SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 8-K
CURRENT REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Date of Report (Date of earliest event reported):
April 24, 1998
THE ST. PAUL COMPANIES, INC.
(Exact name of registrant as specified in its charter)
MINNESOTA 0-3021 41-0518860
(State or other jurisdiction (Commission (IRS Employer
of incorporation) File Number) Identification No.)
385 Washington Street
St. Paul, Minnesota 55102
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (612) 310-7911
N/A
(Former name or former address, if changed since last report)
<PAGE>
ITEM 1. NOT APPLICABLE.
ITEM 2. ACQUISITION OR DISPOSITION OF ASSETS.
On April 24, 1998, USF&G Corporation, a Maryland corporation ("USF&G")
became a wholly owned subsidiary of The St. Paul Companies, Inc., a Minnesota
corporation ("St. Paul"), upon the consummation of the merger (the "Merger") of
SP Merger Corporation, a Maryland corporation and a wholly owned subsidiary of
St. Paul ("Merger Sub"), with and into USF&G in accordance with the terms of the
Agreement and Plan of Merger, dated as of January 19, 1998, as amended (the
"Merger Agreement"), among USF&G, St. Paul and Merger Sub. At the effective time
of the Merger, each share of common stock, par value $2.50 per share ("Shares"),
of USF&G issued and outstanding immediately prior to the effective time of the
Merger (other than Shares owned by St. Paul, USF&G or any of their respective
direct or indirect subsidiaries (and in each case not held on behalf of third
parties)) was converted into the right to receive 0.2821 shares of common stock,
no par value ("St. Paul Common Stock"), of St. Paul (the "Exchange Ratio"). The
Exchange Ratio was determined pursuant to a formula set forth in the Merger
Agreement and was a result of arms' length negotiations between the parties. No
fractional shares of St. Paul Common Stock are being issued as a result of the
Merger. Instead, each holder of Shares who would otherwise be entitled to
receive a fractional share of St. Paul Common Stock will receive such holder's
proportionate interest in the net proceeds from the sale by First Chicago Trust
Company, as Exchange Agent, on behalf of such holders of the fractional shares
of St. Paul Common Stock that such holders would otherwise be entitled to
receive. Based on 117,846,687, the number of outstanding Shares as of April 22,
1998 as reflected on the stock transfer books of USF&G, St. Paul estimates that
it will issue approximately 33,244,550 shares of St. Paul Common Stock pursuant
to the Merger. St. Paul currently intends to continue to use USF&G's plant,
equipment and other physical property to conduct insurance operations as it
further develops and implements its integration strategy.
Pursuant to the Merger Agreement, the Company intends to expand its
board of directors to 16, and to elect Norman P. Blake, Jr. and two other
members of the pre-merger board of directors of USF&G, to the board of directors
of the Company. Such expansion of the board and election of directors is
expected to take place shortly after the Company's Annual Meeting of
Shareholders, which is scheduled to be held on May 5, 1998.
ITEMS 3-6. NOT APPLICABLE.
-2-
<PAGE>
ITEM 7. FINANCIAL STATEMENTS, PRO FORMA FINANCIAL INFORMATION AND EXHIBITS.
(a) Financial Statements of Businesses Acquired.
Copies of the USF&G Corporation historical financial statements as of
December 31, 1997 and 1996 and for the years ended December 31, 1997, 1996 and
1995 are attached hereto as Exhibit 99.2 and incorporated herein by reference.
(b) Pro Forma Financial Information.
Copies of The St. Paul Companies, Inc. and USF&G Corporation unaudited
pro forma condensed combined balance sheet as of December 31, 1997, and
unaudited pro forma condensed combined statements of income for the years ended
December 31, 1997, 1996 and 1995 are attached hereto as Exhibit 99.3 and
incorporated herein by reference.
(c) Exhibits.
23. Consent of Ernst & Young LLP
99.1 Press Release of The St. Paul Companies, Inc., dated April 24,
1998.
99.2 USF&G Corporation historical financial statements as
of December 31, 1997 and 1996 and for the years ended
December 31, 1997, 1996 and 1995.
99.3 The St. Paul Companies, Inc. and USF&G Corporation unaudited
pro forma condensed combined balance sheet as of December 31,
1997, and unaudited pro forma condensed combined statements of
income for the years ended December 31, 1997, 1996 and 1995.
ITEM 8. NOT APPLICABLE.
-3-
<PAGE>
SIGNATURE
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 hereunto duly authorized.
THE ST. PAUL COMPANIES, INC.
Date: April 24, 1998 By: /s/ Bruce A. Backberg
-------------------------------------
Name: Bruce A. Backberg
Title: Senior Vice President and
Chief Legal Counsel
-4-
<PAGE>
EXHIBIT INDEX
EXHIBIT NO. DESCRIPTION
- ----------- -----------
23. Consent of Ernst & Young LLP
99.1 Press Release of The St. Paul Companies, Inc.,
dated April 24, 1998.
99.2 USF&G Corporation historical financial statements
as of December 31, 1997 and 1996 and for the
years ended December 31, 1997, 1996 and 1995.
99.3 The St. Paul Companies, Inc. and USF&G Corporation
unaudited pro forma condensed combined balance sheet
as of December 31, 1997, and unaudited pro forma
condensed combined statements of income for the
years ended December 31, 1997, 1996 and 1995.
Exhibit 23 - Consent of Independent Auditors
We consent to the incorporation by reference in this Current Report on
Form 8-K of The St. Paul Companies, Inc. of our report dated February 20, 1998,
included in USF&G Corporation's Current Report on Form 8-K dated February 26,
1998.
We consent to the incorporation by reference in the Registration
Statements on Form S-8 (SEC File No. 2-69894, No. 33-15392, No. 33- 20516, No.
33- 23446, No. 33-23948, No. 33-24220, No. 33-24575, No. 33-26923, No. 33-49273,
No. 33-56987, No. 333-01065, No. 333-22329, No. 333-25203, No. 333-28915 and No.
333- 48121), Form S-3 (SEC File No. 33-33931, No. 33-50115, No. 33-58491 and No.
333- 06465) and Form S-4 (SEC File No. 333-47007) of The St. Paul Companies,
Inc., of our report dated February 20, 1998 with respect to the consolidated
financial statements of USF&G Corporation included or incorporated
by reference in this Current Report on Form 8-K.
/s/ ERNST & YOUNG LLP
Baltimore, Maryland
April 24, 1998
NEWS RELEASE
From:
Corporate Communications Department
The St. Paul Companies, Inc.
385 Washington Street
St. Paul, MN 55102
Contact: Mark Hamel
Telephone: (612) 310-3588
April 24, 1998 -- THE ST. PAUL COMPANIES COMPLETES
MERGER WITH USF&G CORPORATION
SAINT PAUL, Minn -- The St. Paul Companies (NYSE:SPC) today announced the
completion of its merger with USF&G Corporation. The merger, which creates the
United States' eighth-largest property-liability insurance company, was
announced January 19, 1998 pending shareholder and regulatory approvals. The
approval process was completed Thursday.
"I am extremely pleased with the rapid approval this transaction has
received from all constituencies," said Douglas W. Leatherdale, chairman and
chief executive officer of The St. Paul. "The overwhelming approval by
shareholders earlier this month, and the rapid review by regulators demonstrates
that this is a positive development for all of our stakeholders. The St. Paul
will now be even better-positioned to succeed in a highly competitive industry."
On a combined basis, The St. Paul and USF&G had 1997 revenues of $9.6
billion, total assets of more than $37 billion, and written premiums of more
than $7 billion.
<PAGE>
The record date for USF&G's first-quarter dividend preceded today's
closing. Accordingly, the USF&G dividend of $.07 per share payable to USF&G
shareholders of record on April 6, 1998, will be paid as scheduled on April 30,
1998. The St. Paul Companies, headquartered in Saint Paul, Minn., provides
property-liability insurance underwriting and reinsurance products and services
worldwide.
-2-
I. FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
USF&G CORPORATION Consolidated Statement of Operations
<S> <C> <C> <C>
Years Ended December 31
(dollars in millions except per share data) 1997 1996 1995
--------------------------------------------
Revenues
Premiums earned $2,682 $2,731 $2,666
Net investment income 691 705 733
Other 16 18 53
--------------------------------------------
Revenues before net realized gains 3,389 3,454 3,452
Net realized gains on investments 15 44 7
--------------------------------------------
Total revenues 3,404 3,498 3,459
--------------------------------------------
Expenses
Losses, loss expenses and policy benefits 2,071 2,181 2,178
Underwriting, acquisition and operating expenses 1,002 1,044 1,048
Interest expense 34 39 44
Reorganization severance 5 17 --
Facilities exit costs/(sublease income) -- (42) (6)
--------------------------------------------
Total expenses 3,112 3,239 3,264
--------------------------------------------
Income from operations before income taxes 292 259 195
Provision for income taxes 84 (2) (14)
Distributions on USF&G-obligated mandatorily redeemable preferred capital
securities of subsidiary trusts holding solely junior subordinated
deferrable interest debentures of USF&G, net of tax 14 -- --
--------------------------------------------
Net income $ 194 $ 261 $ 209
--------------------------------------------
Preferred stock dividend requirements 2 20 28
--------------------------------------------
Net income available to common stock $ 192 $ 241 $ 181
--------------------------------------------
Basic earnings per share $ 1.72 $ 2.05 $ 1.63
--------------------------------------------
Diluted earnings per share 1.63 1.95 1.53
--------------------------------------------
Weighted-average common shares outstanding (in 000s):
Basic 111,688 117,674 111,474
Diluted 120,109 127,734 130,064
--------------------------------------------
See Notes to Consolidated Financial Statements.
</TABLE>
-1-
<PAGE>
<TABLE>
<CAPTION>
USF&G CORPORATION Consolidated Statement of Financial Position
<S> <C> <C>
At December 31
(dollars in millions except per share data) 1997 1996
---------------------------
Assets
Investments:
Fixed maturities available for sale, at market (cost, 1997, $8,183; 1996, $8,066) $ 8,495 $ 8,164
Common and preferred stocks, at market (cost, 1997, $51; 1996, $16) 49 16
Short-term investments 571 535
Mortgage loans 641 406
Real estate 336 554
Other invested assets 852 401
---------------------------
Total investments 10,944 10,076
---------------------------
Cash 90 73
Accounts, notes and other receivables 878 763
Reinsurance receivables 1,646 1,576
Servicing carrier receivables 710 661
Deferred policy acquisition costs 468 456
Other assets 1,083 802
---------------------------
Total assets $15,819 $14,407
---------------------------
Liabilities
Unpaid losses, loss expenses and policy benefits $10,017 $ 9,584
Unearned premiums 1,148 1,113
Corporate debt 516 477
Real estate and other debt 5 5
Other liabilities 1,760 1,159
---------------------------
Total liabilities 13,446 12,338
---------------------------
USF&G-obligated mandatorily redeemable preferred capital securities of subsidiary
trusts holding solely junior subordinated deferrable interest debentures of USF&G 296 100
---------------------------
Shareholders' Equity
Preferred stock, par value $50.00 (12,000,000 shares authorized;
shares issued, 1996, 3,999,910) __ 200
Common stock, par value $2.50 (240,000,000 shares authorized; shares
issued, 1997, 116,402,199; 1996, 114,240,489) 291 286
Paid-in capital 1,126 1,091
Net unrealized gains on investments and foreign currency 167 62
Retained earnings 493 330
---------------------------
Total shareholders' equity 2,077 1,969
---------------------------
Total liabilities, capital securities and shareholders' equity $15,819 $14,407
---------------------------
See Notes to Consolidated Financial Statements.
</TABLE>
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<PAGE>
<TABLE>
<CAPTION>
USF&G CORPORATION Consolidated Statement of Cash Flows
<S> <C> <C> <C>
Years Ended December 31
(in millions) 1997 1996 1995
---------------------------------------------
Operating Activities
Direct premiums collected $ 2,166 $ 2,183 $ 2,078
Net investment income collected 699 707 743
Direct losses, loss expenses and policy benefits paid (1,681) (1,751) (1,725)
Net reinsurance activity (159) (13) 69
Underwriting and operating expenses paid (844) (769) (760)
Interest paid (30) (37) (37)
Income taxes paid (7) (5) (5)
Other items, net 1 15 36
---------------------------------------------
Net cash provided from operating activities 145 330 399
---------------------------------------------
Investing Activities
Net (purchases), sales and maturities of short-term investments (30) (249) 148
Sales of fixed maturities held to maturity -- -- 21
Maturities/repayments of fixed maturities held to maturity -- -- 110
Purchases of fixed maturities available for sale (2,022) (1,189) (1,123)
Sales of fixed maturities available for sale 1,293 588 489
Maturities/repayments of fixed maturities available for sale 743 702 443
Purchases of other investments (414) (228) (302)
Sales, maturities and repayments of other investments 430 412 332
Purchase of subsidiaries (67) (57) --
Purchases of property and equipment (86) (59) (32)
Sales of property and equipment 3 14 2
---------------------------------------------
Net cash (used in) provided from investing activities (150) (66) 88
---------------------------------------------
Financing Activities
Deposits for universal life and investment contracts 460 438 310
Withdrawals of universal life and investment contracts (209) (535) (659)
Purchase of structured settlement annuity coinsurance contract (104) -- --
Net repayments of short-term borrowings 2 -- (227)
Long-term borrowings -- -- 228
Repayments of long-term borrowings -- (125) (42)
Issuances of capital securities 198 98 --
Issuances of common stock 21 11 6
Repurchases of common stock (101) (150) --
Redemptions of preferred stock (200) (2) --
Cash dividends paid to shareholders (33) (45) (53)
Cash distributions paid to holders of capital securities (12) -- --
---------------------------------------------
Net cash provided from (used in) financing activities 22 (310) (437)
---------------------------------------------
Increase (decrease) in cash 17 (46) 50
Cash at beginning of year 73 119 69
---------------------------------------------
Cash at end of year $ 90 $ 73 $ 119
---------------------------------------------
Noncash Transactions
Coinsurance transactions:
Transfer of investments and other assets in
exchange for reinsurance receivables $ 40 $ 964 $ --
---------------------------------------------
See supplemental cash flow information at Note 1.15.
See Notes to Consolidated Financial Statements.
</TABLE>
-3-
<PAGE>
<TABLE>
<CAPTION>
USF&G CORPORATION Consolidated Statement of Shareholders' Equity
<S> <C> <C> <C>
Years Ended December 31
(in millions except per share data) 1997 1996 1995
--------------------------------------------
Preferred Stock
Balance at beginning of year $ 200 $ 213 $ 331
Par value of Series B shares converted to common shares -- (12) (51)
Par value of Series C shares converted to common shares -- -- (66)
Par value of shares redeemed (200) (1) (1)
--------------------------------------------
Balance at end of year -- 200 213
--------------------------------------------
Common Stock
Balance at beginning of year 286 299 262
Par value of shares issued for conversion of Series B shares -- 5 21
Par value of shares issued for conversion of Series C shares -- -- 14
Par value of shares issued in Titan acquisition 13 -- --
Par value of other shares issued 4 3 2
Par value of shares repurchased (12) (21) --
--------------------------------------------
Balance at end of year 291 286 299
--------------------------------------------
Paid-In Capital
Balance at beginning of year 1,091 1,188 1,104
Excess of proceeds over par value of Series B shares converted -- 7 29
Excess of proceeds over par value of Series C shares converted -- -- 50
Excess of proceeds over par value of shares issued in Titan acquisition 99 -- --
Excess of proceeds over par value of other shares issued 17 8 5
Excess of cost over par value of shares repurchased (90) (129) --
Accrued stock-based compensation 4 15 --
Tax benefit from exercise of stock options 5 2 --
--------------------------------------------
Balance at end of year 1,126 1,091 1,188
--------------------------------------------
Net Unrealized Gains (Losses) on Investments and Foreign Currency
Balance at beginning of year 62 271 (147)
Change in unrealized gains (losses) 105 (209) 418
--------------------------------------------
Balance at end of year 167 62 271
--------------------------------------------
Minimum Pension Liability
Balance at beginning of year -- (100) (63)
Change in unfunded accumulated benefits -- 100 (37)
--------------------------------------------
Balance at end of year -- -- (100)
--------------------------------------------
Retained Earnings (Deficit)
Balance at beginning of year 330 113 (46)
Net income 194 261 209
Common stock dividends declared (per share, 1997, $.26; 1996 and 1995, $.20) (29) (24) (22)
Preferred stock dividend declared (per share, 1997, Series A, $1.03;
1996, Series A, $4.10, Series B $7.69; 1995, Series A $4.10,
Series B, $10.25) (2) (20) (28)
--------------------------------------------
Balance at end of year 493 330 113
--------------------------------------------
Total shareholders' equity $2,077 $1,969 $1,984
--------------------------------------------
See Notes to Consolidated Financial Statements.
</TABLE>
-4-
<PAGE>
II. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
USF&G CORPORATION Notes to Consolidated Financial Statements
Note 1 Summary of Significant Accounting Policies
1.1. Basis of presentation
The consolidated financial statements are prepared in accordance with generally
accepted accounting principles ("GAAP"). These statements include the accounts
of USF&G Corporation and its subsidiaries (collectively, "USF&G" or "the
Corporation"). Certain of the subsidiaries are consolidated on a one-month lag,
the effect of which is not material. Certain prior year amounts have been
reclassified to conform to the 1997 presentation.
The preparation of the consolidated financial statements in conformity with GAAP
requires management to make estimates and assumptions that affect the amounts
reported in the consolidated financial statements and accompanying notes. Actual
results could differ from these estimates.
USF&G is primarily engaged in the business of insurance. Property/casualty
insurance, which accounted for 88 percent of revenues before net realized gains
in 1997, is written primarily by United States Fidelity and Guaranty Company
("USF&G Company") and is sold primarily through independent agents and brokers
supported by USF&G Company's underwriting, marketing, administrative and claim
services offices located throughout the United States. Life insurance and
annuities, which accounted for 12 percent of revenues before net realized gains
in 1997, are written by Fidelity and Guaranty Life Insurance Company and its
subsidiary (collectively, "F&G Life"), and are sold throughout the United States
through independent agents, managing general agents and specialty insurance
brokerage firms. Noninsurance operations are composed primarily of the parent
company and asset management services. Additional information on the
Corporation's business segments is included in Note 16, "Information on Business
Segments".
1.2. Subsequent event
On January 19, 1998, The St. Paul Companies, Inc. ("St. Paul"), a Minnesota
corporation, and USF&G announced the signing of a definitive merger agreement
pursuant to which a wholly-owned subsidiary of St. Paul will be merged into
USF&G. The combined company will operate under the St. Paul name and be based in
St. Paul, Minnesota. The transaction is expected to be accounted for as a
pooling of interests and is intended to qualify as a tax-free reorganization. If
the merger is completed, the combined company would become the eighth-largest
property/casualty company in the United States, based on 1996 net written
premiums. Completion of the transaction is subject to, among other things,
approvals by the shareholders of USF&G and St. Paul, in addition to certain
regulatory approvals, and is expected to occur in mid-1998.
Under the terms of the merger agreement, each issued and outstanding share of
USF&G common stock will be converted into a number of shares of St. Paul common
stock determined according to a specified exchange ratio. That exchange ratio
will be based on the average of the average of the high and low market prices of
St. Paul's common stock during a 20-day trading period ending on the third
trading day prior to the date USF&G's shareholders vote on the approval of the
merger (the "St. Paul Average Price"). If the St. Paul Average Price is greater
than $78, USF&G shareholders will receive 0.2821 of a share of St. Paul common
stock for each USF&G share; if the St. Paul Average Price is less than $74 per
share, USF&G shareholders will receive 0.2973 of a share of St. Paul common
stock for each USF&G share; and if the St. Paul Average Price is between $74 and
$78 per share, USF&G shareholders will receive a fraction of a St. Paul share
equal to $22 divided by the St. Paul Average Price.
In connection with the merger, St. Paul and USF&G entered into a Stock Option
Agreement dated as of January 19, 1998. Pursuant to this agreement, USF&G
granted St. Paul an option, exercisable only in certain circumstances, to
purchase shares of USF&G common stock in an amount equal to 19.9 percent of the
shares of USF&G common stock outstanding at the time of exercise.
1.3. New accounting pronouncements
In February 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings per
Share" ("EPS"), which simplifies the standards for computing EPS. SFAS No. 128
replaces primary EPS with basic EPS, which excludes common stock equivalents,
and requires disclosure of EPS on the face of the income statement for all
entities, such as USF&G, with complex capital structures. USF&G adopted SFAS No.
128 effective December 31, 1997. In accordance with SFAS No. 128, all prior
periods presented have been restated to conform to the 1997 presentation.
-5-
<PAGE>
In June 1996, the FASB issued SFAS No. 125, "Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities", which
provides new accounting and reporting standards for transfers and servicing of
receivables and other financial assets and extinguishments of liabilities. As
issued, the standard was effective for transactions occurring after December 31,
1996, and was to be applied prospectively. SFAS No. 127, "Deferral of the
Effective Date of Certain Provisions of FASB Statement No. 125", was issued in
December 1996, and deferred for one year both the criteria for determination of
a sale versus a secured borrowing for certain transactions, and new accounting
standards for assets transferred as collateral. Once adopted for transactions
occurring after December 31, 1997, SFAS No. 125 will impact USF&G's accounting
for participation in securities lending programs as well as for assets pledged
as collateral; however, this impact will primarily be limited to
reclassifications on the Consolidated Statement of Financial Position.
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income",
which establishes standards for the reporting and display of comprehensive
income and its components in a full set of general-purpose financial statements.
SFAS No. 130 is effective for fiscal years beginning after December 15, 1997 and
requires that an enterprise: (a) classify items of other comprehensive income by
their nature in a financial statement, and (b) display the accumulated balance
of other comprehensive income separately from retained earnings and additional
paid-in capital in the equity section of a statement of financial position. Once
adopted, USF&G anticipates that the major impact of SFAS No. 130 will be the
required reporting of unrealized gains or losses on available for sale
securities in comprehensive income.
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information". The Statement establishes standards for the
way that public business enterprises report information about operating segments
in annual financial statements and requires that selected information about
operating segments be included in interim financial reports issued to
shareholders. It also establishes standards for related disclosures about
products and services, geographic areas and major customers. The definition of
operating segments in this standard is based on the way that management
organizes and manages the segments within an enterprise. SFAS No. 131 is
effective for fiscal years beginning after December 15, 1997, and will require
USF&G to revise and expand its business segment disclosures.
In December 1997, the American Institute of Certified Public Accountants issued
Statement of Position ("SOP") No. 97-3, "Accounting by Insurance and Other
Enterprises for Insurance-Related Assessments". The SOP provides guidance for
determining when an entity should recognize a liability for guaranty fund and
other insurance-related assessments and on the measurement of the liability.
Additionally, it provides guidance on when an asset should be recognized for a
portion or all of the liability or paid assessment that can be recovered through
premium tax offsets of policy surcharges. The SOP is effective for fiscal years
beginning after December 15, 1998. The cumulative effect of adopting SOP No.
97-3 may be material; however, no reasonable estimation can be made at this
time.
1.4. Permitted statutory accounting practices
USF&G has both domestic and foreign subsidiaries. Reporting practices for
insurance subsidiaries prescribed or permitted by domestic or foreign regulatory
authorities (statutory accounting practices) differ from GAAP. Statutory amounts
for USF&G's insurance operations follow.
(in millions) 1997 1996 1995
------------------------
Statutory Net Income for the
Years Ended December 31:
Property/casualty insurance* $ 210 $ 167 $--
Subsidiaries and affiliates** 24 8 --
Life insurance 21 27 15
----------------------
Statutory Surplus at December 31:
Property/casualty insurance* $1,455 $1,374
Subsidiaries and affiliates** 236 243
Life insurance 195 213
----------------
- -------------------
* Includes USF&G Company and all subsidiaries required to be included in its
combined statutory statements.
** Includes those property/casualty subsidiaries and affiliates not included
in USF&G Company's combined statutory statements.
-6-
<PAGE>
USF&G's primary insurance subsidiaries, USF&G Company and F&G Life, are
domiciled in the State of Maryland and prepare their statutory financial
statements in accordance with statutory accounting practices prescribed or
permitted by the Maryland Insurance Administration. Prescribed statutory
accounting practices include state laws, regulations and general administrative
rules issued by the State of Maryland as well as a variety of publications and
manuals of the National Association of Insurance Commissioners ("NAIC").
Permitted statutory accounting practices encompass all accounting practices not
so prescribed, but allowed by the state of domicile.
The NAIC is currently in the process of developing a codification of statutory
accounting principles. The project, if finalized and implemented, could cause
changes to the calculation of statutory net income and statutory surplus. The
impact of any changes cannot be reasonably estimated at this time.
Property/Casualty Insurance: USF&G Company has received written approval from
the Maryland Insurance Administration to extend the required disposal period for
certain real property acquired as security for loans or other obligations. Under
the current Maryland Insurance Code, these assets are required to be disposed of
within five years from the date of acquisition. The Maryland Insurance
Administration extended this time period for certain properties. At December 31,
1997 and 1996, permitted transactions increased statutory surplus by $20 million
over what it would have been had prescribed accounting practices been followed
without the variances permitted by the regulatory authorities.
Life Insurance: In 1997, F&G Life received permission from the Maryland
Insurance Administration to release $39 million of capital gains related to a
coinsurance contract from the Interest Maintenance Reserve ("IMR"). In
conjunction with this release from the IMR, F&G Life established a $10 million
voluntary investment reserve funded from policyholders' surplus. The voluntary
investment reserve cannot be reduced until 1999 and requires Maryland Insurance
Administration permission to do so. As of December 31, 1997 and 1996, this
permitted practice had the effect of increasing statutory surplus by $23 million
and $38 million, respectively, over what it would have been had prescribed
accounting practices been followed without the variances permitted by the
regulatory authorities.
Since Maryland does not specifically prescribe by law or regulation reserves for
universal life ("UL") policies or group annuities, F&G Life follows reserving
practices which are permitted by the State of Maryland. For older generation
universal life policies, F&G Life holds the full account value as a reserve. For
newer generation UL policies, reserves are held based on a calculation according
to the NAIC UL Model Regulation, which has been adopted by many states. Many of
the group annuities sold by F&G Life are used to fund qualified pension and/or
profit sharing plans. For these annuities, the funds are not allocated to
individual participants, and the full account value is held as the reserve. For
group annuities where the funds and/or benefits are allocated to the individual
certificate holder, reserves are calculated according to laws prescribed for
individual annuities.
1.5. Investments
Fixed Maturities: USF&G classifies all of its fixed maturities as "available for
sale". These securities are held for an indefinite period of time and may be
sold in response to changes in interest rates and the yield curve, prepayment
risk, liquidity needs, or other factors. Fixed maturities classified as
"available for sale" are carried at market value, with unrealized gains and
losses recorded as a separate component of shareholders' equity. Unrealized
gains or losses on fixed maturities available for sale are offset by an
adjustment to life insurance deferred policy acquisition costs ("DPAC") which is
made on a pro forma basis as if the unrealized gains or losses on those assets
which match certain life insurance liabilities were realized. Specific
write-downs in the carrying value of fixed maturities are recognized in income
when an impairment is deemed other than temporary.
Common and Preferred Stocks: Investments in common and preferred stocks where
USF&G has significant influence over the investees' operating and financial
policies are accounted for using the equity method and included in other
invested assets. Other investments in common and preferred stocks are carried at
market value with the resulting unrealized gains or losses reported directly in
shareholders' equity.
Securities Lending: USF&G participates in a securities lending program whereby
certain securities from its portfolio are loaned to other institutions for short
periods of time. A fee is paid to USF&G by the borrower. Collateral that exceeds
the market value of the loaned securities is maintained by the lending agent and
reported in USF&G's other invested assets with an offsetting liability reported
in other liabilities. Invested assets and other liabilities include $515 million
and $128 million at December 31, 1997 and 1996, respectively, related to
securities lending collateral.
-7-
<PAGE>
USF&G's policy is to require collateral equal to 102 percent of the market value
of the loaned securities. The securities are marked to market on a daily basis
to maintain the value of the collateral. The cash collateral is held by lending
agents and reinvested in certain approved types of securities. USF&G has an
indemnification agreement with the lending agents in the event a borrower
becomes insolvent or fails to return securities.
Mortgage Loans and Real Estate: Mortgage loans are carried at unpaid principal
balances. Real estate investments are reported at cost adjusted for equity
participation. Real estate acquired through foreclosure or deed-in-lieu of
foreclosure is initially recorded at estimated market value. Valuation
allowances are recognized for mortgage loans with deteriorations in collateral
performance which are deemed other than temporary, based on quarterly
evaluations. Impairments in the value of real estate investments are recorded as
direct reductions in the carrying value of those investments and are recognized
in income when indicators of impairment are present and the undiscounted cash
flows estimated to be generated by those assets are less than the assets'
carrying amount.
Interest and Dividend Income: Interest on fixed maturity investments is recorded
as income when earned and is adjusted for any amortization of purchase premium
or discount. Dividends on equity securities are recorded as income on
ex-dividend dates.
Realized Gains and Losses: Realized gains and losses on the sale of investments
are determined based on specific cost. Realized losses are also recorded when an
investment's net realizable value is below cost and the decline is deemed other
than temporary.
1.6. Recognition of premium revenues
Property/Casualty Insurance: Property/casualty insurance premiums are earned
principally on a pro rata basis over the lives of the policies and include
accruals for ultimate premium revenue anticipated under auditable and
retrospectively rated policies. Unearned premiums represent the portion of
premiums written applicable to the unexpired terms of policies in force.
Unearned premiums also include estimated and unbilled premium adjustments.
Life Insurance: Premiums on life insurance policies with fixed and guaranteed
premiums and benefits, and premiums on annuities with significant life
contingencies are recognized when due. Premiums received on UL policies and
annuity contracts are not recorded as revenues; instead, they are recognized as
deposits. Policy charges and surrender penalties are recorded as revenues.
1.7. Unpaid losses, loss expenses and policy benefits
Property/Casualty Insurance: The liability for unpaid property/casualty
insurance losses and loss expenses is based on an evaluation of reported losses
and on estimates of incurred but unreported losses. The reserve liabilities are
determined using adjusters' individual case estimates and statistical
projections. The liability was reported net of estimated salvage and subrogation
recoverables of $78 million and $99 million at December 31, 1997 and 1996,
respectively. Adjustments to the liability based on subsequent developments or
other changes in the estimate are reflected in results of operations in the
period in which such adjustments become known.
Certain liabilities for unpaid losses and loss expenses related to workers'
compensation and assumed reinsurance coverage are discounted to present value.
The carrying amount of such liabilities, net of reinsurance and net of discounts
of $401 million was $1.3 billion and $1.4 billion at December 31, 1997 and 1996,
respectively. Interest rates of up to four percent are used to discount these
liabilities.
Life Insurance: Ordinary life insurance reserves are computed under the net
level premium method using assumptions for future investment yields, mortality
and withdrawal rates. These assumptions reflect F&G Life's experience, modified
to reflect anticipated trends, and provide for possible adverse deviation.
Reserve interest rate assumptions are graded and range from 2.5 percent to 6.0
percent.
Universal life and deferred annuity reserves are computed on the retrospective
deposit method, which produces reserves equal to the cash value of the
contracts. Such reserves are not reduced for charges that would be deducted from
the cash value of policies surrendered. Reserves on immediate annuities with
guaranteed payments are computed on the prospective deposit method, which
produces reserves equal to the present value of future benefit payments.
-8-
<PAGE>
1.8. Deferred policy acquisition costs
Acquisition costs, consisting of commissions, brokerage and other expenses
incurred at policy issuance, are generally deferred. Amortization of DPAC
totaled $687 million, $707 million and $714 million for the years ended December
31, 1997, 1996 and 1995, respectively, and was included in underwriting,
acquisition and operating expenses in the Consolidated Statement of Operations.
Property/Casualty Insurance: Anticipated losses, loss expenses, remaining costs
of servicing the policies and anticipated investment income are considered in
determining the recoverability of deferred property/ casualty insurance
acquisition costs. Such deferrals are amortized over the period that related
premiums are earned.
Life Insurance: Anticipated policy benefits, remaining costs of servicing the
policies and anticipated investment income are considered in determining the
recoverability of DPAC for interest-sensitive life and annuity products. Life
insurance acquisition costs are amortized based on assumptions consistent with
those used for computing policy benefit reserves. DPAC on ordinary life business
are amortized over their assumed premium paying periods. Universal life and
investment annuity acquisition costs are amortized in proportion to the present
value of their estimated gross profits over the products' assumed durations,
which are regularly evaluated and adjusted as appropriate.
1.9. Foreign currency translation
The functional currency for USF&G's foreign operations is typically the
applicable local currency. For those subsidiaries in highly inflationary
economies, however, the functional currency is the reporting currency (the U.S.
dollar).
Local currency balance sheet accounts are translated to U.S. dollars using
exchange rates in effect at the balance sheet date, and revenue and expense
accounts maintained in the local currency are translated using the average
exchange rates prevailing during the year. The unrealized gains or losses, net
of applicable deferred income taxes, resulting from translation are included in
shareholders' equity.
In highly inflationary economies (e.g., Mexico), monetary assets and liabilities
are remeasured into U.S. dollars using exchange rates in effect at the balance
sheet date, whereas nonmonetary balances are remeasured using historical
exchange rates. Revenue and expense accounts are remeasured using the average
exchange rates prevailing during the year for monetary transactions and
historical exchange rates for nonmonetary transactions. Realized gains or losses
resulting from remeasurement are included in net income.
USF&G's exposure to fluctuating currency exchange rates may be reduced or
effectively eliminated by certain financial instruments.
1.10. Goodwill
Goodwill, which represents the excess of cost over the fair value of net assets
acquired, is amortized on a straight-line basis over periods not exceeding 40
years. USF&G regularly evaluates the recoverability of goodwill to determine if
there has been any permanent impairment. The assessment is performed based on
the estimated future cash flows compared with the carrying value of the asset.
If impairment were indicated, a writedown to fair value (normally measured by
discounting estimated cash flows) would be taken.
1.11. Earnings per share
Basic earnings per share are computed by dividing income available to common
shareholders by the weighted-average common shares outstanding during the
period. Common stock equivalents are excluded from the calculation. Diluted
earnings per share assume the conversion of all securities whose contingent
issuance would have a dilutive effect on earnings.
-9-
<PAGE>
The following table sets forth the computations of basic and diluted earnings
per share.
(dollars in millions except per
share data, shares in thousands) 1997 1996 1995
---------------------------
Numerator:
Net income $194 $261 $209
Preferred Stock Dividends:
Series A (2) (16) (16)
Series B -- (4) (12)
---------------------------
Total preferred stock dividends (2) (20) (28)
---------------------------
Numerator for basic EPS (income
available to common shareholders) 192 241 181
---------------------------
Effect of Dilutive Securities:
Series B preferred stock dividends -- 4 12
Zero coupon convertible notes 3 5 6
---------------------------
3 9 18
---------------------------
Numerator for diluted EPS
(income available to common
shareholders after assumed
conversions) $195 $250 $199
---------------------------
Denominator:
Denominator of basic EPS
(weighted-average shares) 111,688 117,674 111,474
Effect of dilutive securities:
Stock options 2,954 1,846 1,432
Contingent stock (variable
award plan) 285 279 --
Convertible preferred stock -- 2,151 9,931
Zero coupon convertible notes 5,182 5,784 7,227
---------------------------
Dilutive potential common shares 8,421 10,060 18,590
---------------------------
Denominator for diluted EPS
(adjusted weighted-average
shares and assumed conversions) 120,109 127,734 130,064
---------------------------
Basic earnings per share $1.72 $2.05 $1.63
Diluted earnings per share 1.63 1.95 1.53
---------------------------
Stock options to purchase a total of 10 million shares of USF&G's common stock
were outstanding at December 31, 1997. Of this total, 2.3 million options with
exercise prices ranging from $22.19 to $30.82 per share were not included in the
computation of diluted earnings per share in 1997 because the exercise prices of
these options exceeded the average market price of the common shares and,
therefore, would be antidilutive. The weighted-average exercise price for these
outstanding options was $22.92 per share.
Additionally, based upon certain cumulative multi-year income targets, a maximum
of 1.3 million shares of common stock could be issued under USF&G's Long-Term
Incentive Program ("LTIP"). In 1997, approximately 740,000 of these potentially
issuable shares of common stock were not included in the calculation of diluted
earnings per share because the applicable multi-year income targets were not
currently being achieved.
-10-
<PAGE>
1.12. Reorganization severance
Severance costs covering approximately 280 and 700 employees in 1997 and 1996,
respectively, totaled $5 million and $17 million, respectively. During 1997,
USF&G's field structure was reorganized to accommodate the transfer of certain
policy and claim processing activities from the branch offices to three new
Centers for Agency Services and the Claim Reception Center. In 1998, the field
will be further consolidated and support functions will be centralized in
response to worsening market conditions.
1.13. Facilities exit costs/sublease income
During 1994, USF&G committed to a plan to consolidate its home office operations
in Baltimore, Maryland at its Mount Washington facility. The facilities exit
costs recorded in 1994 represented the present value of the rent and other
operating expenses to be incurred under the lease on the Corporation's principal
office building (the "Tower") from the time USF&G vacated the Tower through the
expiration of the lease in September 2009, but did not consider any potential
future sublease income, as such income was neither probable nor reasonably
estimable at that time. To the extent that additional or extended subleases are
subsequently negotiated, the present value of income to be received over the
term of those subleases is recognizable in the period such income becomes
probable and reasonably estimable. Sublease income of $54 million and $6 million
was recognized under the facilities exit plan in 1996 and 1995, respectively, as
a result of USF&G's negotiation of subleases with new and existing tenants. A
credit of $12 million was also recognized in 1996 related to reduced property
tax assessments on the Tower. During 1997, 1996 and 1995, the reserve for
facilities exit costs was increased by $12 million, $13 million and $16 million,
respectively, due to the amortization of the present value discount, and was
reduced by $20 million, $12 million and $10 million, respectively, of rent and
other operating expenses which were paid in 1997, 1996 and 1995 but were
recognized in the 1994 charge.
Additionally, USF&G recognized approximately $24 million of facilities exit
costs in 1996, representing the present value of the rent and other operating
expenses estimated to be incurred over the life of certain leases as a result of
the downsizing or closure of numerous branch offices. The reserve was reduced in
1997 by $6 million of rent and other operating expenses which were paid in 1997
but were recognized in the 1996 charge.
1.14. Business combinations
On December 22, 1997, USF&G acquired TITAN Holdings, Inc. ("Titan"), a
property/casualty insurance company located in San Antonio, Texas, for $259
million including assumed debt. Titan specializes in the non-standard automobile
and government entities insurance markets. The transaction was accounted for as
a purchase and resulted in goodwill of approximately $151 million. The
consideration paid included 5.1 million shares of the Corporation's common
stock, valued at approximately $112 million. As of December 31, 1997, $47
million in cash payments were made to reduce debt and cover certain other
acquisition-related expenses. The remaining consideration of $97 million,
consisting of cash payments to Titan's shareholders, was subsequently paid in
February 1998. The results of Titan's operations for the period from December 22
through December 31, 1997 have not been included in USF&G's Consolidated
Statement of Operations for 1997 as they were not material.
On December 17, 1996, USF&G acquired Afianzadora Insurgentes, S.A. de C.V.
("Afianzadora"), a surety bond company in Mexico, for $65 million in cash. This
acquisition, which was accounted for as a purchase, resulted in goodwill of $18
million. The results of Afianzadora's operations for the period from December 17
through December 31, 1996 were not included in USF&G's Consolidated Statement of
Operations for 1996 as they were not material.
-11-
<PAGE>
1.15. Supplemental cash flow information
The Consolidated Statement of Cash Flows is presented using the "direct method",
which reports major classes of cash receipts and cash payments. A reconciliation
of net income to net cash provided from operating activities is as follows:
(in millions) 1997 1996 1995
-----------------------
Net income $ 194 $ 261 $209
Adjustments to reconcile net
income to net cash provided from
operating activities:
Net realized gains on investments (15) (44) (7)
Reorganization severance 5 17 --
Facilities exit costs/(sublease income) -- (42) (6)
Change in accrued income taxes 77 (7) (20)
Distributions on capital securities 14 -- --
Depreciation expense 38 29 25
Change in insurance liabilities 58 66 294
Change in DPAC (18) 38 (36)
Change in receivables (145) (167) (99)
Change in other liabilities 76 61 79
Change in other assets (123) 122 (31)
Change in other items, net (16) (4) (9)
-----------------------
Net cash provided from operating activities $ 145 $ 330 $399
-----------------------
Cash provided from operating activities does not include a $104 million portion
of a coinsurance contract purchased to cede certain structured settlement
annuity obligations (refer to Note 12, "Reinsurance"). This transaction is
considered financing in nature as it transfers a fixed payment obligation to the
coinsurer.
Note 2 Investments
2.1. Components of net investment income
(in millions) 1997 1996 1995
------------------------
Fixed maturities $593 $630 $664
Common and preferred stocks 1 3 4
Short-term investments 32 20 23
Mortgage loans and real estate 69 48 46
Other investment income, net of
interest expense on funds held 11 19 13
------------------------
Total investment income 706 720 750
Investment expenses (15) (15) (17)
------------------------
Net investment income $691 $705 $733
------------------------
2.2. Net realized gains on investments
(in millions) 1997 1996 1995
------------------------
Net Gains (Losses) on Sales:
Fixed maturities $ 3 $(12) $ 6
Common and preferred stocks -- 79 4
Mortgage loans and real estate 34 17 2
Other 14 18 18
------------------------
Net gains on sales 51 102 30
Impairments (36) (58) (23)
------------------------
Net realized gains on investments $ 15 $ 44 $ 7
------------------------
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<PAGE>
2.3. Unrealized gains (losses)
At December 31
(in millions) 1997 1996
----------------
Unrealized Gains:
Fixed maturities available for sale $319 $161
Common and preferred stocks 3 2
Foreign currency and other 20 20
----------------
Gross unrealized gains 342 183
----------------
Unrealized Losses:
Fixed maturities available for sale (7) (63)
Common and preferred stocks (5) (2)
Foreign currency and other (6) (4)
----------------
Gross unrealized losses (18) (69)
DPAC and policy benefits adjustment (67) (19)
Deferred taxes on net unrealized gains (90) (33)
----------------
Net unrealized gains $167 $ 62
----------------
2.4. Change in net unrealized gains (losses)
(in millions) 1997 1996 1995
------------------------
Fixed maturities available for sale $214 $(242) $ 524
DPAC and policy benefits adjustment (48) 54 (106)
Common and preferred stocks (2) 2 4
Foreign currency and other (2) 10 (4)
------------------------
Total change in unrealized
gains (losses) before taxes 162 (176) 418
Deferred taxes on net unrealized gains (57) (33) --
------------------------
Net change in unrealized
gains (losses) $105 $(209) $ 418
------------------------
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<PAGE>
2.5. Estimated market values of fixed maturity investments
There were no fixed maturities classified as "held to maturity" at December 31,
1997 and 1996. The cost and market value of fixed maturities available for sale
were as follows:
At December 31, 1997
Gross
Unrealized Market
(in millions) Cost Gains Losses Value
---------------------------------
U.S. Government bonds $ 497 $ 12 $(1) $ 508
Mortgage-backed securities 1,392 29 -- 1,421
Asset-backed securities 664 14 -- 678
Corporate bonds 4,249 199 (3) 4,445
State and political subdivision bonds 1,209 53 (1) 1,261
Foreign government bonds 172 12 (2) 182
---------------------------------
Total $8,183 $319 $(7) $8,495
---------------------------------
At December 31, 1996
Gross
Unrealized Market
(in millions) Cost Gains Losses Value
---------------------------------
U.S. Government bonds $ 334 $ 7 $ (3) $ 338
Mortgage-backed securities 1,464 22 (3) 1,483
Asset-backed securities 731 11 (1) 741
Corporate bonds 4,882 107 (51) 4,938
State and political subdivision bonds 425 6 (1) 430
Foreign government bonds 230 8 (4) 234
---------------------------------
Total $8,066 $161 $(63) $8,164
---------------------------------
2.6. Stated due dates of fixed maturities
The following table shows the stated due dates of fixed maturities available for
sale at December 31, 1997.
Market
(in millions) Cost Value
------------------
In 1998 $ 239 $ 240
1999 through 2002 2,090 2,141
2003 through 2007 1,613 1,683
After 2007 2,185 2,332
------------------
Subtotal 6,127 6,396
Mortgage/asset-backed securities 2,056 2,099
securities
------------------
Fixed maturities available
for sale $8,183 $8,495
------------------
Actual maturities may differ from stated due dates as borrowers may have the
right to call or prepay obligations.
Information regarding sales, repayments and maturities of fixed maturities
available for sale during 1997 is set forth in the following table.
Gross Gross
(in millions) Cost Proceeds Gains Losses
-------------------------------
Proceeds from sales $1,295 $1,293 $28 $(30)
Proceeds from 738 743 5 --
maturities/repayments
-------------------------------
Total proceeds $2,033 $2,036 $33 $(30)
-------------------------------
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<PAGE>
Proceeds from sales of fixed maturities classified as available for sale in 1996
totaled $588 million with gross gains of $14 million and gross losses of $28
million. In 1995, such sales totaled $489 million with gross gains of $16
million and gross losses of $13 million.
Proceeds from sales of fixed maturities held to maturity were $21 million (with
no gross gains and gross losses of $3 million) in 1995. These sales involved
five different issuers and were based on evidence of significant deterioration
of the issuers' creditworthiness, as determined from developments related
specifically to the issuers. USF&G performed a detailed analysis of the issuers'
operating trends, cash flows and ability to meet debt service.
From January 1, 1995 through December 3, 1995, reclassifications from held to
maturity to available for sale totaled $31 million of amortized cost. These
reclassifications were based on evidence of significant deterioration of the
issuers' creditworthiness. Gross unrealized losses on these securities totaled
$9 million at the time of the reclassifications. On December 4, 1995, all
remaining securities classified as held to maturity were reclassified to
available for sale as permitted by supplemental guidance to SFAS No. 115 issued
by the FASB in November 1995. This reclassification was made to allow maximum
flexibility in the management of the investment portfolio without being
restricted by accounting interpretations. The securities had a total amortized
cost of $4.5 billion, with gross unrealized gains of $117 million, at the time
of the reclassification.
2.7. Nonincome-producing investments
Fixed maturities at December 31, 1997 and 1996, for which no income was recorded
during those years, totaled $1 million. In addition, nonincome-producing real
estate totaled $20 million and $28 million at December 31, 1997 and 1996,
respectively.
Note 3 Insurance Liabilities
3.1. Property/casualty insurance reserves - unpaid losses and loss expenses
Activity in unpaid losses and loss expenses for the property/casualty segment is
summarized as follows:
(in millions) 1997 1996 1995
------------------------
Total reserve at beginning of year, gross $6,032 $6,097 $6,158
Less reinsurance recoverables 987 984 1,016
------------------------
Net balance at January 1 5,045 5,113 5,142
------------------------
Incurred Related To:
Current year 1,933 2,030 1,856
Prior years (139) (162) (54)
------------------------
Total incurred 1,794 1,868 1,802
------------------------
Paid Related To:
Current year 726 764 635
Prior years 1,225 1,190 1,196
------------------------
Total paid 1,951 1,954 1,831
------------------------
Net balance at December 31 4,888 5,027 5,113
Plus reserves acquired* 140 18 --
Plus reinsurance recoverables 1,172 987 984
------------------------
Total reserve at end of year, gross $6,200 $6,032 $6,097
------------------------
*Reserves acquired relate to the purchases of Titan in 1997 and Afianzadora in
1996.
Losses and loss expenses recorded in the current period financial statements are
affected by changes in estimates of insured events occurring in prior periods.
Loss and loss expense reserves are established based on actuarial evaluation of
required reserves by accident year. Each accident year is independently
evaluated. Typically, the reserve requirements are greatest in the most recent
accident year, where there is the higher degree of uncertainty.
-15-
<PAGE>
Losses incurred in 1997, 1996 and 1995 included $116 million, $110 million and
$77 million, respectively, of favorable development related to prior years'
experience in the assumed reinsurance business. Given the inherent uncertainty
in reserving for assumed reinsurance losses, current accident year reserves are
established on a conservative basis. Based on actuarial analysis in 1997 and
1996, the favorable development in assumed reinsurance from prior accident years
was substantially offset by the establishment of current accident year reserves.
The workers' compensation line was the key contributor of the remaining
favorable development of $23 million in 1997 and $52 million in 1996. These
favorable trends in older accident years are attributable to reform efforts by
various states in the early 1990s to contain workers' compensation loss costs,
the results of which are emerging in recent calendar years. In addition,
favorable development in 1996 included recognition of the effect on reserve
estimation models of the increased use of structured settlement annuities to
close workers' compensation claims. Prior years' loss reserve decreases in
workers' compensation were substantially offset by reserve increases in
liability lines for the current accident years.
Reserves for asbestos-related illnesses and environmental claims cannot be
estimated with traditional loss reserving techniques. Liabilities are
established for known claims (including the cost of litigation) when sufficient
information has been developed to indicate the involvement of a specific
insurance policy and management can reasonably estimate its liability. In
addition, liabilities have been established to cover additional exposures on
both known and unasserted claims. Estimates of the liabilities are reviewed and
updated continually. Developed case law and adequate claim history do not exist
for such claims, especially because significant uncertainty exists about the
outcome of coverage litigation and whether past claim experience will be
representative of future loss experience.
3.2. Life benefit reserves
The table below shows F&G Life's benefit reserves by policy type.
At December 31
(in millions) 1997 1996
-----------------
Single Premium Annuities:
Deferred $1,374 $1,314
Immediate 1,048 1,001
Other annuities 367 610
Universal/term/group life 1,027 627
-----------------
Gross balance 3,816 3,552
Reinsurance receivable 786 782
-----------------
Total reserves, net $3,030 $2,770
-----------------
Note 4 Debt
4.1. Debt outstanding
At December 31
(in millions) 1997 1996
----------------
Corporate:
Short-term and Current Maturities of
Long-term:
Credit facility $ 35 $--
7% Senior Notes due 1998 145 --
Long-term:
Zero Coupon Convertible
Notes due 2009 107 102
8 3/8% Senior Notes due 2001 149 150
7% Senior Notes due 1998 -- 145
7 1/2% Senior Notes due 2005 80 80
----------------
Total corporate debt 516 477
Real estate and other debt 5 5
----------------
Total debt outstanding $521 $482
----------------
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<PAGE>
4.2. Short-term debt
For general corporate purposes, USF&G maintained two committed, standby credit
facilities with a group of foreign and domestic banks totaling $450 million at
December 31, 1997. The facility in place for $200 million will expire in
December 1998 and the remaining facility will expire in 2002. These facilities
replaced the $250 million committed, standby credit facility and the $150
million multi-currency credit facility in place at December 31, 1996, and permit
either borrowing of funds or letter of credit issuances. USF&G pays facility
fees on the total amount of the commitments based on its long-term debt credit
ratings. Borrowings at December 31, 1997 totaled $35 million. There were no
borrowings against the committed, standby credit facility or the multi-currency
credit facility at December 31, 1996.
Interest rates on borrowed funds are based on current market rates. At December
31, 1997 and 1996, the annual weighted-average interest rate under the
facilities was 5.96% and 5.76%, respectively. USF&G was in compliance with the
covenants contained in these agreements at December 31, 1997 and 1996. The most
restrictive covenants require USF&G to maintain a tangible net worth of at least
$1.3 billion plus 50 percent of the net income earned during the commitment
period and an indebtedness-to-capital ratio below 55 percent.
4.3. Debt extinguishments
From April through August 1996, USF&G repurchased approximately $39 million of
outstanding Zero Coupon Convertible Notes through the use of excess corporate
cash and borrowings from the credit facility. The balance of the credit facility
was repaid in December 1996 with excess corporate cash and proceeds from the
issuance of capital securities (refer to Note 6).
In 1996, real estate and other debt was reduced by $11 million as a result of a
deed-in-lieu of foreclosure whereby property with an outstanding $7 million note
was conveyed back to the lender and a $4 million loan was repaid.
4.4. Shelf registration
USF&G Corporation has available $142 million of unissued debt, preferred stock,
common stock and warrants under a 1994 shelf registration.
4.5. Redeemable debt
The Zero Coupon Convertible Notes are redeemable beginning in 1999 for an amount
equal to the original issue price plus amortized original issue discount.
-17-
<PAGE>
4.6. Maturities of long-term debt
Real
Estate
(in millions) Corporate and
Other
-------------------------
1998 $145 $--
1999 -- --
2000 -- --
2001 149 --
2002 -- --
-------------------------
Note 5 Leases
USF&G occupies office facilities under lease agreements that expire at various
dates through 2009. In addition, data processing, office and transportation
equipment is leased under agreements that expire at various dates through 2002.
Most leases contain renewal options that may provide for rent increases based on
prevailing market conditions. Some leases also may contain purchase options
based on fair market value or contractual values, if greater. Capital leases are
immaterial in amount. Rent expense for the years ended December 31, 1997, 1996
and 1995 was $25 million, $40 million and $44 million, respectively.
The following table shows the future minimum payments to be made under
noncancelable leases at December 31, 1997.
Home Other
Office Office Equip-
(in millions) Building Space ment Total
-----------------------------------
1998 $ 16 $22 $15 $ 53
1999 19 19 7 45
2000 25 15 5 45
2001 26 9 14 49
2002 25 5 -- 30
After 2002 174 1 -- 175
-----------------------------------
Total $285 $71 $41 $397
-----------------------------------
USF&G is also the lessor under various subleases on its office facilities. The
minimum rentals to be received in the future under noncancelable subleases is
$96 million at December 31, 1997.
USF&G's principal office lease involves the Tower which the Corporation sold in
1984 and subsequently leased back. As of January 1997, USF&G has vacated the
Tower (refer to Note 1.13); however, USF&G is obligated to continue to make
rental payments under the lease, which provides for rent increases every five
years through its expiration in September 2009.
Note 6 Capital Securities of Subsidiary Trusts
Series A: On December 24, 1996, USF&G Capital I ("Capital I"), a business trust
wholly owned by USF&G, issued $100 million (100,000 shares) of 8.5% Capital
Securities, Series A ("Series A Securities"). Payments on the Series A
Securities are guaranteed by USF&G on a subordinated basis, but only to the
extent Capital I has funds available to make such payments. This guarantee,
considered together with the terms of debentures issued by USF&G (described
below) and an agreement for USF&G to pay other expenses and liabilities of
Capital I, constitutes a full and unconditional subordinated guarantee by USF&G
of Capital I's obligations under the Series A Securities.
Capital I used the proceeds from the Series A Securities issuance to purchase
$100 million principal amount of 8.5% Junior Subordinated Debentures issued by
USF&G ("Series A Debentures"). The Series A Debentures rank junior and
subordinate in right of payment to certain other indebtedness of USF&G, and
mature on December 15, 2045.
Interest payments on the Series A Debentures are deferrable, at USF&G's option,
at any time for up to five years at a time, and provided there has not been an
event of default. In the event USF&G elects to defer interest payments on the
Series A Debentures, payments of distributions on the Series A Securities will
likewise be deferred. Interest and distributions continue to accrue during any
payment deferral period.
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<PAGE>
The Series A Debentures are redeemable under certain circumstances related to
tax events at a price of $1,000 per debenture plus any accrued and unpaid
interest and a "make whole" payment. Proceeds from any redemptions of the Series
A Debentures will be used to redeem a like amount of the Series A Securities.
Additionally, USF&G has the right, under certain circumstances related to tax
events, to shorten the maturity of the Series A Debentures to a date no earlier
than June 24, 2016, in which case the stated maturity of the Series A Securities
will likewise be affected.
Series B: On January 10, 1997, USF&G Capital II ("Capital II"), a second
business trust wholly owned by USF&G, issued $100 million (100,000 shares) of
8.47% Capital Securities, Series B ("Series B Securities"). Payments on the
Series B Securities are guaranteed on the same basis as the guarantee of the
Series A Securities.
Capital II used the proceeds from the Series B Securities issuance to purchase
$100 million principal amount of 8.47% Deferrable Interest Junior Subordinated
Debentures, Series B ("Series B Debentures") issued by USF&G, which mature on
January 10, 2027. The Series B Debentures also rank junior and subordinate to
certain other indebtedness of USF&G, but rank equal with the Series A
Debentures. The Series B Debentures and Series B Securities have interest/
distribution deferral terms similar to those of the Series A Debentures and
Series A Securities, described above. The Series B Debentures are redeemable at
USF&G's option at any time beginning in January 2007 at scheduled redemption
prices ranging from $1,042 to $1,000 per debenture, plus any accrued and unpaid
interest.
The Series B Debentures are also redeemable prior to January 2007 under certain
circumstances related to tax and other special events. Proceeds from any
redemptions of the Series B Debentures will be used to redeem a like amount of
the Series B Securities. Additionally, USF&G has the right, under certain
circumstances related to tax events, to shorten the maturity of the Series B
Debentures to a date no earlier than July 10, 2016, in which case the stated
maturity of the Series B Securities will likewise be affected.
Series C: On July 8, 1997, USF&G Capital III ("Capital III"), a third business
trust wholly owned by USF&G, issued $100 million (100,000 shares) of 8.312%
Capital Securities, Series C ("Series C Securities"). Payments on the Series C
Securities are guaranteed on the same basis as the guarantee of the Series A and
Series B Securities.
Capital III used the proceeds from the Series C Securities issuance to purchase
$100 million principal amount of 8.312% Junior Subordinated Debentures issued by
USF&G ("Series C Debentures"). The Series C Debentures rank junior and
subordinate in right of payment to certain other indebtedness of USF&G, but rank
equal with the Series A and Series B Securities. The Series C Debentures and
Series C Securities have interest/distribution deferral terms similar to those
of the Series A and Series B Debentures and Series A and Series B Securities,
described above.
The Series C Debentures mature on July 1, 2046, and are redeemable under certain
circumstances related to tax events at a price of $1,000 per debenture plus any
accrued and unpaid interest and a "make whole" payment. Proceeds from any
redemptions of the Series C Debentures will be used to redeem a like amount of
the Series C Securities. Additionally, USF&G has the right, under certain
circumstances related to tax events, to shorten the maturity of the Series C
Debentures to a date no earlier than April 8, 2012, in which case the stated
maturity of the Series C Securities will likewise be affected.
The Series A , Series B and Series C Debentures and related interest expense and
income, as well as USF&G's interest in Capital I, Capital II and Capital III,
are eliminated in consolidation. The Series A, Series B and Series C Securities
are shown in the Consolidated Statement of Financial Position under the caption,
"USF&G-obligated mandatorily redeemable preferred capital securities of
subsidiary trusts holding solely junior subordinated deferrable interest
debentures of USF&G". Distributions on the Series A, Series B and Series C
Securities are shown, net of tax, in the Consolidated Statement of Operations
under the caption "Distributions on USF&G-obligated mandatorily redeemable
preferred capital securities of subsidiary trusts holding solely junior
subordinated deferrable interest debentures of USF&G, net of tax".
The sole assets of Capital I, Capital II and Capital III are the Series A,
Series B and Series C Debentures, respectively. Neither Capital I, Capital II
nor Capital III have operations independent of the aforementioned relationships
with USF&G and the holders of their respective capital securities. In the event
USF&G exercises its right to defer interest payments on the Series A, Series B
or Series C Debentures, it will be prohibited from making payments with respect
to any capital debt or securities which rank equal or junior in right of payment
to the Series A, Series B and Series C Debentures, including cash dividends on
its common or preferred stock. In no case may the deferral of payments described
above extend beyond the stated maturity dates of the respective securities.
-19-
<PAGE>
Note 7 Shareholders' Equity
7.1. Classes of stock
USF&G is authorized to issue 12 million shares of $50 par value preferred stock
and 240 million shares of $2.50 par value common stock.
7.2. Preferred stock
USF&G had no preferred stock outstanding at December 31, 1997. At December 31,
1996 and 1995, there were 4 million shares of $4.10 Series A Convertible
Exchangeable Preferred Stock ("Series A Preferred Stock") issued and
outstanding. During the first half of 1997, USF&G called for redemption all of
the remaining outstanding shares of its Series A Preferred Stock. Holders of
10,227 shares of the Series A Preferred Stock converted their shares into 12,308
shares of common stock. USF&G redeemed all of the remaining outstanding shares
of its Series A Preferred Stock for $200 million cash.
USF&G had 277,550 shares and 1.3 million shares of $10.25 Series B Cumulative
Convertible Preferred Stock ("Series B Preferred Stock") issued and outstanding
at December 31, 1996 and 1995, respectively. During 1996 and 1995, USF&G called
for redemption 233,550 shares and 832,650 shares, respectively, of its Series B
Preferred Stock. These shares were converted into 1.9 million shares and 6.9
million shares, respectively, of common stock in accordance with the terms of
the Series B Preferred Stock. Holders of an additional 20,000 shares and 189,800
shares of Series B Preferred Stock voluntarily converted their shares into
166,320 shares and 1.6 million shares, respectively, of common stock during 1996
and 1995. The holder of another 24,000 shares of Series B Preferred Stock
voluntarily redeemed those shares for cash during 1996.
7.3. Changes in common stock shares
1997 1996 1995
--------------------------------------
Outstanding, January 1 114,240,489 119,606,095 104,810,794
Shares repurchased (4,706,430) (8,400,700) --
Shares issued 6,868,140 3,035,094 14,795,301
--------------------------------------
Outstanding, December 31 116,402,199 114,240,489 119,606,095
--------------------------------------
In December 1997, USF&G issued approximately 5.1 million shares of common stock
in consideration for its acquisition of Titan. In conjunction with a stock
repurchase program instituted in 1996, USF&G repurchased 4.7 million and 8.4
million shares of its common stock during 1997 and 1996, respectively. USF&G
also issued 2.1 million shares of common stock during 1996 for the conversion of
the Series B Preferred Stock. During 1995, USF&G issued 8.5 million shares of
common stock for the conversion of the Series B Preferred Stock, and 5.5 million
shares of common stock for the conversion of the $5.00 Series C Cumulative
Convertible Preferred Stock.
7.4. Shareholder rights plan
USF&G has a shareholder rights plan ("the plan") to deter coercive or unfair
takeover tactics and to prevent a potential purchaser from gaining control of
USF&G without offering a fair price to all of the Corporation's shareholders.
The plan, which otherwise would have expired in 1997, was extended until 2007
and amended in several respects in February 1997. Under the plan, as amended,
each outstanding share of USF&G's common stock has one preferred share purchase
right (a "right") expiring in 2007. Each right entitles the registered holder to
purchase 1/100 of a share of a new class of junior preferred stock for $105. The
rights cannot be exercised unless certain events occur that might lead to a
concentration in ownership of common shares or unless certain other events
relating to a change in control take place. At that time, each right may be
converted into rights to acquire common stock having a value of twice the $105
exercise price. In certain circumstances, the plan also provides that the rights
can be exchanged for USF&G's common stock without payment of the purchase price.
Rights held by holders of 15 percent or more of USF&G's common stock, or their
associates, may be null and void. Under certain conditions, the rights also
become convertible into the rights to acquire shares of common stock of an
acquiror having a value of twice the exercise price. USF&G will generally be
entitled to redeem the rights, at $.01 per right, any time before the tenth day
(subject to further deferral) after a 15 percent position is acquired. In
January 1998, the plan was amended to provide that the rights would not become
exercisable as a result of the transactions contemplated with St. Paul under the
merger agreement or the related stock option agreement.
-20-
<PAGE>
7.5. Dividend restrictions
There are certain restrictions on payments of dividends by insurance
subsidiaries that may limit USF&G Corporation's ability to receive funds from
its subsidiaries. Under the Maryland Insurance Code, Maryland insurance
subsidiaries, such as USF&G Company and F&G Life, must provide the Maryland
Insurance Commissioner (the "Commissioner") with not less than thirty days'
prior written notice before payment of an "extraordinary dividend" to its
holding company. (Refer to Section 4.3, "Dividend Restrictions", of Management's
Discussion and Analysis of Financial Condition and Results of Operations.) In
addition, ten days' prior notice of any other dividend must be given to the
Maryland Insurance Commissioner prior to payment, and the Commissioner has the
right to prevent payment of such dividend if it is determined that such payment
could impair the insurer's surplus or financial condition.
Cash dividends of $136 million, $134 million and $83 million were paid during
1997, 1996 and 1995, respectively, to USF&G Corporation by USF&G Company. Such
dividends were not subject to the requirements for extraordinary dividends. In
addition, effective June 1, 1995, and with the Commissioner's consent, USF&G
Company declared an extraordinary dividend payable to USF&G Corporation valued
at $323 million, which consisted of all of the issued and outstanding capital
stock of F&G Life. Prior to payment of such dividend, F&G Life was a
wholly-owned subsidiary of USF&G Company. As a result of such dividend payment,
F&G Life is now a direct, wholly-owned subsidiary of USF&G Corporation.
Dividends of up to $146 million will be available for payment from USF&G Company
to USF&G Corporation during 1998 without being deemed extraordinary.
Cash dividends of $40 million, $139 million and $31 million were paid during
1997, 1996 and 1995, respectively, to USF&G Corporation by F&G Life. In
addition, effective December 17, 1997 and December 29, 1995 and with the
Commissioner's consent, F&G Life declared extraordinary dividends payable to
USF&G Corporation consisting of investments in various real estate properties,
totaling $25 million and $28 million, respectively. Consequently, all of the
1997 and 1996 dividends were deemed extraordinary, and were paid with the
Commissioner's consent. Further, any dividends which F&G Life would propose to
pay in 1998 would be deemed extraordinary dividends and subject to the
thirty-day notice period.
Note 8 Financial Instruments and Derivatives
Fair value information is based on quoted market prices where available. In
cases where quoted market prices are not available, fair values are based on
internal estimates using present value or other valuation techniques. Those
techniques are significantly affected by the assumptions used, such as
applicable discount rate and estimated future cash flows. Therefore, the derived
fair value estimates cannot be substantiated by comparison to independent
markets and, in many cases, could not be realized in immediate settlement of the
instrument. Fair value disclosure requirements exclude certain financial
instruments and all nonfinancial instruments. The fair value of many
insurance-related liabilities do not require disclosure. However, in its
strategy of asset/liability matching, USF&G takes into consideration the future
cash requirements of its insurance-related liabilities. Had a presentation of
these liabilities been made, due to their long-term nature, the fair value of
insurance-related liabilities would have been significantly less than their
carrying value.
8.1. Financial instruments
Cash and Short-Term Investments: The carrying amounts reported in the
Consolidated Statement of Financial Position for these instruments approximate
their fair values.
Fixed Maturity Investments: Fair values for publicly-traded fixed maturity
investments are based on quoted market prices. For privately-placed fixed
maturities, estimated fair values are derived by discounting expected future
cash flows using a current market rate applicable to the yield, credit quality
and maturity of the investment. At December 31, 1997, the amortized costs and
market values of fixed maturity investments were as follows:
Amortized Market
(in millions) Cost Value
------------------------
Publicly traded $7,696 $8,015
Private placements 487 480
------------------------
Total fixed maturity investments $8,183 $8,495
------------------------
All fixed maturities are classified as available for sale and are reported in
the Consolidated Statement of Financial Position at market value.
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<PAGE>
Common and Preferred Stocks: The carrying values of common and preferred stocks
as reported in the Consolidated Statement of Financial Position are based on
quoted market prices and reflect their fair values.
Mortgage Loans and Policy Loans: The fair values for mortgage loans and policy
loans are estimated based on discounted cash flow analyses, using interest rates
currently being offered for loans with similar credit risk. Loans with similar
characteristics are aggregated for purposes of the calculations. At December 31,
1997, the carrying amounts and fair values of investments in mortgage loans and
policy loans were as follows:
Carrying Fair
(in millions) Amount Value
------------------------
Mortgage loans $641 $658
Policy loans 82 86
------------------------
Other Assets and Other Liabilities: Other invested assets considered financial
instruments include equity interests in minority ownership investments,
interests in limited partnerships and related notes receivable. It is not
practicable to estimate their fair value due to the closely-held nature of these
investments.
Other assets and liabilities considered financial instruments include agents'
balances receivable, prepaid and accrued expenses and other receivables
generally of a short-term nature. It is assumed the carrying value of these
financial instruments approximates their fair value.
Short- and Long-Term Debt: The carrying amount of USF&G's short-term borrowings
approximates its fair value. The fair value of long-term debt is based on market
quotes or estimated discounted cash flow analyses, based on USF&G's current
incremental borrowing rates for similar types of borrowing arrangements. The
carrying amounts and estimated fair value of debt instruments at December 31,
1997 were as follows:
Carrying Fair
(in millions) Amount Value
------------------------
Corporate $516 $545
Real estate and other 5 5
------------------------
Total debt $521 $550
------------------------
Investment Contracts: Fair values for F&G Life's single premium deferred
annuities, other deferred annuities, single premium immediate annuities and
supplementary contracts are primarily derived by estimating the cost to
extinguish its liabilities under an assumption reinsurance transaction. The
estimated statutory profits the assuming company would realize from the
transaction are discounted at a typical internal rate of return objective. If
such a transaction were to occur, GAAP would require the unamortized balance of
deferred policy acquisition costs associated with these liabilities to be
immediately expensed. The amount of the related unamortized DPAC was
approximately $136 million at December 31, 1997. The fair values of the
remaining liabilities under investment contracts are estimated using discounted
cash flow calculations, based on interest rates currently being offered for like
contracts with similar maturities.
The carrying amounts and estimated fair values of F&G Life's liabilities for
investment contracts at December 31, 1997 were as follows:
Carrying Fair
(in millions) Amount Value
------------------------
Single premium deferred annuities $ 699 $ 654
Other deferred annuities 709 637
Single premium immediate annuities
and supplementary contracts 85 81
Group annuities 65 63
------------------------
Total $1,558 $1,435
------------------------
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<PAGE>
Off-Balance Sheet Financial Instruments: The fair values of USF&G's financial
guarantees written totaled $2 million at December 31, 1997, and were estimated
using discounted cash flow analyses based on USF&G's current incremental
borrowing rate for similar types of borrowing arrangements. The fair value of
foreign exchange options, which are derived from quoted market prices, were less
than $1 million at December 31, 1997. The estimates of the fair value of USF&G's
interest rate swaps were obtained from the counterparties to the agreement or
were derived by discounting the expected future cash flows, and totaled $4
million at December 31, 1997.
8.2. Derivatives
USF&G uses derivative instruments, including options and swaps, to manage
foreign exchange and interest rate risk, reduce borrowing costs and minimize the
impact of rate fluctuations on the settlement of debt and other financial
instruments. USF&G limits its use of derivative instruments.
Foreign exchange options are used to manage exposure to the effects of foreign
currency exchange rate fluctuations on foreign-denominated transactions.
Cash-settled equity swaps on USF&G common stock are used to manage exposure to
stock price fluctuations on stock-based incentive compensation expense. Interest
rate swaps are used to manage the exposure to fluctuating rates and the
relationship of fixed/floating interest rates on corporate debt. Individually,
and in the aggregate, the impact of these transactions on the financial position
and results of operations is not material. At December 31, 1997, the
Corporation's mark-to-market position on these derivative instruments was a
gross gain of $4 million and a gross loss of less than $1 million.
In addition, exchange-traded and over-the-counter catastrophe options and swaps,
linked to an index of losses related to natural disasters, are an additional
insurance-related source of income. USF&G limits and monitors its maximum
exposure to loss. Individually, and in the aggregate, the impact of these
transactions on the financial position and results of operations is not
material. At December 31, 1997, the maximum exposure to loss was less than $3
million and gross unrealized gains and gross unrealized losses were
approximately $1 million.
USF&G is subject to the risk that the counterparties will fail to perform.
However, these risks are mitigated by the credit quality of the counterparties
and the gains and losses of the underlying instruments. USF&G seeks to manage
the credit risk by establishing minimum credit ratings for counterparties to the
transactions.
Note 9 Stock-Based Compensation
Stock options have been granted to full-time officers and key employees under
four incentive plans: Stock Option Plan of 1987, Stock Option Plan of 1990,
Stock Incentive Plan of 1991, and Stock Incentive Plan of 1997 (collectively,
the "Management Plans"). In addition, the 1994 Stock Plan for Employees of USF&G
(the "Broad-Based Plan") grants eligible employees, other than officers and key
employees participating in other stock incentive plans, options to purchase
shares.
The Corporation applies Accounting Principles Board Opinion ("APB") No. 25 and
related interpretations in accounting for its employee stock options. Under APB
No. 25, no compensation expense is recognized since the exercise price of the
options is equal to the market price of the underlying stock on the date of the
grant.
In addition, under the Corporation's Long-Term Incentive Program, USF&G awards
shares of common stock to full-time officers based on three-year performance
goals established by the Board of Directors. Compensation expense, determined
under APB No. 25 as the number of shares to be issued at a given performance
level times the current market price of the stock, is accrued over the
three-year performance cycle. Net income for 1997 and 1996 included $6 million
and $13 million, respectively, of compensation expense for LTIP awards.
Under the Management Plans and Broad-Based Plan, the Corporation may grant
options to participating employees to purchase up to 16 million and 5 million
shares of common stock, respectively. At December 31, 1997, 7 million and 1
million options were available for future grant under the Management Plans and
Broad-Based Plan, respectively. Under all plans, the exercise price of each
option equals the market price of USF&G's stock on the date of grant, and an
option's maximum term is ten years. Options vest ratably over three years under
the Management Plans, and vest after two years under the Broad-Based Plan.
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<PAGE>
Had compensation expense for these plans been determined based on the fair value
of awards at the grant date, as prescribed by SFAS No. 123, net income and
earnings per share would have been as follows:
1997 1996 1995
--------------------
Pro forma net income (in millions) $ 182 $ 254 $ 205
Pro forma basic earnings per share 1.61 1.99 1.59
Pro forma diluted earnings per share 1.52 1.89 1.49
--------------------
Note: The effects of applying SFAS No. 123 shown here are not likely to be
representative of the effects in future years due to the exclusion of awards
granted in prior years but vesting (and therefore expensed) in 1995, 1996 and
1997.
The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model. The weighted-average assumptions used for
grants in each year were as follows:
1997 1996 1995
-------------------------------
Expected volatility 21.1% 25.0% 25.4%
Dividend yield 1.13% 1.24% 1.53%
Management Plans:
Risk-free interest rates 6.52% 6.36% 7.25%
interest rates
Expected lives 5 years 7 years 7 years
Broad-Based Plan:
Risk-free interest rates 6.35% 5.98% 7.07%
Expected lives 3 years 4 years 4 years
-------------------------------
The Black-Scholes method is one of many models used to calculate the fair value
of an option. Because the models are sensitive to changes in the different
assumptions used, the effect on fair value estimates can be significant.
Accordingly, the derived fair value of options cannot be substantiated by
comparison to independent markets. The fair value also cannot be realized in
immediate settlement.
A summary of the status of USF&G's stock option plans as of December 31, 1997,
1996 and 1995, and changes during the years ended on those dates are presented
in the table below. The 1997 activity includes options granted pursuant to the
merger agreement with Titan, in which the Corporation assumed 899,731
exercisable outstanding options, based on the exchange ratio applicable to the
acquisition.
Weighted-Average
Exercise
Shares Price
-----------------------------
Outstanding at January 1, 1997 9,101,408 $13.95
Granted 2,404,142 22.52
Granted in conjunction with acquistion 899,731 12.14
Exercised (1,533,314) 13.20
Surrendered or canceled (873,341) 18.23
-----------------------------
Outstanding at December 31, 1997 9,998,626 $15.58
-----------------------------
Options exercisable at December 31, 1997 5,146,295 $13.24
-----------------------------
Weighted-average fair value of options
granted during 1997 $ 5.66
-----------------------------
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<PAGE>
Weighted-Average
Exercise
Shares Price
-----------------------------
Outstanding at January 1, 1996 7,290,207 $12.97
Granted 3,363,988 14.63
Exercised (910,396) 11.45
Surrendered or canceled (642,391) 15.30
-----------------------------
Outstanding at December 31, 1996 9,101,408 $13.95
-----------------------------
Options exercisable at December 31, 1996 3,714,777 $13.39
-----------------------------
Weighted-average fair value of options
granted during 1996 $ 4.55
-----------------------------
Weighted-Average
Exercise
Shares Price
-----------------------------
Outstanding at January 1, 1995 5,908,451 $12.86
Granted 2,714,806 13.72
Exercised (733,603) 7.33
Surrendered or canceled (599,447) 16.86
-----------------------------
Outstanding at December 31, 1995 7,290,207 $12.97
-----------------------------
Options exercisable at December 31, 1995 2,707,398 $12.82
-----------------------------
Weighted-average fair value of options
granted during 1995 $ 4.63
-----------------------------
The following table summarizes information about stock options outstanding at
December 31, 1997:
Range of Options Outstanding Options Exercisable
Exercise Remaining Average Average
Price Number Life* Price** Number Price**
--------------------------------------------------------
$6.25-10 1,129,256 3.6 $ 9.19 1,129,256 $ 9.19
11-15 6,236,325 7.2 13.97 3,708,650 13.74
16-20 378,312 6.4 16.78 176,940 16.94
21-28 2,129,005 9.2 22.53 5,721 22.50
29-30.82 125,728 1.7 29.48 125,728 29.48
--------------------------------------------------------
$6.25-30.82 9,998,626 7.1 $15.30 5,146,295 $13.24
--------------------------------------------------------
*Represents the weighted-average remaining contractual life of options in
years.
**Represents the weighted-average exercise price of options.
Under the terms of the merger agreement with St. Paul, all options outstanding
as of the effective date of the merger and that were granted prior to January
19, 1998, will become fully vested and exercisable upon consummation of the
merger.
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<PAGE>
Note 10 Retirement Benefits
10.1. Retirement plans
USF&G has noncontributory retirement plans covering most regular full-time
employees of the Corporation and its affiliates. An employee's pension benefit
is based on salary, years of service and Social Security benefits. USF&G makes
contributions to the retirement plans based on amounts required to be funded
under provisions of the Employee Retirement Income Security Act of 1974, as
amended. The plans' funded status and amounts recognized in the consolidated
financial statements were as follows:
At December 31
(dollars in millions) 1997 1996
-------------------
Actuarial Present Value of:
Accumulated benefit obligation $410 $370
Vested benefits 392 355
-------------------
Plan assets at fair value $439 $379
Projected benefit obligation 427 385
-------------------
Funded status 12 (6)
Unrecognized net loss 91 105
Unrecognized prior service cost
(benefit) (12) (15)
Adjustment for minimum pension
liability -- --
-------------------
Net prepaid pension cost $ 91 $ 84
-------------------
Actuarial Assumptions:
Weighted-average discount rate 7.00% 7.50%
Average rate of increase in future
compensation levels 5.00 5.00
-------------------
As a result of the lower interest rate environment, USF&G decreased the discount
rate assumption as of December 31, 1997, which increased the accumulated benefit
obligation. The expected long-term rate of return on assets was 8.5% for 1997,
1996 and 1995.
The assets held by the plan consist primarily of fixed-income and equity
securities. USF&G classifies prepaid pension cost with other assets in the
Consolidated Statement of Financial Position.
The components of net pension expense were as follows:
(in millions) 1997 1996 1995
------------------------
Service cost $ 7 $ 8 $ 5
Interest cost 29 28 27
Actual return on plan assets (71) (20) (63)
Net amortization (deferral) 43 (4) 43
------------------------
Net periodic pension expense $ 8 $ 12 $ 12
------------------------
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<PAGE>
10.2. Postretirement benefits
USF&G sponsors a defined-dollar postretirement health care (medical and dental)
plan and noncontributory life insurance plan covering most regular full-time
employees of the Corporation and its affiliates. USF&G's contributions and costs
are determined based on the annual salary and the type of coverage elected by
covered employees. USF&G's contributions to the plan are a percentage of plan
costs based on age and service of employees at retirement. Additionally, the
plan costs are capped at projected 1998 cost levels, and retiree contributions
are increased for the total medical costs over the projected levels.
USF&G accrues the cost of health care, life insurance and other retiree benefits
when the employees' services are rendered, and funds the health care and life
insurance benefit costs principally on a pay-as-you-go basis.The plans' combined
funded status and amounts recognized in the consolidated financial statements
were as follows:
At December 31
(in millions) 1997 1996
----------------
Accumulated Postretirement Benefit
Obligation:
Retirees $43 $43
Fully-eligible active plan participants 1 1
Other active plan participants 8 7
----------------
52 51
Plan assets at fair value -- --
----------------
Unfunded obligation 52 51
Unrecognized net (loss) gain (1) 2
----------------
Accrued postretirement benefit costs $51 $53
----------------
USF&G classifies accrued postretirement benefit costs with other liabilities in
the Consolidated Statement of Financial Position.
Net periodic postretirement benefit costs consisted of $1 million of service
cost and $4 million of interest cost for each of the years ended December 31,
1997, 1996 and 1995.
The weighted-average annual assumed rate of increase in per capita cost of
covered benefits (i.e., medical trend rate) for the plans is 7.25 percent for
1998 and 1997, and is assumed to decrease to 5.25 percent in 2003 for
participants age 65 or younger, and 7.00 percent for 1998 and 1997, decreasing
to 5.25 percent for participants over age 65, and remain at that level
thereafter. Increasing the assumed medical trend rate by one percentage point in
each year would increase the accumulated postretirement benefit obligation by
approximately $4 million and the aggregate of the service and interest cost
components of net periodic postretirement benefit cost for the year by less than
$1 million. The weighted-average discount rate used in determining the
accumulated postretirement benefit obligation was 7.00 percent and 7.50 percent
at December 31, 1997 and 1996, respectively.
Note 11 Income Taxes
USF&G Corporation and its subsidiaries file a consolidated federal income tax
return. Deferred tax liabilities or assets are recognized for the estimated
future tax effects attributable to net operating loss carryforwards ("NOLs") and
to temporary differences between the tax basis and GAAP basis of an asset or a
liability. A valuation allowance is required if, based on the weight of
available evidence, it is more likely than not that some or all of the deferred
tax asset will not be realized.
At December 31, 1997, the net deferred tax asset of $317 million recorded by
USF&G was supported by a combination of forecasted taxable income and a tax
strategy that USF&G would implement to prevent NOLs from expiring. Based on the
weight of positive and negative evidence, USF&G believes that it is more likely
than not that it will be able to realize all of its deferred tax assets.
Accordingly, no valuation allowance was provided at December 31, 1997.
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<PAGE>
11.1. Significant components of deferred tax assets and liabilities
At December 31
(in millions) 1997 1996
----------------
Deferred Tax Liabilities:
DPAC $145 $146
Net unrealized gains 90 33
Prepaid pension cost 32 29
Real estate 24 15
Other invested assets 5 4
Other 38 37
----------------
Total deferred tax liabilities 334 264
----------------
Deferred Tax Assets:
Facilities exit costs 48 51
Unpaid losses and loss expenses 220 228
Future policy benefits 66 59
Unearned premiums 52 54
Foreign reinsurance 48 47
Postretirement benefits 18 19
Other 15 40
NOLs 184 202
----------------
Total deferred tax assets 651 700
Valuation allowance for deferred tax assets -- --
----------------
Deferred tax assets, net of
valuation allowance 651 700
----------------
Net deferred tax assets $317 $436
----------------
The components of the changes in the valuation allowance were recorded through
shareholders' equity and operations, as follows:
(in millions) 1997 1996 1995
---------------------
Changes Recognized in Shareholders'Equity:
Changes related to net unrealized
(gains) losses $-- $ 95 $(147)
Change related to minimum pension liability -- (35) 13
---------------------
Total changes recognized in
shareholders' equity -- 60 (134)
---------------------
Changes Recognized in Statement of Operations:
Reduction for increased likelihood
of realization -- (96) (81)
Other adjustments -- -- 2
---------------------
Total changes recognized in
statement of operations -- (96) (79)
---------------------
Total change in valuation allowance $-- $(36) $(213)
---------------------
-28-
<PAGE>
11.2. Income tax expense (benefit)
The components of the total income tax expense (benefit) were recorded through
shareholders' equity and operations, as follows:
(in millions) 1997 1996 1995
----------------------
Recorded in Shareholders' Equity:
Benefit from deduction of employee
stock options exercised $ (5) $(2) $ --
Deferred expense for change in
unrealized gain on investments 57 33 --
---------------------
Net expense recorded in
shareholders' equity 52 31 --
---------------------
Recorded in Statement of Operations:
Expense on net income 84 (2) (14)
Benefit from distributions on
capital securities (7) -- --
---------------------
Total expense (benefit) recorded
in statement of operations 77 (2) (14)
---------------------
Total income tax expense (benefit)
recorded $129 $29 $(14)
---------------------
11.3. Components of provision for income taxes (benefit)
(in millions) 1997 1996 1995
----------------------
Current tax $ 28 $ 8 $ 61
NOL utilization (18) (5) (56)
----------------------
Current tax, net of NOL utilization 10 3 5
Deferred tax (benefit) 67 91 62
Tax benefit of capital securities 7 -- --
Adjustment of the beginning of the
year valuation allowance -- (96) (81)
----------------------
Provision for income taxes
(benefit) $ 84 $ (2) $(14)
----------------------
Income taxes paid $ 7 $ 5 $ 5
----------------------
11.4. Reconciliation of taxes at federal rates to provision for income taxes
(benefit)
(in millions) 1997 1996 1995
----------------------
Tax at federal rates $102 $ 91 $ 68
Tax Effect (Benefit):
Adjustment of the beginning of the
year valuation allowance -- (96) (81)
Tax-exempt interest income (14) (2) (2)
Other (4) 5 1
----------------------
Provision for income taxes (benefit) $ 84 $ (2) $(14)
----------------------
-29-
<PAGE>
11.5. Net operating loss carryforwards
At December 31, 1997, USF&G had NOLs remaining for tax return purposes expiring
in 2006. The amount and timing of recognizing the benefit of these NOLs depends
on future taxable income and limitations imposed by tax laws. The approximate
amounts of USF&G's NOLs on a regular tax basis and an alternative minimum tax
("AMT") basis at December 31, 1997 were as follows:
(in millions) Tax Return NOLs
-----------------
Regular tax basis $525
AMT basis 393
-----------------
Note 12 Reinsurance
USF&G reinsures portions of its policy risks with other insurance companies or
underwriters, and assumes policy risks from other insurance companies and
through participation in pools and associations. Reinsurance gives USF&G the
ability to write larger risks and control its exposure to losses from
catastrophes or other events that cause unfavorable underwriting results.
USF&G's ceding reinsurance agreements are generally structured on a treaty basis
whereby all risks meeting certain criteria are automatically reinsured. Amounts
recoverable from reinsurers are estimated in a manner consistent with the claim
liability associated with the reinsured policy. Reinsurance contracts do not
relieve USF&G from its obligation to policyholders. Failure of reinsurers to
honor their obligations could result in losses to USF&G. USF&G evaluates the
financial condition of its reinsurers and monitors concentrations of credit
risks arising from similar economic characteristics of the reinsurers to
minimize its exposure to significant losses from reinsurer insolvencies.
At December 31, 1997 and 1996, property/casualty reinsurance receivables totaled
$860 million and $794 million, respectively. Of these amounts, approximately $89
million and $95 million, respectively, were associated with the Workers'
Compensation Reinsurance Bureau ("WCRB"), a single voluntary reinsurance
association of primary workers' compensation insurers formed for the purpose of
providing excess of loss reinsurance to its members. USF&G is a member of this
pool. Each member is required to hold collateral, for the benefit of all member
companies, in the form of investment-grade securities equaling 115 percent of
the member's share of outstanding receivables of the WCRB. This collateral
requirement mitigates the risk of the WCRB becoming insolvent. Risk of loss is
minimal for the remainder of receivables due to similar pool arrangements with
collateral requirements, other contracts where funds are withheld, or letters of
credit maintained. Credit risk is also diversified among numerous reinsurers.
Additionally, USF&G has been active in the involuntary market as a servicing
carrier whereby USF&G processes business for a pool but takes no direct
underwriting risk because it is directly reimbursed for the cost of processing
policies and settling any related claims. Servicing carrier receivables of $710
million and $661 million associated with this business are separately disclosed
in the Consolidated Statement of Financial Position at December 31, 1997 and
1996, respectively.
In August 1996, F&G Life entered into a coinsurance contract with an
unaffiliated life insurance company to cede a significant portion of F&G Life's
block of single premium deferred annuities (the "broker SPDA block"). As part of
the transaction, F&G Life transferred $932 million of investments and other
assets to the coinsurer, and recorded a reinsurance receivable of $964 million.
In December 1997, F&G Life entered into another coinsurance agreement with an
unaffiliated life reinsurance company whereby F&G Life transferred approximately
$144 million of investments and other assets to the reinsurer and recorded a
reinsurance receivable of $131 million. These transactions had no material
effect on USF&G's 1997 or 1996 net income. As of December 31, 1997, the addition
of receivables under the 1997 contract, offset by surrender activity under the
1996 contract, reduced the reserves for the transferred annuity blocks and the
related reinsurance receivable balances to $765 million. At December 31, 1997
and 1996, F&G Life's reinsurance receivables totaled $786 million and $782
million, respectively.
-30-
<PAGE>
The effect of reinsurance on USF&G's premiums and losses was as follows:
1997
Premiums Losses Unpaid Unearned
(in millions) Written Earned Incurred Losses Premiums
--------------------------------------------
Property/Casualty:
Direct $2,391 $2,386 $1,699 $4,703 $1,057
Assumed 539 573 355 1,451 91
--------------------------------------------
Gross 2,930 2,959 2,054 6,154 1,148
Ceded (478) (414) (260) (1,125) (184)
--------------------------------------------
Net 2,452 2,545 1,794 5,029 964
Life N/A 137 277 3,816 N/A
--------------------------------------------
Total $2,452 $2,682 $2,071 $8,845 $ 964
--------------------------------------------
1996
Premiums Losses Unpaid Unearned
(in millions) Written Earned Incurred Losses Premiums
--------------------------------------------
Property/Casualty:
Direct $2,401 $2,346 $1,721 $4,614 $ 991
Assumed 621 609 372 1,418 122
--------------------------------------------
Gross 3,022 2,955 2,093 6,032 1,113
Ceded (383) (369) (225) (987) (120)
--------------------------------------------
Net 2,639 2,586 1,868 5,045 993
Life N/A 145 313 3,552 N/A
--------------------------------------------
Total $2,639 $2,731 $2,181 $8,597 $ 993
--------------------------------------------
1995
Premiums Losses Unpaid Unearned
(in millions) Written Earned Incurred Losses Premiums
--------------------------------------------
Property/Casualty:
Direct $2,318 $2,253 $1,607 $4,675 $ 945
Assumed 634 637 436 1,422 110
--------------------------------------------
Gross 2,952 2,890 2,043 6,097 1,055
Ceded (389) (398) (241) (984) (136)
--------------------------------------------
Net 2,563 2,492 1,802 5,113 919
Life N/A 174 376 3,719 N/A
--------------------------------------------
Total $2,563 $2,666 $2,178 $8,832 $ 919
--------------------------------------------
Included in assumed unpaid losses in the preceding tables are $18 million and
$34 million related to loss portfolio transfer agreements at December 31, 1997
and 1996, respectively. USF&G has not entered into any such agreements to cede
its unpaid losses.
Note 13 Financial Guarantees
As of December 31, 1997, USF&G was contingently liable for par value amounts
totaling approximately $89 million on financial guarantee exposures ceded
through reinsurance agreements with a monoline insurance company in which USF&G
formerly had a minority ownership interest. In addition, USF&G has other
financial guarantee obligations where the par value guaranteed totaled $3
million at December 31, 1997, maturing at various dates through 2005. USF&G has
also committed, in connection with the sale of certain real estate mortgages, to
assumption of the first $15 million in losses, if any, that would arise as a
result of default on multi-family mortgages securitized as mortgage-backed
securities.
-31-
<PAGE>
Note 14 Legal Contingencies
USF&G's insurance subsidiaries are routinely engaged in litigation in the normal
course of their businesses, including defending claims for punitive damages. As
insurers, they defend third-party claims brought against their insureds, as well
as defend themselves against first-party and coverage claims. Additionally,
contingencies may arise from insurance regulatory matters and regulatory
litigation matters (refer to Note 14.3).
In the opinion of management, such contingencies and the contingencies described
below are not expected to have a material adverse effect on USF&G's consolidated
financial position, although it is possible that the results of operations in a
particular quarter or annual period would be materially affected by an
unfavorable outcome.
14.1. Workers' compensation litigation
A series of class actions have been filed against the National Council on
Compensation Insurance ("NCCI"), the insurance companies which served as
servicing carriers in various states, and the National Workers' Compensation
Reinsurance Pool ("NWCRP"). The complaints generally allege that the defendants
conspired to fix servicing carrier fees at unreasonably high and noncompetitive
levels thereby allegedly causing inflated deficits in the voluntary market,
excessive expansion of the residual market and excessive contraction of the
voluntary market. The plaintiffs generally seek unspecified compensatory and
punitive damages and, in some cases, civil penalties, treble damages under state
antitrust laws, and temporary and permanent injunctive relief. Plaintiffs'
counsel in these cases have, from time to time, indicated that similar cases may
be filed in other states. USF&G believes that it has meritorious defenses to
each of the class actions and has determined to defend the actions vigorously. A
determination of the outcome of these cases cannot be made at this time. Each of
the currently pending cases is described below.
North Carolina: On November 24, 1993, N.C. Steel, Inc., and six other North
Carolina employers filed a class action captioned N.C. Steel, Inc., et al., v.
National Council on Compensation Insurance, et al., in the General Court of
Justice, Superior Court Division, Wake County, North Carolina against the NCCI,
North Carolina Rate Bureau, USF&G and eleven other insurance companies that
served as servicing carriers for the North Carolina involuntary workers'
compensation market. On January 20, 1994, the plaintiffs filed an amended
complaint seeking to certify a class of all employers who purchased workers'
compensation insurance in the State of North Carolina after November 24, 1989.
On February 14, 1995, the trial court granted the defendants' motion to dismiss
the complaint. The plaintiffs appealed, and on July 16, 1996, the North Carolina
Court of Appeals affirmed the dismissal of the plaintiffs' first claim for
relief, which is premised on alleged excessive rates, but reversed the trial
court's decision to dismiss the plaintiffs' second claim for relief, which is
premised on employers allegedly being improperly shifted from the voluntary
market to the assigned risk market as a result of stricter underwriting caused
by high residual market burdens. The parties are awaiting the decision of the
North Carolina Supreme Court following a hearing of both issues on March 18,
1997.
-32-
<PAGE>
South Carolina: On August 22, 1994, the Attorney General of the State of South
Carolina filed a suit captioned State of South Carolina, County of Greenville,
et al., v. National Council on Compensation Insurance, et al., in the County of
Greenville, South Carolina against the NCCI, the NWCRP, USF&G and seven other
insurance companies that served as servicing carriers for the South Carolina
involuntary workers' compensation market. The Attorney General alleges that the
conspiracy occurred for an unspecified period of time prior to January 1994.
Discovery is underway in the case and a trial is scheduled for November 1998.
Kansas: On October 3, 1996, a Kansas employer filed a class action captioned
Amundson & Associates Art Studies, Ltd., et al., v. National Council on
Compensation Insurance, et al., in the District Court of Wyandotte County,
Kansas against the NCCI and the insurance companies that acted as servicing
carriers for the Kansas involuntary workers' compensation market. The defendants
removed the case to the United States District Court for the District of Kansas,
but on September 17, 1997, the federal District Court granted the plaintiff's
motion to remand the case to the state court. The defendants have filed a motion
to dismiss the case, and a hearing on that motion is scheduled for March 2,
1998. No trial date has yet been set.
Tennessee: On December 31, 1996, four Tennessee employers filed a class action
captioned Jo Ann Forman, Inc., et al., v. National Council on Compensation
Insurance, et al., in the Chancery Court of Marion County, Tennessee against the
NCCI, NWCRP and the insurance companies that acted as servicing carriers for the
Tennessee involuntary workers' compensation market. The defendants have filed a
motion to dismiss the case and are awaiting the decision of the trial court
following a hearing on July 14, 1997. No discovery has yet occurred.
Missouri: On February 20, 1997, six Missouri employers filed a class action
captioned Atlas Reserve Temporaries, Inc., et al., v. Vanliner Insurance Co., et
al., in the Circuit Court of Cole County, Missouri against the NCCI, USF&G and
other insurance companies that acted as servicing carriers for the Missouri
involuntary workers' compensation market. On August 26, 1997, the trial court
denied the defendants' motion to dismiss the case, and the defendants appealed
that decision. On September 26, 1997, the Missouri Court of Appeals denied the
defendants' appeal. The defendants have moved for a change in venue. No
discovery has yet occurred.
-33-
<PAGE>
14.2. Shareholder lawsuits
On January 23 and February 2, 1998, two shareholders of USF&G filed separate
suits against the Corporation captioned Sam Dickstein v. USF&G Corporation, et
al., and Ethel Theodore v. USF&G Corporation, et al., in the Circuit Court for
Baltimore City, Maryland. In these actions, the Corporation and some or all of
its directors were named as defendants, along with St. Paul. The suits generally
allege that the proposed merger agreement between USF&G and St. Paul is
wrongful, unfair and harmful to USF&G's public shareholders and that USF&G's
directors failed to: (1) undertake an adequate evaluation of USF&G's worth; (2)
take adequate steps to enhance USF&G's value; (3) effectively expose USF&G to
the marketplace; and (4) act independently to protect the interests of USF&G's
shareholders. St. Paul is accused of aiding and abetting the alleged breaches of
duty. The suits seek to have a plaintiff class certified of all shareholders of
USF&G (excluding the individual defendants) and seek to enjoin the proposed
merger and/or obtain monetary damages for the alleged conduct. USF&G believes
the allegations in the suits are without merit, and is determined to defend the
actions vigorously. A determination of the outcome of these cases cannot be made
at this time.
14.3. Regulation
USF&G's insurance subsidiaries are subject to extensive regulatory oversight in
the jurisdictions where they do business. From time to time, the insurance
regulatory framework has been the subject of increased scrutiny. At any one time
there may be numerous initiatives within state legislatures or state insurance
departments to alter and, in many cases, increase state authority to regulate
insurance companies and their businesses. It is not possible to predict the
future impact of increasing regulation on USF&G's operations. (Additional
information regarding regulatory matters may be found in Section 9,
"Regulation", of Management's Discussion and Analysis of Financial Condition and
Results of Operations.)
-34-
<PAGE>
Note 15 Interim Financial Data (Unaudited)
(in millions except Quarter
per share data) First Second Third Fourth*
------------------------------------
Revenues 1997 $845 $872 $828 $859
1996 867 858 871 902
1995 818 856 885 900
------------------------------------
Net income 1997 $45 $47 $48 $54
1996 57 67 35 102
1995 49 46 49 65
------------------------------------
Basic EPS** 1997 $.38 $.43 $.43 $.48
1996 $.43 $.52 $.26 $.84
1995 .39 .35 .37 .52
------------------------------------
Diluted EPS** 1997 $.36 $.40 $.40 $.46
1996 .42 .50 .25 .79
1995 .36 .33 .36 .48
------------------------------------
*The fourth quarter 1996 and 1995 results reflect tax benefits of $3 million and
$15 million, respectively (refer to Note 11). The fourth quarter 1996 results
also reflect $(30) million in facilities exit costs/(sublease income) as
discussed in Note 1.13.
**The sum of quarterly income per share amounts may not equal the full year's
amount due to stock issuances, repurchases and redemptions during presented
periods.
Note 16 Information on Business Segments
USF&G's principal business segments are property/casualty insurance and life
insurance.
16.1. Assets
The assets of the insurance operations are primarily investments. Foreign
assets, consisting primarily of the assets of Afianzadora (refer to Note 1.14),
are not material. Assets of the business segments were as follows:
At December 31
(in millions) 1997 1996
-------------------
Property/casualty insurance $11,204 $10,099
Life insurance 4,478 4,204
Noninsurance operations and
eliminations 137 104
-------------------
Consolidated total $15,819 $14,407
-------------------
-35-
<PAGE>
16.2 Operations
USF&G's insurance business is geographically diversified throughout North
America. Reinsurance and noninsurance operations are located in the United
States, Europe and various foreign countries. Foreign operations, in total, are
not material. Summarized financial information for the business segments is as
follows:
<TABLE>
<S> <C> <C> <C> <C> <C> <C>
Income (Loss) from Operations
Revenues Before Income Taxes**
(in millions) 1997 1996 1995 1997 1996 1995
----------------------------------------------------------------------
Property/Casualty Insurance
Underwriting Results:
Commercial Insurance Group $ 936 $ 954 $ 876 $ (89) $ (82) $ (97)
Family and Business Insurance Group 932 989 982 (71) (147) (119)
Discover Re 29 22 25 4 2 1
F&G Re 459 480 490 30 52 43
Surety Group 189 141 119 27 8 16
-----------------------------------------------------------------------
Property/casualty underwriting results 2,545 2,586 2,492 (99) (167) (156)
Net investment income* 443 441 438 443 441 438
Net realized gains on investments* 12 63 14 12 63 14
Other 9 10 12 (27) (106) (42)
-----------------------------------------------------------------------
Total property/casualty insurance 3,009 3,100 2,956 329 231 254
-----------------------------------------------------------------------
Life Insurance:
Premium income 137 145 174
Net investment income 253 269 306
Net realized gains (losses) on investments 14 (57) 1
Other -- -- 1
-----------------------------------------------------------------------
Total life insurance 404 357 482 78 (8) 28
-----------------------------------------------------------------------
Noninsurance operations and eliminations (9) 41 21 (115) 36 (87)
-----------------------------------------------------------------------
Consolidated total $3,404 $3,498 $3,459 $ 292 $ 259 $ 195
-----------------------------------------------------------------------
* Net investment income and net realized gains (losses) on investments are not
allocated to property/casualty business units.
** Income (loss) from operations before income taxes for 1996 included
facilities exit (costs)/income by segment as follows:
Property/casualty, $(28) million; and Noninsurance operations, $70 million.
</TABLE>
-36-
<PAGE>
USF&G CORPORATION Report of Independent Auditors
Board of Directors
USF&G Corporation
We have audited the accompanying consolidated statement of financial position of
USF&G Corporation as of December 31, 1997 and 1996, and the related consolidated
statements of operations, cash flows and shareholders' equity for each of the
three years in the period ended December 31, 1997. These financial statements
are the responsibility of the Corporation's management. Our responsibility is to
express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of USF&G Corporation
at December 31, 1997 and 1996, and the consolidated results of its operations
and its cash flows for each of the three years in the period ended December 31,
1997, in conformity with generally accepted accounting principles.
/s/ ERNST & YOUNG LLP
Baltimore, Maryland
February 20, 1998
UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL STATEMENTS
OF ST. PAUL AND USF&G
The following unaudited pro forma financial information combines the
historical consolidated balance sheets and statements of income of St. Paul and
USF&G, including their respective subsidiaries, after giving effect to the
Merger. The unaudited pro forma condensed combined balance sheet at December 31,
1997, set forth below, gives effect to the Merger as if it had occurred at
December 31, 1997. The unaudited pro forma condensed combined statements of
income for each of the three years ended December 31, 1997, 1996 and 1995 give
effect to the Merger as if it had occurred on January 1, 1995. These statements
are prepared on the basis of accounting for the Merger as a "pooling of
interests" and are based on the assumptions set forth in the notes thereto.
The following pro forma financial information has been prepared from, and
should be read in conjunction with, the audited historical consolidated
financial statements and related notes thereto of St. Paul and USF&G,
incorporated by reference herein. The following information is not necessarily
indicative of the financial position or operating results that would have
occurred had the Merger been consummated on the date, or at the beginning of the
period for which the Merger is being given effect, nor is it necessarily
indicative of future financial position or operating results. See "Where You Can
Find More Information."
-1-
<PAGE>
ST. PAUL AND USF&G
UNAUDITED PRO FORMA CONDENSED COMBINED BALANCE SHEET
AS OF DECEMBER 31, 1997
<TABLE>
<CAPTION>
HISTORICAL PRO FORMA
----------------------- ------------------------
ST. PAUL USF&G ADJUSTMENTS COMBINED
---------- ----------- ----------- -----------
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
<S> <C> <C> <C> <C>
ASSETS
Investments............................................ $ 15,036 $ 10,944 $ 0 $ 25,980
Reinsurance recoverables............................... 1,963 2,355 (12)(6) 4,306
Receivables............................................ 1,798 878 0 2,676
Deferred income taxes.................................. 845 317 66(9) 1,228
Other assets........................................... 1,859 1,325 (41)(7) 3,143
---------- ----------- ----------- -----------
TOTAL ASSETS....................................... $ 21,501 $ 15,819 $ 13 $ 37,333
---------- ----------- ----------- -----------
---------- ----------- ----------- -----------
LIABILITIES
Insurance reserves:
Losses, loss adjustment expenses and policy
benefits........................................... $ 11,817 $ 10,017 $ 135(6)$ 21,969
Unearned premiums.................................... 2,380 1,148 0 3,528
---------- ----------- ----------- -----------
Total insurance reserves........................... 14,197 11,165 135 25,497
Debt................................................... 783 521 0 1,304
Other liabilities...................................... 1,687 1,760 28(8) 3,475
---------- ----------- ----------- -----------
TOTAL LIABILITIES.................................. 16,667 13,446 163 30,276
---------- ----------- ----------- -----------
Company-obligated mandatorily redeemable preferred
securities of subsidiary............................. 207 296 0 503
---------- ----------- ----------- -----------
SHAREHOLDERS' EQUITY
PREFERRED SHAREHOLDERS' EQUITY......................... 17 0 0 17
---------- ----------- ----------- -----------
COMMON:
Common stock........................................... 512 1,417 0 1,929
Retained earnings...................................... 3,451 493 (150)(9) 3,794
Other.................................................. 647 167 0 814
---------- ----------- ----------- -----------
TOTAL COMMON SHAREHOLDERS' EQUITY.................. 4,610 2,077 (150) 6,537
---------- ----------- ----------- -----------
TOTAL SHAREHOLDERS' EQUITY......................... 4,627 2,077 (150) 6,554
---------- ----------- ----------- -----------
TOTAL LIABILITIES, REDEEMABLE PREFERRED SECURITIES
AND SHAREHOLDERS' EQUITY........................... $ 21,501 $ 15,819 $ 13 $ 37,333
---------- ----------- ----------- -----------
---------- ----------- ----------- -----------
Book value per common share............................ $ 55.06 $ 17.84 $ 56.08
Common shares outstanding.............................. 83,727,800 116,402,199 32,837,060(3) 116,564,860
</TABLE>
------------------------
The accompanying notes are an integral part of these pro
forma condensed combined financial statements.
-2-
<PAGE>
ST. PAUL AND USF&G
UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF INCOME
FOR THE YEAR ENDED DECEMBER 31, 1997
<TABLE>
<CAPTION>
HISTORICAL PRO FORMA
--------------------- -----------------------
ST. PAUL USF&G ADJUSTMENTS COMBINED
--------- ---------- ----------- ----------
<S> <C> <C> <C> <C>
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
REVENUES:
Premiums earned......................................... $ 4,616 $ 2,682 $ 0 $ 7,298
Net investment income................................... 886 691 0 1,577
Realized gains.......................................... 408 15 0 423
Asset management-investment banking..................... 262 0 0 262
Other................................................... 47 16 0 63
--------- ---------- ----------- ----------
Total revenues from continuing operations........... 6,219 3,404 0 9,623
--------- ---------- ----------- ----------
EXPENSES:
Insurance losses, loss adjustment expenses and policy
benefits.............................................. 3,345 2,071 (37)(7) 5,379
Policy acquisition expenses............................. 1,021 687 0 1,708
Operating and administrative............................ 834 375 5(7) 1,214
--------- ---------- ----------- ----------
Total expenses...................................... 5,200 3,133 (32) 8,301
--------- ---------- ----------- ----------
INCOME BEFORE INCOME TAXES.......................... 1,019 271 32 1,322
Income tax expense...................................... 246 77 11(9) 334
--------- ---------- ----------- ----------
INCOME FROM CONTINUING OPERATIONS................... $ 773 $ 194 $ 21 $ 988
--------- ---------- ----------- ----------
--------- ---------- ----------- ----------
INCOME FROM CONTINUING OPERATIONS PER COMMON SHARE:
Basic................................................... $ 9.10 $ 1.72 $ 8.46
Diluted................................................. $ 8.39 $ 1.63 $ 7.85
ADJUSTED AVERAGE COMMON SHARES OUTSTANDING:
Basic................................................... 83,572,000 111,688,000 31,507,000 115,079,000
Diluted................................................. 92,261,000 120,109,000 33,883,000 126,144,000
</TABLE>
------------------------
The accompanying notes are an integral part of these pro
forma condensed combined financial statements.
-3-
<PAGE>
ST. PAUL AND USF&G
UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF INCOME
FOR THE YEAR ENDED DECEMBER 31, 1996
<TABLE>
<CAPTION>
HISTORICAL PRO FORMA
--------------------- -----------------------
ST. PAUL USF&G ADJUSTMENTS COMBINED
--------- ---------- ----------- ----------
<S> <C> <C> <C> <C>
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
REVENUES:
Premiums earned...................................... $ 4,448 $ 2,731 $ 0 $ 7,179
Net investment income................................ 807 705 0 1,512
Realized gains....................................... 219 44 4(7) 267
Asset management-investment banking.................. 220 0 0 220
Other................................................ 40 18 0 58
--------- ---------- ----------- ----------
Total revenues from continuing operations........ 5,734 3,498 4 9,236
--------- ---------- ----------- ----------
EXPENSES:
Insurance losses, loss adjustment expenses and policy
benefits........................................... 3,318 2,181 (28)(7) 5,471
Policy acquisition expenses.......................... 975 707 0 1,682
Operating and administrative......................... 742 351 12(7) 1,105
--------- ---------- ----------- ----------
Total expenses................................... 5,035 3,239 (16) 8,258
--------- ---------- ----------- ----------
INCOME BEFORE INCOME TAXES....................... 699 259 20 978
Income tax expense (benefit)......................... 141 (2) 7(9) 146
--------- ---------- ----------- ----------
INCOME FROM CONTINUING
OPERATIONS..................................... $ 558 $ 261 $ 13 $ 832
--------- ---------- ----------- ----------
--------- ---------- ----------- ----------
INCOME FROM CONTINUING OPERATIONS PER COMMON SHARE:
Basic................................................ $ 6.57 $ 2.05 $ 6.87
Diluted.............................................. $ 6.11 $ 1.95 $ 6.45
ADJUSTED AVERAGE COMMON SHARES OUTSTANDING:
Basic................................................ 83,474,000 117,674,000 33,196,000(3) 116,670,000
Diluted.............................................. 91,897,000 127,734,000 36,034,000(3) 127,931,000
</TABLE>
------------------------
The accompanying notes are an integral part of these pro
forma condensed combined financial statements.
-4-
<PAGE>
ST. PAUL AND USF&G
UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF INCOME
FOR THE YEAR ENDED DECEMBER 31, 1995
<TABLE>
<CAPTION>
HISTORICAL PRO FORMA
--------------------- -----------------------
ST. PAUL USF&G ADJUSTMENTS COMBINED
--------- ---------- ----------- ----------
<S> <C> <C> <C> <C>
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
REVENUES:
Premiums earned......................................... $ 3,971 $ 2,666 $ 0 $ 6,637
Net investment income................................... 741 733 0 1,474
Realized gains.......................................... 85 7 0 92
Asset management-investment banking..................... 221 0 0 221
Other................................................... 38 53 0 91
--------- ---------- ----------- ----------
Total revenues from continuing operations........... 5,056 3,459 0 8,515
--------- ---------- ----------- ----------
EXPENSES:
Insurance losses, loss adjustment expenses and policy
benefits.............................................. 2,864 2,178 (32)(6) 5,010
Policy acquisition expenses............................. 857 714 0 1,571
Operating and administrative............................ 666 372 1(7) 1,039
--------- ---------- ----------- ----------
Total expenses...................................... 4,387 3,264 (31) 7,620
--------- ---------- ----------- ----------
INCOME BEFORE INCOME TAXES.......................... 669 195 31 895
Income tax expense (benefit)............................ 131 (14) 11(9) 128
--------- ---------- ----------- ----------
INCOME FROM CONTINUING
OPERATIONS........................................ $ 538 $ 209 $ 20 $ 767
--------- ---------- ----------- ----------
--------- ---------- ----------- ----------
INCOME FROM CONTINUING OPERATIONS PER COMMON SHARE:
Basic................................................... $ 6.26 $ 1.63 $ 6.29
Diluted................................................. $ 5.88 $ 1.53 $ 5.91
ADJUSTED AVERAGE COMMON SHARES OUTSTANDING:
Basic................................................... 84,385,000 111,474,000 31,447,000(3) 115,832,000
Diluted................................................. 91,637,000 130,064,000 36,691,000(3) 128,328,000
</TABLE>
------------------------
The accompanying notes are an integral part of these pro
forma condensed combined financial statements.
-5-
<PAGE>
ST. PAUL AND USF&G
NOTES TO UNAUDITED PRO FORMA
CONDENSED COMBINED FINANCIAL STATEMENTS
1. DESCRIPTION OF TRANSACTIONS
The Merger Agreement provides that each share of USF&G Common Stock will be
converted into and become the right to receive a number of shares of St. Paul
Common Stock based upon the Exchange Ratio. For purposes of the unaudited pro
forma condensed combined financial statements, an Exchange Ratio of 0.2821 has
been assumed. If the maximum Exchange Ratio of 0.2973 were assumed, pro forma
combined diluted earnings per share for the years ended December 31, 1997, 1996
and 1995 would be $7.74, $6.35 and $5.82, respectively.
2. RECLASSIFICATIONS AND RESTATEMENTS
Certain items in USF&G's historical financial statements have been
reclassified to conform to St. Paul's presentation.
St. Paul sold its insurance brokerage operation, Minet, in May 1997. St.
Paul's historical financial data for all periods presented reflect Minet as a
discontinued operation.
3. PER COMMON SHARE DATA
The pro forma combined per common share data has been computed based on the
combined historical income from continuing operations as adjusted for
retroactive changes in certain accounting methods of both companies in order to
achieve conformity on the combined historical weighted average common shares
outstanding. For purposes of this calculation, USF&G's weighted average common
shares outstanding was multiplied by the assumed Exchange Ratio of 0.2821.
4. INTERCOMPANY TRANSACTIONS
Transactions between St. Paul and USF&G are not material in relation to the
pro forma condensed combined financial statements and therefore intercompany
balances have not been eliminated from the pro forma combined amounts.
5. RESTRUCTURING CHARGE
The pro forma condensed combined financial statements do not reflect a
planned Merger-related restructuring charge that is currently expected to be
between $300 million and $500 million, primarily for costs related to the
combination of headquarters, the integration of the information technology
systems of St. Paul and USF&G, headcount reduction and legal expenses, because
such restructuring charges are non-recurring. Although there can be no assurance
that the restructuring charge will fall within the range provided, this range
represents management's best estimate based upon the information currently
available.
6. LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES
Liabilities for unpaid losses and loss adjustment expenses related to
workers' compensation coverages were discounted to present value in the
historical financial statements of USF&G. St. Paul did not discount workers'
compensation reserves. On a combined basis, St. Paul and USF&G will discount
certain workers' compensation reserves using an interest rate of up to four
percent. Accordingly, the pro forma income
-6-
<PAGE>
ST. PAUL AND USF&G
NOTES TO UNAUDITED PRO FORMA
CONDENSED COMBINED FINANCIAL STATEMENTS (CONTINUED)
6. LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES (CONTINUED)
statement adjustments for all periods presented include a reduction in insurance
losses and loss adjustment expenses to conform the accounting policies of both
companies. Those pro forma adjustments to the condensed combined statements of
income for the years ended December 31, 1997, 1996 and 1995 are $46 million, $33
million and $32 million, respectively.
7. SOFTWARE CAPITALIZATION
Included in USF&G's historical financial statements are capitalized costs
for internal use software. These costs were amortized over their useful lives.
St. Paul does not capitalize such expenditures. On a combined basis, St. Paul
and USF&G do not expect to capitalize development costs for internal use
software. Accordingly, the pro forma adjustments for all periods presented
conform the historical financial statements of USF&G to the combined
presentation. Those pro forma adjustments to the condensed combined statements
of income are as follows:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
----- ----- -----
(IN MILLIONS)
<S> <C> <C> <C>
Insurance losses and loss adjustment expenses..................... $ 9 $ 5 $ 0
Operating and administrative expenses............................. 5 12 1
Realized loss..................................................... 0 (4) 0
------- -------- ------
Total............................................................. $ 14 $ 13 $ 1
======= ======== ======
</TABLE>
8. ADJUSTMENTS TO RECORD ANTICIPATED TRANSACTION COSTS
Transaction costs of the Merger, representing investment banker and other
professional fees, are expected to be approximately $28 million. The unaudited
pro forma condensed combined statements of income do not reflect these charges.
The unaudited pro forma condensed combined balance sheet reflects these charges.
It is anticipated that these charges will be incurred by St. Paul and USF&G and
expensed at the Effective Time, which is currently expected to be in mid-1998.
9. INCOME TAXES
The income tax effect of adjustments made to the unaudited pro forma
condensed combined financial statements was calculated using St. Paul's
statutory income tax rate of 35%.
10. STOCK SPLIT
Historical per share data for St. Paul has been adjusted to reflect a
two-for-one split of the St. Paul Common Stock which took place in 1994. All per
share amounts contained in the unaudited pro forma condensed combined financial
statements and the notes thereto reflect such stock split. This data does not
reflect the St. Paul Stock Split.
-7-
