SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
/x/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2000
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number 001-13135
HSB GROUP, INC.
(Exact name of registrant as specified in its charter)
CONNECTICUT 06-1475343
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
P.O. BOX 5024, ONE STATE STREET,
HARTFORD, CONNECTICUT 06102-5024
(Address of principal executive offices) (Zip Code)
(860) 722-1866
(Registrant's telephone number, including area code)
Not applicable
(Former name, former address and former fiscal year,
if changed since the last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
The number of shares outstanding of the registrant's common stock without par
value, as of October 31, 2000: 29,186,041.
<PAGE>
HSB GROUP, INC.
INDEX
PART I FINANCIAL STATEMENTS PAGE
Item 1 - Financial Statements
Consolidated Statements of Operations for the
Quarters ended September 30, 2000 and 1999
and the Nine Months ended September 30, 2000
and 1999 (unaudited)............................ 3
Consolidated Statements of Comprehensive Income
for the Quarters ended September 30, 2000 and
1999 and the Nine Months ended September 30,
2000 and 1999 (unaudited)....................... 4
Consolidated Statements of Financial Position
as of September 30, 2000 (unaudited) and
December 31, 1999............................... 5
Consolidated Statements of Cash Flows for
the Nine Months ended September 30, 2000
and 1999 (unaudited)............................ 6
Notes to Consolidated Financial Statements
(unaudited)..................................... 7
Item 2 - Management's Discussion and Analysis
of Consolidated Financial Condition and Results of
Operations................................................. 13
Item 3 - Quantitative and Qualitative Disclosures About
Market Risk................................................ 22
PART II OTHER INFORMATION
Item 1 - Legal Proceedings.................................... 22
Item 6 - Exhibits and Reports on Form 8-K..................... 23
SIGNATURES.......................................................... 24
2
<PAGE>
ITEM 1 - FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
HSB GROUP, INC.
Consolidated Statements of Operations
Unaudited
(in millions, except per share data)
Quarter Nine Months
Ended September 30, Ended September 30,
2000 1999 2000 1999
----------- ----------- ----------- ------------
<S> <C> <C> <C> <C>
Revenues:
Gross earned premium $157.2 $200.6 $515.7 $616.3
Ceded premiums 51.4 107.9 219.2 333.4
----------- ----------- ----------- ------------
Insurance premiums 105.8 92.7 296.5 282.9
Engineering services 38.7 30.6 115.9 86.0
Net investment income 16.0 16.5 46.5 48.8
Realized investment gains 15.3 13.5 38.8 30.8
Gain on sale of interests in Integrated Process Technologies, LLC 9.8 - 9.8 -
----------- ----------- ----------- ------------
Total revenues 185.6 153.3 507.5 448.5
----------- ----------- ----------- ------------
Expenses:
Claims and adjustment 74.0 44.5 150.9 120.7
Policy acquisition 23.3 21.6 64.8 65.5
Underwriting and inspection 31.3 24.4 88.7 72.6
Provision for international large risk business charges 20.7 - 20.7 -
Engineering services 36.2 29.5 107.8 80.3
Interest 1.5 0.6 2.6 1.6
----------- ----------- ----------- ------------
Total expenses 187.0 120.6 435.5 340.7
----------- ----------- ----------- ------------
Income (loss) before income taxes, distributions on capital
securities and extraordinary item $ (1.4) $ 32.7 $ 72.0 $107.8
Income taxes (benefit):
Current 17.7 11.7 47.3 31.0
Deferred (15.1) (2.4) (20.2) 0.6
----------- ----------- ----------- ------------
Total income taxes $ 2.6 $9.3 $ 27.1 $ 31.6
Distribution on capital securities of subsidiary trusts,
net of income tax benefits of $2.2, $2.4, $7.3 and $7.2 4.1 4.6 13.5 13.6
----------- ----------- ----------- ------------
Income (loss) before extraordinary item $ (8.1) $ 18.8 $ 31.4 $ 62.6
Loss on extinguishment of capital securities of subsidiary Trust
II, net of income tax benefits of $5.4, $-, $5.4 and $- 9.9 - 9.9 -
----------- ----------- ----------- ------------
Net income (loss) $(18.0) $ 18.8 $ 21.5 $ 62.6
=========== =========== =========== ============
Per share data:
Earnings (loss) per common share-basic:
Income (loss) before extraordinary item $ (0.28) $ 0.65 $ 1.08 $ 2.16
Extraordinary item (0.34) - (0.34) -
=========== =========== =========== ============
Net income (loss) $ (0.62) $ 0.65 $ 0.74 $ 2.16
=========== =========== =========== ============
Weighted-average common shares outstanding 28.8 29.1 28.9 29.0
Earnings (loss) per common share-assuming dilution:
Income (loss) before extraordinary item $ (0.28) $ 0.64 $ 1.08 $ 2.10
Extraordinary item (0.34) - (0.34) -
=========== =========== =========== ============
Net income (loss) $ (0.62) $ 0.64 $ 0.74 $ 2.10
=========== =========== =========== ============
Diluted weighted-average common shares outstanding 28.8 34.7 29.1 34.6
Dividends declared per share $ 0.44 $ 0.44 $ 1.32 $ 1.28
See Notes to Consolidated Financial Statements.
</TABLE>
3
<PAGE>
<TABLE>
<CAPTION>
HSB GROUP, INC.
Consolidated Statements of Comprehensive Income
Unaudited
(in millions)
Quarter Ended Nine Months Ended
September 30 September 30
2000 1999 2000 1999
------- ------- ------ -----
<S> <C> <C> <C> <C>
Net income (loss) $(18.0) $ 18.8 $ 21.5 $ 62.6
Other comprehensive income (loss), net of tax:
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising during
the period, net of taxes (benefits) of $10.1;
($13.6); $14.8; and ($18.0) 17.9 (24.9) 31.6 (33.2)
Add: reclassification adjustments for gains
included in net income (loss) (10.7) (8.8) (24.9) (20.0)
-------- --------- --------- ---------
Total unrealized gains (losses) on securities 7.2 (33.7) 6.7 (53.2)
Foreign currency translation adjustments, net of income
taxes (0.5) 0.2 (1.3) 1.1
-------- --------- --------- ---------
Other comprehensive income (loss) 6.7 (33.5) 5.4 (52.1)
-------- ---------- --------- ---------
Comprehensive income (loss) $(11.3) $ (14.7) $ 26.9 $ 10.5
======== ========== ========= =========
See Notes to Consolidated Financial Statements
</TABLE>
4
<PAGE>
<TABLE>
<CAPTION>
HSB GROUP, INC.
Consolidated Statements of Financial Position
(in millions, except per share data)
September
30, 2000 December 31,
(Unaudited) 1999
------------ -----------
<S> <C> <C>
Cash and cash equivalents $ 79.9 $ 73.0
Short-term investments, at cost 38.9 53.5
Fixed maturities, at fair value (cost - $532.5; $545.7) 486.3 489.8
Equity securities, at fair value (cost - $321.4; $316.5) 384.1 381.8
----------- ----------
Total cash and invested assets 989.2 998.1
Reinsurance assets 625.4 850.3
Insurance premiums receivable 78.5 104.4
Engineering services receivable 39.5 39.1
Fixed assets 53.5 58.2
Prepaid acquisition costs 37.6 52.9
Capital lease 13.2 13.8
Deferred income taxes 16.9 -
Other assets 153.0 146.4
---------- -----------
Total assets $2,006.8 $2,263.2
========== ===========
Liabilities:
Unearned insurance premiums $ 259.1 $ 420.1
Claims and adjustment expenses 735.3 782.3
Short-term borrowings 27.6 41.5
Long-term borrowings 315.0 25.1
Capital lease 27.7 27.8
Deferred income taxes - 2.8
Dividends and distributions on capital securities 14.4 24.0
Ceded reinsurance payable 18.1 66.3
Other liabilities 141.1 87.8
--------- -----------
Total liabilities 1,538.3 1,477.7
--------- -----------
Company obligated mandatorily redeemable capital securities of
subsidiary Trust I holding solely junior subordinated deferrable
interest debentures of the Company, net of unamortized discount of
$1.0 in 2000 and 1999 105.0 109.0
Company obligated mandatorily redeemable convertible capital securities
of subsidiary Trust II holding solely junior subordinated deferrable
interest debentures of the Company - 300.0
Shareholders' equity:
Common stock (stated value; shares authorized 50.0; shares issued and
outstanding 28.9; 29.1) 10.0 10.0
Additional paid-in capital 34.9 36.2
Accumulated other comprehensive income 3.5 (1.9)
Retained earnings 321.0 339.1
Benefit plans (5.9) (6.9)
---------- -----------
Total shareholders' equity 363.5 376.5
---------- -----------
Total $2,006.8 $2,263.2
========== ===========
Shareholders' equity per common share $ 12.56 $ 12.95
See Notes to Consolidated Financial Statements.
</TABLE>
5
<PAGE>
<TABLE>
<CAPTION>
HSB GROUP, INC.
Consolidated Statements of Cash Flows
Unaudited
(in millions)
Nine Months Ended
September 30,
2000 1999
----------- ---------
<S> <C> <C>
Operating Activities:
Net income $ 21.5 $ 62.6
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization 23.1 14.7
Deferred income taxes (benefit) (20.2) 0.6
Realized investment gains, net (38.8) (30.8)
Distributions on capital securities 20.8 20.8
Gain on sale of interests in Integrated Process Technologies, LLC (9.8) -
Loss on extinguishment of capital securities of Subsidiary Trust II 15.3 -
Change in balances, net of effects from purchases and sales of subsidiaries:
Insurance premiums receivable 25.9 13.1
Engineering services receivable (3.3) (5.5)
Prepaid acquisition costs 15.3 (4.5)
Reinsurance assets 224.9 (195.9)
Unearned insurance premiums (161.0) (37.0)
Claims and adjustment expenses (46.9) 210.4
Ceded reinsurance payable (48.2) (3.6)
Other 46.2 (9.1)
----------- ---------
Cash provided by operating activities 64.8 35.8
----------- ---------
Investing Activities:
Fixed asset additions, net (5.9) (9.4)
Investments:
Sale of short-term investments, net 14.6 17.7
Purchase of fixed maturities (98.2) (123.8)
Proceeds from sale of fixed maturities 94.6 113.6
Redemption of fixed maturities 15.6 13.6
Purchase of equity securities (208.4) (254.8)
Proceeds from sale of equity securities 241.8 279.2
Purchase of Structural Integrity Associates, Inc., net of cash acquired - (5.3)
Proceeds from disposition of Integrated Process Technologies, LLC, net of cash
disposed 4.2 -
----------- ---------
Cash provided by investment activities 58.3 30.8
----------- ---------
Financing Activities:
(Decrease) increase in short-term borrowings (13.9) 22.1
Proceeds from long-term borrowings 315.0 -
Repayment of long-term borrowings (25.1) -
Dividends and distributions on capital securities (68.5) (62.5)
Reacquisition of stock (9.6) (2.2)
Exercise of stock options 4.6 4.1
Reacquisition of company obligated mandatorily redeemable capital securities of
Subsidiary Trust I (3.7) -
Retirement of company obligated mandatorily redeemable capital securities of
Subsidiary Trust II (315.0) -
----------- ---------
Cash used in financing activities (116.2) (38.5)
----------- ---------
Net increase in cash and cash equivalents 6.9 28.1
Cash and cash equivalents at beginning of period 73.0 18.3
----------- ---------
Cash and cash equivalents at end of period $ 79.9 $ 46.4
=========== =========
Interest paid $ 3.5 $ 2.5
----------- ---------
Federal income tax paid $ 30.1 $ 19.8
----------- ---------
Non-cash investing activity:
Additional proceeds of $11.1 million from the sale of IPT were received by HSB after quarter end.
See Notes to Consolidated Financial Statements.
</TABLE>
6
<PAGE>
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(in millions, except per share amounts)
(Unaudited)
1. General
The interim consolidated financial statements in this report present
the consolidated accounts of HSB Group, Inc. and its subsidiaries
(collectively, HSB or the Company). They include adjustments based on
management's best estimates and judgments, including estimates of
future loss payments, which are necessary to present a fair statement
of the results for the interim periods reported. These adjustments are
of a normal, recurring nature with the exception of the provision for
international large risk business charges (see Note 5). The financial
statements are prepared on the basis of generally accepted accounting
principles and should be read in conjunction with the financial
statements and related notes in the 1999 Annual Report.
2. Accounting Policy for Premium Deficiency
For purposes of determining whether a premium deficiency exists on
insurance contracts, contracts are grouped consistent with the
Company's manner of acquiring, servicing and measuring the
profitability on such contracts. Due to the nature of the variables
involved, subjective judgement is an integral component of these
calculations. If a premium deficiency exists, all related prepaid
acquisition costs are written off to the extent of the deficiency and a
liability is established for any excess amounts remaining. Such amounts
are charged to operations as incurred and the effects of changes in
estimated premium deficiency reserves are included in the results of
operations in the period in which the estimates change.
3. Corporate Activity
Proposed Merger with American International Group, Inc.
-------------------------------------------------------
HSB and American International Group, Inc. (AIG) entered into a
definitive Agreement and Plan of Merger (Merger Agreement) dated as of
August 17, 2000, under which AIG would acquire 100 percent of the
outstanding stock of HSB through a merger of HSB into Engineering
Acquisition Corporation, a wholly owned subsidiary of AIG. This
transaction has been approved by the Boards of Directors of both
companies and the shareholders of HSB. The transaction is expected to
be completed later this year, upon receipt of pending regulatory
approvals.
If the merger is completed, each shareholder other than those
exercising dissenter rights is entitled to receive AIG common stock
with a total value equal to $41.00 for each share of HSB common stock.
The total value for the transaction is approximately $1.2 billion. The
transaction will be treated as a purchase for accounting purposes. It
is anticipated that the transaction will qualify as a tax-free
reorganization for federal income tax purposes. HSB is obligated to pay
AIG a fee of $45.0 million, if the Merger Agreement is terminated under
certain conditions.
Industrial Risk Insurers
------------------------
The joint underwriting association that was known as HSB Industrial
Risk Insurers is now known as Industrial Risk Insurers (IRI), effective
January 1, 2000. The reinsurance agreements effective January 1, 1998,
between The Hartford Steam Boiler Inspection and Insurance Company
(HSBIIC), Employers Reinsurance Corporation (ERC) and Industrial Risk
Insurers were terminated with respect to loss or liabilities arising
out of occurrences taking place on or after January 1, 2000. As a
result, HSBIIC no longer retains 85 percent of the equipment breakdown
insurance and 15 percent of the property insurance of the combined
insurance portfolio for risks arising on or after January 1, 2000.
7
<PAGE>
Concurrent with the termination of the reinsurance agreements, HSBIIC,
ERC and IRI also replaced the operating agreement dated January 1,
1998. The new agreement, effective January 1, 2000, called for HSBIIC
to retain 0.5 percent membership share in IRI with the ability to
increase its total share up to a maximum of 10 percent, at no cost, at
HSBIIC's option. In addition, the new agreements also established an
arrangement for HSB to perform equipment breakdown engineering and
inspection services for clients of IRI.
Effective September 14, 2000, in connection with an agreement between
ERC and HSB under which HSB redeemed $300 million of Convertible
Capital Securities held by ERC (see Note 4, below) HSB transferred its
0.5 percent membership share to ERC. In addition, HSB agreed to enter
into agreements with ERC under which HSB will continue to provide
inspection, engineering and mechanical breakdown services to IRI for
each of the two annual periods commencing January 1, 2001 and 2002.
Gain on sale of interests in Integrated Process Technologies, LLC
-----------------------------------------------------------------
On September 29, 2000, HSBIIC completed the sale of its 51 percent
membership interest in Integrated Process Technologies, LLC (IPT) to
Enron Energy Services Operations, Inc. (EESO) pursuant to an LLC
Membership Interest Purchase Agreement between HSBIIC and EESO dated
September 28, 2000. In a related transaction, HSBIIC completed the
sale of a call option it held on an additional 29 percent interest to
the other 49 percent holder in IPT. HSBIIC recognized a pre-tax gain
of $9.8 million from the two IPT sales transactions.
4. Capital Structure
Redemption of the Convertible Capital Securities
-------------------------------------------------
On December 31, 1997, HSB sold $300 million of Convertible Capital
Securities to ERC in a private placement. The Convertible Capital
Securities were issued through HSB Capital II (Trust II), a Delaware
business trust created by HSB. The Convertible Capital Securities were
redeemable, under certain conditions, at par plus a redemption premium,
at the option of ERC, in the event of a change in control of HSB.
On August 28, 2000, in contemplation of the proposed merger with AIG
(see Note 3), HSB and ERC entered into a Redemption Agreement with
respect to the exercise by ERC of the change in control redemption
right provided at the time of the original issuance of the Convertible
Capital Securities.
On September 14, 2000, HSB redeemed the Convertible Capital Securities
issued by Trust II for $315.0 million plus accrued and unpaid interest
using funds borrowed from AIG (see "Borrowings" below). This amount
included the change in control redemption premium. Trust II was
subsequently dissolved. The early extinguishment of the Convertible
Capital Securities resulted in an extraordinary charge of $9.9 million
after-tax or $0.34 per common share for the quarter.
Borrowings
----------
On September 14, 2000, AIG lent $315.0 million in principal to HSB to
fund the redemption of the Convertible Capital Securities. The loan is
a five-year term loan that matures on September 30, 2005. The loan
bears interest at an annual rate of 7.47 percent and interest is
payable quarterly and on the date of any repayment of principal. After
the principal amount of the loan becomes due and payable, the loan
bears interest at an annual rate of 9.47 percent. The loan contains an
optional prepayment provision, whereby HSB has the option to prepay
the loan, in whole or in part, subject to certain notification and
minimum payment requirements.
8
<PAGE>
5. Provision for international large risk business
The $20.7 million provision for international large risk business
recognized in the third quarter of 2000, relates to the special risk
insurance business of the Company's London-based affiliate, HSB
Engineering Insurance Limited (EIL). On a pre-tax basis, these charges
include amounts recognized for estimated future claims and expenses
that resulted from the Company's evaluation of a premium deficiency of
$12.2 million as well as the recognition of an impairment of goodwill
of $7.6 million and a reserve for severance and other costs of $0.9
million relating to that business. The Company determined that the
goodwill associated with EIL's insurance business was not recoverable
when measured using estimated future undiscounted cash flows.
6. Recent Accounting Developments
Statement of Position 98-7
--------------------------
In October 1998, AcSEC issued Statement of Position 98-7, "Deposit
Accounting: Accounting for Insurance and Reinsurance Contracts That Do
Not Transfer Insurance Risk (SOP 98-7)." SOP 98-7 identifies several
methods of deposit accounting and provides guidance on the application
of each method. This SOP became effective for financial statements for
fiscal years beginning after June 15, 1999. The adoption and impact of
SOP 98-7 has not had a material impact on the Company's results of
operations, financial condition or cash flows, as the Company is not
party to any contracts that do not comply with the risk transfer
provisions of issued Statement of Financial Accounting Standards (SFAS)
No. 113, "Accounting and Reporting for Reinsurance of Short-Duration
and Long-Duration Contracts."
Statements of Financial Accounting Standards Nos. 133, 137 and 138
-------------------------------------------------------------------
In June 1998, the Financial Accounting Standards Board (FASB) issued
SFAS No. 133, "Accounting for Derivative Instruments and Hedging
Activities" subsequently amended by SFAS Nos. 137 and 138. This
statement establishes accounting and reporting standards for
derivative instruments, including certain derivative instruments
embedded in other contracts and for hedging activities. It requires
that all derivatives be recognized as either assets or liabilities in
the statement of financial position and that such instruments be
measured at fair value. In addition, all hedging relationships must be
designated, reassessed and documented pursuant to the provisions of
SFAS No. 133. This statement is effective for the Company for the
first quarter of 2001. Based on the Company's current investment
policies and practices, the Company anticipates that the adoption of
the provisions of SFAS No. 133, as amended by SFAS Nos. 137 and 138
will not have a significant effect on results of operations, financial
condition or cash flows.
Statement of Financial Accounting Standards No. 140
---------------------------------------------------
In September 2000, FASB issued SFAS No. 140 " Accounting for Transfers
and Servicing of Financial Assets and Extinguishment of Liabilities"
which replaces SFAS No. 125 " Accounting for Transfers and Servicing of
Financial Assets and Extinguishment of Liabilities." SFAS No. 140
revises the standards for accounting for securitizations and other
transfers of financial assets and collateral and requires certain
disclosures, but it carries over most of SFAS No. 125's provisions
without reconsideration.
This statement is effective for transfers and servicing of financial
assets and extinguishments of liabilities occurring after March 31,
2001 and for recognition and reclassification of collateral and for
disclosures relating to securitization transactions and collateral for
fiscal years ending after December 15, 2000. Generally, earlier or
retroactive application of the accounting provisions of SFAS No. 140
is not permitted. Based on the Company's current policies and
practices, the
9
<PAGE>
Company anticipates that the adoption of the provisions of SFAS No.
140 will not have a significant effect on results of operations,
financial condition or cash flows.
Codification of Statutory Accounting Principles
-----------------------------------------------
In 1998, the National Association of Insurance Commissioners (NAIC)
adopted the Codification of Statutory Accounting Principles guidance
(Codification), which will replace the current Accounting Practices and
Procedures manual as the NAIC's primary guidance on statutory
accounting. In 2000, the Connecticut legislature adopted Codification.
The Company is in the process of estimating the effect of Codification
that becomes effective January 1, 2001.
7. Legal Proceedings
The Company is involved in various legal proceedings as defendant or
co-defendant that have arisen in the normal course of its business. In
the judgment of management, after consultation with counsel, it is
improbable that any liabilities, which may arise from litigation, will
have a material adverse impact on the results of operations or the
financial position of the Company.
8. Earnings per Common Share
The following table presents a reconciliation of the numerator and
denominator of the calculation of basic and diluted Earnings per Common
Share from income (loss) before extraordinary item.
<TABLE>
<CAPTION>
Quarter Ended Nine Months Ended
September 30, September 30,
------------- -------------
2000 1999 2000 1999
----------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Income (loss) before extraordinary item $ (8.1) $ 18.8 $ 31.4 $ 62.6
After-tax distributions on convertible
capital securities (1) - 3.4 - 10.3
------- ------ ------ -----
Adjusted for diluted computation $ (8.1) $ 22.2 $ 31.4 $ 72.9
----------------------------------------------------------------------------------------
Weighted-average common shares outstanding 28.8 29.1 28.9 29.0
Stock options (2) - 0.3 0.2 0.3
Convertible capital securities (1) - 5.3 - 5.3
---- ---- ---- ----
Adjusted for diluted computation 28.8 34.7 29.1 34.6
----------------------------------------------------------------------------------------
Earnings (loss) per Common Share before
extraordinary item:
Basic (3) (4) $ (0.28) $ 0.65 $ 1.08 $ 2.16
Assuming dilution (4) $ (0.28) $ 0.64 $ 1.08 $ 2.10
-----------------------------------------------------------------------------------------
</TABLE>
(1) Includes only the dilutive effect of convertible capital
securities. See Note 4 "Capital Structure" - "Redemption of the
Convertible Capital Securities".
(2) Includes only the dilutive effect of stock options computed using
the treasury stock method and shares issuable under deferred stock
awards.
(3) Represents income applicable to common stock divided by
weighted-average common shares outstanding.
(4) Computation excludes rounding.
10
<PAGE>
9. Segment Information
HSB has 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
offer professional scientific and technical consulting for industry and
government worldwide. The Company's investment assets are managed by
its Investment operating segment.
The accounting policies of the segments are consistent with generally
accepted accounting principles 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.
The following presents revenue and net income from the Company's
reportable segments and reconciles these amounts to the corresponding
consolidated totals:
<TABLE>
<CAPTION>
Quarter Ended Nine Months Ended
September 30, September 30,
----------------------- ------------------
2000 1999 2000 1999
---------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Revenues from continuing operations
Insurance premiums:
Commercial $ 94.1 $ 82.7 $ 275.0 $ 245.2
Global Special Risks 11.5 10.1 22.9 36.9
Engineering services * 48.5 30.6 125.7 86.0
Net investment income and realized
investment gains 31.3 30.0 85.3 79.6
----------- ---------- ----------- ------------
Total revenues from reportable segments 185.4 153.4 508.9 447.7
Other segments 0.2 (0.1) (1.4) 0.8
----------- ---------- ----------- ------------
Total revenues $ 185.6 $ 153.3 $ 507.5 $ 448.5
=========== ========== =========== ============
Net income (loss):
Commercial $ 3.4 $ 4.2 $ 13.7 $ 10.1
Global Special Risks (31.7) (1.6) (35.3) 6.3
Engineering services * 7.4 0.5 9.9 3.0
Investment 20.1 21.3 56.5 55.9
----------- ---------- ----------- ------------
Total net income from reportable
segments (0.8) 24.4 44.8 75.3
Other segments (5.1) (2.2) (5.7) (3.7)
Corporate account 1.9 1.2 5.8 4.6
Distributions on capital securities (4.1) (4.6) (13.5) (13.6)
----------- ---------- ----------- ------------
Net income (loss) before extraordinary
item (8.1) 18.8 31.4 62.6
Loss on extinguishment of capital
securities of subsidiary Trust II, net
of tax (9.9) - (9.9) -
----------- ---------- ----------- ------------
Net income (loss) $ (18.0) $ 18.8 $ 21.5 $ 62.6
=========== ========== =========== ============
</TABLE>
*Includes gain on sale of interests in Integrated Process Technologies,
LLC (see Note 3).
11
<PAGE>
10. Global Floating Rate Capital Securities
On July 15, 1997, a trust sponsored and wholly owned by the Company
issued $110,000,000 aggregate liquidation amount of capital securities
in a private placement and 3,403 shares of common securities to the
Company, the proceeds of which were invested by the trust in
$113,403,000 aggregate principal amount of the Company's debt
securities. On November 5, 1997, an exchange offer was commenced,
pursuant to which the capital securities originally issued in the
private placement were exchanged for capital securities that were
registered with the Securities and Exchange Commission (the "Capital
Securities") and the debt securities were exchanged for debt securities
that were registered with the Securities and Exchange Commission (the
"Debt Securities").
The Debt Securities represent all of the assets of the trust. The
proceeds from the issuance of the Debt Securities were used by the
Company for general corporate purposes. The Debt Securities and
related income statement effects are eliminated in the Company's
consolidated financial statements. The Debt Securities accrue and pay
cash distributions quarterly in arrears at a variable rate of LIBOR
plus .91 percent of the stated liquidation amount of $1,000 per Debt
Security, and are scheduled to mature on July 15, 2027.
The Capital Securities accrue and pay cash distributions quarterly in
arrears at a variable rate of LIBOR plus .91 percent of the stated
liquidation amount of $1,000 per Capital Security. The terms of the
Debt Securities, the guarantee of the Company with respect to the
Capital Securities, the Indenture and the Trust Agreement together
provide a full guarantee of amounts due on the Capital Securities.
The Capital Securities are mandatorily redeemable upon the maturity of
the Debt Securities on July 15, 2027, or earlier to the extent of any
redemption by the Company of any Debt Securities. The redemption price
in either such case will be $1,000 per share plus accrued and unpaid
distributions to the date fixed for redemption.
In the second and third quarters of 2000, the Company purchased
$4,000,000 in face amount of Capital Securities. Since September 30,
2000, the Company has repurchased an additional $11,000,000 in face
amount of Capital Securities.
11. Stock Purchase Rights
Under the shareholders rights plan (Rights Agreement) approved by the
Board of Directors on September 21, 1998, the Board declared a dividend
of one right for each outstanding share of common stock to shareholders
of record on November 28, 1998. Under the terms of the Rights
Agreement, if certain conditions are met, the rights 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.
In connection with the merger, the Rights Agreement was amended to
provide that neither the signing of the Merger Agreement or the stock
option agreement (under which AIG was granted the option to acquire up
to 19.9 percent of HSB common stock) nor completion of the merger or
the exercise of the stock option would cause AIG to become an
"acquiring person" or constitute a "triggering event" as these terms
are defined in the Rights Agreement.
12
<PAGE>
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS
OF CONSOLIDATED FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
SEPTEMBER 30, 2000
RESULTS OF OPERATIONS
---------------------
(in millions, except per share amounts)
<TABLE>
<CAPTION>
Consolidated Overview
---------------------
Quarter Ended Nine Months Ended
September 30, September 30,
2000 1999 2000 1999
---- ---- ---- ----
<S> <C> <C> <C> <C>
Revenues:
Gross earned premiums $ 157.2 $ 200.6 $ 515.7 $ 616.3
Ceded premiums 51.4 107.9 219.2 333.4
--------- --------- --------- --------
Insurance premiums 105.8 92.7 296.5 282.9
Engineering services 38.7 30.6 115.9 86.0
Net investment income 16.0 16.5 46.5 48.8
Realized investment gains 15.3 13.5 38.8 30.8
Gain on sale of interests in IPT 9.8 - 9.8 -
--------- ---------- --------- --------
Total revenues $ 185.6 $ 153.3 $ 507.5 $ 448.5
========= =========== ========= ========
Pre-tax income (loss) $ (1.4) $ 32.7 $ 72.0 $ 107.8
Income taxes 2.6 9.3 27.1 31.6
Distributions on capital securities, net of tax 4.1 4.6 13.5 13.6
--------- --------- --------- --------
Income (loss) before extraordinary item $ (8.1) $ 18.8 $ 31.4 $ 62.6
Loss on extinguishment of capital securities of
subsidiary Trust II, net of tax 9.9 - 9.9 -
--------- --------- --------- --------
Net income (loss) $ (18.0) $ 18.8 $ 21.5 $ 62.6
========== ========= ========= ========
Earnings (loss) per common share-basic:
Income (loss) before extraordinary item $ (0.28) $ 0.65 $ 1.08 $ 2.16
Net income (loss) $ (0.62) $ 0.65 $ 0.74 $ 2.16
Earnings (loss) per common share-assuming
dilution:
Income (loss) before extraordinary item $ (0.28) $ 0.64 $ 1.08 $ 2.10
Net income (loss) $ (0.62) $ 0.64 $ 0.74 $ 2.10
</TABLE>
13
<PAGE>
Overview of Results of Operations
---------------------------------
Total revenues for the third quarter and first nine months of 2000 increased
21.1 and 13.2 percent from comparable periods in 1999. The third quarter growth
in insurance premiums primarily reflects growth in our Commercial business. The
year to date growth in insurance premiums reflects growth in our Commercial
business offset in part by declines in our Global Special Risks business. The
growth in Engineering Services revenues of 26.5 percent for the third quarter
and 34.8 percent year to date, which excludes the impact of the third quarter
2000 gain on sale of interests in Integrated Process Technologies, LLC (IPT)
(see "Engineering Services Operations"), reflects the impact of new business as
well as continued growth in certain engineering affiliates and subsidiaries. The
third quarter and year to date increase in realized investment gains reflect the
shift of a portion of investments out of common stocks.
The Company's pre-tax earnings decreased 104.3 and 33.2 percent for the third
quarter and first nine months of 2000 compared to 1999. The decrease in pre-tax
earnings for the third quarter and year to date 2000 was due primarily to
reduced underwriting profits in our Global Special Risks business which reflects
$23.2 million of third quarter 2000 adverse loss experience, net of reinsurance
recoveries of $24.5 million. The claims associated with this experience occurred
after July 1, 2000, of which the majority of the gross loss experience related
to international risks. In addition, results for the third quarter of 2000
include a charge of $20.7 million with respect to the special risk insurance
business generated by the Company's London-based affiliate, HSB Engineering
Insurance Limited (EIL). This charge includes provisions for future claims and
certain other expenses as well as a non-tax-deductible write-down with respect
to the goodwill impairment of that business.
The effective tax rates for the third quarter and year to date 2000 were 185.7
and 37.6 percent compared to 28.4 and 29.3 percent for the comparable prior
periods. The increase in the third quarter and year to date 2000 effective tax
rate compared to 1999 relates to increases in non-deductible goodwill and
reduced foreign tax credits. The increase in non-deductible goodwill for these
periods primarily relates to a charge of $7.6 million related to EIL, which is a
component of the $20.7 million pre-tax special risk insurance business charge
discussed above. Typically tax rate fluctuations occur as 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. The Company continues to manage its use of
tax advantageous investments to maximize after-tax earnings.
Third quarter and year to date 2000 after-tax results also include a $9.9
million extraordinary loss on the early extinguishment of capital securities of
subsidiary Trust II which resulted when the Convertible Capital Securities were
redeemed. The early redemption resulted from action taken by Employers
Reinsurance Corporation (ERC) to exercise its change in control redemption
option, provided at the time of the original issuance of the Convertible Capital
Securities, to require the redemption of the Convertible Capital Securities
under certain conditions (see Note 4 "Capital Structure").
Proposed Merger with American International Group, Inc.
-------------------------------------------------------
HSB Group, Inc. (HSB) and American International Group, Inc. (AIG) entered into
a definitive Agreement and Plan of Merger (Merger Agreement) dated as of August
17, 2000 under which AIG would acquire 100 percent of the outstanding stock of
HSB through a merger of HSB into Engineering Acquisition Corporation, a wholly
owned subsidiary of AIG. This transaction has been approved by the Boards of
Directors of both companies and the shareholders of HSB. The transaction is
expected to be completed later this year, upon receipt of pending regulatory
approvals.
If the merger is completed, each shareholder other than those exercising
dissenter rights is entitled to receive AIG common stock with a total value
equal to $41.00 for each share of HSB common stock. The total value for the
transaction is approximately $1.2 billion. The transaction will be treated as a
purchase for accounting purposes. It is anticipated that the transaction will
qualify as a tax-free reorganization for federal income tax purposes. HSB is
obligated to pay AIG a fee of $45.0 million, if the Merger Agreement is
terminated under certain conditions.
14
<PAGE>
Recent Accounting Developments
------------------------------
Statement of Position 98-7
In October 1998, AcSEC issued Statement of Position 98-7, "Deposit Accounting:
Accounting for Insurance and Reinsurance Contracts That Do Not Transfer
Insurance Risk (SOP 98-7)." SOP 98-7 identifies several methods of deposit
accounting and provides guidance on the application of each method. This SOP
became effective for financial statements for fiscal years beginning after June
15, 1999. The adoption and impact of SOP 98-7 has not had a material impact on
the Company's results of operations, financial condition or cash flows, as the
Company is not party to any contracts that do not comply with the risk transfer
provisions of Statement of Financial Accounting Standards (SFAS) No. 113,
"Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration
Contracts."
Statements of Financial Accounting Standards Nos. 133, 137 and 138
In June 1998, the Financial Accounting Standards Board (FASB) issued SFAS No.
133, "Accounting for Derivative Instruments and Hedging Activities" subsequently
amended by SFAS Nos. 137 and 138. This statement establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts and for hedging activities. It requires
that all derivatives be recognized as either assets or liabilities in the
statement of financial position and that such instruments be measured at fair
value. In addition, all hedging relationships must be designated, reassessed and
documented pursuant to the provisions of SFAS No. 133. This statement is
effective for the Company for the first quarter of 2001. Based on the Company's
current investment policies and practices, the Company anticipates that the
adoption of the provisions of SFAS No. 133, as amended by SFAS Nos. 137 and 138,
will not have a significant effect on results of operations, financial condition
or cash flows.
Statement of Financial Accounting Standards No. 140
In September 2000, FASB issued SFAS No. 140 " Accounting for Transfers and
Servicing of Financial Assets and Extinguishment of Liabilities" which replaces
SFAS No. 125 " Accounting for Transfers and Servicing of Financial Assets and
Extinguishment of Liabilities." SFAS No. 140 revises the standards for
accounting for securitizations and other transfers of financial assets and
collateral and requires certain disclosures, but it carries over most of SFAS
No. 125's provisions without reconsideration.
This statement is effective for transfers and servicing of financial assets and
extinguishments of liabilities occurring after March 31, 2001 and for
recognition and reclassification of collateral and for disclosures relating to
securitization transactions and collateral for fiscal years ending after
December 15, 2000. Generally, earlier or retroactive application of the
accounting provisions of SFAS No. 140 is not permitted. Based on the Company's
current policies and practices, the Company anticipates that the adoption of the
provisions of SFAS No. 140 will not have a significant effect on results of
operations, financial condition or cash flows.
Codification of Statutory Accounting Principles
In 1998, the National Association of Insurance Commissioners (NAIC) adopted the
Codification of Statutory Accounting Principles guidance (Codification), which
will replace the current Accounting Practices and Procedures manual as the
NAIC's primary guidance on statutory accounting. In 2000, the Connecticut
legislature adopted Codification. The Company is in the process of estimating
the effect of Codification that becomes effective January 1, 2001.
15
<PAGE>
Insurance Operations
--------------------
<TABLE>
<CAPTION>
Quarter Ended Nine Months Ended
September 30, September 30,
------------- -------------
2000 1999 2000 1999
---- ---- ---- ----
<S> <C> <C> <C> <C>
Gross earned premiums $ 157.2 $ 200.6 $ 515.7 $ 616.3
Ceded premiums 51.4 107.9 219.2 333.4
--------- --------- --------- --------
Insurance premiums 105.8 92.7 296.5 282.9
Claims and adjustment expenses 74.0 44.5 150.9 120.7
Underwriting, acquisition and other expenses 54.6 46.0 153.5 138.1
--------- --------- --------- -----
Underwriting gain (loss) $ (22.8) $ 2.2 $ (7.9) $ 24.1
Provision for international large
risk business charges 20.7 - 20.7 -
---------- --------- ---------- --------
Pre-tax income (loss) $ (43.5) $ 2.2 $ (28.6) $ 24.1
========== ========= ========== ========
Combined ratio excluding the provision
for international large risk business charges:
Loss ratio * 70.0% 48.1% 50.9% 42.7%
Expense ratio * 51.5% 49.6% 51.7% 48.8%
-------- --------- --------- --------
Combined ratio * 121.5% 97.7% 102.6% 91.5%
======== ========= ========= ========
</TABLE>
* Computation excludes rounding.
Results from insurance operations include those of The Hartford Steam Boiler
Inspection and Insurance Company (HSBIIC), 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 Industrial Risk Insurers (IRI) and various other pools.
Gross earned premiums in the third quarter and year to date 2000 decreased 21.6
and 16.3 percent from comparable periods in 1999. The decrease in gross earned
premiums largely relates to declines in Global Special Risks gross earned
premiums of 47.9 and 38.7 percent for the quarter and year to date,
respectively. These declines primarily resulted from the Company's decision to
reduce its risk position in IRI effective January 1, 2000. The declines in
Global Special Risks were offset by increases in Commercial gross earned
premiums of 9.3 and 10.2 percent for the quarter and year to date, respectively,
which related primarily to increases in our domestic commercial assumed
equipment breakdown business.
Ceded premiums in the third quarter and year to date decreased 52.4 and 34.3
percent to comparable periods in 1999. This is consistent with declines in gross
earned premiums for the same periods and reflects changes in the structure of
some of the Company's reinsurance programs which now utilize less quota share
reinsurance on certain books of business as well as changes in the IRI
agreements.
The loss ratio increased from 48.1 percent in the third quarter of 1999 to 70.0
percent in the current quarter; and from 42.7 percent year to date 1999 to 50.9
percent year to date 2000. For the third quarter and year to date 2000, the
increase in the loss ratios primarily related to adverse loss experience in our
Global Special Risks large risk business. The claims associated with this
experience occurred after July 1, 2000 and totaled $23.2 million after
reinsurance recoveries of $24.5 million. The majority of the gross loss
experience was related to international risks. Net of the effects of reinsurance
recoverable, this adverse loss experience had a 21.9 percent and 7.8 percent
impact on the Company's third quarter and year to date 2000 loss ratios,
respectively. The increase in the loss ratio for the quarter and year to date
reflects to some extent management's decision to increase the retention on
certain claims, in order to provide increased reinsurance capacity for our
domestic businesses. Third quarter 1999 results include $10 million in
weather-related events domestically and the Taiwan earthquake.
16
<PAGE>
The third quarter and year to date results include a $20.7 million provision for
international large risk business charges which are more fully discussed in Note
5. Excluding the provision for international large risk business, the expense
ratio increased from 49.6 percent in the third quarter of 1999 to 51.5 percent
in the current quarter, and from 48.8 percent year to date in 1999 to 51.7
percent year to date in 2000. The increases in the expense ratio were primarily
attributed to increases in underwriting and inspection expenses, which increased
$6.9 million for the third quarter and $16.1 million year to date. These
increases were largely due to the reduced management fees related to the
Company's decision to reduce its risk bearing position in IRI, changes in the
Company's reinsurance programs which resulted in reduced ceding commissions, and
marketing incentive increases related to the growth in our Commercial business.
Policy acquisition costs increased $1.7 million for the quarter and were flat
year to date compared to 1999 amounts due primarily to the reduction in IRI net
policy acquisition costs. These changes were offset, however, by increased
policy acquisition costs in our Commercial business.
IRI management fees are reflected as expense reductions to underwriting and
inspection expenses and policy acquisition costs. The expense ratio would be
approximately 2.5 and 3.8 percent higher for the quarter and year to date,
respectively, absent the IRI arrangements.
The following information summarizes net earned premiums and net income by
reportable insurance segment:
Quarter Ended Nine Months Ended
September 30, September 30,
------------- -------------
2000 1999 2000 1999
---- ---- ---- ----
Commercial:
Net earned premiums $ 94.1 $82.7 $275.0 $245.2
Net income 3.4 4.2 13.7 10.1
Global Special Risks:
Net earned premiums $ 11.5 $10.1 $ 22.9 $ 36.9
Net income (loss) (31.7) (1.6) (35.3) 6.3
Net earned premiums in the Commercial segment rose $11.4 million or 13.8 percent
in the third quarter and $29.8 million or 12.2 percent for the first nine months
of 2000 due primarily to continued growth in our domestic client company
business through our ReSource product. Net income for the third quarter of 2000
reflected increased frequency of small claims as well as a higher percentage of
policy acquisition and other underwriting costs to net earned premiums compared
to the third quarter of 1999. Net income year to date 2000 was favorably
impacted by reduction in the loss ratio and the absorption of fixed costs on
higher net earned premiums.
Global Special Risks net earned premiums for the third quarter increased $1.4
million and declined $14.0 million year to date from the comparable periods in
1999. The quarter to date increase in net earned premiums was due primarily to
the impact of increases in our domestic special risk business, offset in part by
decreases in the IRI net earned premiums. The year to date decrease in net
earned premiums was due primarily to the impact of changes in the IRI
agreements. Global Special Risks net loss for the third quarter and year to date
2000 compared to net income (loss) for the same periods in 1999 reflects
increased loss as well as a portion ($15.1 million after-tax) of the provision
for international large risk business charges described in Note 5. The increased
losses in 2000 include the previously discussed impact of $23.2 million of large
third quarter losses, net of reinsurance recoveries of $24.5 million related to
international risks. In addition, Global Special Risks domestic and
international loss ratios were also unfavorably impacted by reduced quota share
reinsurance coverages. Global Special Risks 1999 results presented reflect the
impact of third quarter 1999 losses from weather-related events domestically and
the Taiwan earthquake. Global Special Risks may continue to have an adverse
impact on underwriting results until such time as needed pricing improvements
are accepted in the marketplace. During the third quarter, the Company
re-evaluated EIL's contribution to Global Special Risks and has taken action to
curtail writings and address costs as the Company continues to evaluate various
future strategies regarding Global Special Risks business.
17
<PAGE>
Engineering Services Operations
<TABLE>
<CAPTION>
Quarter Ended Nine Months Ended
September 30, September 30,
------------- -------------
2000 1999 2000 1999
---- ---- ---- ----
<S> <C> <C> <C> <C>
Engineering services revenues $ 38.7 $ 30.6 $ 115.9 $ 86.0
Engineering services expenses 36.2 29.5 107.8 80.3
--------- -------- -------- -------
Operating gain $ 2.5 $ 1.1 $ 8.1 $ 5.7
Gain on sale of interests in IPT 9.8 - 9.8 -
--------- -------- -------- -------
Pre-tax income $ 12.3 $ 1.1 $ 17.9 $ 5.7
========= ======== ======== =======
Operating margin * 6.5% 3.6% 7.0% 6.6%
</TABLE>
* Excludes gain on sale of interests in IPT.
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, Solomon Associates, Inc. (SAI),
Structural Integrity Associates, Inc. (Structural) and the Company's interests
in IPT until September 29, 2000 when its interests were sold.
Engineering services revenues for the third quarter and first nine months of
2000 increased $8.1 and $29.9 million compared to the same periods in 1999. The
growth in Engineering services revenues for the third quarter was largely due to
growth in license and service fees which were generated from the Company's
agreements with Enron Energy Services Operations, Inc. (EESO), an Enron Corp.
affiliate, new agreements with IRI that became effective January 1, 2000 and the
continued expansion of EIL's Haughton engineering business and HSBRT. The year
to date growth in Engineering services revenues was attributable to these
factors as well as increased revenue generated by Structural that was acquired
in July 1999 and IPT. Under agreements with EESO, which became effective in the
first quarter of 2000, the Company provides certain energy services, project
management and other technical assistance.
Engineering services operating margin was 6.5 and 7.0 percent for the third
quarter and first nine months of 2000, respectively, compared to 3.6 and 6.6
percent for comparable periods in 1999. The improvements in engineering services
operating margins were largely due to license and service fees. This improvement
was offset in part by the negative impact of IPT and the increased investment of
operating funds to develop new products.
On September 29, 2000, HSBIIC completed the sale of its 51 percent membership
interest in IPT to EESO pursuant to an LLC Membership Interest Purchase
Agreement between HSBIIC and EESO dated September 28, 2000. In a related
transaction, HSBIIC completed the sale of a call option it held on an additional
29 percent interest to the other 49 percent holder in IPT. HSBIIC recognized a
pre-tax gain of $9.8 million from the two IPT sales transactions.
Investment Operations
---------------------
Quarter Ended Nine Months Ended
September 30, September 30,
------------- -------------
2000 1999 2000 1999
---- ---- ---- ----
Net investment income $ 16.0 $ 16.5 $ 46.5 $ 48.8
Realized investment gains 15.3 13.5 38.8 30.8
------ ------ ------ ------
Income before interest expense $ 31.3 $ 30.0 $ 85.3 $ 79.6
Interest expense 1.5 0.6 2.6 1.6
---- ------ ------ ------
Pre-tax income $ 29.8 $ 29.4 $ 82.7 $ 78.0
====== ====== ====== ======
18
<PAGE>
Pre-tax income from investment operations increased $0.4 million for the third
quarter and $4.7 million for the first nine months of 2000 compared to the same
periods in 1999. The decrease in net investment income for the third quarter and
year to date 2000 primarily related to reduced investable funds which resulted
from the repositioning of our investment portfolio. A portion of the proceeds
generated from repositioning the investment portfolio was used to repurchase
$9.6 million of HSB stock and repay $25.1 million in long-term debt. The third
quarter and year to date 2000 increase in realized investment gains over
comparable periods in 1999 reflected the shift of some investments out of common
stocks in accordance with the investment portfolio's asset allocation targets.
Realized investment gains for the third quarter and year to date 2000 also
include $0.2 and $5.6 million, respectively, of losses arising from declines in
the realizable value of certain venture capital and other investments considered
to be other than temporary. Management continues to evaluate the credit risk on
its venture capital investments. The Company continues to evaluate its
investments for exposure to declines in realizable value considered to be other
than temporary. 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.
Interest expense increased $0.9 million for the third quarter and $1.0 million
for the first nine months of 2000 compared to the same periods in 1999. The
increase in interest expense for the third quarter and year to date 2000
primarily resulted from the impact of the Company's $315.0 million loan with
AIG, the proceeds of which were used to redeem the Convertible Capital
Securities on September 14, 2000.
Market Risk
-----------
The value of the Company's financial instruments reacts to changes in macro
economic variables. Market risk generally encompasses systemic risks or risks
associated with macro factors relating to the economic impact of 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
continues to be 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, debt and capital securities servicing requirements
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 rates
and equity price risk.
For purposes of this disclosure market risk sensitive instruments are
categorized as instruments entered into for trading purposes and instruments
entered into for purposes other than trading. The Company does not hold any
financial instruments entered into for trading purposes and, therefore, market
risk sensitive instruments are classified as held for purposes other than
trading.
Interest Rate Risk
Interest rate risk is the major price risk facing the Company's fixed income
portfolio and relates to the effect of changes in the level of interest rates on
the return on financial instruments. The Company attempts to mitigate this risk
by investing in high quality issues of various maturities using a buy and hold
approach and by structuring its portfolio such that the impact on regulatory
capital is moderated.
Equity Market Risk
Equity market risk is the possibility that market influences will adversely
affect the expected returns on equity investments. The Company attempts to
reduce this risk through diversification and focus on high quality, blue chip
investments.
Foreign Exchange Risk
Foreign currency risk is the chance that fluctuations in foreign currency
exchange rates will impact the value of financial instruments. The Company has
foreign exchange exposure when it buys or sells foreign currencies or financial
19
<PAGE>
instruments denominated in a foreign currency. The Company's foreign
transactions are primarily denominated in Canadian dollars.
Sensitivity Analysis
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 September 30, 2000, 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 $49.3 million and $70.5,
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 $49.3 and $70.5 million, respectively.
Portfolio sensitivity to these variables tends to change over time due to
changes in portfolio composition and changes in market environment. For the
fixed maturity portfolio, sensitivity, as measured by duration, was 8.13 at
September 30, 2000, essentially the same as at December 31, 1999.
The Company's long-term borrowings were issued at a fixed rate of 7.47 percent,
and as such, interest expense would not be impacted by interest rate shifts. The
effect of 100 and 150 basis point increases in interest rates on the $315.0
million in long-term borrowings to AIG would result in an estimated market value
of $302.3 million and $296.2 million, respectively. For purposes of determining
the impact of changes in interest rates on market value, it is assumed that the
Company does not exercise its optional prepayment rights. If the Company
exercises its prepayment rights, the impact on market values due to increases in
interest rates could be less severe.
The impact of 100 and 150 basis point increases in interest rates on the
variable rate capital securities would result in an additional annualized charge
to pre-tax income of $1.1 million and $1.6 million, respectively. A 100 and 150
basis point decrease in interest rates would increase annualized 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 September 30, 2000 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 $18.0 and $45.0 million increase or
decrease, respectively, in the net financial instrument position. The Company's
equity instruments' sensitivity to equity market risk, as measured by portfolio
beta, decreased from 0.98 at December 31, 1999 to 0.85 at September 30, 2000.
This change is generally attributed to portfolio repositioning during the
period.
The sensitivity analysis also assumes an instantaneous 10 percent and 20 percent
change in the foreign currency exchange rates versus the U.S. dollar from their
levels at September 30, 2000, with all other variables held constant. A 10
percent and 20 percent strengthening of the U.S. dollar would result in
decreases of $10.2 and $10.6 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 September 30, 2000 Value Rate Risk Risk Risk
--------------------------------------------------------------------------------
Fixed maturity securities $ 486.3 $ (34.7) $ (6.7) $ -
Equity securities 384.1 (14.1) (2.2) (18.0)
Short term investments 38.9 (0.5) (1.3) -
--------------------------------------------------------------------------------
Total all Securities $ 909.3 $ (49.3) $(10.2) $ (18.0)
--------------------------------------------------------------------------------
20
<PAGE>
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 20 percent decline in foreign currency exchange rates, and a
decline of 25 percent in the S& P 500 Index.
Held For Other Than Trading Purposes
Market Interest Currency Equity
At September 30, 2000 Value Rate Risk Risk Risk
--------------------------------------------------------------------------------
Fixed maturity securities $ 486.3 $ (49.7) $ (6.9) $ -
Equity securities 384.1 (20.0) (2.1) (45.0)
Short term investments 38.9 (0.8) (1.6) -
--------------------------------------------------------------------------------
Total all securities $ 909.3 $ (70.5) $(10.6) $ (45.0)
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Statements of Comprehensive Income
----------------------------------
In addition to the impact of HSB's results of operations, the Consolidated
Statements of Comprehensive Income display the effects of price movements on
HSB's invested assets. As a result of market fluctuations, cumulative holding
gains, net of taxes, for the first nine months of 2000 increased $5.4 million
compared to a decrease of $52.1 million in the same period in 1999. Exclusive of
realized gains, the change in 2000 when compared to the first nine months of
1999 is largely due to rising interest rates.
Liquidity and Capital Resources
-------------------------------
Balances at
--------------------------------
September 30, December 31,
2000 1999
--------------- -------------
Total assets $ 2,006.8 $ 2,263.2
Short-term investments 38.9 53.5
Cash and cash equivalents 79.9 73.0
Short-term borrowings 27.6 41.5
Long-term borrowings 315.0 25.1
Capital securities of subsidiary Trust I 105.0 109.0
Capital securities of subsidiary Trust II - 300.0
Shareholders' equity 363.5 376.5
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 and long-term borrowings. 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 borrowings and
capital securities. HSB also maintains a highly liquid short-term portfolio to
provide for immediate cash needs and to offset a portion of interest rate risk
relating to the Capital Securities of subsidiary Trust I.
Cash provided from operations was $64.8 million in the first nine months of 2000
compared to $35.8 million for the same period in 1999. The decreases in
reinsurance assets, insurance premiums receivable, prepaid acquisition costs,
unearned insurance premiums, claims and adjustments expenses and other
liabilities on the Consolidated Statement of Position from December 31, 1999 to
September 30, 2000 largely relate to changes in the IRI arrangement, which
became effective January 1, 2000. This trend is expected to continue through the
remainder of 2000. Cash provided by investment activities was $58.3 million in
the first nine months of 2000 compared to $30.8 for the same period in 1999.
This reflects investment portfolio repositioning to asset allocation targets.
Cash used in financing activities was $116.2 million in the first nine months of
2000 compared to $38.5 million for the same period in 1999. This increase is
largely
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due to the decrease in short-term borrowings and the settlement of $25.1 million
of senior notes that matured during the second quarter of 2000. In the third
quarter of 2000, the proceeds of a $315.0 million loan from AIG were used to
retire the Company obligated mandatorily redeemable capital securities of
subsidiary Trust II. The Cash used in financing activities for the first nine
months of 2000 also includes the repurchase of $4.0 million in face amount of
capital securities of subsidiary Trust I at a discount. Since September 30, 2000
the Company has repurchased an additional $11.0 million in face amount of
capital securities at a discount.
Capital resources consist of debt outstanding, shareholders' equity and capital
securities, and represent those funds deployed or available to be deployed to
support business operations. Common shareholders' equity decreased by
approximately $13.0 million since December 31, 1999. The decrease primarily
reflects comprehensive income of $26.9 million less dividends of $38.2 million,
stock repurchases of $9.6 million and the exercise of stock options of $4.6
million. Shareholders' equity as a percent of assets was 18.1 percent, up from
16.6 percent at December 31, 1999, as changes in the balance sheet reflect the
Company's decision to reduce its risk bearing position in IRI effective January
1, 2000. During the first nine months of 2000, the Company repurchased
approximately 365,000 shares of its outstanding shares.
On September 14, 2000, AIG lent $315.0 million in principal to HSB to fund the
redemption of the Convertible Capital Securities. The loan is a five-year term
loan that matures on September 30, 2005. The loan bears interest at an annual
rate of 7.47 percent and is payable quarterly and on the date of any repayment
of principal. After the principal amount of the loan becomes due and payable,
the loan bears interest at an annual rate of 9.47 percent. The loan contains an
optional prepayment provision, whereby HSB has the option to prepay the loan, in
whole or in part, subject to certain notification and minimum payment
requirements.
At September 30, 2000, HSBIIC had significant short-term and long-term borrowing
capacity. HSBIIC is currently authorized to issue up to $100 million of
commercial paper, an increase of $25 million since December 31, 1999. Commercial
paper outstanding at September 30, 2000 was approximately $27 million. The
weighted-average interest rate was 6.6 percent at September 30, 2000. Standard &
Poor's and Fitch (formerly Duff & Phelps) credit rating services have assigned
their highest ratings for the commercial paper.
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: consummation of the
proposed merger with AIG; 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 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 3 - Quantitative and Qualitative Disclosures About Market Risk
See Item 2, "Management's Discussion and Analysis of Consolidated Financial
Condition and Results of Operations", "Market Risk".
PART II - OTHER INFORMATION
Item 1 - Legal Proceedings
See Note 7 to Consolidated Financial Statements, Part I, Item 1.
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Item 6 - Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit 2 - Agreement and Plan of Merger among Registrant, American
International Group, Inc. (AIG) and Engine Acquisition Corporation dated
August 17, 2000, incorporated by reference to Exhibit 2 to Registrant's
Current Report on Form 8-K dated August 18, 2000.
Exhibit 10(ii)(a) - Redemption Agreement dated August 23, 2000 between
Employers Reinsurance Corporation and Registrant, incorporated by reference
to Exhibit 10(ii)(a) to Registrant's Current Report on Form 8-K dated
September 6, 2000.
Exhibit 10(ii)(b) - Term Loan Agreement dated as of September 6, 2000
between AIG and Registrant, incorporated by reference to Exhibit 10(ii)(b)
to Registrant's Current Report on Form 8-K dated September 6, 2000.
Exhibit 10(iii)(a) - Form of Employment Agreement among Registrant, Engine
Acquisition Corporation and various executive officers.*
Exhibit 10(iii)(b) - Employment Agreement among Registrant, Engine
Acqusition Corporation and Richard H. Booth dated September 1, 2000.*
Exhibit 27 - Financial Data Schedule
Exhibit 99 - Stock Option Agreement dated August 17, 2000 between
Registrant and AIG, incorporated by reference to Exhibut 99.2 to
Registrant's Current Report on Form 8-K dated August 18, 2000.
* Management contract, compensatory plan or arrangement required to be filed
as an exhibit pursuant to Item 6(a).
(b) Reports on Form 8-K
Form 8-K dated July 24, 2000 reporting on Registrant's second quarter
earnings and the declaration of a dividend.
Form 8-K dated August 18, 2000 reporting on the signing of a merger
agreement among Registrant, American International Group, Inc. (AIG) and
Engine Acquisition Corporation.
Form 8-K dated September 6, 2000 reporting on the agreement between
Registrant and Employers Reinsurance Corporation under which Registrant has
agreed to redeem the convertible capital securities issued by HSB Capital
II. This Form 8-K also reported that Registrant and AIG entered into a Term
Loan Agreement under which AIG will loan Registrant $315 million in
connection with the redemption of the securities.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HSB GROUP, INC.
Date: November 14, 2000 By: /s/ Saul L. Basch
Saul L. Basch
Senior Vice President,
Treasurer and Chief
Financial Officer
Date: November 14, 2000 By: /s/ Robert C. Walker
Robert C. Walker
Senior Vice President
and General Counsel
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