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 March 31, 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 April 30, 2000: 29,026,521.
<PAGE>
HSB GROUP, INC.
INDEX
PART I FINANCIAL STATEMENTS PAGE
Item 1 - Financial Statements
Consolidated Statements of Operations for the
Quarters ended March 31, 2000 and 1999 (unaudited).............. 3
Consolidated Statements of Comprehensive Income
for the Quarters ended March 31, 2000 and 1999 (unaudited)...... 4
Consolidated Statements of Financial Position
as of March 31, 2000 (unaudited) and December 31, 1999 ......... 5
Consolidated Statements of Cash Flows for the
Quarters ended March 31, 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...10
PART II OTHER INFORMATION
Item 1 - Legal Proceedings.......................................18
Item 6 - Exhibits and Reports on Form 8-K........................18
SIGNATURES.............................................................19
2
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HSB GROUP, INC.
Consolidated Statements of Operations
Unaudited
(in millions, except per share data)
Quarter
Ended March 31
2000 1999
------------------------
Revenues:
Gross earned premium $ 182.1 $ 208.9
Ceded premiums 90.8 112.4
------------------------
Insurance premiums 91.3 96.5
Engineering services 37.0 27.6
Net investment income 14.9 15.7
Realized investment gains 13.3 7.1
------------------------
Total revenues 156.5 146.9
------------------------
Expenses:
Claims and adjustment 38.8 38.3
Policy acquisition 19.8 22.6
Underwriting and inspection 26.6 24.0
Engineering services 34.0 25.2
Interest 0.6 0.4
------------------------
Total expenses 119.8 110.5
------------------------
Income before income taxes and distributions
on capital securities $ 36.7 $ 36.4
Income taxes (benefit):
Current 16.1 8.2
Deferred (3.9) 2.7
------------------------
Total income taxes $ 12.2 $ 10.9
Distribution on capital securities
of subsidiary trust, net of income tax
benefits of $2.5 and $2.4 4.7 4.5
-------------------------
Net income $ 19.8 $ 21.0
========================
Per share data:
Net income per common share-basic $ 0.68 $ 0.72
========================
Basic weighted-average common shares outstanding 29.1 28.9
Net income per common share-assuming dilution $ 0.68 $ 0.71
========================
Diluted weighted-average common shares outstanding 34.4 34.5
Dividends declared per share $ 0.44 $ 0.42
See Notes to Consolidated Financial Statements.
3
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HSB GROUP, INC.
Consolidated Statements of Comprehensive Income
Unaudited
(in millions)
Quarter
Ended March 31,
2000 1999
----------------------------
Net income $ 19.8 $ 21.0
Other comprehensive income, net of tax:
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising
during the period, net of taxes
(benefits) of $2.3 and ($4.2) 3.9 (8.0)
Add: reclassification adjustments for
gains included in net income (8.6) (4.6)
----------------------------
Total unrealized losses on securities (4.7) (12.6)
Foreign currency translation adjustments,
net of income taxes (0.3) 0.3
----------------------------
Other comprehensive income (5.0) (12.3)
----------------------------
Comprehensive income $ 14.8 $ 8.7
============================
See Notes to Consolidated Financial Statements.
4
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HSB GROUP, INC.
Consolidated Statements of Financial Position
(In millions, except per share data)
March 31,
2000 December 31,
(Unaudited) 1999
------------------------------------
Assets:
Cash and cash equivalents $ 77.0 $ 73.0
Short-term investments, at cost 41.1 53.5
Fixed maturities, at fair value
(cost - $540.1; $545.7) 488.6 489.8
Equity securities, at fair value
(cost - $310.6; $316.6) 364.5 381.8
--------------------------------
Total cash and invested assets 971.2 998.1
Reinsurance assets 713.8 850.3
Insurance premiums receivable 58.2 104.4
Engineering services receivable 39.5 39.1
Fixed assets 55.6 58.2
Prepaid acquisition costs 43.5 52.9
Capital lease 14.9 13.8
Deferred income taxes 3.5 -
Other assets 150.3 146.4
--------------------------------
Total assets $ 2,050.5 $ 2,263.2
================================
Liabilities:
Unearned insurance premiums $ 324.5 $ 420.1
Claims and adjustment expenses 735.5 782.3
Short-term borrowings 24.5 41.5
Long-term borrowings 25.1 25.1
Capital lease 29.0 27.8
Deferred income taxes - 2.8
Dividends and distributions on
capital securities 18.6 24.0
Ceded reinsurance payable 17.9 66.3
Other liabilities 93.2 87.8
--------------------------------
Total liabilities 1,268.3 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 109.0 109.0
Company obligated mandatorily
redeemable convertible capital
securities of subsidiary Trust
II holding solely junior subordinated
deferrable interest debentures of
the Company 300.0 300.0
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 35.0 36.2
Accumulated other comprehensive income (6.9) (1.9)
Retained earnings 342.7 339.1
Benefit plans (7.6) (6.9)
--------------------------------
Total shareholders' equity 373.2 376.5
--------------------------------
Total $ 2,050.5 $ 2,263.2
================================
Shareholders' equity per common share $ 12.92 $ 12.95
See Notes to Consolidated Financial Statements.
5
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HSB GROUP, INC.
Consolidated Statements of Cash Flows
Unaudited
(in millions)
Quarter
Ended March 31,
2000 1999
--------------------
Operating Activities:
Net income $ 19.8 $ 21.0
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization 6.0 5.1
Deferred income taxes (benefit) (3.9) 2.7
Realized investment gains, net (13.3) (7.1)
Distributions on capital securities 7.2 6.9
Change in balances:
Insurance premiums receivable 46.2 37.0
Engineering services receivable (0.4) (6.3)
Prepaid acquisition costs 9.4 (3.9)
Reinsurance assets 136.5 (6.9)
Unearned insurance premiums (95.6) (23.3)
Claims and adjustment expenses (46.8) 7.7
Ceded reinsurance payable (48.4) (7.2)
Other 1.2 (3.3)
-------------------
Cash provided by operating activities 17.9 22.4
-------------------
Investing Activities:
Fixed asset additions, net (1.5) (3.3)
Investments:
Sale (purchase) of short-term investments, net 12.3 (28.3)
Purchase of fixed maturities (22.3) (13.6)
Proceeds from sale of fixed maturities 27.0 16.0
Redemption of fixed maturities - 2.7
Purchase of equity securities (34.9) (56.6)
Proceeds from sale of equity securities 55.0 68.1
-------------------
Cash provided by (used in) investment activities 35.6 (15.0)
-------------------
Financing Activities:
(Decrease) increase in short-term borrowings (17.1) 4.4
Dividends and distributions on capital securities (25.3) (24.4)
Reacquisition of stock (7.1) (2.2)
Exercise of stock options - 0.2
-------------------
Cash used in financing activities (49.5) (22.0)
-------------------
Net increase (decrease) in cash and cash equivalents 4.0 (14.6)
Cash and cash equivalents at beginning of period 73.0 18.3
-------------------
Cash and cash equivalents at end of period $ 77.0 $ 3.7
===================
Interest paid $ 0.9 $ 1.3
-------------------
Federal income tax paid $ 3.0 $ 1.8
------------------
See notes to Consolidated Financial Statements.
6
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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. 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. 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.
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, calls 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 establish an arrangement
for HSB to perform equipment breakdown engineering and inspection
services for clients of IRI.
3. Recent Accounting Developments
In June 1998, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting
for Derivative Instruments and Hedging Activities" subsequently amended
by SFAS No. 137. This statement establishes accounting and reporting
standards for derivative instruments, including certain derivative
instruments embedded in other contracts and for hedging activities. It
requires that all derivatives be recognized as either assets or
liabilities in the statement of financial position and that such
instruments be measured at fair value. In addition, all hedging
relationships must be designated, reassessed and documented pursuant to
the provisions of SFAS No. 133. This statement is effective for the
Company for the first quarter of 2001. Based on the Company's current
investment policies and practices, the Company anticipates that the
adoption of the provisions of SFAS No. 133 will not have a significant
effect on results of operations, financial condition or cash flows.
In October 1998, AcSEC issued SOP 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
7
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comply with the risk transfer provisions of SFAS No. 113, "Accounting
and Reporting for Reinsurance of Short-Duration and Long-Duration
Contracts."
4. 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.
5. Earnings per Share
Computation of Earnings per Share for the quarter ended March 31:
<TABLE>
<CAPTION>
2000 1999
--------------------------------- --------------------------------
Income Shares Per Share Income Shares Per Share
<S> <C> <C> <C> <C> <C> <C>
Net Income $ 19.8 $ 21.0
Basic Earnings per Share:
Income available to common
shareholders $ 19.8 $ 21.0
Weighted average common
shares outstanding 29.1 28.9
Earnings per Share - basic $ 0.68 * $ 0.72 *
Effect of dilutive securities:
After-tax distributions on
convertible capital securities $ 3.4 $ 3.4
Convertible capital securities 5.3 5.3
Stock options - 0.3
Diluted Earnings per Share:
Net Income available to
common shareholders and
assumed conversions $ 23.2 34.4 $ 24.4 34.5
Earnings per Share - assuming
dilution $ 0.68 * $ 0.71 *
</TABLE>
* Computation excludes rounding.
6. 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
offers 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
8
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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:
For the quarters ended March 31, 2000 1999
---------------------------------------------------------------------
Revenues from continuing operations
Insurance premiums:
Commercial $ 88.0 $ 80.3
Global Special Risks 4.4 15.7
Engineering services 37.0 27.6
Net investment income and
realized investment gains 28.2 22.8
------------- -----------
Total revenues from reportable segments 157.6 146.4
Other segments (1.1) 0.5
------------- -----------
Total revenues $ 156.5 $ 146.9
============= ===========
Net income (loss):
Commercial $ 4.4 $ 1.4
Global Special Risks (1.9) 5.2
Engineering services 1.3 1.3
Investments 19.1 16.0
------------- -----------
Total net income from reportable segments 22.9 23.9
Other segments (0.3) -
Corporate account 1.9 1.6
Distributions on capital securities (4.7) (4.5)
------------- -----------
Net income $ 19.8 $ 21.0
============= ===========
9
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MANAGEMENT'S DISCUSSION AND ANALYSIS
OF CONSOLIDATED FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
MARCH 31, 2000
RESULTS OF OPERATIONS
(dollar amounts in millions)
Consolidated Overview
Quarter Ended
March 31,
2000 1999
---- ----
Revenues:
Gross earned premiums $ 182.1 $ 208.9
Ceded premiums 90.8 112.4
----------- --------
Insurance premiums 91.3 96.5
Engineering services 37.0 27.6
Net investment income 14.9 15.7
Realized investment gains 13.3 7.1
----------- --------
Total revenues $ 156.5 $ 146.9
----------- --------
Pre-tax income $ 36.7 $ 36.4
Income taxes 12.2 10.9
Distributions on capital securities, net of tax 4.7 4.5
----------- --------
Net income $ 19.8 $ 21.0
----------- --------
Net income per common share:
Basic $ 0.68 $ 0.72
Assuming dilution $ 0.68 $ 0.71
Overview of Results of Operations
The Company's first quarter 2000 after-tax earnings decreased 6 percent from the
first quarter of 1999 due primarily to reduced underwriting profits, offset in
part by higher income from engineering services and income from investment
operations. The change in underwriting results reflects higher claim severity in
our Global Special Risk business, partially offset by solid growth in our
domestic commercial equipment breakdown business. In addition, insurance
premiums and net income were negatively impacted by the change in the
reinsurance agreements with IRI effective January 1, 2000. The gains in
engineering services reflect a 34 percent increase in engineering service
revenues over the first quarter of 1999. Realized gains increased to $13.3
million for the quarter as the Company shifted some investments out of common
stocks and utilized a portion of the proceeds to fund share repurchases.
10
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The effective tax rate for the first quarter was 33 percent compared to 30
percent for the comparable prior period. The change in the effective tax rate
for the first quarter of 2000 relates to increases in non-deductible goodwill
and less dividends received deductions. 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.
Recent Accounting Developments
In June 1998, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative
Instruments and Hedging Activities" subsequently amended by SFAS No. 137. This
statement establishes accounting and reporting standards for derivative
instruments, including certain derivative instruments embedded in other
contracts and for hedging activities. It requires that all derivatives be
recognized as either assets or liabilities in the statement of financial
position and that such instruments be measured at fair value. In addition, all
hedging relationships must be designated, reassessed and documented pursuant to
the provisions of SFAS No. 133. This statement is effective for the Company for
the first quarter of 2001. Based on the Company's current investment policies
and practices, the Company anticipates that the adoption of the provisions of
SFAS No. 133 will not have a significant effect on results of operations,
financial condition or cash flows.
In October 1998, AcSEC issued SOP 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
SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and
Long-Duration Contracts."
Insurance Operations
Quarter Ended
March 31,
2000 1999
---- ----
Gross earned premiums $ 182.1 $ 208.9
Ceded premiums 90.8 112.4
----------- --------
Insurance premiums 91.3 96.5
Claims and adjustment expenses 38.8 38.3
Underwriting, acquisition and other expenses 46.4 46.6
----------- -------
Underwriting gain $ 6.1 $ 11.6
============ =======
Loss ratio 42.4% 39.7%
Expense ratio 50.9% 48.0%
----------- -------
Combined ratio 93.3% 87.7%
=========== =======
Insurance operations include the underwriting results of The Hartford Steam
Boiler Inspection and
11
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Insurance Company (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 Industrial Risk Insurers and various other pools.
Gross earned premiums in the first quarter of 2000 decreased 12.8 percent in
comparison to the first quarter of 1999. This was primarily attributed to a 31
percent decline in Global Special Risks gross earned premiums, offset, in part,
by an 11% increase in Commercial premiums. The decline in Global Special Risks
gross earned premiums primarily resulted from the Company's decision to reduce
its risk bearing position in Industrial Risk Insurers, effective January 1,
2000. The increase in Commercial gross earned premiums related primarily to
increases in our domestic commercial assumed equipment breakdown business
through our HSB ReSource product.
Ceded premiums decreased 19.2 percent for the first quarter of 2000 compared to
the first quarter of 1999. This is consistent with the decline in gross earned
premiums for the same period and also reflects changes in the structure of some
of the Company's reinsurance programs which now utilize significantly less quota
share reinsurance on certain of our books of business as well as changes in the
IRI agreements.
The loss ratio increased from 39.7 percent in the first quarter of 1999 to 42.4
percent in the current quarter. The increase primarily related to increased
severity in the first quarter of 2000 related to equipment breakdown failures in
our Global Special Risk large risk business. This increase in the loss ratio was
offset, in part, by improvement in the Commercial loss ratio.
The expense ratio increased from 48.0 percent in the first quarter of 1999 to
50.9 percent in first quarter of 2000. The increase in the expense ratio was
primarily attributed to increases in underwriting and inspection expenses. This
increase was largely due to the reduced management fees related to the Company's
decision to reduce its risk bearing position in IRI, which are reflected as a
reduction of expenses. The expense ratio increase was offset, in part, by the
domestic Commercial expense ratio which decreased as certain fixed costs were
absorbed on higher net earned premiums.
The following information summarizes net earned premiums and net income by
reportable insurance segment:
Quarter Ended
March 31,
2000 1999
---- ----
Commercial:
Net earned premiums $ 88.0 $ 80.3
Net income 4.4 1.4
Global Special Risks:
Net earned premiums $ 4.4 $ 15.7
Net income (1.9) 5.2
Net earned premiums in the Commercial segment increased $7.7 million in the
first quarter of 2000 compared with the first quarter of 1999 due primarily to
continued growth in our client company business. Net income for the quarter was
also favorably impacted by reduced claim frequency and the absorption of fixed
costs on higher retained gross earned premiums. This resulted in favorable
changes in the Commercial loss and expense ratios compared with the first
quarter of 1999.
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Global Special Risks' net earned premiums declined $11.3 million in the first
quarter of 2000 compared to the first quarter of 1999 due primarily to the
changes in the IRI agreements. In addition, these decreases related to price
erosion and are reflective of the Company's continued commitment to follow
strict pricing and underwriting guidelines. Global Special Risks' net income for
first quarter of 2000 compared to the first quarter of 1999 was negatively
impacted by increased loss severity and reduced underwriting income resulting
from changes in the IRI agreements.
Engineering Services Operations
Quarter Ended
March 31
2000 1999
---- ----
Engineering services revenues $ 37.0 $ 27.6
Engineering services expenses 34.0 25.2
------- ------
Operating gain $ 3.0 $ 2.4
======= ======
Net margin 8.0% 8.4%
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 interest in
Integrated Process Technologies, LLC (IPT).
Engineering services revenues increased $9.4 million or 34 percent in the first
quarter of 2000 compared to the same period in 1999. The growth in Engineering
services revenues for the quarter was due primarily to growth in license and
service fees which resulted from the Company's new agreement with Enron Energy
Services (Enron) to provide energy services, project management and other
technical assistance. Engineering revenue growth also reflected increased
revenue generated by Structural, acquired in July 1999, and IPT as well as
engineering revenue resulting from the new agreements with IRI, effective
January 1, 2000.
Engineering services operating margin was 8.0 percent for the first quarter of
2000 compared to 8.4 percent for the first quarter of 1999 on substantially
increased engineering services revenue. The engineering services operating
margin for the first quarter of 2000 reflected increased investment of operating
funds to develop new products and establish start up operations, including IPT
which had a negative impact on the operating margin for the first quarter of
2000. This negative impact was offset by margins earned on the Enron agreement.
IPT may continue to have an adverse impact on engineering services operating
margins during 2000 as the Company continues to develop this business.
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.
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Investment Operations
Quarter Ended
March 31
2000 1999
---- ----
Net investment income $ 14.9 $ 15.7
Realized investment gains 13.3 7.1
--------- ---------
Pretax income from
investment operations $ 28.2 $ 22.8
--------- ---------
Income from investment operations for the first quarter increased $5.4 million
compared to the first quarter of 1999, primarily due to increased realized
investment gains. The increase in realized investment gains in the first quarter
of 2000 as compared to the first quarter of 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 first quarter of
2000 include $2.8 million of losses arising from declines in the realizable
value of investments 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.
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, 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 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.
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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
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 March 31, 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 $47.4 million and $67.8,
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 $47.4 and $67.8 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 8.11 at
March 31, 2000, essentially the same as at December 31, 1999.
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 less than $0.1 million each. The effect of 100 and 150 basis point
increases in interest rates on the $300 million convertible capital securities
would result in an estimated market value of $250.8 million and $ 240.0 million,
respectively. This 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 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 March 31, 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 $19.5 and $48.7 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 slightly from 0.98 at December 31, 1999 to .97 at March 31,
2000. This change is generally attributed to portfolio repositioning during the
period.
15
<PAGE>
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 March 31, 2000, with all other variables held constant. A 10 percent
and 20 percent strengthening of the U.S. dollar would result in decreases of
$6.1 and $11.9 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 March 31, 2000 Value Rate Risk Risk Risk
- --------------------------------------------------------------------------------
Fixed maturity securities $488.6 $ (33.9) $ (2.6) $ -
Equity securities 364.5 (12.8) (2.0) (19.5)
Short term investments 41.1 (0.7) (1.5) -
-----------------------------------------------------
Total all securities $894.2 $ (47.4) $ (6.1) $ (19.5)
-----------------------------------------------------
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 March 31, 2000 Value Rate Risk Risk Risk
- --------------------------------------------------------------------------------
Fixed maturity securities $488.6 $ (48.7) $ (5.1) $ -
Equity securities 364.5 (18.1) (4.0) (48.7)
Short term investments 41.5 (1.0) (2.8) -
-----------------------------------------------------
Total all securities $894.2 $ (67.8) $ (11.9) $ (48.7)
-----------------------------------------------------
Statement 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 quarter of 2000 decreased $5.0 million as
compared to the decrease of $12.3 million in the same period in 1999. Exclusive
of realized gains, the decrease in 2000 when compared to the first quarter of
1999 is mainly due to rising interest rates.
16
<PAGE>
Liquidity and Capital Resources
Balances at
March 31, December 31,
2000 1999
--------- ------------
Total assets $ 2,050.5 $ 2,263.2
Short-term investments 41.1 53.5
Cash and cash equivalents 77.0 73.0
Short-term borrowings 24.5 41.5
Long-term borrowings 25.1 25.1
Capital securities of subsidiary Trust I 109.0 109.0
Capital securities of subsidiary Trust II 300.0 300.0
Common shareholder's equity 373.2 376.5
Liquidity refers to the Company's ability to generate sufficient funds to meet
the cash requirements of its business operations. HSB Group, Inc. (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 to offset a portion of interest rate risk relating to the Capital
Securities of subsidiary Trust I.
Cash provided from operations was $17.9 million in the first three months of
2000 compared to $22.4 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, ceded reinsurance
payable and other liabilities on the Consolidated Statement of Position from
December 31, 1999 to March 31, 2000 largely relate to changes in the IRI
arrangement, which became effective January 1, 2000. This trend is expected to
continue during 2000. As a result of the changes in the IRI arrangement,
effective for risks arising on or after January 1, 2000, HSBIIC no longer
retains 85 percent of the equipment breakdown insurance and 15 percent of the
property insurance of the combined insurance portfolio. In addition, the new
agreements with IRI, call 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.
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 $373.2 million at
March 31, 2000, decreased by $3.3 million since December 31, 1999. The reduction
in shareholders' equity was caused by the impact of rising interest rate levels
on our fixed income investments. The decrease primarily reflects comprehensive
income of $14.8 million less dividends of $12.5 million and stock repurchases of
$7.0 million. During the first quarter of 2000, the Company repurchased
approximately 280,000 shares or about 1 percent of its outstanding shares.
At March 31, 2000, HSBIIC had significant short-term and long-term borrowing
capacity. HSBIIC is currently authorized to issue up to $75 million of
commercial paper. Commercial paper outstanding at March 31, 2000 was
approximately $20 million. The weighted-average interest rate was 6.0 percent at
March 31, 2000. In 1999, Standard & Poor's and Duff & Phelps credit rating
services reaffirmed their highest ratings for the commercial paper.
17
<PAGE>
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.
PART II - OTHER INFORMATION
Item 1 - Legal Proceedings
See Note 4 to Consolidated Financial Statements, Part I, Item 1.
Item 6 - Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit 27 - Financial Data Schedule
(b) Reports on Form 8-K
Form 8-K dated January 18, 2000 reporting on the anticipated 1999 net
income.
Form 8-K dated January 24, 2000 reporting on the fourth quarter and 1999
year-end results and announcing the declaration of a dividend.
Form 8-K dated March 6, 2000 announcing that Richard H. Booth has been
elected chairman of the board.
18
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HSB GROUP, INC.
Date: May 15, 2000 By: /s/ Saul L. Basch
Saul L. Basch
Senior Vice President,
Treasurer and
Chief Financial Officer
Date: May 15, 2000 By: /s/ Robert C. Walker
Robert C. Walker
Senior Vice President
and General Counsel
19
<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> 3-mos
<FISCAL-YEAR-END> DEC-31-2000
<PERIOD-END> MAR-31-2000
<DEBT-HELD-FOR-SALE> 478
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 365
<MORTGAGE> 11
<REAL-ESTATE> 0
<TOTAL-INVEST> 853
<CASH> 118 <F1>
<RECOVER-REINSURE> 714
<DEFERRED-ACQUISITION> 44
<TOTAL-ASSETS> 2051
<POLICY-LOSSES> 736
<UNEARNED-PREMIUMS> 325
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 50
409 <F2>
0
<COMMON> 10
<OTHER-SE> 363
<TOTAL-LIABILITY-AND-EQUITY> 2051
91
<INVESTMENT-INCOME> 15
<INVESTMENT-GAINS> 13
<OTHER-INCOME> 37
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<UNDERWRITING-AMORTIZATION> 20
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<INCOME-PRETAX> 32
<INCOME-TAX> 12
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<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 20
<EPS-BASIC> 0.68<F4>
<EPS-DILUTED> 0.68<F5>
<RESERVE-OPEN> 782
<PROVISION-CURRENT> 0 <F6>
<PROVISION-PRIOR> 0 <F6>
<PAYMENTS-CURRENT> 0 <F6>
<PAYMENTS-PRIOR> 0 <F6>
<RESERVE-CLOSE> 736
<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 engineering services, underwriting and inspection and interest
expense.
<F4>Per SFAS No. 128 "Earnings per Share", this item represents EPS-Basic.
<F5>Per SFAS No. 128 "Earnings per Share", this item represents EPS-Assuming
Dilution.
<F6>Not calculated at interim periods.
</FN>
</TABLE>
