997
higher interest costs resulted from a larger amount of commercial paper
outstanding.
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). Each contract
had a notional value of $50 million and maturity dates ranging from November
1997 to January 1998. The contracts were European style, which means they only
settled upon maturity. The contracts, which were entered into when the Standard
& Poor's 500 Index (S&P 500 Index) was 744.3, allowed HSBIIC to recover from the
counterparty if the index was below 695.2 at the time of maturity, and required
HSBIIC to reimburse the counterparty if the index was above a range of 811.3 to
818.7 at the time of maturity.
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In the fourth quarter of 1997, HSBIIC settled all of its outstanding contracts
that required HSBIIC to pay its counterparty $30.7 million in foregone
appreciation on its portfolio. In 1997, the Company's U.S. common stock
portfolio 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.
Through its U.K. subsidiary, EIL, the Company writes business in Malaysia and up
through December 31, 1997 was required to maintain approximately 50 million
ringgit denominated investments ($12.8 million) on deposit in that country. At
December 31, 1998 the Company's deposits in that currency was 29 million
ringgit, which equated to $7.7 million. Due to the recent fluctuations of
currencies in southeast Asia, realized investment gains increased by $0.1
million in 1998 and were reduced by $7.4 million during 1997.
HSB's investment portfolio continues to consist of high grade domestic and
foreign investments. Excluding short-term investments, HSB's investments are
primarily comprised of publicly traded, highly liquid securities. At the end of
1998, HSB's fixed maturities portfolio comprised 53.6 percent of the value of
the invested assets. The credit quality of HSB's bond investments at December
31, 1998, 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, 1998, had
a fair value of $357.9 million. Redeemable preferred stocks averaged a BBB
rating. 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.
The carrying value of the equity securities portfolio represented 40.6 percent
of the investments at December 31, 1998. This included $110.8 million of
unrealized investment gains, which had a net increase of $18.3 million from 1997
as a result of strong performance of certain S&P 500 "large cap" stocks. HSB
also recorded $20.4 million of dividends and $20.7 million of net pre-tax
realized gains from this portfolio in 1998. The Company's largest single holding
accounted for less than 1 percent of total consolidated assets. Realized
investment gains increased in 1998 over 1997 (and in 1997 over 1996) as HSB
managed its portfolio to respond to changing market conditions and tax planning
opportunities.
Market Risk
Market risk generally encompasses systemic risks or risks associated with macro
factors relating to economic losses due to adverse changes in the fair value of
a financial instrument. Market risk relates to the variability of market prices
and/or cash flows associated with changes in interest rates, securities prices,
market indices, yield curves or currency exchange rates and is inherent to all
financial instruments. The Company's investment strategy is to maximize total
return on the investment portfolio through investment income and capital
appreciation and is based on such factors as operational results, tax
implications, regulatory requirements, interest rates, dividends to
stockholders, servicing requirements of capital securities and market
conditions.
The focus of this disclosure is on one element of market risk - price risk. For
the Company, price risk relates to changes in the level of prices of financial
instruments due to changes in interest rates, equity prices or foreign exchange
rates. The primary price risk exposures of the Company relate to interest rate
and equity price risk.
For purposes of this disclosure market risk sensitive instruments are to be
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.
Interest Rate Risk
Interest rate risk is the major price risk facing the Company's fixed income
portfolio. Such exposure can subject the Company to economic losses due to
changes in the level or volatility of interest rates. Bond prices change
inversely with the direction of interest rates. Generally, as interest rates
rise prices for fixed
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income instruments will fall. As rates decline the inverse is true. The Company
attempts to mitigate this risk by investing in high quality issues using a buy
and hold approach.
Equity Market Risk
Equity market risk is defined as the chance that market influences will affect
the expected returns of all equities. Returns are influenced not only by the
fundamental attributes of investment securities, but by the price movements of
the general marketplace. Much of this depends on the sensitivity to the overall
market of the individual issue. The Company attempts to reduce this risk through
diversification and a focus on high quality, blue chip investments.
Foreign Exchange Risk
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.
Sensitivity Analysis
The following analysis illustrates the sensitivity of the market value of the
Company's financial instruments to selected changes in market rates and prices.
The range of changes selected reflects the Company's view of reasonably possible
market movements over a one-year period. The range of values selected should not
be interpreted as the Company's prediction of future market events, but rather
an illustration of the impact of such events.
The analysis assumes that the composition of the Company's interest rate
sensitive assets and liabilities existing at the beginning of the period remains
constant over the period being measured and also assumes that a particular
change in interest rates is reflected uniformly across the yield curve
regardless of the time to maturity. Also, the interest rates on certain types of
assets and liabilities may fluctuate in advance of changes in market interest
rates, while interest rates on other types may lag behind changes in market
rates. Accordingly, the analysis may not be indicative of, is not intended to
provide and does not provide a precise forecast of the effect of changes of
market interest rates on the Company's income or stockholders' equity. Further,
the computations do not contemplate any actions the Company would undertake in
response to changes in interest rates.
The sensitivity analysis assumes an instantaneous shift in market interest
rates, with scenarios of interest rates increasing and decreasing 100 and 150
basis points from their levels at December 31, 1998 with all other variables
held constant. The analysis assumes the yield to worst methodology. A 100 and
150 basis point increase in the market interest rates would result in a pre-tax
decrease in the net financial instrument position of $38.2 million and $55.1
million, respectively. Similarly, a 100 and 150 basis point decrease in market
interest rates would result in a pre-tax increase in the net financial
instrument position of $38.2 million and $55.1 million, respectively.
The Company's long term debt of $25.1 million as of December 31, 1998 is
denominated in U.S. 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 and $0.5 million,
respectively. The effect on the convertible capital securities is estimated to
be $14.7 million and $21.7 million 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
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charge to pre-tax income of $1.1 million and $1.6 million, respectively, per
year. A 100 and 150 basis point decrease in interest rates would increase
pre-tax income by $1.1 million and $1.6 million, respectively, per year.
Equity price risk was measured assuming an instantaneous 10 percent and 25
percent change in the S&P 500 Index from its level at December 31, 1998 with all
other variables held constant. The Company's equity holdings (comprised of
common stocks and non-redeemable preferreds) were assumed to be 100 percent
correlated to this index. A 10 percent and 25 percent increase or decrease in
the S&P 500 Index would result in a $24.9 million and $62.4 million increase or
decrease, respectively in the net financial instrument position.
The sensitivity analysis also assumes an instantaneous 10 percent and 20 percent
change in the foreign currency exchange rates versus the U.S. dollar from their
levels at December 31, 1998 with all other variables held constant. A 10 percent
and 20 percent strengthening of the U.S. dollar would result in decreases of
$6.4 million and $12.4 million, respectively, in the net financial instrument
position. Weakening of the U.S. dollar versus all other currencies would result
in like increases in the net financial instrument position.
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.
Held For Other Than Trading Purposes
Market Interest Currency Equity
At December 31, 1998 Value Rate Risk Risk Risk
- --------------------------------------------------------------------------------
Fixed maturity securities $ 577.1 $(27.1) $(2.1) $ --
Equity securities 437.1 (10.2) (1.9) (24.9)
Short term investments 62.3 (0.9) (2.4) --
-------- -------- ------- --------
Total all securities $1,076.5 $(38.2) $(6.4) $(24.9)
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.
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Held For Other Than Trading Purposes
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)
- --------------------------------------------------------------------------------
Statement of Comprehensive Income
In addition to the impact of HSB's results of operations, the Consolidated
Statements of Comprehensive Income displays the effects of price movements on
HSB's invested assets. As a result of the market corrections and subsequent
rebounds, 1998 cumulative holding gains, net of taxes, increased $28.1 million
as compared to the increase in 1997 of $21.3 million and $16.7 million in 1996.
Liquidity and Capital Resources
At December 31, 1998 1997
- ---------------------------------------------- ---------------- --------------
Total assets $2,144.0 $1,537.2
Short-term investments 62.3 131.3
Cash and cash equivalents 18.3 293.2
Short-term borrowings 21.0 42.4
Capital securities of subsidiary Trust I 108.9 108.9
Capital securities of subsidiary Trust II 300.0 300.0
Common shareholders' equity 419.3 345.3
- ---------------------------------------------- ---------------- --------------
Liquidity refers to the Company's ability to generate sufficient funds to meet
the cash requirements of its business operations. HSB is a holding company whose
principal subsidiary is HSBIIC. HSB relies on investment income, primarily in
the form of dividends from HSBIIC, in order to meet its short and long-term
liquidity requirements including the service requirements for its capital
securities. The Company receives a regular inflow of cash from maturing
investments, engineering services and insurance operations. The mix of the
investment portfolio is managed to respond to expected claim pay-out patterns
and the service requirements of the Company's capital securities. HSB also
maintains a highly liquid short-term portfolio to provide for immediate cash
needs and since the issuance of the $110 million of Global Floating Rate Capital
Securities in July 1997, which are discussed below, to offset a portion of
interest rate risk relating to such securities. The Company's cash equivalents
and short-term portfolio at December 31, 1997 reflects the temporary investment
of the proceeds from the $300 million Convertible Capital Securities discussed
below.
On July 15, 1997, HSB sold $110 million of 30 year Global Floating Rate Capital
Securities (Capital Securities) in a private placement. The securities are
generally non-callable for ten years, but may be called earlier by HSB upon the
occurrence of certain tax events including loss of deductibility of interest on
the securities. The securities were issued through HSB Capital I (Trust I), a
Delaware business trust created by HSB, at a floating rate equal to 90 day LIBOR
plus 0.91 percent. The current coupon is 6.3 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. 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
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Company has irrevocably and unconditionally guaranteed all of Trust I's
obligations under the Capital Securities. The Company has used or may use the
proceeds for general corporate purposes, including the repurchase of HSB common
stock; funding investments in, or extensions of credit to subsidiaries;
repayment of maturing debt; and financing possible future acquisitions. HSB
subsequently filed a registration statement covering securities with terms
identical in all material respects and offered to exchange registered securities
for the original Capital Securities. The exchange was completed on December 11,
1997. The floating rate 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, 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. Were ERC to exercise its
conversion rights in total, it would hold at December 31, 1998, on a fully
diluted basis, approximately 15.5 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 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.
Cash provided from operations was $55.6 million in 1998 compared to $26.1
million for 1997. Insurance operations cash flows (excluding HSB Industrial Risk
Insurers) were impacted by a decline in net claims paid of 2.9 percent compared
to the same period in 1997 while premiums collected were 6.2 percent higher in
1998. Payments to reinsurers for ceded premiums increased approximately 72
percent in the current year. HSBIIC's participation in HSB Industrial Risk
Insurers impacted components of the Consolidated Statements of Cash Flows,
including a positive impact of $35.3 million and $1.5 million for 1998 and 1997,
respectively, to cash provided from operations.
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 $419.3 million at
December 31, 1998 increased $74.0 million since December 31, 1997. The increase
reflects net income of $134.4 million and an increase in unrealized gains, net
of tax, of $11.0 million, offset by dividends of $47.9 million and $22.2 million
net share repurchases. On October 30, 1997, the sole holder
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of convertible redeemable preferred stock converted those shares into 597,609
shares of common stock, restated to reflect the May 22, 1998 three-for-two stock
split (formerly 398,406 shares) adding $20 million to common shareholders'
equity.
Pursuant to the share repurchase authorization approved by the Board, during
1998, HSB repurchased approximately 1.2 million shares at a cost of $47.7
million. At December 31, 1997, treasury stock of $85.9 million was reclassified
to retained earnings and additional paid-in capital to reflect the elimination
of the concept of treasury shares in accordance with the Connecticut Business
Corporation Act which became effective January 1, 1997. On January 25, 1999, the
Board renewed the authorization to repurchase up to 3 million shares of common
stock.
At December 31, 1998, HSBIIC had significant short-term borrowing capacity.
HSBIIC is currently authorized to issue up to $75 million of commercial paper.
Commercial paper outstanding at December 31, 1998 and 1997 was $20.0 million and
$42.3 million, respectively. In 1998, Standard & Poor's and Duff & Phelps credit
rating services reaffirmed their highest ratings for the commercial paper.
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 is not
expected to result in a substantial change in the business or a significant
increase in costs in the short term. In part, this is due to the fact that much
of the business is U.S. dollar denominated. The U.K. is not a first wave euro
country and as such the primary impact will be in Spain and the Irish Republic.
Over time, if the U.K. adopts the euro as its currency, there may be more of an
impact, however, the number of affected transactions are such that a manual
backup system is practicable. The Company will continue to monitor developments
and assess impacts on markets, pricing and reporting.
Year 2000
Year 2000 Plan and State of Readiness
In 1996, the Company began a comprehensive effort to assess and address issues
affecting the Company, which related to the inability of computer equipment and
embedded computer chips to distinguish between the year 1900 and the year 2000.
As has been well publicized, many computer systems and date controlled equipment
may cease to function or may function in a different manner when the year 2000
arrives because they are programmed to recognize only the last two digits of the
year.
As a part of this effort, the Company established a Year 2000 Program to address
four key areas: (i) applications software, primarily consisting of the Company's
policy management, claims, financial recording and reporting, human resource
systems, and engineering databases and systems; (ii) infrastructures, such as
mainframe and corporate servers, workstations and networking components; (iii)
embedded technology in facilities in which the Company conducts its operations
and in testing equipment used by the Company's engineering staff; and (iv) key
business partners and suppliers. In addition, the Company is evaluating
potential coverage exposures arising out of the Year 2000 and its impact on
insured equipment. The Company's Year 2000 Program consists of six partially
overlapping stages for the key areas listed above: (i) assessment and analysis;
(ii) development, renovation and replacement; (iii) implementation; (iv) testing
and certification; (v) contingency planning; and (vi) audit and review. The
Company is using members of its internal information technology staff as well as
external consultants and programmers to complete various tasks in connection
with its Year 2000 Program and is currently on schedule.
The Company has completed the assessment and analysis phase for its policy
management, claims, and financial recording and reporting, and human resource
systems and engineering databases and systems. The Company has largely completed
the development, renovation, replacement and implementation phases for
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all of these applications as of December 31, 1998 with the exception of human
resource and certain non-critical financial reporting and engineering systems
which are expected to be compliant by mid-1999.
The Company has completed the assessment and analysis phase with respect to
infrastructure items. The mainframe is Year 2000 compliant and the Company
expects to complete the migration to Year 2000 compliant servers and supporting
hardware and software by September 1999. Replacement of the various components
of non-compliant workstations and peripheral equipment also is expected to be
completed by September 1999. Many of the third-party software applications
utilized by the Company in its desktop environment are already Year 2000
compliant. The Company expects to complete the installation of such compliant
programs on virtually all of its workstations during the first half of 1999.
In the area of embedded chip technology, the Company's principal exposure
relates to the prevalence of such technology in office buildings in which the
Company leases space for conducting its business operations. The Company has
sent questionnaires to the leasing vendors for all of its principal facilities
with respect to Year 2000 readiness and has received assurances of readiness
from most of its vendors.
The Company is currently in the process of identifying and contacting key
suppliers of services and business partners, such as client companies, agents
and brokers, with whom the Company has significant business relations and who
may either electronically provide to, or receive from, the Company certain
financial and other information. The Company expects to compile the assessment
of the potential impact on the Company of such parties' Year 2000 state of
readiness and remediation plans by the end of the first quarter of 1999 and
conduct renovations and/or replacement and compliance testing, as appropriate.
The Company is relying upon Year 2000 readiness statements of other entities and
has not independently verified the accuracy of such statements.
Costs
It is currently estimated that the Company's aggregate spending in connection
with the Year 2000 Program will be in the range of $26 million of which
approximately $19.7 million has been expended through December 31, 1998. Certain
of these costs are being expensed as they are incurred and are being funded
through operating cash flow. The Company has expensed $5.1 million, $1.5 million
and $0.2 million in 1998, 1997 and 1996, respectively. It is estimated that
expenditures of $5.2 million for 1999 will be expensed as incurred. The
remainder of the $26 million estimate relates 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 and renovation 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. The current
estimate also does not include any costs associated with the implementation of
contingency plans that are in the process of being developed.
The Company does not expect the costs relating to its Year 2000 Program to have
a material effect on its results of operations, liquidity or financial
condition. However, the Year 2000 Program is an ongoing process and the
estimated costs, as well as the estimated completion dates for various phases of
the program, are subject to change.
Risks
The failure of one or more critical software applications or components of the
Company's infrastructure to be Year 2000 compliant could cause a material
disruption in the normal business operations of the Company. Such disruptions
could include the inability to process policies, register and collect premiums
and engineering receivables, process claims or schedule inspections and
engineering services. Due to the difficulty in estimating the scope and duration
of such failures, the Company is unable to determine at this time whether the
consequences of such failures will have a material impact on the Company's
results of
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operations, liquidity, or financial condition. Moreover, the Company's
operations are interdependent with systems of business partners and service
providers, such as financial institutions, communication service providers and
utilities, over which the Company has no control. The failure of one or more of
such business partners or service providers to be Year 2000 compliant could have
a material adverse impact on the Company. However, the Company believes that
with the implementation of its Year 2000 Program as scheduled, including the
contingency plans discussed below, the risk of material disruptions to its
normal business operations should be significantly reduced.
As an insurance company, the Company maintains a significant portfolio of
investments in cash, short-term fixed income, and equity securities. Inasmuch as
the advent of the Year 2000 may cause events, business interruptions and altered
economic facts and circumstances, the value of the Company's investments may be
affected favorably or unfavorably. The Company is selectively monitoring the
Year 2000 compliant status of the corporate issuers of the securities in its
investment portfolio primarily through reviewing public disclosure documents.
State government and municipal bonds held by the Company are general obligations
and/or are credit-enhanced and therefore the Company does not perceive there to
be a significant credit risk with these securities in the absence of a severe
Year 2000 disruption affecting governments and businesses generally. An
immaterial portion of the Company's portfolio is invested in non-public issues
where public disclosure documents are unavailable. Due to the difficulty in
estimating the scope and duration of such events, the Company is unable to
determine at this time whether the consequences of such developments will have a
material impact on the Company's investment portfolio and therefore, on the
Company's results of operations, liquidity or financial condition.
Contingency Plans
As a component of the Year 2000 Program, the Company is concurrently developing
contingency plans intended to mitigate the possible disruption of business
operations arising out of the Year 2000 event. These plans will be continuously
refined during 1999 as the Company completes compliance testing on its internal
applications software and infrastructure and further assesses the Year 2000
readiness status of its business partners. Contingency plans may include
securing back-up power for the Company's data center, manual processing,
short-term fixes to non-compliant programs or business partner interfaces and
modifying the Company's asset selection criteria for its investment activities.
Insurance Coverage Issues
The Company continues to evaluate the potential coverage exposures arising out
of the Year 2000 event and its impact on insured equipment. The Company has
filed with the various jurisdictions an endorsement to its equipment breakdown
forms which reiterates that coverage is 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 is being included in policies in
all states that have approved the endorsement. In the four jurisdictions that
have not approved the endorsement, a notice reiterating the Company's coverage
intent with respect to Year 2000 exposures is being sent to policyholders. The
Company has recently filed a similar endorsement for use with its all-risk
policy and expects to receive approvals consistent with those received for its
equipment breakdown endorsement. Many of the insurers that the Company reinsures
for equipment breakdown coverage are issuing similar endorsements to their
policies. The Company is conducting an on-going communications program with its
client company insurers and agents to disseminate to the ultimate policyholders
its Year 2000 loss control suggestions and policy coverage position.
Quantification of the Company's exposure to Year 2000 losses and loss adjustment
expenses are not reasonably estimable at this time as applicable policy and
reinsurance contract wordings have not been legally tested in the context of
such losses.
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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 its arrangement with HSB Industrial Risk
Insurers; 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.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk.
See "Market Risk" in Management's Discussion and Analysis of Consolidated
Financial Condition and Results of Operations in Item 7.
Item 8. Financial Statements and Supplementary Data.
INDEX TO FINANCIAL STATEMENTS
AND FINANCIAL STATEMENT SCHEDULES
Page No.
Report of Independent Accountants 45
Financial Statements
Consolidated Statements of Operations
for the years ended December 31, 1998,
1997 and 1996. 46
Consolidated Statements of Comprehensive Income
for the years ended December 31, 1998,
1997 and 1996. 47
Consolidated Statements of Financial
Position - December 31, 1998 and 1997. 48
Consolidated Statements of Cash Flows
for the years ended December 31, 1998,
1997 and 1996. 49
43
<PAGE>
Consolidated Statements of Changes in
Shareholders' Equity for the years ended
December 31, 1998, 1997 and 1996. 50
Notes to Consolidated Financial Statements 51
Schedule I - Summary of Investments-
Other than Investments in Related Parties 79
Schedule II - Condensed Financial Information of
HSB Group, Inc. 80-82
Schedule III - Supplementary Insurance Information 83
Schedule IV - Reinsurance 84
Schedule V - Valuation and Qualifying Accounts 85
Schedule VI - Supplemental Information Concerning
Property-Casualty Insurance Operations 86
Schedules other than the ones listed above are omitted for the reason that they
are not required or are not applicable or the required information is shown in
the financial statements or notes thereto.
44
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Shareholders and Board of Directors of HSB Group, Inc.:
In our opinion, the consolidated financial statements and the financial
statement schedules of HSB Group, Inc. and its subsidiaries listed in Item 8 of
this Form 10-K present fairly, in all material respects, the consolidated
financial position of HSB Group, Inc. and its subsidiaries at December 31, 1998
and 1997, and the consolidated results of their operations and their cash flows
for each of the three years in the period ended December 31, 1998, in conformity
with generally accepted accounting principles. These consolidated financial
statements are the responsibility of the Company's management; our
responsibility is to express an opinion on these consolidated financial
statements based on our audits. We conducted our audits of these consolidated
statements in accordance with generally accepted auditing standards which
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for the opinion expressed above.
/s/ PricewaterhouseCoopers LLP
January 26, 1999
45
<PAGE>
Financial Statements
Consolidated Statements of Operations
For the years ended December 31, (in millions, except per share amounts)
1998 1997 1996
- --------------------------------------------------------------------------------
Revenues:
Gross earned premiums $770.5 $609.3 $556.5
Ceded premiums 374.4 118.1 107.9
------------------------------------
Insurance premiums 396.1 491.2 448.6
Engineering services 93.5 61.3 55.8
Net investment income 64.2 36.8 32.3
Realized investment gains 25.4 14.1 12.1
------------------------------------
Total revenues 579.2 603.4 548.8
------------------------------------
Expenses:
Claims and adjustment 174.9 217.9 204.4
Policy acquisition 66.3 90.7 86.0
Underwriting and inspection 113.7 142.8 136.4
Engineering services 86.2 57.0 48.5
Interest 0.8 1.3 0.6
------------------------------------
Total expenses 441.9 509.7 475.9
------------------------------------
Gain on sale of IRI 36.6 -- --
Income from continuing operations
before income taxes and
distributions on capital
securities 173.9 93.7 72.9
Income taxes (benefit):
Current 45.0 23.8 24.7
Deferred 6.4 1.3 (6.4)
------------------------------------
Total income taxes 51.4 25.1 18.3
------------------------------------
Distributions on capital
securities of subsidiary
trusts, net of income
taxes of $9.9; $1.2; and $- 18.4 2.3 --
------------------------------------
Income from continuing operations 104.1 66.3 54.6
------------------------------------
Discontinued operations:
Loss from operations, net of income
tax benefits of $3.2; $0.1; $0.4 (6.6) -- (1.2)
Gain on disposal, net of income taxes
of $23.7; $-; and $- 36.9 -- --
------------------------------------
Total discontinued operations 30.3 -- (1.2)
------------------------------------
Net income $134.4 $ 66.3 $ 53.4
------------------------------------
Earnings (loss) per common share-basic:
Income from continuing operations $ 3.55 $ 2.21 $ 1.81
Discontinued operations 1.04 -- (0.04)
------------------------------------
Net income $ 4.59 $ 2.21 $ 1.77
------------------------------------
29.3 29.5 30.3
Average common shares outstanding
Earnings (loss) per common
share-assuming dilution:
Income from continuing operations $ 3.35 $ 2.20 $ 1.81
Discontinued operations 0.86 -- (0.04)
------------------------------------
Net income $ 4.21 $ 2.20 $ 1.77
------------------------------------
Average common shares outstanding and
common stock equivalents 35.2 30.2 30.3
The accompanying notes are an integral part of the consolidated financial
statements.
46
<PAGE>
Consolidated Statements of Comprehensive Income
For the years ended December 31, (in millions)
<TABLE>
<CAPTION>
1998 1997 1996
- ----------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Net Income: $134.4 $66.3 $53.4
Other comprehensive income, net of tax:
Unrealized gains on securities:
Unrealized holding gains arising
during the period, net of income
taxes of $16.6; $15.7; and $11.6 28.1 21.3 16.7
Add: reclassification adjustments
for gains included in net income (16.0) (13.5) (7.7)
----------------- ---------------- -----------------
Total unrealized gains on securities 12.1 7.8 9.0
Minimum pension liability adjustments,
net of income taxes (0.1) (0.3) (0.1)
Foreign currency translation adjustments,
net of income taxes (1.1) (0.8) (0.1)
----------------- ---------------- -----------------
Other comprehensive income 10.9 6.7 8.8
----------------- ---------------- -----------------
Comprehensive income $145.3 $73.0 $62.2
- ----------------------------------------------------------------------------------------------------
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
47
<PAGE>
Consolidated Statements of Financial Position
At December 31, (in millions, except per share amounts)
1998 1997
- ------------------------------------------------------------------- ------------
Assets:
Cash and cash equivalents $ 18.3 $ 293.2
Short-term investments, at cost 62.3 131.3
Fixed maturities, at fair value
(cost-$568.5; $241.1) 577.1 248.4
Equity securities, at fair value
(cost-$326.3; $231.3) 437.1 323.8
---------------------------------
Total cash and invested assets 1,094.8 996.7
Reinsurance assets 630.4 124.5
Insurance premiums receivable 146.7 138.0
Engineering services receivable 26.1 12.2
Fixed assets 54.9 36.4
Prepaid acquisition costs 46.6 42.5
Capital lease 14.6 15.3
Investment in Radian 0.0 83.4
Other assets 129.9 88.2
---------------------------------
Total assets $2,144.0 $1,537.2
---------------------------------
Liabilities:
Unearned insurance premiums $ 477.9 $ 287.3
Claims and adjustment expenses 550.3 276.7
Short-term borrowings 21.0 42.4
Long-term borrowings 25.1 25.1
Capital lease 27.9 27.9
Deferred income taxes 42.7 31.5
Dividends and distributions
on capital securities 23.2 13.3
Ceded reinsurance payable 64.1 3.9
Other liabilities 83.6 74.9
---------------------------------
Total liabilities 1,315.8 783.0
---------------------------------
Company obligated mandatorily
redeemable capital securities of
subsidiary Trust I holding solely
junior subordinated deferrable
interest debentures of the
Company, net of unamortized
discount of $1.1 in 1998 and 1997 108.9 108.9
Company obligated mandatorily redeemable
convertible capital securities
of subsidiary Trust II holding solely
junior subordinated deferrable interest
debentures of the Company 300.0 300.0
Shareholders' equity:
Common stock (stated value; shares
authorized 50.0;shares issued and
outstanding 28.9; 29.4) 10.0 10.0
Additional paid-in capital 33.5 31.6
Accumulated other comprehensive income 66.8 55.9
Retained earnings 311.2 248.8
Benefit plans (2.2) (1.0)
---------------------------------
Total shareholders' equity 419.3 345.3
---------------------------------
Total $2,144.0 $1,537.2
---------------------------------
Common shareholders' equity
per common share $ 14.53 $ 11.75
1997 amounts restated to reflect 1998 stock split.
- ------------------------------------------------------------------- ------------
The accompanying notes are an integral part of the consolidated financial
statements.
48
<PAGE>
Consolidated Statements of Cash Flows
<TABLE>
<CAPTION>
For the years ended December 31, (in millions)
1998 1997 1996
- -------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Operating activities:
Net income $134.4 $ 66.3 $ 53.4
Adjustments to reconcile net income to
cash provided by operating activities:
Depreciation and amortization 15.9 9.5 10.6
Deferred income taxes (benefit) 6.4 1.3 (10.0)
Realized investment gains, including market
adjustments for derivative instruments (25.4) (14.1) (12.1)
Distributions on capital securities 28.3 3.5 --
Gain from disposition of Radian, net of income taxes (30.3) -- --
Gain from disposition of IRI, net of income taxes (23.8) -- --
Change in balances, net of effects from
purchases and sales of subsidiaries:
Insurance premiums receivable (8.7) (31.6) (19.2)
Engineering services receivable (11.2) (0.5) (2.7)
Prepaid acquisition costs (4.1) (4.9) (6.5)
Reinsurance assets (505.9) 38.4 (103.4)
Unearned insurance premiums 190.6 19.7 54.4
Ceded reinsurance payable 60.2 (1.5) 1.9
Claims and adjustment expenses 273.6 (26.2) 112.0
Investment in Radian -- (3.7) 12.9
Other (44.4) (30.1) 1.6
----------------------------------------------------------
Cash provided by operating activities 55.6 26.1 92.9
----------------------------------------------------------
Investing activities:
Fixed asset additions, net (20.8) (10.4) (1.7)
Investments:
(Sale) purchase of short-term investments, net 69.0 (78.7) (16.1)
Purchase of fixed maturities (423.5) (60.6) (89.0)
Proceeds from sale of fixed maturities 66.5 27.9 93.1
Redemption of fixed maturities 30.8 14.4 11.5
Purchase of equity securities (326.7) (252.9) (149.3)
Proceeds from sale of equity securities 251.8 254.1 131.2
Proceeds from disposition of Radian 128.9 -- --
Proceeds from disposition of IRI 49.1 -- --
Purchase of Solomon Associates, Inc.,
net of cash acquired (2.1) -- --
Purchase of Kemper books of business (27.5) -- --
Settlement of collar contracts -- (30.7) --
Cash transferred to investment in Radian -- -- (0.7)
----------------------------------------------------------
Cash used in investment activities (204.5) (136.9) (21.0)
----------------------------------------------------------
Financing activities:
Proceeds from Company obligated mandatorily redeemable
capital securities of subsidiary Trust I -- 108.9 --
Proceeds from Company obligated mandatorily redeemable
convertible capital securities of subsidiary Trust II -- 300.0 --
(Decrease) increase in short-term borrowings (21.4) 39.1 (10.2)
Repayment of long-term debt -- -- (0.5)
Dividends and distribution on capital securities (66.2) (46.7) (46.1)
Reacquisition of stock (47.7) (54.0) (13.0)
Exercise of stock options 9.3 7.0 1.1
----------------------------------------------------------
Cash (used in) provided by financing activities (126.0) 354.3 (68.7)
----------------------------------------------------------
Net (decrease) increase in cash and cash equivalents (274.9) 243.5 3.2
Cash and cash equivalents at beginning of period 293.2 49.7 46.5
----------------------------------------------------------
Cash and cash equivalents at end of period $ 18.3 $293.2 $ 49.7
----------------------------------------------------------
Interest paid $ 2.5 $ 3.2 $ 2.3
Federal income tax paid $ 52.4 $ 33.8 $ 25.7
</TABLE>
Non-cash investing and financing activities:
Issuance of HSB convertible preferred stock in exchange for EIG, Co. preferred
stock in 1996; conversion into HSB common stock in 1997; and issuance of HSB
common stock in connection with the acquisition of Solomon Associates, Inc. in
1998 (see note 3).
The accompanying notes are an integral part of the consolidated financial
statements.
49
<PAGE>
Consolidated Statements of Changes in Shareholders' Equity
<TABLE>
<CAPTION>
For the years ended December 31, (in millions)
Total Common Additional Accumulated Retained Treasury Benefit
Shareholders' Stock Paid-in Other Earnings Stock Plans
Equity Capital Comprehensive
Income
- ---------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balances at December 31, 1995 $341.1 $10.0 $33.9 $40.4 $305.1 $(47.7) $(0.6)
- --------------------------------------------------------------------------------------------------------------------------------
Net income 53.4 -- -- -- 53.4 -- --
Dividends declared (45.9) -- -- -- (45.9) -- --
Change in accumulated other
comprehensive income,
net of tax 8.8 -- -- 8.8 -- -- --
Benefit plans 0.1 -- -- -- -- 0.2 (0.1)
Purchase of treasury stock (13.0) -- -- -- -- (13.0) --
Exercise of stock options 1.1 -- 0.1 -- -- 1.0 --
Reclassification of treasury stock -- -- (2.0) -- (57.5) 59.5 --
- --------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1996 $345.6 $10.0 $32.0 $49.2 $255.1 $ 0.0 $(0.7)
- --------------------------------------------------------------------------------------------------------------------------------
Net income 66.3 -- -- -- 66.3 -- --
Dividends declared (47.0) -- -- -- (47.0) -- --
Change in accumulated other
comprehensive income,
net of tax 6.7 -- -- 6.7 -- -- --
Benefit plans (0.3) -- -- -- -- -- (0.3)
Reacquisition of stock (54.0) -- (1.8) -- (52.2) -- --
Conversion of redeemable preferred stock 20.0 -- 0.7 -- 19.3 -- --
Exercise of stock options 7.0 -- 0.5 -- 6.5 -- --
Issuance of reacquired stock, net of 1.0 -- 0.2 -- 0.8 -- --
forfeitures
- --------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1997 $345.3 $10.0 $31.6 $55.9 $248.8 $ 0.0 $(1.0)
- --------------------------------------------------------------------------------------------------------------------------------
Net income 134.4 -- -- -- 134.4 -- --
Dividends declared (47.9) -- -- -- (47.9) -- --
Change in accumulated other
comprehensive income,
net of tax 10.9 -- -- 10.9 -- -- --
Benefit plans (1.2) -- -- -- -- -- (1.2)
Reacquisition of stock (47.7) -- (5.0) -- (42.7) -- --
Exercise of stock options 9.3 -- 1.8 -- 7.5 -- --
Issuance of reacquired stock, net of 16.2 -- 5.1 -- 11.1 -- --
forfeitures
- --------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1998 $419.3 $10.0 $33.5 $66.8 $311.2 $ 0.0 $(2.2)
- --------------------------------------------------------------------------------------------------------------------------------
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
50
<PAGE>
Notes to Consolidated Financial Statements
(in millions, except per share amounts)
1. Accounting Policies
Consolidation
The accompanying financial statements present the consolidated accounts of HSB
Group, Inc. and its subsidiaries (collectively, HSB or the Company) and are
prepared in accordance with generally accepted accounting principles (GAAP).
Significant intercompany transactions and balances have been eliminated in
consolidation. The preparation of financial statements in accordance with GAAP
requires the use of estimates in reporting certain assets and liabilities.
Actual results could differ from those estimates. Certain amounts for 1997 and
1996 have been reclassified to conform with the 1998 presentation.
Insurance
Insurance premium revenues are net of reinsurance ceded and are generally earned
on a pro rata basis over the contract period. The portion of gross insurance
premiums not earned at the end of the period is recorded as unearned insurance
premiums on the Consolidated Statements of Financial Position.
Prepaid acquisition costs, consisting principally of commissions, premium taxes
and certain underwriting expenses are amortized as the related insurance
premiums are earned. Unearned ceded commissions arising from certain reinsurance
transactions are netted in prepaid acquisition costs. All other acquisition
costs are charged to operations as incurred.
Liabilities for claims and adjustment expenses for boiler and machinery,
property and other coverages represent estimated reserves on claims and
adjustment expenses reported but not yet settled and the cost of claims and
adjustment expenses incurred but not yet reported. Reserves for claims and
adjustment expenses are undiscounted and are gross of amounts recoverable from
reinsurers. Reserves are reduced for estimated amounts of salvage and
subrogation and deductibles from customers. HSB records subrogation when
recoverability is probable, such as when a judgment is returned, liability is
admitted to or settlement is reached. The length of time that reserves for
claims and adjustment expenses are carried on the Consolidated Statements of
Financial Position is a function of the pay-out patterns associated with the
types of coverages involved. Estimates for these reserves reflect such variables
as past loss experience, changes in judicial interpretation of legal liability,
policy coverage and inflation. The establishment of such reserves frequently
requires complex engineering judgments. Due to the nature of the variables
involved in the reserving process, subjective judgments are an integral
component. Previously estimated reserves are regularly adjusted as loss
experience develops and new information becomes available. Since reserves are
based on estimates, the ultimate liability may be more or less than such
reserves. The effects of changes in estimated reserves are included in the
results of operations in the period in which the estimates are changed (see note
11).
Reinsurance assets represent amounts due from reinsurers for paid and unpaid
claims, paid and unpaid loss adjustment expenses and the unearned portion of
premiums ceded through reinsurance agreements.
Engineering Services
HSB recognizes the majority of its engineering services revenues as the service
is provided. Costs on such contracts are included in operations as incurred.
Provisions are made for losses on contracts at the time such losses become
known.
51
<PAGE>
Investments
Cash and cash equivalents include cash on hand and short-term highly liquid
investments with maturities of three months or less. Short-term investments have
a maturity of one year or less and are carried at cost, which together with
accrued interest thereon, approximates fair value. Fixed maturities include
bonds, notes and redeemable preferred stocks. Equity securities include common
and non-redeemable preferred stocks. All fixed maturities and equity securities
are classified as available for sale. Accordingly, these investments are carried
at estimated fair value. Estimated fair values of securities classified as
available for sale are based principally upon quoted market prices. Unrealized
gains and losses on investments classified as available for sale and foreign
exchange gains and losses on certain investments in foreign operations where the
U.S. dollar is not the functional currency are included net of income tax in
shareholders' equity.
Investment income is net of investment expenses. Realized investment gains and
losses are determined on the basis of costs related to those investments sold
and are recorded on the trade date. Also, included in realized investment gains
and losses are losses arising from declines in the realizable value of
investments considered to be other than temporary.
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.
Financial instruments which qualify for hedge accounting are recorded at market
with gains and losses reflected in shareholders' equity. To the extent such
instruments do not qualify for hedge accounting, related gains and losses are
reflected in results of operations.
Income Taxes
Deferred tax assets and liabilities are generally determined based on the
difference between financial statement and tax bases for certain assets and
liabilities using tax rates in effect for the year in which the differences are
expected to reverse. Deferred tax assets are allowed if future realization is
more likely than not. Deferred income taxes are provided for unrealized
appreciation/depreciation on fixed maturities and equity securities available
for sale, prepaid acquisition costs, loss reserve discounting, unearned
premiums, certain employee benefit costs and other items which are the result of
temporary differences in the treatment of such items for tax and financial
statement purposes (see note 12).
Fixed Assets
Fixed assets include real and personal property and certain eligible capitalized
system development costs. Fixed assets are carried at cost less accumulated
depreciation and amortization. Depreciation and amortization is calculated on
the basis of estimated useful lives using straight-line and accelerated methods.
Upon retirement or replacement, any gain or loss is included in results of
operations.
Goodwill and Other Intangible Assets
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 7 to 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 $57.7 and $20.7 million at December 31, 1998 and 1997,
respectively. HSB evaluates the reliability of goodwill based upon projections
of undiscounted cash flows.
2. Changes in Accounting Principles
In June 1998, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standard (SFAS) No. 133, "Accounting for Derivative
Instruments and Hedging Activities." This statement establishes
52
<PAGE>
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 fiscal years beginning after June 15, 1999. The
Company anticipates that the adoption of the provisions of SFAS No. 133 will not
have a material impact on results of operations, financial condition or cash
flows.
In December 1997, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants (AcSEC) issued Statement of Position
(SOP) 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related
Assessments." This statement provides guidance for the recording of a liability
for insurance related assessments. The statement requires that a liability be
recorded when all of the following conditions have been met: an assessment has
been imposed or it is probable that an assessment will be imposed; the event
obligating an entity to pay an imposed or probable assessment has occurred on or
before the date of the financial statements; and the amount of the assessment
can be reasonably estimated. This statement is effective for fiscal years
beginning after December 15, 1998. The Company anticipates that the adoption of
the provisions of SOP 97-3 will not have a material impact on results of
operations, financial condition or cash flows.
In March 1998, AcSEC issued SOP 98-1, "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use." This statement specifies the
types of costs that must be capitalized and amortized over the software's
expected useful life and the types of costs which must be immediately recognized
as expense. For purposes of this SOP, internal-use software is software
acquired, internally developed or modified solely to meet the entity's internal
needs for which no substantive plan exists or is being developed to market the
software externally during the software's development or modification. Certain
internal and external costs incurred to develop internal-use computer software
that relate to system design, software configuration and interfaces, coding,
testing and installation to hardware should generally be capitalized. This
statement is effective for fiscal years beginning after December 15, 1998. The
Company's current policy is to capitalize such costs and therefore anticipates
that the adoption of the provisions of SOP 98-1 will not have a material impact
on results of operations, financial condition or cash flows.
In April 1998, AcSEC issued SOP 98-5, "Reporting on the Costs of Start-Up
Activities." This statement requires the costs of start-up activities and
organization costs to be expensed as incurred. Start-up costs are defined
broadly as those one-time activities related to opening a new facility,
introducing a new product or service, conducting business in a new territory,
conducting business with a new class of customer, initiating a new process in an
existing facility, or commencing some new operation. Start-up costs include
activities related to organizing a new entity (commonly referred to as
organization costs). This SOP applies to development stage entities as well as
established entities. This statement is effective for fiscal years beginning
after December 15, 1998 and initial application should be reported as a
cumulative effect of a change in accounting principle. The Company does not
expect the application of SOP 98-5 will have a material impact on results of
operations, financial condition or 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 statement classifies insurance and
reinsurance contracts for which the deposit method is appropriate as contracts
that (i) transfer only significant timing risk; (ii) transfer only significant
underwriting risk; (iii) transfer neither significant timing nor underwriting
risk; and (iv) have an indeterminate risk. This SOP is effective for financial
statements for fiscal years beginning after June 15, 1999. Restatement of
previously issued financial statements is not permitted. The effect of initially
adopting SOP 98-7 should be reported as a cumulative effect of a change in
accounting principle. Currently 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," and,
therefore, does not anticipate the adoption of this statement will have a
material impact on results of operations, financial condition or cash flows.
53
<PAGE>
3. Corporate Activity
Acquisitions / Divestitures
Industrial Risk Insurers
On January 6, 1998, The Hartford Steam Boiler Inspection and Insurance Company
(HSBIIC) sold its 23.5 percent share in Industrial Risk Insurers (IRI) to
Employers Reinsurance Corporation (ERC), one of the world's largest reinsurance
companies, in accordance with a previously announced purchase and sale agreement
between ERC and IRI's twenty-three member insurers. The gain on the sale of IRI
was $36.6 million pre-tax and $23.8 million after-tax. IRI is a voluntary,
unincorporated joint underwriting association, which provides property insurance
for the class of business known as "highly protected risks" (HPR) - larger
manufacturing, processing, and industrial businesses which have invested in
protection against loss through the use of sprinklers and other means. HSBIIC
received gross proceeds of $49.1 million, prior to transaction costs, for its
23.5 percent share in IRI. Because the sale was structured in part as a
reinsurance transaction, a portion of HSBIIC's gross proceeds was utilized to
reinsure in-force policies with ERC.
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 has been renamed HSB Industrial Risk Insurers. HSBIIC writes
the business for HSB Industrial Risk Insurers using its insurance licenses and
provides 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 retains 85 percent of the equipment breakdown
insurance and 15 percent of the property insurance of the combined insurance
portfolio.
To support HSB's expanded role, on December 31, 1997, a business trust formed by
HSB sold $300 million of 20 year Convertible Capital Securities in a private
placement to ERC. These capital securities are convertible into HSB common
stock, at any time, subject to regulatory approval, at a conversion price of
$56.67, restated to reflect the May 22,1998 three-for-two stock split. $250
million of the proceeds were contributed by HSB to HSBIIC and $50 million was
retained at HSB (see note 13).
Radian
On January 2, 1998, HSBIIC exercised its option to put its 40 percent share in
Radian International LLC (Radian LLC) to The Dow Chemical Company (Dow), for
approximately $129 million, net of expenses. Radian LLC was formed in January
1996 as a joint venture with Dow to provide environmental, engineering,
information technology, remediation and strategic chemical management services
to industries and governments worldwide. In connection with the formation of the
new company, HSBIIC contributed substantially all of the assets and liabilities
of its wholly owned subsidiary, Radian Corporation at historical cost to Radian
LLC. No gain was recognized on the transfer. The results of Radian LLC were
classified as discontinued operations following ratification on July 28,1997 by
HSB's Board of Directors of management's decision to exercise its put. The
Company's share of Radian LLC's losses incurred subsequent to such decision of
approximately $6.6 million after-tax was deferred and recognized at the time the
gain was recognized in 1998. This transaction resulted in an after-tax gain of
approximately $36.9 million which was recorded in the first quarter of 1998. In
1996 and prior to June 1997, the Company's share of the joint venture's results
were recorded as equity in Radian.
54
<PAGE>
Summarized financial data for Radian follows:
1997 1996
- ------------------------------- ------------------ ----------------
Assets $159.7 $156.3
Liabilities 88.4 62.1
Revenues 288.0 229.6
Expenses 314.0 233.6
- ------------------------------- ------------------ ----------------
Presented at 100 percent - HSBIIC's interest in Radian during these periods was
40 percent.
EIG
In December 1994, HSBIIC acquired the remaining 50 percent interest in
Engineering Insurance Group (EIG), a partnership which was jointly formed by
HSBIIC and General Reinsurance Corporation (Gen Re) in 1988. The partnership was
the parent of Engineering Insurance Company Limited, a London based insurer
formed in 1989 principally to offer machinery breakdown coverage to business and
industry outside the United States and Canada. Coincident with the December 1994
acquisition, the partnership was incorporated with HSBIIC acquiring all
outstanding common shares and Gen Re acquiring preferred shares of the new
company, EIG, Co. HSBIIC had the option to request Gen Re to exchange the EIG,
Co. preferred stock for HSBIIC convertible redeemable preferred stock at the end
of 1996. This option was exercised on December 30, 1996 resulting in the
issuance of 2,000 shares of HSBIIC convertible redeemable preferred stock. On
October 30, 1997, these shares were converted into 597,609 shares of common
stock of HSB, restated to reflect the May 22,1998 three-for-two stock split
discussed in Other Activities below (formerly 398,406 shares).
Kemper
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 as part of Kemper's commercial package policies.
Solomon Associates, Inc.
In April 1998, HSB acquired Solomon Associates, Inc. (SAI) based in Dallas,
Texas. SAI is an engineering management consulting firm that provides
comparative performance benchmarking consulting to the refining, petro-chemical
and power generation industries. SAI establishes efficiency and productivity
benchmarks for 80 percent of the worldwide petroleum refining industry.
Other Activities
Holding Company Formation
At a special meeting of HSBIIC on June 23, 1997, shareholders voted to approve a
proposal which enabled the formation of a new holding company, HSB Group, Inc.
Shareholders of HSBIIC's common stock and convertible redeemable preferred stock
automatically became holders of HSB Group, Inc. common stock and convertible
redeemable preferred stock, respectively, through a share exchange approved by
the shareholders. Certificates
55
<PAGE>
representing HSBIIC's common and convertible redeemable preferred stock
automatically represent the corresponding shares of HSB Group, Inc. common and
convertible redeemable preferred stock. HSBIIC remains the principal subsidiary
of HSB.
Stock Split
On April 21, 1998, the Board of Directors approved a three-for-two stock split
for shares held of record on May 1, 1998. Additional shares of HSB's stock
resulting from the split were distributed on May 22, 1998. In accordance with
SFAS No. 128 "Earnings per Share"(see note 4), all earnings per share
presentations have been adjusted to reflect the impact of the stock split,
including retroactive restatement of prior periods. Shares have also been
restated for comparative purposes.
Capital Securities
On July 15, 1997, HSB sold $110 million of 30 year Global Floating Rate Capital
Securities in a private placement. On December 31, 1997, HSB issued $300 million
of 20 year fixed rate Convertible Capital Securities to ERC, a subsidiary of GE
Capital Services (see note 13).
4. Earnings per Share
Pursuant to the provisions of SFAS No. 128, all EPS presentations have been
adjusted to reflect the impact of the stock split (see note 3). Previously, the
Company reported basic EPS from continuing operations of $3.32 and $2.71 per
share and assuming dilution EPS of $3.29 and $2.71 per share for the years ended
1997 and 1996, respectively.
The following table presents a reconciliation of the numerator and denominator
of the calculation of basic and diluted EPS for income from continuing
operations:
1998 1997 1996
- --------------------------------------------------------------------------------
Income from continuing operations $104.1 $66.3 $54.6
Dividends on preferred shares -- (1.1) --
-------------------------------------------
Income applicable to common stock 104.1 65.2 54.6
Convertible preferred stock -- 1.1 --
After-tax distributions on
convertible capital securities(1) 13.7 -- --
-------------------------------------------
Adjusted for diluted computation $117.8 $66.3 $54.6
- --------------------------------------------------------------------------------
Weighted average common shares
outstanding(2) 29.3 29.5 30.3
Convertible capital securities 5.3 -- --
Convertible preferred stock -- 0.5 --
Stock options(3) 0.6 0.2 --
-------------------------------------------
Adjusted for diluted computation 35.2 30.2 30.3
- --------------------------------------------------------------------------------
From continuing operations:
Earnings per share-basic (4) $ 3.55 $2.21 $1.81
Earnings per share-assuming
dilution $ 3.35 $2.20 $1.81
- --------------------------------------------------------------------------------
(1)See note 13.
(2)Average shares reflect the repurchase of approximately 1.2, 1.5 and 0.4
million in 1998, 1997 and 1996, 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.
56
<PAGE>
5. Segment Information
In 1998, HSB implemented the provisions of 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 utilizing the management approach to defining operating
segments. It includes disclosure requirements relating to products and services,
geographic areas and major customers. The adoption of SFAS No. 131 did not
affect consolidated results of operations, financial position or cash flows but
did affect the disclosure of segment information.
The prior year's segment information has been restated to present HSB's four
reportable segments - Commercial insurance, Global Special Risk insurance,
Engineering services and Investments. HSB is a multi-national company operating
primarily in North American, European and Asian markets. Through its Commercial
segment operations, HSB provides risk modification services, equipment breakdown
insurance and loss recovery services to commercial businesses. The Global
Special Risk operating segment focuses on the needs of equipment-intensive
industries by offering all-risk coverage with customized engineering consulting
and risk management. HSB's Engineering services operations offers professional
scientific and technical consulting for industry and government on a worldwide
basis. The Company's investment assets are managed by its Investment operating
segment.
The accounting policies of the segments are the same as those described in
"Accounting Policies" (see note 1), except for certain benefit charges which
comprise the Corporate Account. HSB evaluates the performance of its segments
and allocates resources to them based on net income (loss). Segment assets are
not included in this evaluation process. Interest income and expense are
included in the results of Investment operations.
HSB's foreign operations (primarily insurance) are widely dispersed such that no
country or logical aggregation of countries in a geographic area comprise a
significant concentration with respect to either revenues or identifiable
assets. Export sales from HSB's domestic operations are minimal due to the
existence of the Company's foreign subsidiaries which are responsible for
virtually all of the Company's foreign sales.
The following presents financial data of the Company based on geographic
location:
For the years ended December 31, 1998 1997 1996
- --------------------------------------------------------------------------------
Revenues from continuing operations:
U.S. $ 491.0 $ 483.1 $ 437.4
Non-U.S. 88.2 120.3 111.4
-------------- ------------- -----------
Total $ 579.2 $ 603.4 $ 548.8
Income from continuing operations
before taxes and distributions
on capital securities:
U.S. $ 168.2 $ 78.4 $ 52.9
Non-U.S. 5.7 15.3 20.0
----------------------------------------
Total $ 173.9 $ 93.7 $ 72.9
- --------------------------------------------------------------------------------
At December 31, 1998 1997 1996
- --------------------------------------------------------------------------------
Identifiable assets:
U.S. $1,769.2 $1,244.7 $ 854.3
Non-U.S. 374.8 292.5 258.0
----------------------------------------
Total $2,144.0 $1,537.2 $1,112.3
- --------------------------------------------------------------------------------
57
<PAGE>
The following presents revenue and net income from the Company's reportable
segments and reconciles these amounts to the corresponding consolidated totals:
For the years ended December 31, 1998 1997 1996
- --------------------------------------------------------------------------------
Revenues from continuing operations:
Insurance premiums:
Commercial $306.3 $269.0 $253.1
Global Special Risks 83.6 217.1 187.7
Engineering services 93.5 61.3 55.8
Net investment income
and realized investment
gains 89.6 50.9 44.4
-------------------------------------------
Total revenues from
reportable segments 573.0 598.3 541.0
Other segments 6.2 5.1 7.8
-------------------------------------------
Total revenues $579.2 $603.4 $548.8
Net income (loss):
Commercial $ 14.8 $ 13.4 $ 11.8
Global Special Risks 9.8 10.7 (3.0)
Engineering services 4.6 3.0 4.0
Investments 65.1 37.7 36.3
-------------------------------------------
Total net income from
reportable segments 94.3 64.8 49.1
Other segments (0.3) (1.3) 0.4
Corporate account 4.7 5.1 5.1
Distributions on
capital securities (18.4) (2.3) --
Discontinued operations 30.3 -- (1.2)
Gain on sale of IRI, net of
income taxes 23.8 -- --
-------------------------------------------
Net income $134.4 $ 66.3 $ 53.4
- --------------------------------------------------------------------------------
Specified items included in the measure of net income for reportable segments
are as follows:
For the years ended December 31, 1998 1997 1996
- --------------------------------------------------------------------------------
Depreciation and amortization
expense:
Commercial $ 7.3 $ 3.4 $ 5.2
Global Special Risks 2.2 3.2 2.3
Engineering services 5.9 2.7 3.0
Investments 0.3 -- --
Income tax expense (benefit):
Commercial 4.6 6.1 6.9
Global Special Risks 7.7 6.2 (1.3)
Engineering services 1.6 0.1 2.0
Investments 22.5 10.3 7.0
- --------------------------------------------------------------------------------
58
<PAGE>
6. Statutory Financial Information
HSBIIC is a Connecticut domiciled insurance company which is licensed to conduct
business in all 50 states, the District of Columbia, Puerto Rico and the U.S.
Virgin Islands. The annual statements for state insurance regulatory authorities
are currently prepared using accounting methods prescribed or permitted by such
authorities (statutory basis) and are not consolidated. Statutory Accounting
Practices (SAP) also differ in certain other respects from GAAP. With respect to
HSBIIC, these differences are primarily comprised of the accounting for prepaid
acquisition costs, deferred income taxes, fixed maturity investments, valuation
of certain non-insurance affiliates and employee benefit plans. At year-end 1998
and 1997, policyholders' surplus on a statutory basis was $612.6 and $550.8
million, respectively. Statutory net income, adjusted to include the earnings of
all HSBIIC domestic insurance subsidiaries for 1998, 1997 and 1996 was $202.5,
$42.9 and $32.1 million, respectively.
HSBIIC and its insurance subsidiaries are currently subject to various
regulations that limit the maximum amount of dividends ultimately available to
HSBIIC's parent company without prior approval of insurance regulatory
authorities. Under SAP, approximately $200.2 million of statutory surplus is
available for distribution to HSB Group, Inc. in 1999 without prior regulatory
approval.
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 if adopted by the Connecticut
Insurance Department.
59
<PAGE>
7. Investments
For the years ended December 31, 1998 1997 1996
- --------------------------------------------------------------------------------
Income from Investment Operations:
Net investment income:
Short-term interest $ 8.7 $ 6.7 $ 4.8
Fixed maturities:
Taxable interest 31.9 9.6 9.8
Tax exempt interest 2.5 2.1 1.8
Redeemable preferred dividends 5.9 7.2 7.9
Equity securities:
Common dividends 6.4 4.7 4.6
Non-redeemable preferred
dividends 14.0 8.3 5.9
Other 0.2 2.1 1.0
------------------------------------
Total investment income 69.6 40.7 35.8
Investment expenses (5.4) (3.9) (3.5)
------------------------------------
Net investment income $64.2 $36.8 $32.3
Realized investment gains (losses):
Fixed maturities:
Bonds:
Gains $ 2.1 $ 0.5 $ 2.0
Losses (0.2) (0.3) (0.2)
------------------------------------
Net gains 1.9 0.2 1.8
Redeemable preferred stocks:
Gains 2.3 0.4 0.3
Losses (0.1) (0.3) (1.5)
------------------------------------
Net gains (losses) 2.2 0.1 (1.2)
Equity securities:
Common stocks:
Gains 20.5 48.1 14.6
Losses (7.0) (5.1) (3.3)
------------------------------------
Net gains 13.5 43.0 11.3
Non-redeemable preferred stocks:
Gains 10.3 7.7 4.2
Losses (3.1) (0.2) (4.0)
------------------------------------
Net gains 7.2 7.5 0.2
Foreign exchange gains (losses) 0.3 (7.4) --
Collar contracts losses -- (30.7) --
Other gains 0.3 1.4 --
------------------------------------
Realized investment gains $25.4 $14.1 $12.1
- --------------------------------------------------------------------------------
There were no material declines in the realizable value of investments
considered to be other than temporary for 1998 and 1997. Realized investment
gains and losses for 1996 included $0.8 million of losses on non-redeemable
preferred stock arising from declines in the realizable value of investments
considered to be other than temporary.
60
<PAGE>
At December 31, 1998 1997 1996
- ---------------------------------------------- ----------------- ---------------
Unrealized Investment Gains,
Net of Tax
Fixed maturities:
Gains $13.0 $ 7.9 $ 6.1
Losses (4.4) (0.6) (1.6)
--------------- ----------------- ---------------
Net gains 8.6 7.3 4.5
Equity securities:
Gains 122.9 94.3 82.0
Losses (12.1) (1.8) (2.2)
--------------- ----------------- ---------------
Net gains 110.8 92.5 79.8
Foreign exchange losses (6.3) (4.5) (2.9)
--------------- ----------------- ---------------
Total unrealized
investment gains 113.1 95.3 81.4
Income taxes (42.3) (35.5) (28.6)
--------------- ----------------- ---------------
Unrealized investment
gains, net of tax $70.8 $59.8 $52.8
- ---------------------------------------------- ----------------- ---------------
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:
<TABLE>
<CAPTION>
1998
- -----------------------------------------------------------------------------------------------
Amortized Estimated Gross Gross
Category Cost Fair Unrealized Unrealized
Value Gains Losses
- --------------------------------- -------------------------------------------------------------
<S> <C> <C> <C> <C>
Redeemable preferred stocks $215.5 $219.2 $ 5.0 $1.3
States and municipalities 47.4 49.3 2.1 0.2
Foreign governments 21.0 21.3 0.4 0.1
Corporate and other 284.6 287.3 5.5 2.8
-------------------------------------------------------------
Total fixed maturities $568.5 $577.1 $13.0 $4.4
</TABLE>
<TABLE>
<CAPTION>
1997
- -----------------------------------------------------------------------------------------------
Category Amortized Estimated Gross Gross
Cost Fair Unrealized Unrealized
Value Gains Losses
- --------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Redeemable preferred stocks $131.2 $135.4 $4.7 $0.5
States and municipalities 37.6 39.7 2.2 0.1
Foreign governments 33.1 33.5 0.4 --
Corporate and other 39.2 39.8 0.6 --
------------------------------------------------------------------
Total fixed maturities $241.1 $248.4 $7.9 $0.6
- ---------------------------------------------------------------------------------------------------
</TABLE>
61
<PAGE>
The amortized cost and estimated fair value of fixed maturities at December 31,
by contractual years-to-maturity is as follows (actual maturities may differ
from contractual maturities because borrowers may have the right to prepay
obligations):
1998
- --------------------------------------------------------------------------------
Maturity Amortized Estimated
Cost Fair Value
- --------------------------------------------------------------------------------
One year or less $ 18.8 $ 18.9
Over one year through five years 93.3 96.4
Over five years through ten years 47.3 48.9
Over ten years 409.1 412.9
--------------------------------------------
Total fixed maturities $568.5 $577.1
- --------------------------------------------------------------------------------
Equity Securities
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:
1998
- --------------------------------------------------------------------------------
Estimated Gross Gross
Fair Unrealized Unrealized
Cost Value Gains Losses
- --------------------------------------------------------------------------------
Common stocks $141.3 $249.3 $112.3 $ 4.3
Non-redeemable
preferred stocks 185.0 187.8 10.6 7.8
--------------------------------------- -----------
Total equity securities $326.3 $437.1 $122.9 $ 12.1
- -------------------------------------------------------------------- -----------
1997
- --------------------------------------------------------------------------------
Estimated Gross Gross
Fair Unrealized Unrealized
Cost Value Gains Losses
- --------------------------------------------------------------------------------
Common stocks $ 97.5 $179.0 $ 82.2 $ 0.7
Non-redeemable
preferred stocks 133.8 144.8 12.1 1.1
-----------------------------------------------
Total equity securities $231.3 $323.8 $ 94.3 $ 1.8
- --------------------------------------------------------------------------------
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). Each contract
had a notional value of $50 million and maturity dates ranging from November
1997 to January 1998. The contracts, which were entered into when the S&P 500
Index was 744.3, allowed HSBIIC to recover from the counterparty if the index
was below 695.2 at the time of maturity, and required HSBIIC to reimburse the
counterparty if the index was above a range of 811.3 to 818.7 at the time of
maturity. 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
includes price appreciation of approximately $54 million) and had a price
movement correlation with the S&P 500 Index well in excess of 80 percent.
62
<PAGE>
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.
8. Fixed Assets
Fixed assets are summarized as follows:
At December 31, 1998 1997
- -----------------------------------------------------------------------------
Land and buildings $ 5.1 $ 5.0
Furniture, equipment,
leasehold improvements,
and other 68.0 57.1
Systems development costs 23.9 6.6
--------------------------------------
97.0 68.7
Less: accumulated depreciation
and amortization (42.1) (32.3)
--------------------------------------
Total fixed assets $54.9 $36.4
- -----------------------------------------------------------------------------
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 relates
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. It is currently estimated that the Company's aggregate
spending in connection with the Year 2000 Program will be in the range of $26
million. Certain of these costs are being expensed as incurred. The Company has
expensed $5.1 million for 1998, $1.5 million for 1997 and $0.2 million for 1996.
It is estimated that expenditures of $5.2 million for 1999 will be expensed as
incurred. The remainder of the $26 million estimate is related to systems that
the Company anticipated replacing in the normal course of information technology
development, however, the timetable was accelerated in contemplation of the Year
2000 event. The costs associated with replacement of such systems are being
capitalized in accordance with the Company's existing capitalization policy.
9. Leases
The Company leases its home office facility at One State Street under a
long-term capital lease with the One State Street Limited Partnership
(Partnership). The lease obligation of $26.1 million was recorded at July 1,
1983 at an interest rate of 15 percent. An asset of $26.1 million was also
recorded in 1983. Accumulated amortization on the asset was $11.6 and $10.8
million at December 31, 1998 and 1997, respectively. Terms of the lease require
annual payments of approximately $4 million a year through June 30, 2018. In
addition, the Company is required to pay over the lease
63
<PAGE>
term a proportional share of the facility's variable operating expenses. This
amounted to approximately $2.9, $2.6 and $2.8 million for the years ended 1998,
1997 and 1996, respectively.
The Company owns the One State Street land and leases it to the Partnership. The
Company receives a base rent for the land and a participation in the net cash
flow of the Partnership. If the facility is sold, the Company will receive 50
percent or more of the sales proceeds in excess of the mortgages, all operating
expenses and costs of sale and the rental obligations pursuant to the land
lease. Under certain circumstances, the Company has the right to purchase the
facility.
In addition to its home office facility, the Company leases facilities and
certain equipment which are accounted for as operating leases. Lease expenses
amounted to $10.2, $8.4 and $5.7 million in 1998, 1997 and 1996, respectively.
At December 31, 1998, future minimum rental commitments under noncancelable
leases accounted for as operating leases with initial or remaining terms of more
than one year were as follows:
1999 $ 6.4
2000 4.6
2001 3.1
2002 2.5
2003 1.9
2004 and thereafter 2.6
---
Total $21.1
10. Reinsurance
The components of net written and net earned insurance premiums were as follows:
For the years ended December
31, 1998 1997 1996
- --------------------------------------------------------------------------------
Written premiums:
Direct $ 478.2 $ 361.4 $ 338.6
Assumed 318.5 257.1 232.6
Ceded (444.1) (120.0) (116.8)
--------------------------------------------------
Net written premiums $ 352.6 $ 498.5 $ 454.4
Earned premiums:
Direct $ 408.8 $ 370.1 $ 343.4
Assumed 361.7 239.2 213.1
Ceded (374.4) (118.1) (107.9)
--------------------------------------------------
Insurance premiums $ 396.1 $ 491.2 $ 448.6
- --------------------------------------------------------------------------------
In 1998 HSBIIC became the direct writer for business written on behalf of HSB
Industrial Risk Insurers. This business is ceded to that entity and HSBIIC's
share of the equipment breakdown and property business is 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, claims and adjustment
expenses.
64
<PAGE>
The Company writes direct business, which in 1998 includes HSB Industrial Risk
Insurers business, through agencies and brokerage firms. In addition, the
Company assumes boiler and machinery exposures from over 100 insurance companies
and several insurance pools. Under the reinsurance agreements, the Company's
reinsured companies may include equipment breakdown exposures in their
multi-peril policies, and such risks will be assumed by the Company under the
terms of the agreement. These agreements generally provide that the Company will
assume 100 percent of each boiler and machinery risk, subject to the capacity
specified in the agreement, and will receive the entire equipment breakdown
premium except for a ceding commission, which will be retained by the reinsured
company for commissions to agents and brokers, premium taxes and handling
expenses.
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.
The insurance industry, in general, is undergoing a shakeout and consolidation.
A significant amount of merger and acquisition activity has occurred recently
and may continue in the future. Depending on the specific companies involved in
these activities and other market factors, the level of reinsured business the
Company assumes in the future could be impacted.
Recently there has been significant consolidation in the international brokerage
business, including the merger of Marsh & McLennan and Johnson & Higgins during
1997, and the subsequent merger with Sedgwick Group. For 1998, approximately 35
percent of the Company's gross written premium generated by its Global Special
Risk business, which includes HSB Industrial Risk Insurers, was produced by
J&HMarsh & 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 $436.4, $45.2 and $113.9 million
of reinsurance recoveries as a reduction of its claims and adjustment expenses
for the years ended December 31, 1998, 1997 and 1996, respectively. Reinsurance
recoverable on paid claims and adjustment expenses was $14.6 and $8.0 million at
December 31, 1998 and 1997, respectively.
65
<PAGE>
11. Reconciliation of Liability for Claims and Adjustment Expenses
The following tables provide reconciliations of the beginning and ending
reserves for claims and adjustment expenses on both a gross liability and net
(of reinsurance) liability basis:
Reconciliation of Gross Liability for Claims and Adjustment Expenses
1998 1997 1996
- --------------------------------------------------------------------------------
Gross liability for claims and
adjustment expenses at
January 1, $276.7 $302.9 $190.9
Plus:
Provision for claims and
adjustment expenses occurring
in the current year 564.8 263.3 313.3
Increase (decrease) in estimated
claims and adjustment expenses
arising in prior years(1) 46.9 (0.2) 16.1
-----------------------------------------
Total incurred claims and
adjustment expenses $611.7 $263.1 $329.4
-----------------------------------------
Less:
Payment for claims arising in:
Current year 141.0 90.6 103.3
Prior years 197.1 198.7 114.1
-----------------------------------------
Total payments $338.1 $289.3 $217.4
-----------------------------------------
Gross liability for claims and
adjustment expenses at December 31, $550.3 $276.7 $302.9
- --------------------------------------------------------------------------------
Reconciliation of Net Liability for Claims and Adjustment Expenses
1998 1997 1996
- --------------------------------------------------------------------------------
Net liability for claims and
adjustment expenses at January 1, $190.8 $177.8 $145.5
Plus:
Provision for claims and
adjustment expenses occurring
in the current year 164.0 209.5 214.2
Increase (decrease) in estimated
claims and adjustment expenses
arising in prior years 10.9 8.4 (9.8)
-----------------------------------------
Total incurred claims and
adjustment expenses $174.9 $217.9 $204.4
-----------------------------------------
Less:
Payment for claims arising in:
Current year 84.2 82.3 91.4
Prior years 111.8 122.6 80.7
-----------------------------------------
Total payments $196.0 $204.9 $172.1
-----------------------------------------
Net liability for claims and
adjustment expenses at December 31, $169.7 $190.8 $177.8
- --------------------------------------------------------------------------------
(1)The 1998 increase primarily resulted from the decision rendered under an
arbitration proceeding and adverse claims experience in international
operations.
66
<PAGE>
1998, 1997 and 1996 claims and adjustment expenses incurred have been reduced by
subrogation recoveries of approximately $5.0, $3.3 and $4.9 million,
respectively.
A reconciliation of the net liability to the gross liability for claims and
adjustment expenses is as follows:
1998 1997 1996
At December 31,
- --------------------------------------------------------------------------------
Net liability for claims and
adjustment expenses at December 31, $169.7 $190.8 $177.8
Reinsurance recoverable on unpaid
claims and adjustment expenses 380.6 85.9 125.1
----------------------------------------
Gross liability for claims and
adjustment expenses at December 31, $550.3 $276.7 $302.9
- --------------------------------------------------------------------------------
The Company utilizes well-capitalized domestic and international reinsurance
companies and syndicates for its reinsurance program and monitors their
financial condition on an ongoing basis. For reinsurers that are not accredited
in their state of domicile, the Company requires collateral for reinsurance
recoverable from such carriers. Uncollectible reinsurance recoverables have not
had, and are not expected by management to have in the future, a material
adverse effect on the consolidated results of operations or financial position
of the Company.
The following table displays information concerning the primary participants in
the Company's current reinsurance program as of December 31, 1998.
Reinsurer Ceded
Written Reinsurance 1998 A.M.
Premium Asset Best's Rating
- --------------------------------------------------------------------------------
Employers Reinsurance Corporation* $167.7 $ 248.6 A++(Superior)
General Reinsurance Corporation $ 44.7 $ 66.0 A++(Superior)
Gerling-Konzern Globale $ 9.6 $ 13.3 n/a
Hartford Fire Insurance Company $ 9.3 $ 13.4 A+ (Superior)
American Re-Insurance Company $ 8.7 $ 13.2 A++(Superior)
NAC Reinsurance Corporation $ 8.3 $ 12.8 A+ (Superior)
* net of business assumed by HSB from ERC
As of December 31, 1998 no other reinsurance asset of the Company from any
single reinsurer exceeded 3.0 percent of shareholders' equity. Certain Lloyd's
syndicates participate in the excess of loss reinsurance program, primarily in
the excess layers. The highest aggregate percentage participation of such
syndicates, at 31.9 percent, is in the $50 million excess of $100 million layer.
No individual syndicate has more than 6.8 percent participation in any of the
excess layers. In addition, certain syndicates participate in two of our quota
share treaties, aggregating 7.9 percent participation in one and 13.5 percent
participation in another. Lloyd's participation in our catastrophe cover is 77.3
percent with no individual syndicate retaining more than 5.3 percent. The
Company's reinsurance asset in the aggregate from all Lloyd's syndicates is less
than 8.0 percent of shareholders' equity at December 31, 1998. Lloyd's has
historically participated more heavily in the higher treaty layers, including
those years relating to the arbitration and litigation cases discussed below.
HSBIIC is currently involved in a claim-related dispute concerning the extent to
which a certain explosion event is insured under the boiler and machinery
coverage of HSBIIC or under coverages of other insurers. A final decision in an
67
<PAGE>
arbitration proceeding on this matter has concluded with a decision requiring
HSBIIC to pay $22 million of the amount that was in dispute. The $22 million,
less HSBIIC's retention of $3 million, which was reserved for in prior years, is
fully reinsured. In response to the ruling, the Company increased both its gross
reserves and reinsurance recoverable by $19 million, resulting in no impact to
net income. HSBIIC has filed a motion in Connecticut Superior Court to confirm
the arbitration award. The other insurers have contested the award. In the event
the award is not confirmed, subsequent proceedings could result in additional
amounts on the order of $100 million potentially becoming recoverable from
HSBIIC's reinsurers.
The obligations of HSBIIC's reinsurers with respect to this litigation are not
in dispute. Therefore, management believes that any adverse outcome in this case
will not have a material effect on either the results of operations or financial
condition of the Company. HSBIIC's reinsurance contracts do not require HSBIIC
to reimburse its reinsurers for any loss such reinsurers might incur should this
case not be decided in HSBIIC's favor. Nevertheless, reinsurers often quote
rates for future coverages based upon their or other reinsurers' experience on a
particular account. Therefore, in the event HSBIIC's reinsurers pay significant
sums pursuant to the litigation described above, it is likely HSBIIC's
reinsurance rates would increase in future periods. However, given the insured
capacity that exists in reinsurance markets worldwide, coupled with HSBIIC's
ability to negotiate a redesign or restructuring of its reinsurance program, it
does not necessarily mean that such an increase would be material.
HSBIIC was involved in another litigation regarding an explosion event and the
extent of HSBIIC's coverage in that matter. The 7th Circuit Court of Appeals
recently ruled in HSBIIC's favor and remanded the case for a judgment of no
liability to be entered for HSBIIC.
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.
12. Income Taxes
Tax Provision
A reconciliation of income taxes (benefit) at U.S. statutory rates to the income
taxes (benefit) as reported is as follows:
<TABLE>
<CAPTION>
1998 1997 1996
- -----------------------------------------------------------------------------------------------------------
% of % of % of
Pre-tax Pre-tax Pre-tax
Amount Income Amount Income Amount Income
- -----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Income from continuing operations
before income taxes and
distributions on capital
securities $173.9 100% $93.7 100% $72.9 100%
------------------------------------------------------------------------
Tax at statutory rates $ 60.9 35% $32.8 35% $25.5 35%
Income taxed at foreign rates (0.6) -- 1.0 1 0.5 1
Dividends received deduction (4.3) (2) (4.9) (5) (4.5) (6)
Tax exempt interest (0.9) (1) (0.8) (1) (0.6) (1)
Tax credits and others (3.7) (2) (3.0) (3) (2.6) (4)
------------------------------------------------------------------------
Total income taxes and effective
tax rate $ 51.4 30% $25.1 27% $18.3 25%
- ------------------------------------------------------------------------------------------------------------
</TABLE>
68
<PAGE>
Income taxes (benefit) consisted of the following:
1998 1997 1996
- --------------------------------------------------------------------------------
Current provision:
U.S. $45.3 $16.8 $17.3
Foreign (0.3) 7.0 7.4
------------------------------------------------
Total current provision 45.0 23.8 24.7
------------------------------------------------
Deferred provision:
U.S. 6.2 1.1 (6.0)
Foreign 0.2 0.2 (0.4)
------------------------------------------------
Total deferred provision 6.4 1.3 (6.4)
------------------------------------------------
Total income taxes $51.4 $25.1 $18.3
- --------------------------------------------------------------------------------
Deferred Income Taxes
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, 1998 and 1997
are as follows:
1998 1997
- ------------------------------------ -------------------- ----------------------
Deferred tax liabilities:
Prepaid acquisition costs $(17.1) $(13.2)
Accelerated depreciation (0.5) (0.3)
Pension asset (14.4) (13.3)
Unrealized investment gains (42.3) (35.5)
Other (14.0) (12.5)
-------------------- ----------------------
Total deferred tax liabilities (88.3) (74.8)
-------------------- ----------------------
Deferred tax assets:
Benefit plans 9.2 9.0
Capital lease 4.7 4.4
Unearned insurance premiums 12.1 15.0
Loss reserve discounting 3.3 5.9
Other 16.3 9.0
-------------------- ----------------------
Total deferred tax assets 45.6 43.3
-------------------- ----------------------
Net deferred tax liabilities $(42.7) $(31.5)
- ------------------------------------ -------------------- ----------------------
Other Information
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.
69
<PAGE>
13. Capital Structure
HSB's capital structure is as follows at December 31:
1998 1997
- --------------------------------------------------------------------------------
Short-term borrowings $ 21.0 $ 42.4
Long-term borrowings * $ 25.1 $ 25.1
Company obligated mandatorily redeemable
capital securities of subsidiary Trust I holding
solely junior subordinated deferrable interest
debenture of the Company $108.9 $108.9
Company obligated mandatorily redeemable convertible
capital securities of subsidiary Trust II holding
solely junior subordinated deferrable interest
debenture of the Company $300.0 $300.0
Common shareholders' equity $419.3 $345.3
- --------------------------------------------------------------------------------
*excludes capital lease (see note 9).
Short-term and Long-term Borrowings
HSBIIC has a commercial paper program with a limit of $75 million. Commercial
paper outstanding at December 31, 1998 and 1997 was $20.0 and $42.3 million,
respectively. Commercial paper outstanding at year end 1998 matures on or before
April 20, 1999. Long-term debt includes $25.1 million of senior notes due May
15, 2000 at an interest rate of 6.83 percent. Current market value is estimated
to be $26.2 million.
Capital Securities
On July 15, 1997, HSB sold $110 million of 30 year Global Floating Rate Capital
Securities (Capital Securities) in a private placement. The securities are
generally non-callable for ten years but may be called earlier by HSB upon the
occurrence of certain tax events including loss of deductibility of interest on
the securities. The securities were issued through HSB Capital I (Trust I), a
Delaware business trust created by HSB, at a floating rate tied to 90 day LIBOR.
The current coupon is approximately 6.3 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. 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 HSB will be prohibited from paying any cash dividends on its
common stock. HSB has irrevocably and unconditionally guaranteed all of Trust
I's obligations under the Capital Securities. The Company has used or may use
the proceeds for general corporate purposes, including the repurchase of HSB
common stock; funding investments in, or extensions of credit to, subsidiaries;
repayment of maturing debt; and financing possible future acquisitions. HSB
subsequently filed a registration statement covering securities with terms
identical in all material respects and offered to exchange registered securities
for the original Capital Securities. The exchange was completed on December 11,
1997.
On December 31, 1997, HSB 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
70
<PAGE>
event that the Company 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 the Company 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 Company
common stock at a conversion price of $56.67 per share, restated to reflect the
May 22,1998 three-for-two stock split (formerly a conversion price of $85.00 per
share) (see note 3), subject to adjustment. The Company 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. Were ERC to exercise its conversion rights in
total, it would hold, on a fully diluted basis, approximately 15.5 percent of
the Company'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 the Company, other than by exercise of its
conversion rights, and will limit its ability to take certain other actions with
respect to the Company during that period.
The securities were issued through HSB Capital II (Trust II), a Delaware
business trust created by HSB Group, Inc., at a 7 percent coupon, payable
semi-annually. The Convertible Capital Securities rank pari passu with the
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 estimated fair value of the Capital Securities issued by Trust I is equal to
their carrying value. The estimated fair value of the Capital Securities issued
by Trust II is $311.1 million 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.
Common 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 $112.8 and $85.9 million as of December
31, 1998 and 1997, respectively. The reclassifications were distributed as
follows:
At December 31, 1998 1997
- -------------------------------------------------------------
Additional paid-in capital $ 5.5 $ 2.8
Retained earnings 107.3 83.1
-------------------------------
Total $112.8 $85.9
- -------------------------------------------------------------
2,000 shares of HSBIIC's convertible redeemable preferred stock held by Gen Re
were converted into 597,609 shares of HSB common stock on October 30,1997 at a
price of $33.47 per share, restated to reflect the May 22, 1998 three-for-two
stock split (formerly 398,406 shares at $50.20 per share)(see note 3).
71
<PAGE>
The components of accumulated other comprehensive income (net of taxes) are as
follows:
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------
Total
Accumulated Unrealized Minimum
Other Gains Pension Foreign
Comprehensive On Liability Exchange
Income Securities Adjustment Losses
- -----------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Balances at December 31, 1996 $49.2 $54.6 $(3.6) $(1.8)
Current period change 6.7 7.8 (0.3) (0.8)
- -----------------------------------------------------------------------------------------------
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)
- -----------------------------------------------------------------------------------------------
</TABLE>
14. Pension and Other Benefit Programs
In February 1998, the FASB issued SFAS No. 132 "Employer's Disclosure about
Pension and Other Postretirement Benefits" which standardizes the disclosure
requirements for pensions and other postretirement benefits. While it does not
change the measurement or recognition of the plans, it does require additional
information on changes in the benefit obligation and fair value of plan assets.
The statement is effective for fiscal years beginning after December 15, 1997
and requires restatement of prior periods. Pursuant to the requirements of this
statement, the Company has combined the pension and postretirement benefit
disclosures and restated 1997 and 1996 disclosures to conform to current year
presentation.
HSB maintains various types of pension and postretirement medical plans covering
employees of the Company and certain subsidiaries. The pension plans are
non-contributory and benefits are based upon an employee's years of service and
final average pay based upon the highest three out of five years. Vesting occurs
after five years of service in compliance with the provisions of the Tax Reform
Act of 1986.
Under the terms of the HSB Group, Inc. Thrift Incentive Plan, a defined
contribution plan, covered employees are allowed to contribute up to 15 percent
of their pay, on a pre-tax basis, limited by the maximum allowed under Internal
Revenue Service regulations. The Company makes a matching contribution of 50
percent of employee contributions up to 6 percent of compensation. Total expense
for the plan was $2.1, $1.7 and $1.8 million for 1998, 1997 and 1996,
respectively.
The Company makes available health care and life insurance benefits for retired
employees of the Company and certain subsidiaries. The Company makes
contributions to the plans as claims are incurred. Retirees' contributions to
these plans vary, based upon retiree's age, years of service and coverage
elected. The Company periodically amends the plans changing the contribution
rate of retirees and amounts of coverage.
72
<PAGE>
The following chart summarizes the balance sheet impact, as well as the benefit
obligations, assets, funded status and rate assumptions associated with the U.S.
pension and postretirement medical benefit plans:
<TABLE>
<CAPTION>
Pension Benefits Other Benefits
- --------------------------------------------------------------------------------------------------------------------------
1998 1997 1998 1997
- --------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Change in benefit obligation:
Benefit obligation at beginning of year $156.0 $140.0 $ 29.9 $ 26.7
Service cost 5.3 4.1 0.3 0.3
Interest cost 11.9 10.7 1.9 2.1
Net benefit payments (10.3) (9.2) (1.9) (1.9)
Liability loss (gain) 0.7 2.5 (2.7) 1.8
Assumption changes 9.6 7.9 1.2 0.9
Acquisitions 4.2 -- -- --
Amendments 2.8 -- -- --
----------------------------------------------------------------------------
Benefit obligation at end of year $180.2 $156.0 $ 28.7 $ 29.9
Change in plan assets:
Fair value of plan assets at beginning $213.0 $178.0 $ -- $ --
of year
Actual return on plan assets 40.8 42.4 -- --
Acquisitions 3.5 -- -- --
Employer contributions 0.4 -- 1.5 1.5
Participants' contributions -- -- 0.4 0.4
Benefits paid (8.6) (7.4) (1.9) (1.9)
----------------------------------------------------------------------------
Fair value of plan assets at end of $249.1 $213.0 $ -- $ --
year
Funded status:
Funded status at end of year $ 68.9 $ 57.0 $(28.7) $(29.9)
Unrecognized actuarial (loss) gain (25.6) (13.2) 4.0 5.5
Unrecognized transition amount (4.7) (6.5) -- --
Unrecognized prior service cost 4.2 2.6 -- --
----------------------------------------------------------------------------
Net amount recognized $ 42.8 $ 39.9 $(24.7) $(24.4)
Amounts recognized in the consolidated
statements of financial position consist of:
Prepaid benefit cost $ 34.6 $ 31.7 $ -- $ --
Accrued benefit liability -- -- (24.7) (24.4)
Intangible asset 2.0 2.2 -- --
Accumulated other comprehensive income 6.2 6.0 -- --
----------------------------------------------------------------------------
Net amount recognized $ 42.8 $ 39.9 $(24.7) $(24.4)
Weighted-average assumptions at December 31:
Discount rate 6.75% 7.25% 6.75% 7.25%
Long-term rate of return on assets 10.00% 10.00% n/a n/a
Rate of increase in future 4.25% 4.50% n/a n/a
compensation levels
Current year health care cost trend n/a n/a 6.00% 7.00%
rate
Ultimate health care cost trend rate n/a n/a 4.25% 4.50%
- --------------------------------------------------------------------------------------------------------------------------
</TABLE>
For measurement purposes, the annual rate of increase in the per capita cost of
covered health care benefits range from 6 percent in 1998 decreasing gradually
to 4.25 percent by the year 2001 and remaining level thereafter.
73
<PAGE>
Assets available for pension plan benefits include approximately $24.2 and $20.9
million of Company stock at December 31, 1998 and 1997, respectively.
The following chart summarizes the cost components associated with the pension
and postretirement medical benefit plans:
<TABLE>
<CAPTION>
Pension Benefits Other Benefits
- ------------------------------------------------------------------------------------------------------------------------------
For the years ended December 31, 1998 1997 1996 1998 1997 1996
- ------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Components of net periodic benefit
(credit) cost:
Service cost $ 5.3 $ 4.1 $ 3.6 $0.3 $0.3 $0.3
Interest cost 11.9 10.7 10.2 1.9 2.1 2.0
Expected return on plan assets (18.5) (16.8) (15.3) -- -- --
Amortization of transition amount (1.9) (1.8) (1.8) -- -- --
Amortization of prior service cost 0.8 0.5 0.5 -- -- --
Recognized actuarial loss 1.0 0.5 0.5 -- 0.1 --
------------------------------------------------------------------------------------
Net periodic benefit (credit) cost $ (1.4) $(2.8) $ (2.3) $2.2 $2.5 $2.3
- -----------------------------------------------------------------------------------------------------------------------------
</TABLE>
The projected benefit obligation, accumulated benefit obligation and fair value
of plan assets for the pension plan with accumulated benefit obligations in
excess of plan assets were $36.6, $29.7 and $3.2 million, respectively, as of
December 31, 1998 and $27.9 million, $23.8 million and $0, respectively, as of
December 31, 1997.
The Company's acquisition of SAI in April 1998, resulted in the increase of the
pension benefit obligation by $4.2 million and pension plan assets by $3.5
million.
Assumed health care cost trend rates have a significant 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:
1% Point 1% Point
Increase Decrease
- --------------------------------------------------------------------------------
Effect on total of service and
interest cost components $0.1 $(0.1)
Effect on postretirement
benefit obligation 1.3 (1.2)
15. Stock Compensation Plans
HSB has a Stock Option Plan under which key employees may be granted restricted
stock and stock options.
HSB's Long-Term Incentive Plan grants senior management awards contingent upon
achievement of specified performance objectives over a three year period, which
may be paid out in cash or shares of common stock (which may be restricted
shares). The number of shares subject to issuance under this plan cannot exceed
375,000.
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 $1.0 million in 1998 and $0.6 million
in 1997 and 1996. The unamortized compensation expense related to this plan is
included in benefit plans as a component of shareholders' equity. These amounts
were $2.2 and $1.0 million in 1998 and 1997, respectively.
74
<PAGE>
A summary of grants follows (1997 and 1996 numbers have been adjusted to reflect
the April 1998 stock split - see note 3):
1998 1997 1996
- --------------------------------------------------------------------------------
Restricted shares awarded 54,434 30,594 19,875
Weighted-average fair value
of shares on grant date $39.86 $31.93 $32.57
- --------------------------------------------------------------------------------
A stock option award under the HSB's Stock Option Plan allows for the purchase
of HSB common stock at no less than the market price on the date of grant.
Options granted to date are exercisable no earlier than one year after the grant
date and expire no more than ten years from the date of grant.
A summary of the status of HSB's stock options as of December 31, 1998, 1997 and
1996 and changes during the years ended on those dates is presented below (1997
and 1996 numbers have been adjusted to reflect the April 1998 stock split - see
note 3):
<TABLE>
<CAPTION>
1998 1997 1996
- ------------------------------------------------------------------------------------------------------------------------------
Weighted- Weighted- Weighted-
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
- ------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Outstanding at beginning of
year 2,227,125 $32.03 1,979,475 $32.44 1,950,000 $33.91
Granted 814,500 39.34 558,750 32.55 591,000 33.21
Exercised (279,450) 34.21 (235,500) 31.12 (36,375) 30.84
Forfeited (31,950) 37.81 (75,600) 33.49 (525,150) 38.86
---------------------------------------------------------------------------------------------
Outstanding at end of year 2,730,225 33.92 2,227,125 32.03 1,979,475 32.44
---------------------------------------------------------------------------------------------
Options exercisable at year-end 1,923,225 $31.65 1,681,875 $32.51 1,424,475 $32.15
Weighted-average fair value of
options granted during the
year $ 4.68 $ 4.24 $ 4.70
- -------------------------------- ---------------------------------------------------------------------------------------------
</TABLE>
The following table summarizes information about stock options outstanding as of
December 31, 1998:
<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
- -------------------------------------------------------------------------------------------------
Weighted-
Average Weighted- Weighted-
Range of Remaining Average Average
Exercise Number Contractual Exercise Number Exercise
Prices Outstanding Life Price Exercisable Price
- -------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
$27-$30.99 1,103,250 6.08 $29.97 1,103,250 $29.97
$31-$34.99 689,700 6.08 $33.25 689,700 $33.25
$35-$38.99 787,275 7.74 $38.51 130,275 $37.41
$39-$42.99 150,000 9.14 $42.02 -- --
---------- ---------
2,730,225 1,923,225
- -------------------------------------------------------------------------------------------------
</TABLE>
75
<PAGE>
SFAS No. 123, "Accounting for Stock Based Compensation" was issued in October
1995 for implementation by year-end 1996. SFAS No. 123 allows the use of a fair
value based method of accounting for an employee stock option or similar equity
instruments or the intrinsic value based method prescribed by Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" with
pro forma disclosures of net income and earnings per share as if the fair value
based method of accounting had been applied. The Company has elected to continue
using the intrinsic value based method. Had the Company elected to recognize
compensation cost using the fair value based method, compensation would have
been measured at date of grant and recognized over the service period. Pro forma
net income and earnings per share would have been imputed as follows for 1998
and 1997:
1998 1997
- --------------------------------------------------------------------------------
Net Income As reported $ 134.4 $ 66.3
Pro forma 131.4 64.5
Earnings per common share-basic As reported $ 4.59 $ 2.21
Pro forma 4.49 2.15
Earnings per common share-assuming dilution As reported $ 4.21 $ 2.20
Pro forma 4.12 2.13
These pro forma disclosure amounts derived by the use of SFAS No. 123 are not
indicative of future amounts. SFAS No. 123 is not applicable to options granted
prior to 1995, and additional options may be granted in future years.
The fair value of each option grant was estimated on the date of grant using the
Black-Scholes option-pricing model with the following assumptions for 1998 and
1997, respectively: risk-free interest rates of 4.9 percent in 1998 and 6.3
percent in 1997; dividend yield of 4.7 percent in 1998 and 5.0 percent in 1997;
expected lives of 6 years; and volatility of 15.7 percent in 1998 and 15.8
percent in 1997.
16. Stock Purchase Rights
On September 21, 1998, the Board of Directors approved the adoption of a new
shareholder rights plan to replace the plan that was set to expire on November
28, 1998. Pursuant to the new plan, which is substantially similar to the
expiring plan, the Board declared a dividend of one right for each outstanding
share of common stock to shareholders of record on November 28, 1998.
The rights will separate from the common stock and become exercisable if a
person or group acquires ownership of 15 percent or more of the outstanding
common stock of the Company or commences a tender or exchange offer to acquire
15 percent or more of the outstanding shares.
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 acquiror will entitle the holder to purchase common
shares of the Company (or, under certain circumstances, of the acquiror) at a 50
percent discount. Under the plan ERC will not be deemed an acquiror in the event
of the conversion of the Convertible Capital Securities it holds into common
stock of the Company unless it acquires 1 percent or more additional shares.
The rights expire on November 28, 2008 and may be redeemed by the Company for
$0.01 per right any time until the tenth business day following public
announcement that a 15 percent position has been acquired.
76
<PAGE>
17. Consolidated Quarterly Data (unaudited)
<TABLE>
<CAPTION>
First Second Third Fourth
1998 Quarter Quarter Quarter Quarter Year
- ------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Gross earned premiums $179.7 $175.7 $212.5 $202.6 $770.5
Ceded premiums 80.3 85.3 113.0 95.8 374.4
--------------------------------------------------------------------------------------
Insurance premiums $ 99.4 $ 90.4 $ 99.5 $106.8 $396.1
Engineering services 19.7 22.7 25.3 25.8 93.5
Net investment income 15.2 15.9 15.5 17.6 64.2
Realized investment gains 3.2 7.3 7.9 7.0 25.4
--------------------------------------------------------------------------------------
Total revenues $137.5 $136.3 $148.2 $157.2 $579.2
--------------------------------------------------------------------------------------
Income from continuing operations
before income taxes and
distributions on capital securities $ 69.6 $ 34.8 $ 36.1 $ 33.4 $173.9
Income taxes 22.5 9.3 9.3 10.3 51.4
Distributions on capital securities
of subsidiary trust, net of income
tax 4.5 4.7 4.6 4.6 18.4
--------------------------------------------------------------------------------------
Income from continuing operations $ 42.6 $ 20.8 $ 22.2 $ 18.5 $104.1
Discontinued operations:
Loss from operations, net of
income tax benefits $ (6.6) $ -- $ -- $ -- $ (6.6)
Gain on disposal, net of income
taxes 36.9 -- -- -- 36.9
--------------------------------------------------------------------------------------
Total discontinued operations $ 30.3 $ -- $ -- $ -- $ 30.3
--------------------------------------------------------------------------------------
Net income $ 72.9 $ 20.8 $ 22.2 $ 18.5 $134.4
--------------------------------------------------------------------------------------
Earnings per common share-basic:
Income from continuing operations $ 1.45 $ 0.71 $ 0.75 $ 0.64 $ 3.55
Discontinued operations 1.04 -- -- -- 1.04
--------------------------------------------------------------------------------------
Net income $ 2.49 $ 0.71 $ 0.75 $ 0.64 $ 4.59
--------------------------------------------------------------------------------------
Earnings per common share-
assuming dilution:
Income from continuing operations $ 1.31 $ 0.68 $ 0.72 $ 0.63 $ 3.35
Discontinued operations 0.86 -- -- -- 0.86
--------------------------------------------------------------------------------------
Net income $ 2.17 $ 0.68 $ 0.72 $ 0.63 $ 4.21
--------------------------------------------------------------------------------------
Dividends declared per common share $ 0.40 $ 0.40 $ 0.42 $ 0.42 $ 1.64
--------------------------------------------------------------------------------------
Common stock price ranges:
High $ 44.92 $ 53.50 $ 57.63 $ 42.00 $ 57.63
Low $ 36.45 $ 43.17 $ 40.38 $ 36.00 $ 36.00
Close $ 44.92 $ 53.50 $ 40.38 $ 41.06 $ 41.06
Shareholders at December 31, 5,045
- ------------------------------------------------------------------------------------------------------------------------------
</TABLE>
77
<PAGE>
<TABLE>
<CAPTION>
First Second Third Fourth Year
1997 Quarter Quarter Quarter Quarter
- ----------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Gross earned premiums $155.8 $149.2 $151.6 $152.7 $609.3
Ceded premiums 33.5 32.0 30.3 22.3 118.1
------------------------------------------------------------------------------------
Insurance premiums $122.3 $117.2 $121.3 $130.4 $491.2
Engineering services 14.7 15.0 15.5 16.1 61.3
Net investment income 8.0 8.8 9.1 10.9 36.8
Realized investment gains 0.5 3.4 2.3 7.9 14.1
------------------------------------------------------------------------------------
Total revenues $145.5 $144.4 $148.2 $165.3 $603.4
------------------------------------------------------------------------------------
Income from continuing operations
before income taxes and distributions
on capital securities $ 21.4 $ 22.1 $ 21.5 $ 28.7 $ 93.7
Income taxes 5.5 5.7 5.3 8.6 25.1
Distributions on capital securities
of subsidiary trust, net of income
tax -- -- 1.0 1.3 2.3
------------------------------------------------------------------------------------
Income from continuing operations $ 15.9 $ 16.4 $ 15.2 $ 18.8 $ 66.3
Discontinued operations:
Loss from operations, net of
income tax benefits $ -- $ -- $ -- $ -- $ --
Gain on disposal, net of income
taxes -- -- -- -- --
------------------------------------------------------------------------------------
Total discontinued operations $ -- $ -- $ -- $ -- $ --
------------------------------------------------------------------------------------
Net income $ 15.9 $ 16.4 $ 15.2 $ 18.8 $ 66.3
------------------------------------------------------------------------------------
Earnings per common share-basic:
Income from continuing operations $ 0.52 $ 0.54 $ 0.51 $ 0.65 $ 2.21
Discontinued operations -- -- -- -- --
------------------------------------------------------------------------------------
Net income $ 0.52 $ 0.54 $ 0.51 $ 0.65 $ 2.21
------------------------------------------------------------------------------------
Earnings per common share-assuming
dilution:
Income from continuing operations $ 0.52 $ 0.53 $ 0.51 $ 0.64 $ 2.20
Discontinued operations -- -- -- -- --
------------------------------------------------------------------------------------
Net income $ 0.52 $ 0.53 $ 0.51 $ 0.64 $ 2.20
------------------------------------------------------------------------------------
Dividends declared per common share $ 0.38 $ 0.38 $ 0.40 $ 0.40 $ 1.56
------------------------------------------------------------------------------------
Common stock price ranges:
High $ 31.50 $ 35.92 $ 37.67 $ 37.08 $37.67
Low $ 29.83 $ 29.58 $ 35.08 $ 33.67 $29.58
Close $ 29.83 $ 35.58 $ 37.13 $ 36.80 $36.80
Shareholders at December 31, 5,221
- ----------------------------------------------------------------------------------------------------------------------------
</TABLE>
78
<PAGE>
Schedule I
HSB Group, Inc.
Summary of Investments - Other Than Investments in Related Parties
(in millions)
<TABLE>
<CAPTION>
Column A Column B Column C Column D Column E Column F Column G
- ----------------------------------------------------------------------------------------------------------------------------
1998 1997
-------------------------------------------------------------------------------
Amount Amount
Shown Shown
In The In The
Market Balance Market Balance
Type of Investment Cost Value Sheet Cost Value Sheet
- ----------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Fixed Maturities:
Bonds:
U.S. Government and Government
Agencies and Authorities $ 0.0 $ 0.0 $ 0.0 $ 0.0 $ 0.0 $ 0.0
States, Municipalities and Political
Subdivisions 47.4 49.3 49.3 37.6 39.7 39.7
Foreign Governments 21.0 21.3 21.3 33.1 33.5 33.5
Public Utilities 0.0 0.0 0.0 0.0 0.0 0.0
Convertibles and Bonds with Warrants
Attached 0.0 0.0 0.0 0.0 0.0 0.0
All Other Bonds 273.5 276.2 276.2 28.1 28.7 28.7
Certificates of Deposit 0.0 0.0 0.0 0.0 0.0 0.0
Mortgage Receivable 11.1 11.1 11.1 11.1 11.1 11.1
Redeemable Preferred Stocks 215.5 219.2 219.2 131.2 135.4 135.4
-------------------------------------------------------------------------------
Total Fixed Maturities $568.5 $ 577.1 $ 577.1 $241.1 $248.4 $248.4
Equity Securities:
Common Stocks:
Public Utilities 16.6 19.1 19.1 16.3 19.8 19.8
Banks and Insurance 39.9 48.7 48.7 13.4 23.5 23.5
Industrial and Other 84.8 181.5 181.5 67.8 135.7 135.7
Non-Redeemable Preferred Stocks 185.0 187.8 187.8 133.8 144.8 144.8
-------------------------------------------------------------------------------
Total Equity Securities $326.3 $ 437.1 $ 437.1 $231.3 $323.8 $323.8
Short-term Investments and Cash $ 80.6 $ 80.6 $ 80.6 $424.5 $424.5 $424.5
-------------------------------------------------------------------------------
Total Investments $975.4 $1,094.8 $1,094.8 $896.9 $996.7 $996.7
===============================================================================
</TABLE>
79
<PAGE>
HSB GROUP, INC. (Registrant)
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF HSB GROUP, INC.
BALANCE SHEET INFORMATION
December 31,
(In millions)
1998 1997
-----------------------------------
Assets
Cash $ 0.1 $ 0.7
Short-term investments, at cost 2.1 60.5
Investment in subsidiaries 780.2 657.0
Fixed maturities, at fair value
(cost-$47.9; $11.7) 47.2 11.8
Equity securities, at fair value
(cost-$45.2; $27.0) 43.4 27.2
Other assets 2.9 23.9
-----------------------------------
Total assets $875.9 $781.1
===================================
Liabilities
Dividends and distributions on
capital securities $ 23.2 $ 13.3
Other liabilities 24.5 13.6
-----------------------------------
Total liabilities 47.7 26.9
-----------------------------------
Company obligated mandatorily redeemable
capital securities of subsidiary
Trust I holding solely
junior subordinated
deferrable interest
debentures of the Company,
net of unamortized discount
of $1.1 in 1998 and 1997. 108.9 108.9
Company obligated mandatorily redeemable
convertible capital securities of
subsidiary Trust II holding solely
junior subordinated deferrable
interest debentures of the Company. 300.0 300.0
Shareholders' Equity
Common stock 10.0 10.0
Paid in capital 33.5 31.6
Accumulated other comprehensive income 66.8 55.9
Retained earnings 311.2 248.8
Benefit plans (2.2) (1.0)
-----------------------------------
Total shareholders' equity 419.3 345.3
-----------------------------------
Total liabilities and
shareholders' equity $875.9 $781.1
===================================
These condensed financial statements should be read in conjunction with the
consolidated financial statements and accompanying footnotes of HSB Group, Inc.
(see pages 46 through 78).
80
<PAGE>
HSB GROUP, INC. (Registrant)
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF HSB GROUP, INC.
CONDENSED STATEMENTS OF INCOME INFORMATION
For the periods ended December 31,
(In millions)
1998 1997*
--------------------------------
Revenues:
Net investment income $ 6.4 $ 1.4
Realized investment gains 1.0 -
--------------------------------
Income before income taxes and distributions 7.4 1.4
on capital securities
Income taxes 2.5 0.5
Distribution on capital securities of 18.4 2.3
subsidiary trusts, net of income taxes of
$9.9 and $1.2.
--------------------------------
Net loss - parent only (13.5) (1.4)
Equity in net income of subsidiaries 147.9 35.4
--------------------------------
Net income $134.4 $34.0
================================
* For the period from June 23, 1997 through December 31, 1997.
These condensed financial statements should be read in conjunction with the
consolidated financial statements and accompanying footnotes of HSB Group, Inc.
(see pages 46 through 78).
81
<PAGE>
HSB GROUP, INC. (Registrant)
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF HSB GROUP, INC.
CONDENSED STATEMENTS OF CASH FLOWS INFORMATION
For the periods ended December 31,
(In millions)
1998 1997*
---------------------------
Operating Activities:
Net income $134.4 $ 34.0
Undistributed earnings of subsidiaries** (91.8) (21.2)
Distributions on capital securities 28.3 3.5
Realized investment gains (1.0) -
Decrease (increase) in other assets 9.2 (26.2)
Increase in other liabilities 22.2 10.8
---------------------------
Cash provided by operating activities 101.3 0.9
---------------------------
Investing Activities:
Sale (purchase) of short-term investments, net 58.4 (60.5)
Purchase of fixed maturities (48.0) (11.8)
Proceeds from sale of fixed maturities 12.3 -
Purchase of equity securities (26.6) (27.0)
Proceeds from sale of equity securities 8.7 -
Purchase of Solomon Associates, Inc.,
net of cash acquired (2.1) -
Contribution to subsidiaries - (279.5)
---------------------------
Cash provided (used) by investing activities 2.7 (378.8)
---------------------------
Financing Activities:
Dividends and distribution on
capital securities (66.2) (11.9)
Net proceeds from issuance of company
obligated mandatorily
redeemable capital securities - 408.9
Options exercised 9.3 5.5
Reacquisition of stock (47.7) (36.5)
Other - 12.6
---------------------------
Cash (used) provided by financing activities (104.6) 378.6
---------------------------
Change in cash (0.6) 0.7
Cash at beginning of period 0.7 -
Cash at end of period $ 0.1 $ 0.7
===========================
* For the period from June 23, 1997 through December 31, 1997.
** Dividends received from Hartford Steam Boiler Inspection and Insurance
Company were $56.1 million and $12.8 million in 1998 and 1997 respectively.
These condensed financial statements should be read in conjunction with the
consolidated financial statements and accompanying footnotes of HSB Group, Inc.
(see pages 46 through 78).
82
<PAGE>
<TABLE>
<CAPTION>
Schedule III
HSB Group, Inc.
Supplementary Insurance Information
For Years Ended December 31, 1998, 1997, 1996
Column A Column B* Column C* Column D* Column E* Column F Column G** Column H Column I Column J Column K
- ----------------------------------------------------------------------------------------------------------------------------
Segment Deferred Future Unearned Other Premium Net Benefits, Amortiza- Other Premiums
acquisi- policy premiums policy revenue invest claims, tion of operating written
tion benefits claims -ment losses and prepaid expense
costs and and income settlement policy
losses, benefits expenses acquisition
claims and payable costs
loss
expenses
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
1998:
Commercial $- $- $- $- $306.3 $- $124.6 $67.6 $95.6 $327.5
Global Special
Risk - - - - 83.6 - 46.6 0.9 18.1 20.3
Other Segments - - - - 6.2 - 3.7 (2.2) - 4.8
=========================================================================================================
Total $- $- $- $- $396.1 $- $174.9 $66.3 $113.7 $352.6
=========================================================================================================
1997:
Commercial $- $- $- $- $269.0 $- $103.9 $59.5 $83.2 $277.4
Global Special
Risk - - - - 217.1 - 111.4 31.0 58.3 217.3
Other Segments - - - - 5.1 - 2.6 0.2 1.3 3.8
=========================================================================================================
Total $- $- $- $- $491.2 $- $217.9 $90.7 $142.8 $498.5
=========================================================================================================
1996:
Commercial $- $- $- $- $253.1 $- $98.6 $56.3 $78.1 $255.8
Global Special
Risk - - - - 187.7 - 101.9 29.5 57.0 192.2
Other Segments - - - - 7.8 - 3.9 0.2 1.3 6.4
=========================================================================================================
Total $- $- $- $- $448.6 $- $204.4 $86.0 $136.4 $454.4
=========================================================================================================
* Segment assets are not included in management's evaluation of and allocation
of resources to segments.
** Investment assets are managed by and investment income is allocated to the
Company's Investment segment.
</TABLE>
83
<PAGE>
Schedule IV
HSB Group, Inc.
Reinsurance
(in millions)
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------
Column A Column B Column C Column D Column E Column F
Insurance Gross Ceded to Assumed Net Percentage of
Premiums Amount Other From Other Amount Amount
Companies Companies Assumed to Net
- --------------------------------------------------------------------------------------------------------------------
- --------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
1998
Property and Liability
Insurance $408.8 $374.4 $361.7 $396.1 91.3%
1997
Property and Liability
Insurance $370.1 $118.1 $239.2 $491.2 48.7%
1996
Property and Liability
Insurance $343.4 $107.9 $213.1 $448.6 47.5%
</TABLE>
84
<PAGE>
SCHEDULE V
HSB Group, Inc.
Valuation and Qualifying Accounts
(in millions)
<TABLE>
<CAPTION>
Column A Column B Column C Column D Column E Column F
-------------------------------------------------------------------------------------------------------------
Description Balance at Charged to Charged to Deductions Balance At End
Beginning of Costs and Other Accounts Describe (a) of Period
Period Expenses
-------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
1998
Reserve for Accounts
Receivable $3.6 $0.5 $0.0 $0.2 $3.9
1997
Reserve for Accounts
Receivable $3.0 $0.9 $0.0 $0.3 $3.6
1996
Reserve for Accounts
Receivable $3.3 $1.4 $0.0 $1.7 $3.0
</TABLE>
(a) Engineering Services and Insurance Premium Receivables written off as
uncollectible.
85
<PAGE>
Schedule VI
HSB Group, Inc.
Supplemental Information Concerning Property-Casualty Insurance Operations
For Years Ended December 31, 1998, 1997, 1996
<TABLE>
<CAPTION>
Column A Column B Column C Column D Column E Column F Column G Column H Column I Column J Column K
---------------------------------------------------------------------------------------------------------------------------
Affiliati Prepaid Reserves Discount, Unearned Earned Net Claims and Claim Amortiza- Paid Premiums
with Acquisi- for if any, Premium Premium Investment Adjustment tion of Claims and Written
Registrant tion Unpaid deducted Income Expenses Incurred Prepaid Claim
(Consolid- Costs Claims in Related to Policy Adjustment
ated and Column C Acquisi- Expenses
property- Claim tion Costs
casualty Adjustment
entities) Expenses
----------------------------------------------------------------------------------------------------------------------------
Current Prior
Year Year
----------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
1998 46.6 550.3 - 477.9 396.1 64.2 164.0 10.9 66.3 196.0 352.6
1997 42.5 276.7 - 287.3 491.2 36.8 209.5 8.4 90.7 204.9 498.5
1996 40.6 302.9 - 270.6 448.6 32.3 214.2 -9.8 86.0 172.1 454.4
</TABLE>
86
<PAGE>
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure.
None.
PART III
Item 10. Directors and Executive Officers of the Registrant.
"Nominees for Election to the Board of Directors for Three-Year Term
Expiring in 2002" and "Members of the Board of Directors Continuing in Office"
on pages 2-5 of the Company's Proxy Statement dated March 5, 1999 are
incorporated herein by reference. Also see pages 23 -24 herein.
Item 11. Executive Compensation.
"Meetings and Remuneration of the Directors" on pages 5-7, "Human Resources
Committee Report on Executive Compensation" on pages 9-12, "Summary Compensation
Table" on page 13, "Stock Option and Long-Term Incentive Plan Tables" on pages
14-15, "Retirement Plans" on page 16, "Employment Arrangements" on pages 16-17,
"Compensation Committee Interlocks and Insider Participation" on page 17, and
"Performance Graph" on page 18 of the Company's Proxy Statement dated March 5,
1999 are incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners
and Management.
"Security Ownership of Certain Beneficial Owners and Management" on pages 7-9 of
the Company's Proxy Statement dated March 5, 1999 is incorporated herein by
reference.
Item 13. Certain Relationships and Related Transactions.
"Compensation Committee Interlocks and Insider Participation" on page 17 of
the Company's Proxy Statement dated March 5, 1999 is incorporated herein by
reference.
PART IV
Item 14. Exhibits, Financial Statement Schedules, and
Reports on Form 8-K.
(a) The financial statements and schedules listed in the Index to
Financial Statements and Financial Statement Schedules on page 43
herein are filed as part of this report.
(b) Reports on Form 8-K -
(i) Form 8-K dated October 26, 1998 to report third quarter 1998
results of Registrant;
(ii) Form 8-K dated November 2, 1998 to report declaration of dividend
by Registrant;
(iii)Form 8-K dated December 2, 1998 to report adoption of revised
shareholder rights plan;
(iv) From 8-K dated January 25, 1999 to report fourth quarter 1998
Results of Registrant; and
87
<PAGE>
(v) Form 8-K dated January 26, 1999 to report declaration of dividend
by Registrant.
(c) The exhibits listed in the accompanying Index to Exhibits are filed as
part of this report.
88
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 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.
(Registrant)
By: /s/ Gordon W. Kreh
Gordon W. Kreh
Chairman, President and Chief
Executive Officer
March 30, 1999
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
(Signature) (Title)
By:/s/ Gordon W. Kreh
Gordon W. Kreh Chairman, President, Chief
March 30, 1999 Executive Officer and Director
/s/ Saul L. Basch Senior Vice President, Treasurer
Saul L. Basch and Chief Financial Officer
March 30, 1999 (Principal Financial Officer and
Principal Accounting Officer)
/s/ Robert C. Walker
Robert C. Walker Senior Vice President and
March 30, 1999 General Counsel
(Joel B Alvord)* Director
(Richard H. Booth)* Director
(Colin G. Campbell)* Director
(Richard G. Dooley)* Director
(William B. Ellis)* Director
89
<PAGE>
(Henrietta Holsman Fore)* Director
(E. James Ferland)* Director
(Simon W. Leathes)* Director
(Lois Dickson Rice)* Director
*By: /s/ Robert C. Walker
Robert C. Walker
(Attorney-in-Fact)
March 30, 1999
90
<PAGE>
INDEX TO EXHIBITS
Exhibit
Number Description
**(3)(i) Certificate of Incorporation of HSB Group, Inc., incorporated by
reference to Exhibit 3(i) to the Registrant's Form 10-K for the
year ended December 31, 1997, File Number 001-13135.
**(3)(ii) By-laws of HSB Group, Inc., incorporated by reference to Exhibit
3(ii) to the Registrant's Form 10-K for the year ended December
31, 1997, File Number 001-13135.
**(4)(i) Rights Agreement dated as of November 28, 1998 between HSB Group,
Inc. and Bankboston, N.A., as Rights Agent, incorporated by
reference to the Registrant's Report on Form 8-K dated September
21, 1998, File Number 001-13135.
**(4)(ii) Documents related to HSB Capital I:
(a) Indenture of Registrant relating to the Junior
Subordinated Debentures, incorporated by reference to
Exhibit 4 to Registrant's Quarterly Report on Form 10-Q
for the quarter ended June 30, 1997, File No. 001-13135.
(b) First Supplemental Indenture of Registrant, incorporated
by reference to Exhibit 4 to Registrant's Quarterly Report
on Form 10-Q for the quarter ended June 30, 1997, File No.
001-13135.
(c) Form of Certificate of Exchange Junior Subordinated
Debentures, incorporated by reference to Exhibit 4.3 to
Registrant's and HSB Capital I's Registration Statement on
Form S-4 filed with the Commission on October 10, 1997,
Registration No. 333-37581.
(d) Certificate of Trust of HSB Capital I, incorporated by
reference to Exhibit 4.4 to Registrant's and HSB Capital
I's Registration Statement on Form S-4 filed with the
Commission on October 10, 1997, Registration No.
333-37581.
(e) Amended and Restated Trust Agreement of HSB Capital I,
incorporated by reference to Exhibit 4 to Registrant's
Quarterly Report on Form 10-Q for the quarter ended June
30, 1997, File No. 001-13135.
(f) Form of Exchange Capital Security Certificate for HSB
Capital I, incorporated by reference to Exhibit 4.6 to
Registrant's and HSB Capital I's Registration Statement on
Form S-4 filed with the Commission on October 10, 1997,
Registration No. 333-37581.
(g) Form of Exchange Guarantee of Registrant relating to the
Exchange Capital Securities, incorporated by reference to
Exhibit 4.7 to Registrant's and HSB Capital I's
Registration Statement on Form S-4 filed with the
Commission on October 10, 1997, Registration No.
333-37581.
Documents related to HSB Capital II:
91
<PAGE>
(a) Purchase Agreement as of December 31, 1997 among Employers
Reinsurance Corporation, ERC Life Reinsurance Corporation
and Registrant, incorporated by reference to Registrant's
Current Report on Form 8-K. File No. 001-13135, filed
January 12, 1998 (the "January 12, 1998 8-K).
(b) Indenture of Registrant relating to the 7.0% Convertible
Subordinated Deferrable Interest Debentures Due December 31,
2017, incorporated by reference to the January 12, 1998 8-K.
(c) Form of Certificate of 7.0% Convertible Subordinated
Deferrable Interest Debentures due December 31, 2017,
incorporated by reference to the January 12, 1998 8-K.
(d) Certificate of Trust of HSB Capital II, incorporated by
reference to the January 12, 1998 8-K.
(e) Trust Agreement dated as of December 31, 1997 among
Registrant, The First National Bank of Chicago, First
Chicago Delaware Inc. and The Administrative Trustees named
therein, incorporated by reference to the January 12, 1998
8-K.
(f) Form of Capital Securities Certificate of HSB Capital II,
incorporated by reference to the January 12, 1998 8-K.
(g) Guarantee Agreement between Registrant and The First
National Bank of Chicago dated as of December 31, 1997
relating to HSB Capital II, incorporated by reference to the
January 12, 1998 8-K.
(h) Registration Rights Agreement dated as of December 31, 1997
among Employers Reinsurance Corporation, ERC Life
Reinsurance Corporation and Registrant, incorporated by
reference to the January 12, 1998 8-K.
**(10)(i) (a) Lease Agreement between HSBIIC and One State Street
Limited Partnership; incorporated by reference to Exhibit
(10)(i) to HSBIIC's Form 10. File No. 0-13300, filed
March 18, 1985.
**10(ii) (a) Operating Agreement for HSB-IRI Property Insurance
Business by and among Employers Reinsurance Corporation,
HSB Industrial Risk Insurers, and The Hartford Steam
Boiler Inspection and Insurance Company, effective as of
January 1, 1998, incorporated by reference to Exhibit
10(ii) to Registrant's Quarterly Report on Form 10-Q for
the quarter ended March 31, 1998, File Number 001-13135.
**10(ii) (b) Limited Liability Company Agreement of HSB Industrial
Risk Insurers, L.L.C., incorporated by reference to
Exhibit 10(ii) to the Registrant's Quarterly Report on
From 10-Q for the quarter ended September 30, 1998, File
Number 001-13135
(10)(iii) **(a) Employment Agreement dated February 3, 1997 between
HSBIIC and various executive officers, assumed by
Registrant; incorporated by reference to HSBIIC's Form
10-K for the year ended December 31, 1996, filed with the
Commission on March 31, 1997, File No. 001-10527 (the
"1996 10-K").*
92
<PAGE>
**(b) HSB Group, Inc. Long-Term Incentive Plan, as amended and
restated effective September 21, 1998, incorporated by
reference to Exhibit 10(iii)(c) to the Registrant's
Quarterly Report on Form 10-Q for the quarter ended
September 30, 1998, File Number 001-13135.*
**(c) HSB Group, Inc. Short-Term Incentive Plan, as amended and
restated effective January 1, 1998, incorporated by
reference to Exhibit 10 (iii)(b) to the Registrant's
Quarterly Report on Form 10-Q for the quarter ended March
31, 1998, File Number 001-13135.*
**(d) HSB Group, Inc. 1985 Stock Option Plan, as amended and
restated as of September 21, 1998, incorporated by reference
to Exhibit 10(iii)(a) to the Registrant's Quarterly Report
on Form 10-Q for the quarter ended September 30, 1998, File
Number 001-13135.*
**(e) HSB Group, Inc. 1995 Stock Option Plan, as amended and
restated effective September 21, 1998, incorporated by
reference to Exhibit 10(iii)(d) to the Registrant's
Quarterly Report on Form 10-Q for the quarter ended
September 30, 1998, File Number 001-13135.*
**(f) Pre-Retirement Death Benefit and Supplemental Pension
Agreement between HSBIIC and various executive officers, as
amended and restated effective March 14, 1997, assumed by
Registrant, incorporated by reference to the 1996 10-K. *
**(g) Pre-Retirement Death Benefit and Supplemental Pension
Agreement between HSBIIC and William A. Kerr, dated March
14, 1997, assumed by Registrant, incorporated by reference
to the 1996 10-K. *
**(h) Pre-Retirement Death Benefit and Supplemental Pension
Agreement between HSBIIC and Robert C. Walker, dated March
14, 1997, assumed by Registrant, incorporated by reference
to the 1996 10-K.*
**(i) HSB Group, Inc. Directors Stock and Deferred Compensation
Plan, as amended and restated effective September 21, 1998,
incorporated by reference to Exhibit 10(iii)(b) to the
Registrant's Quarterly Report on Form 10-Q for the quarter
ended September 30, 1998, File Number 001-13135.*
**(j) Description of certain arrangements not set forth in any
formal documents, as described on pages 5 - 6 , with respect
to directors' compensation, and on pages 8 -16, with respect
to executive officer's compensation, which pages are
incorporated by reference to Registrant's Proxy Statement
dated and filed March 5, 1999. *
(21) Subsidiaries of the Registrant.
(23) Consent of experts and counsel - consent of
PricewaterhouseCoopers LLP.
(24) Power of attorney.
(27) Financial Data Schedule.
27.1 Financial Data Schedule
27.2 Restated Financial Data Schedule
93
<PAGE>
* Management contract, compensatory plan or arrangement required to be filed as
an exhibit pursuant to Item 14(c) of this report.
** Previously filed.
94
Exhibit (21)
LIST OF SUBSIDIARIES OF HSB GROUP, INC.
NAME OF COMPANY STATE/JURISDICTION OF
INCORPORATION/
FORMATION
The Allen Insurance Company Bermuda
The Boiler Inspection and Insurance Company of Canada
(wholly-owned by HSB Engineering Insurance Ltd.) Canada
EIG, Co. (wholly owned by The Hartford
Steam Boiler Inspection and Insurance Company) Delaware
EMSS (Ireland) Limited (wholly-owned by HSB
Haughton Engineering Insurance Services, Ltd.) Ireland
Hartford Steam Boiler Colombia Ldta. (90% owned
by The Hartford Steam Boiler Inspection and
Insurance Company and 10% by HSB Group, Inc.) Colombia
The Hartford Steam Boiler Inspection and
Insurance Company Connecticut
The Hartford Steam Boiler Inspection
and Insurance Company of Connecticut Connecticut
The Hartford Steam Boiler Inspection
and Insurance Company of Texas Texas
Hartford Steam Boiler International GmbH
(wholly-owned by The Hartford Steam Boiler
Inspection and Insurance Company) Germany
Hartford Steam Boiler (M) Sdn. Bhd.
(wholly-owned by The Hartford Steam Boiler
Inspection and Insurance Company) Malaysia
Hartford Steam Boiler (Singapore) PTE Ltd.
(wholly-owned by The Hartford Steam Boiler
Inspection and Insurance Company) Singapore
HSB Africa (wholly-owned by HSB Engineering
Insurance Limited) South Africa
HSB Associates, Inc. New York
HSB Capital I Delaware
HSB Capital II Delaware
HSB Capital Corp. I, Inc. (wholly-owned by
HSB Engineering Finance Corporation) Delaware
HSB Engineering Finance Corporation Delaware
HSB Engineering Insurance Limited
(wholly-owned by EIG Co.) England
HSB Haughton Engineering Insurance
Services, Ltd. (wholly-owned by
HSB Engineering Insurance Limited) England
95
<PAGE>
HSB Inspection Quality Limited (wholly-owned by
HSB Haughton Engineering Insurance Services, Ltd.) England
HSB Investment Corporation (wholly-owned by
The Hartford Steam Boiler Inspection and
Insurance Company) Connecticut
HSB Professional Loss Control, Inc.
(wholly-owned by The Hartford
Steam Boiler Inspection and
Insurance Company) Tennessee
HSB Reliability Technologies Corp.
(wholly-owned by The Hartford Steam Boiler
Inspection and Insurance Company) Florida
HSB-RS Korea (wholly-owned by The Hartford
Steam Boiler Inspection and Insurance Company) Korea
Integrated Process Technologies, LLC
(51% owned by The Hartford Steam Boiler
Inspection and Insurance Company) Delaware
One State Street Intermediaries Connecticut
Ra-Hart Investment Company (wholly-owned
by The Hartford Steam Boiler
Inspection and Insurance Company) Texas
Solomon Associates, Inc. Texas
Solomon Associates International, Inc.
(wholly-owned by Solomon Associates, Inc.) Texas
Solomon Associates Limited (wholly-owned
by Solomon Associates International, Inc.) United Kingdom
96
Exhibit 23
CONSENT OF INDEPENDENT ACCOUNTANTS
We consent to the incorporation by reference in the registration statements of
HSB Group, Inc. on Form S-3 (File No. 333-53059) and Forms S-8 (File Nos.
33-4397, 33-36519 and 333-29605) of our report dated January 26, 1999, on our
audits of the consolidated financial statements and financial statement
schedules of HSB Group, Inc. and its subsidiaries as of December 31, 1998 and
1997, and for the three years in the period ended December 31, 1998, which
report is included in this Annual Report on Form 10-K.
/s/ PricewaterhouseCoopers LLP
March 29, 1999
POWER OF ATTORNEY Exhibit (24)
We, the undersigned directors of HSB Group, Inc., hereby individually appoint
Robert C. Walker and Roberta A. O'Brien, and each of them singly, with full
power of substitution to each, our true and lawful attorneys with full power to
them and each of them singly, to sign for us in our names in the capacities
stated below the Form 10-K Annual Report, pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934, for the fiscal year ended December 31, 1998 for
HSB Group, Inc., and any and all amendments to said Form 10-K, and generally to
do all such things in our name and on our behalf in our capacities as directors
that will enable the Company to comply with the provisions of the Securities
Exchange Act of 1934, as amended, and all requirements of the Securities and
Exchange Commission, which relate to said Form 10-K and the filing thereof,
hereby ratifying and confirming our signatures as they may be signed by our said
attorneys or any one of them to said Form 10-K and any and all amendments
thereto.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Power
of Attorney has been signed by the following persons in the capacities and on
the date indicated.
(Signature) (Title) (Date)
/s/ Gordon W. Kreh President, Chief February 22, 1999
Gordon W. Kreh Executive Officer
and Director
/s/ Joel B. Alvord
Joel B. Alvord Director February 22, 1999
/s/ Richard H. Booth
Richard H. Booth Director February 22, 1999
/s/ Colin G. Campbell
Colin G. Campbell Director February 22, 1999
/s/ Richard G. Dooley
Richard G. Dooley Director February 22, 1999
97
<PAGE>
(Signature) (Title) (Date)
/s/ William B. Ellis
William B. Ellis Director February 22, 1999
/s/ E. James Ferland
E. James Ferland Director February 22, 1999
/s/ Henrietta Holsman Fore
Henrietta Holsman Fore Director February 22, 1999
/s/ Simon W. Leathes
Simon W. Leathes Director February 22, 1999
/s/ Lois Dickson Rice
Lois Dickson Rice Director February 22, 1999
98
<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> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> DEC-31-1998
<DEBT-HELD-FOR-SALE> 566
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 437
<MORTGAGE> 11
<REAL-ESTATE> 0
<TOTAL-INVEST> 1014
<CASH> 81 <F1>
<RECOVER-REINSURE> 630
<DEFERRED-ACQUISITION> 47
<TOTAL-ASSETS> 2144
<POLICY-LOSSES> 550
<UNEARNED-PREMIUMS> 478
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 46
409 <F2>
0
<COMMON> 10
<OTHER-SE> 409
<TOTAL-LIABILITY-AND-EQUITY> 2144
396
<INVESTMENT-INCOME> 64
<INVESTMENT-GAINS> 25
<OTHER-INCOME> 130 <F3>
<BENEFITS> 175
<UNDERWRITING-AMORTIZATION> 66
<UNDERWRITING-OTHER> 201 <F4>
<INCOME-PRETAX> 156
<INCOME-TAX> 51
<INCOME-CONTINUING> 104
<DISCONTINUED> 30 <F5>
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 134
<EPS-PRIMARY> 4.59<F6><F7>
<EPS-DILUTED> 4.21<F6><F8>
<RESERVE-OPEN> 277
<PROVISION-CURRENT> 565
<PROVISION-PRIOR> 47
<PAYMENTS-CURRENT> 141
<PAYMENTS-PRIOR> 197
<RESERVE-CLOSE> 550
<CUMULATIVE-DEFICIENCY> 0
<FN>
<F1>Cash includes short-term investments.
<F2>Company obligated mandatorily redeemable capital securities and convertible
capital securities classified at mezzanine level on Consolidated Statements of
Financial Position.
<F3>Includes gain on sale of IRI.
<F4>Includes engineering services, underwriting and inspection and interest
expense.
<F5>Net gain on discontinued operations of Radian, after tax.
<F6>Reflects the impact of three-for-two stock split approved by the Board
of Directors on April 21, 1998 for net income.
<F7>Per SFAS No. 128 "Earnings per Share", this item represents EPS-Basic.
<F8>Per SFAS No. 128 "Earnings per Share", this item represents EPS-Assuming
Dilution.
</FN>
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 7
<LEGEND>
THIS RESTATED FINANCIAL DATA SCHEDULE IS BEING FILED AS A RESULT OF A RECLASS OF
$3 MILLION BETWEEN PREPAID ACQUISITION COSTS AND UNEARNED INSURANCE PREMIUM.
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> YEAR
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-END> DEC-31-1997
<DEBT-HELD-FOR-SALE> 237
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 324
<MORTGAGE> 11
<REAL-ESTATE> 0
<TOTAL-INVEST> 572
<CASH> 425 <F1>
<RECOVER-REINSURE> 125
<DEFERRED-ACQUISITION> 43
<TOTAL-ASSETS> 1537
<POLICY-LOSSES> 277
<UNEARNED-PREMIUMS> 287
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 68
409 <F2>
0
<COMMON> 10
<OTHER-SE> 335
<TOTAL-LIABILITY-AND-EQUITY> 1537
491
<INVESTMENT-INCOME> 37
<INVESTMENT-GAINS> 14
<OTHER-INCOME> 61
<BENEFITS> 218
<UNDERWRITING-AMORTIZATION> 91
<UNDERWRITING-OTHER> 201 <F3>
<INCOME-PRETAX> 91
<INCOME-TAX> 25
<INCOME-CONTINUING> 66
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 66
<EPS-PRIMARY> 2.21<F4><F5>
<EPS-DILUTED> 2.20<F4><F6>
<RESERVE-OPEN> 303
<PROVISION-CURRENT> 263
<PROVISION-PRIOR> 0
<PAYMENTS-CURRENT> 90
<PAYMENTS-PRIOR> 199
<RESERVE-CLOSE> 277
<CUMULATIVE-DEFICIENCY> (11)
<FN>
<F1>Cash includes short-term investments.
<F2>Company obligated mandatorily redeemable capital securities and convertible
capital securities classified at mezzanine level on Consolidated Statements of
Financial Position.
<F3>Includes engineering services, underwriting and inspection and interest
expense.
<F4>Reflects the impact of three-for-two stock split approved by the Board of
Directors on April 21, 1998 for net income.
<F5>Per SFAS No. 128 "Earnings per Share", this item represents EPS-Basic.
<F6>Per SFAS No. 128 "Earnings per Share", this item represents EPS-Assuming
Dilution.
</FN>
</TABLE>
