-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, UvmE/Q0P3PIhVFcHDgasKya1HhamwMeXwo7Hk9wf7Z+c0sfKXfNUjrOiL3xngBuu wMFMjZBdRAOaOsIZqF/tRg== 0001034588-98-000006.txt : 19980529 0001034588-98-000006.hdr.sgml : 19980529 ACCESSION NUMBER: 0001034588-98-000006 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980331 SROS: NYSE FILER: COMPANY DATA: COMPANY CONFORMED NAME: HSB GROUP INC CENTRAL INDEX KEY: 0001034588 STANDARD INDUSTRIAL CLASSIFICATION: 6331 IRS NUMBER: 061475343 STATE OF INCORPORATION: CT FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 001-13135 FILM NUMBER: 98582787 BUSINESS ADDRESS: STREET 1: ONE STATE ST STREET 2: P O BOX 5024 CITY: HARTFORD STATE: CT ZIP: 06102-5024 BUSINESS PHONE: 8607221866 MAIL ADDRESS: STREET 1: ONE STATE ST STREET 2: PO BOX 5024 CITY: HARTFORD STATE: CT ZIP: 06102 10-K 1 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K /X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1997 OR / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ______ to ______ Commission File Number 001-13135 HSB GROUP, INC. (Exact name of registrant as specified in its charter) Connecticut 06-1475343 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) P.O. Box 5024 One State Street Hartford, Connecticut 06102-5024 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (860) 722-1866 Securities registered pursuant to Section 12(b) of the Act: Name of each exchange Title of each class on which registered - - ------------------- ------------------- Common stock, without par value New York Stock Exchange, Inc. Rights to Purchase Depositary Receipts New York Stock Exchange, Inc. Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark whether the registrant (1) has filed all reports to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes...X..., No....... Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.....X....... The aggregate market value of the voting stock held by non-affiliates of the registrant as of February 17, 1998 was $1,179,041,668. Number of shares of common stock outstanding as of February 17, 1998: 19,409,870. Documents Incorporated by Reference: Portions of the Proxy Statement dated March 6, 1998 for the Annual Meeting of Shareholders to be held April 21, 1998 are incorporated by reference in Parts III and IV herein. 1 PART I Item 1. Business. A. GENERAL DEVELOPMENT OF BUSINESS HSB Group, Inc. (together with its subsidiaries referred to as the "Company" or "HSB" hereinafter) was formed under the laws of the State of Connecticut in 1997 to serve as the holding company for The Hartford Steam Boiler Inspection and Insurance Company (HSBIIC) and its subsidiaries. The Hartford Steam Boiler Inspection and Insurance Company was chartered as an insurance company by the Connecticut legislature in 1866. The Company's operations are divided into three industry segments - insurance, engineering services and investments. The most significant business of the Company is providing insurance against losses from accidents to boilers, pressure vessels, and a wide variety of mechanical and electrical machinery and equipment along with a high level of inspection services aimed at loss prevention. Earned premiums for the Company's insurance products were $491.2 million for 1997, which accounted for approximately 81.4 percent of the Company's revenues. See Note 9 to the Consolidated Financial Statements located in Item 8 of Part II herein for information on the Company's net written and net earned premiums over the last three years. The Company conducts its business in Canada through its subsidiary, The Boiler Inspection and Insurance Company of Canada. Insurance for risks located in countries other than the United States and Canada is written by HSB Engineering Insurance Limited (HSB EIL). In December 1994, the Company purchased the remaining 50% interest in HSB EIL's parent company, Engineering Insurance Group (EIG) from General Reinsurance Corporation. On January 6, 1998, HSBIIC sold its 23.5 percent share in Industrial Risk Insurers (IRI) to Employers Reinsurance Corporation (ERC), one of the world's largest reinsurance companies, in accordance with a previously announced purchase and sale agreement between ERC and IRI's twenty-three member insurers. IRI is a voluntary, unincorporated joint underwriting association, which provides property insurance for the class of business known as "highly protected risks" (HPR) -- larger manufacturing, processing, and industrial businesses which have invested in protection against loss through the use of sprinklers and other means. Contemporaneous with the close of the sale, IRI was reconstituted with ERC (with a 99.5 percent share) and HSBIIC (with a .5 percent share) as the sole members. HSBIIC will write the business for the reconstituted IRI using its insurance licenses and will provide certain other management and technical services. In addition, through various reinsurance agreements with ERC and IRI, HSBIIC will transfer its manufacturing book of business to IRI and will retain 85% of the equipment breakdown insurance and 15% of the property insurance of the HSB/IRI combined portfolio. See "Participation in Industrial Risk Insurers" on page 12 for additional information. To support the Company's expanded role with IRI, on December 31, 1997, a business trust formed by HSB sold $300 million of 20-year, 7 percent Convertible Capital Securities in a private placement to ERC, of which $250 million was contributed by the Company to HSBIIC. 2 The capital securities are convertible into HSB common stock, at any time, subject to regulatory approval. See Note 12 to the Consolidated Financial Statements located in Item 8 of Part II herein for more information on this transaction. The Company also offers professional scientific and technical consulting services for industry and government on a world-wide basis through its Engineering Department and its engineering subsidiaries. In 1997 net engineering services revenues were $61.3 million, which accounted for approximately 10.2 percent of the Company's revenues. On January 2, 1998, the Company exercised its option to put its 40 percent share in Radian International LLC (Radian LLC) to The Dow Chemical Company for approximately $144 million. Radian LLC was formed in January 1996 as a joint venture with Dow to provide environmental, engineering, information technology, remediation and strategic chemical management services to industries and governments world-wide. In connection with the formation of the new company, the Company contributed substantially all of the assets of its wholly-owned subsidiary, Radian Corporation to Radian LLC. The results of Radian LLC were classified as discontinued operations following ratification by the Board of Directors of management's decision to exercise its put in July 1997 and the Company's share of Radian LLC's losses incurred subsequent to such decision of approximately $10 million was deferred until the closing of the sale on January 2, 1998, at which time an estimated after-tax gain of $30 million was realized. In 1996 and prior to July 1997, the Company's share of the joint venture's results were recorded as equity in Radian. Recently the Company has been focusing on identifying acquisition candidates in the niche engineering management consulting service business, primarily in process industries, in order to grow the engineering services segment of its business. The Company does not currently anticipate that any single acquisition within the next twelve months will be material to the operations or financial position of the Company. During 1997 the Company completed the acquisition of Haughton Engineering Services Limited of England. Haughton offers a wide range of inspection services in the United Kingdom to help ensure compliance with regulatory codes. During 1997 the Company also acquired a 51 percent interest in Integrated Process Technologies LLC, which markets computerized facilities maintenance vendor management systems and services. The Company is a multi-national company operating primarily in North American, European, and Asian markets. Currently, the Company's principal market for its insurance and engineering services is the United States. However, the Company does desire to become a stronger competitor in the international machinery breakdown insurance and related engineering services markets as it believes that there is significant opportunity for profitable growth overseas. In 1997 the revenues and pre-tax income associated with operations outside of the United States were approximately 18.5 percent and 20.9 percent, respectively. Identifiable assets associated with operations outside of the United States are approximately 19.0 percent of the consolidated amount. See Note 1 and Note 4 to the Consolidated Financial Statements located in Item 8 of Part II herein for more financial data based on geographic location and business segments. 3 B. PRODUCTS AND SERVICES Insurance - - --------- Equipment breakdown insurance provides for the indemnification of the policyholder for financial loss resulting from destruction or damage to an insured boiler, pressure vessel, or other item of machinery or equipment caused by an accident. This financial loss can include the cost to repair or replace the damaged equipment (property damage), and product spoilage, lost profits and expenses to avert lost profits (business interruption) stemming from an accident. The Company distinguishes itself from other insurance suppliers by providing a high level of loss prevention, failure analysis and other engineering services with the insurance product. This heavy emphasis on loss prevention historically has had the dual effect of increasing underwriting and inspection expenses, while reducing loss and loss adjustment expenses. An important ancillary benefit for the policyholder is that the inspection performed by the Company's inspector on a boiler, pressure vessel, or other piece of equipment, as part of the insurance process, is normally accepted by state and other regulatory jurisdictions for their certification purposes. Without a certificate of inspection by the insurance carrier or another inspection agency, policyholders cannot legally operate many types of equipment. The Company also writes all risk property insurance for risks with significant machinery and equipment exposures, in addition to its more traditional boiler and machinery products. The all risk line is marketed to customers with equipment and machinery exposures, such as electric utilities, where sophisticated engineering services are important to loss prevention and control. These customers are offered technical services such as computerized evaluations of fire protection systems in addition to fire inspections and boiler and machinery inspections. The Company also writes all risk coverage specifically tailored for data processing systems. Engineering Services - - -------------------- Separate divisions of the Company's Engineering Department provide quality assurance services, training for nondestructive testing, inspections to code standards of the American Society of Mechanical Engineers (ASME), ISO certification services and other specialized consulting and inspection services related to the design and applications of boilers, pressure vessels, and many other types of equipment for domestic and foreign equipment manufacturers and their customers. HSBIIC is the largest Authorized Inspection Agency for ASME codes in the world. In addition, the Company's Engineering Department focuses on researching and developing potential new products and services, and new markets for current services. 4 The Company's engineering subsidiaries include HSB Reliability Technologies Corp. (HSB RT), and HSB Professional Loss Control, Inc. (HSB PLC). HSB RT maintains an extensive database on equipment maintenance and reliability and provides preventive maintenance consulting services and programs to a wide range of businesses and industries. Such services and programs are designed to increase production, reduce maintenance, energy and spare parts inventory costs, and extend equipment life. HSB PLC is a fire protection consulting and engineering firm. Its services include inspections, hazards analysis and risk assessment, engineering design, code consulting, research and testing, and training. HSB Haughton and Integrated Process Technologies LLC, which became affiliated with the Company during 1997, are described above under "A. General Development of Business". C. COMPETITION Insurance - - --------- The Company is the largest writer of equipment breakdown insurance in North America and is establishing a significant presence in the engineering insurance market outside of North America. Based on gross earned premium, the Company's U.S. market share, at approximately 37 percent, has remained fairly stable over the past ten years. Based on net premiums written reported in the 1997 edition of Best's Aggregates and Averages, no other single company has more than a 10 percent market share. Members of the Factory Mutual System, an affiliated group of insurers, have a market share of approximately 20 percent. In general, the insurance market is influenced by the total insurance capacity available based on policyholder surplus. Over the last few years, global capacity has grown as new insurers enter the property casualty market. In addition to available capacity, competition in the equipment breakdown insurance market is based on price and service to the insured. Service includes maintaining customer relationships, engineering and loss prevention activities, and claims settlement. The Company prices its product competitively in the marketplace, but primarily competes by offering a high level of service, not by offering the lowest-priced product. Competition in the equipment breakdown insurance market, as well as the property/casualty market in general, has intensified in recent years as a result of continuing restructuring and consolidation in the insurance industry. However, because the Company primarily underwrites risks which require unique engineering expertise and jurisdictionally mandated inspections, the Company believes that its products and services will continue to be competitive. 5 Engineering Services - - -------------------- The Company provides a wide range of engineering, consulting and inspection services as described on page 4. For most of these services it has numerous competitors, some of whom are much larger and have greater financial resources than the Company. Competition in these areas is based on price and on the qualifications, experience and availability of the individuals who perform the work. The Company's force of inspectors, engineers, and technicians is spread throughout the world. Ongoing training programs ensure that the Company's inspectors, engineers, and technicians are kept up-to-date on the latest engineering and technical developments. D. MARKETING Insurance - - --------- The Company's various functional operations are aligned to focus on its two principal customer groups, commercial risks and special risks. The Company believes that this organizational structure allows it to service its customers more effectively and efficiently and at the same time to be a more aggressive and flexible competitor. Currently, the Company's principal market for its insurance business is the United States. In 1997, 77.1 percent of its net written premiums (exclusive of IRI) related to risks located in the United States. Of the direct premiums written in the United States in 1997 (gross premiums less return premiums and cancellations, excluding reinsurance assumed and before deducting reinsurance ceded), less than 10 percent was written in any one state. With the exception of California, Florida, New York, Pennsylvania and Texas, no state accounted for more than 5 percent of such premiums. The Company has contracts with independent insurance agencies in all fifty states, the District of Columbia, Puerto Rico and Canada. These agencies market the Company's direct insurance to its small and medium commercial accounts. Personal contact with these independent insurance agents is accomplished through the Company's field sales force which operates out of various branch offices across the country and in Canada. It is the Company's policy in appointing agents to be selective, seeking to maintain and strengthen its existing relationships and to develop relationships with new agents whom the Company believes will become a continuing source of profitable business. The Company periodically reviews its agency contracts and selectively reduces them in order to retain only those agents who consistently produce certain minimum levels of business for the Company. Large, engineering-intensive U.S. and international accounts are primarily marketed and serviced by account teams comprised of underwriting, marketing, engineering and claims staff who have specialized knowledge of particular customer industries. U.S. customers are serviced primarily by HSBIIC. Canadian customers are serviced by The Boiler Inspection and Insurance Company of Canada. Overseas customers are serviced by HSB Engineering 6 Insurance Limited, based in London, with additional offices in Hong Kong, Malaysia, Australia, Miami, New York, Spain, Korea and South Africa. Additionally, the Company markets its insurance products through the distribution channels of the companies which it reinsures. IRI markets its products primarily through a small number of large international brokerage firms. A portion of the Company's special risk business is also produced through these brokers. Recently there has been significant consolidation in the international brokerage business, including the merger of Marsh & McLennan and Johnson & Higgins during 1997. For 1997, approximately 18.5 percent of the Company's gross written premium generated by its special risk business and by its 23.5 percent participation in IRI was produced by J&H Marsh & McLennan after giving effect to the merger. Based on writings for 1997 it is anticipated that as a result of the agreements with Employers Reinsurance Corporation relating to IRI as described under "Participation in Industrial Risk Insurers" which went into effect on January 1, 1998, J&H Marsh & McLennan will be responsible for producing approximately 25.2 percent of the Company's gross written premium in 1998. No other insured or broker accounts for more than 10 percent of the consolidated total revenues of the Company. Engineering Services - - -------------------- The Company's engineering services are marketed in a variety of ways. Customized services related to loss prevention, failure analysis, and equipment testing are generally sold in conjunction with the insurance contract but are also available separately. Most other engineering services are marketed on a bid or proposal basis. While such business is usually price sensitive, the exacting standards and requirements set by industry and government for most of the services offered by the Company tend to diminish that effect. Engineering services are marketed and serviced primarily by personnel located in the Company's various domestic and international offices. While the primary market for engineering services continues to be the U.S., the Company has been focusing on expanding its international business, primarily in Europe and the Pacific Rim as demand for engineering services is expected to grow at a faster rate in these developing regions than in the U.S. No engineering services customer accounts for more than 10 percent of the Company's consolidated total revenues. 7 E. REGULATION Insurance - - --------- The Company's insurance subsidiaries' operations are subject to regulation throughout the United States. Various aspects of the insurance operations are regulated, including the type and amount of business that can be written, the price that can be charged for particular forms of coverage, policy forms, trade and claim settlement practices, reserve requirements and agency appointments. Regulations also extend to the form and content of financial statements filed with such regulatory authorities, the type and concentration of permitted investments for insurers, and the extent and nature of transactions between members of a holding company system, including dividends involving insurers. In general, such transactions must be on fair and reasonable terms, and in some cases, prior regulatory approval is required. The nature and extent of regulations pertaining to the business the Company writes outside of the U.S. varies considerably. Regulations cover various financial and operational areas, including such matters as amount and type of reserves, currency, policy language, repatriation of assets and compulsory cessions of reinsurance. In December 1993, the National Association of Insurance Commissioners (NAIC) adopted risk-based capital (RBC) requirements applicable to property and casualty insurers. The RBC formula establishes a required statutory surplus level for an insurer based on the risks inherent in its overall operations which are identified as underwriting risk, invested asset risk, credit risk and off-balance sheet risk. The law provides for regulatory responses ranging from requiring a plan of corrective action to placing the insurer under regulatory control for insurers whose surplus is below the prescribed RBC target. HSBIIC's adjusted capital significantly exceeded the authorized control level RBC for 1997. NAIC Insurance Regulatory Information System (IRIS) ratios are part of the solvency impairment early warning system of the NAIC. They consist of twelve categories of financial data with defined acceptable ranges for each. Companies with ratios outside of the acceptable ranges are selected for closer review by regulators. HSBIIC's IRIS ratios were within acceptable ranges for 1997 with the exception of the change in surplus ratio. This ratio exceeded the normal range for surplus growth because of the $250 million contribution to surplus made by the Company with the proceeds from the $300 million convertible capital securities which were sold to Employers Reinsurance Corporation on December 31, 1997. The Company's insurance subsidiaries' operations are subject to examination by insurance regulators at regular intervals. The most recently concluded insurance examination for HSBIIC was conducted for the year ended December 31, 1994 by the Connecticut Insurance Department, the HSBIIC's domestic regulator. No material findings were included in the final report of the examination. Similar regulatory procedures govern the Company's U.S. and foreign insurance subsidiaries. 8 Insurance guaranty fund laws exist in all states which subject insurers to assessments up to prescribed limits for certain obligations of insolvent insurers to their policyholders and claimants. The Company is permitted to recover a portion of these assessments through premium tax offsets and policy surcharges. See Note 5 to the Consolidated Financial Statements located in Item 8 of Part II herein for additional information on statutory reporting. As discussed earlier, the Company's insureds receive, in addition to the insurance product, inspections which meet state, county or municipally mandated requirements. In order for the Company's inspectors to perform these mandated inspections, they must be commissioned. Commissioning is conducted by the National Board of Boiler and Pressure Vessel Inspectors and the various state jurisdictional authorities. The majority of the Company's inspectors are commissioned, and the Company believes that it has an adequate number of commissioned inspectors to conduct its business affairs. Engineering Services - - -------------------- A portion of the Company's engineering services revenue comes from certifying that boilers and pressure vessels are being constructed according to standards adopted by the American Society of Mechanical Engineers (ASME). The commission that authorizes inspectors to conduct insurance inspections also authorizes them to perform ASME Code inspections. Other - - ----- The Company and members of its professional and technical staff are subject to a variety of other state, local and foreign licensing and permit requirements and other laws generally applicable to corporations and businesses. F. INSURANCE OPERATIONS Policies - - -------- Pricing for the Company's insurance policies is based upon the rates the Company has developed for use with its various products. In many jurisdictions in which the Company does business, such rates, as well as the policy forms themselves, must be approved by the jurisdiction's insurance regulator. Rates for the Company's products are developed based upon estimated claim costs, expenses related to the acquisition and servicing of the business, engineering expenses and a profit component. Coverages for unique risks are judgment-rated, taking into account deductibles, the condition of the insured's equipment, loss prevention and maintenance programs of the insured, and other factors. 9 Policies are normally written for a term of one year. Most of the Company's policies provide coverage for property damage and business interruption to insured property (including buildings and structures under the Company's all risk policy) resulting from covered perils. Property insured under the Company's equipment breakdown policies includes such equipment as steam boilers, hot water boilers, pressure vessels, refrigerating and air conditioning systems, motors, generators, compressors, pumps, engines, fans, blowers, gear sets, turbines, transformers, electrical switch gear, data processing and business equipment and a wide variety of production and processing equipment. The Company's policy with respect to the business it underwrites (exclusive of its participation in IRI) is to generally manage its risks to probable maximum losses (PMLs) not in excess of $50 million and maximum foreseeable losses (MFLs) not in excess of $100 million. The Company's current reinsurance program generally limits the Company's retention on any one loss to $3 million, with potentially higher per risk retentions dependent on aggregate losses experienced by the Company during the reinsurance period. See "Participation in Industrial Risk Insurers" below for information on the underwriting policy of IRI. Reinsurance Assumed - - ------------------- The predominant practice in the insurance industry is to combine several types of insurance coverages into one policy referred to as a package policy. The Company has reinsurance agreements with over 100 multi-line insurance companies to reach the small to mid-size customers that purchase such package policies. This business primarily focuses on small and mid-sized commercial customers and it offers a significant opportunity for growth by the Company because, based on Company estimates, equipment breakdown coverage is only provided currently to less than 5 percent of the over 10 million insured companies and institutions in the United States. Under the reinsurance agreements, the Company's reinsured companies may include equipment breakdown exposures in their multi-peril policies, and such risks will be assumed by the Company under the terms of the agreements. These plans generally provide that the Company will assume 100 percent of each boiler and machinery risk, subject to the capacity specified in the agreement, and will receive the entire equipment breakdown premium except for a ceding commission which will be retained by the reinsured company for commissions to agents and brokers, premium taxes and handling expenses. Although the Company assumes the role of reinsurer, it continues to have selling and underwriting responsibilities as well as involvement in inspecting and claims adjusting. In effect, the Company becomes the equipment breakdown insurance department of the reinsured company and provides all equipment breakdown underwriting (that is, the examination and evaluation of the risk based on its engineering judgments), claims and engineering services as if it were part of that organization. Traditionally, as part of the underwriting process, the Company retains the right to decline or restrict coverage in the 10 same manner as it does for its own business. In 1996 the Company began to write a simplified program (referred to as ReSource) under which a reinsured company agrees to include equipment breakdown insurance on an entire portfolio of accounts meeting specific underwriting guidelines and occupancy parameters, which the Company agrees to reinsure for equipment breakdown losses. The insurance industry, in general, continues to undergo a significant shakeout and consolidation. A significant amount of merger and acquisition activity has occurred recently and may continue in the future. Depending on the specific companies involved in these activities and other market factors, the level of reinsured business the Company assumes in the future under the arrangements described above could be impacted. The Company also assumes reinsurance, primarily on a facultative basis, for certain large risks and several insurance pools. The written premium generated through reinsurance assumed totaled $257.1 million in 1997, representing approximately 41.6 percent of the Company's gross written premium. Reinsurance Ceded - - ----------------- As a property carrier, the Company is subject to losses that may arise from catastrophic events. The Company participates in various facultative, quota share and excess of loss reinsurance agreements to limit its exposure, particularly to catastrophic losses and high risk lines, and to provide additional capacity to write business. Under the Company's current treaty reinsurance program (and not taking into account its participation in IRI), its retention on any one risk is generally limited to $3 million, with potentially higher per risk retentions depending on aggregate losses experienced by the Company during the reinsurance program period. In addition, the Company uses facultative reinsurance on certain high exposure risks and has catastrophe reinsurance for aggregate net losses greater than $15 million. As a result of the Company's growth and global expansion, combined with loss experience in prior years, the Company has been incurring higher ceded reinsurance costs in recent years. In 1995 the Company centralized and consolidated its global ceded reinsurance operations to more closely manage its reinsurance costs. In 1994 and continuing through 1996 the Company increased its non-IRI retentions by adding a $5 million aggregate deductible to its reinsurance program to lessen the impact of higher reinsurance costs. Of the four losses in the 1994 -1995 treaty year that exceeded $3 million, the Company retained an additional $1.4 million in 1994 and $1.2 million in 1995 due to the inclusion of the $5 million annual aggregate deductible. Reinsurance costs were reduced approximately $2.9 million for both 1994 and 1995. In 1996 the Company's reinsurance ceded costs increased $42 million over 1995 which was almost entirely attributable to its increased participation in IRI. Reinsurance ceded costs for 1997 increased by $10 million over 1996 because of the Company's increase in participation in IRI in 1997 and the purchase of facultative insurance at HSB EIL, the Company's U.K. insurance subsidiary. 11 The Company anticipates a greater use of quota share reinsurance in the 1998-1999 treaty year because of the favorable pricing in the international reinsurance market and recent favorable underwriting experience in certain classes of the Company's business. This increased use of reinsurance will likely result in a reduction in net earned premiums for 1998 at the same time as gross premiums are expected to increase as a result of the agreements with Employers Reinsurance Corporation relating to the IRI business. See "Participation in Industrial Risk Insurers" below. The Company utilizes well-capitalized domestic and international reinsurance companies and syndicates for its reinsurance program and monitors their financial condition on an ongoing basis. For reinsurers that are not accredited in their state of domicile, the Company generally requires collateral for reinsurance recoverable from such carriers. In the unlikely event that the Company's reinsurers are unable to meet their obligations, the Company would continue to have primary liability to policyholders for losses incurred. Uncollectible reinsurance recoverables have not had, and are not expected by management to have in the future, a material adverse effect on the consolidated results of operations or financial position of the Company. The Company is not party to any contracts that do not comply with the risk transfer provisions of SFAS 113 "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts". For additional information on reinsurance, see Notes 9 and 10 to the Consolidated Financial Statements located in Item 8 of Part II herein. Pools and Joint Underwriting Associations - - ----------------------------------------- With the exception of Industrial Risk Insurers as described on page 2 and discussed below, the Company does not participate to any significant degree in voluntary reinsurance pools of other insurance companies because the Company generally chooses to insure only those risks which it has inspected or has the right to inspect. The Company is required to participate in certain joint underwriting associations which provide insurance for particular classes of insureds when insurance in the voluntary market is unavailable. Participation in Industrial Risk Insurers - - ----------------------------------------- Industrial Risk Insurers is an unincorporated, voluntary joint underwriting association which provides property insurance for the class of business known as Highly Protected Risks for larger manufacturing, processing and industrial businesses which have invested in protection against loss through the use of sprinklers and other means. IRI primarily writes policies on a syndicate basis which specifies to the insured the percentage share of risk accepted by each member of the association. Each member company, therefore, operates as a direct insurer or reinsurer on such policies and participates in the premiums and losses generated thereunder in proportion to its membership interest. In essence, the IRI facilitates the proportional sharing of risk under one policy where each member is essentially considered to be the direct writer for reporting, premium tax and other regulatory purposes. Liability on such policies is several and not joint, and therefore, members are not 12 responsible for policy liabilities of the other members. An increased participation does not expose HSBIIC to the effect of adverse loss development on claims incurred prior to the effective date of the increase; conversely a decrease in participation doesn't release HSBIIC from the effects of adverse development. On January 6, 1998, HSBIIC and the other IRI members sold their membership shares to Employers Reinsurance Corporation. Contemporaneous with the close of the sale, IRI was reconstituted with ERC (with a 99.5 percent share) and HSBIIC (with a .5 percent share) as the sole members. HSBIIC entered into an operating agreement with ERC pursuant to which HSBIIC will write the business for the reconstituted IRI using its insurance licenses and will provide certain other technical and management services. HSBIIC, ERC and IRI also entered into reinsurance agreements pursuant to which HSBIIC transferred its HPR manufacturing book of business to IRI and agreed to retain 85 percent of the equipment breakdown business and 15 percent of the property business of the combined insurance portfolio. From December 1, 1996 until the close of the sale of its interest in IRI to ERC, HSBIIC's membership interest was 23.5 percent. In 1996 and 1995 its membership share was 14 percent and .5 percent, respectively. The Company increased its share significantly over this two year period because it believed that participation in the IRI represented an opportunity to apply the Company's underwriting, engineering and reinsurance skill sets to a large block of business and to potentially provide a quick turnaround of IRI's underwriting results with only a limited capital outlay of Company funds. The Company's increased share enabled the Company to have a more significant role in helping IRI be an effective and profitable provider of essential property insurance and loss prevention services to larger risks. The new agreements with ERC and IRI continue this opportunity to utilize the Company's skills while at the same time reducing its exposure to the more volatile property business. The agreements with ERC are of indefinite duration and are terminable in the event of the insolvency or loss of accredited reinsurer or licensed insurer status of ERC or HSB, or a material breach which has not been cured within the time frame specified in the agreements, or by mutual consent of the parties. ERC and the Company are in discussions which may result in ERC having the option to buy out the Company's rights under the agreements in the event of a change in control of the Company. Net earned premium attributable to the agreements with ERC and IRI, prior to the placement of reinsurance by the Company for its own account, could approximate 17 percent of the Company's total consolidated revenues for 1998. Ceding commissions, which are netted out of expenses, are estimated to be 13 percent of consolidated revenues for 1998. Pursuant to the agreements with ERC, HSB has the ability to opt out of IRI's reinsurance programs going forward. The Company anticipates incorporating the IRI business into its reinsurance program after a brief transitional period during which the Company will participate in IRI's program. 13 IRI's underwriting policy is to manage its risks to probable maximum losses (PML) not to exceed $150 million and maximum foreseeable losses (MFL) not to exceed $400 million. Based on HSB's 1997 participation in IRI at 23.5 percent, had an MFL event take place, the Company's proportionate share, net of IRI and HSB reinsurance, would have been $ 26.6 million. The Company maintains other reinsurance programs for its own account which could absorb up to 50 percent of this amount. The equipment breakdown PMLs and MFLs within the overall property coverage underwritten by IRI do not generally exceed $50 million and $100 million, respectively. HSB's primary participation effective January 1, 1998 as described above will be attributable to the 85 percent share of the equipment breakdown insurance written through IRI. Based on HSB's 1998 participation in IRI's business, were an equipment breakdown MFL to take place, the Company's proportionate share, net of IRI and HSB reinsurance, would be no more than $5 million. Claims and Claim Adjustment - - --------------------------- Essentially all claims under the Company's policies of insurance are handled by the Company's own claims handlers. Management believes that the Company's handlers are better able to make the connection between loss prevention and loss control. The Company employs claims handlers in its various offices throughout the country, Canada and the U.K. Claims handlers, in many cases, are assigned to particular customer groups in order to apply specialized industry knowledge to the adjustment of claims. Policies underwritten by the Company pursuant to the agreements with Employers Reinsurance Corporation relating to the business of IRI described under "Participation in Industrial Risk Insurers" above will be adjusted by Company and IRI staff claims handlers as determined by the Company in accordance with such agreements. Claims and adjustment expense reserves comprise one of the largest liabilities of the Company. Reserves are established to reflect estimates of total losses and loss adjustment expenses that will ultimately be paid under direct and assumed insurance contracts. Loss reserves include claims and adjustment expenses on claims that have been reported but not settled and those that have been incurred but not yet reported. Loss reserve estimates reflect such variables as past loss experience and inflation. In addition, due to the nature of much of the coverages, complex engineering judgments are involved. Subjective judgments are an integral component of the loss reserving process, due to the nature of the variables involved. Previously established loss reserves are regularly adjusted as loss experience develops and new information becomes available. Adjustments to previously established reserves are reflected in the financial statements in the period in which the estimates are changed. The normal turnaround time in paying small claims is less than six months. The vast majority of claims are settled within one year and very few remain unsettled two years after the loss occurs. This pattern is somewhat skewed in terms of claim dollars (as noted in the schedule on pages 18 - 19) as it is the larger claims that often take longer to adjust. Compared to the property casualty industry as a whole, the Company has a very "short-tail". The Company's claims expenses are based on estimates of the current costs of 14 replacing productive capacity. The Company does not employ discounting techniques in establishing liabilities for claims and claim adjustment expenses. For those relatively few claims involving litigation, the Company uses both its in-house law department and outside counsel, depending on the issues, costs, and staffing requirements. The following table provides a reconciliation of the beginning and ending reserves for net claims and claim adjustment expenses for the years ended December 31, 1997, 1996 and 1995. RECONCILIATION OF NET LIABILITY FOR CLAIMS AND CLAIM ADJUSTMENT EXPENSES ------------------------------------ 1997 1996 1995 ---- ---- ---- (In millions) Net liability for claims and adjustment expenses at January 1 $ 177.8 $ 145.5 $ 161.3 ------ ------ ------ Plus: Provision for claims and adjustment expenses occurring in the current year 209.5 214.2 152.2 Increase (decrease) in estimated claims and adjustment expenses arising in prior years 8.4 (9.8) 2.7 ------ ------ ------ Total incurred claims and adjustment expenses 217.9 204.4 154.9 ------ ------ ------ Less: Payment for claims arising in: Current year 82.3 91.4 58.9 Prior years 122.6 80.7 111.8 ------ ------ ------ Total payments 204.9 172.1 170.7 ------ ------ ------ Net liability for claims and adjustment expenses at December 31 $ 190.8 $ 177.8 $ 145.5 ====== ====== ====== 15 The 1997 loss ratio was 44.4 percent compared to 45.6 percent and 39.8 percent for 1996 and 1995, respectively. The 1.2 percent decrease in loss ratio in 1997 is primarily the result of fewer weather-related losses. The 1996 increase of 5.8 percentage points as compared to 1995, was primarily the result of the high frequency of claims and unusually severe winter weather. Adverse development in 1997 added 1.7 percentage points to the loss ratio, while positive development in 1996 benefited the loss ratio by 2.2 percentage points. The following table shows a reconciliation of the net liability to the gross liability for claims and claim adjustment expenses based on reinsurance recoverable on unpaid losses. RECONCILIATION OF NET LIABILITY TO GROSS LIABILITY FOR CLAIMS AND CLAIM ADJUSTMENT EXPENSES ---------------------------------------- 1997 1996 1995 ---- ---- ---- (In millions) Net liability for claims and adjustment expenses at December 31 $ 190.8 $ 177.8 $ 145.5 Reinsurance recoverable on unpaid claims and adjustment expenses 85.9 125.1 45.4 ------ ------ ------ Gross liability for claims and adjustment expenses at December 31 $ 276.7 $ 302.9 $ 190.9 ====== ====== ====== 16 RECONCILIATION OF GROSS LIABILITY FOR CLAIMS AND CLAIM ADJUSTMENT EXPENSES - - -------------------------------------------------------------------------- 1997 1996 1995 ---- ---- ---- (In millions) Gross liability for claims and claim adjustment expenses at January 1 $ 302.9 $ 190.9 $ 199.4 Plus: Provision for claims and claim adjustment expenses occurring in the current year 263.3 313.3 183.3 Increase in estimated claims and claim adjustment expenses arising in prior years (0.2) 16.1 12.6 ------ ------ ------ Total incurred claims and claim adjustment expenses $ 263.1 $ 329.4 $ 195.9 ------ ------ ------ Less: Payment for claims arising in: Current year $ 90.6 $ 103.3 $ 65.1 Prior years 198.7 114.1 139.3 ------ ------ ------ Total payments $ 289.3 $ 217.4 $ 204.4 ------ ------ ------ Gross liability for claims and claim adjustment expenses at December 31 $ 276.7 $ 302.9 $ 190.9 ====== ====== ====== The claim and claim expense reserve runoff table on the following pages shows the amounts of the net liability for 1987 through 1997 and the amounts of the gross liability for 1993 through 1997. The ten-year development table for gross liabilities is being constructed progressively, with 1993 as the base year. Within the tables for net and gross liabilities, each column shows the reserve established at each calendar year-end as well as cumulative totals for claims payments and re-estimated liabilities for both that accident year and all previous years that combined make up that year-end reserve. The redundancy (deficiency) shown on a gross and net basis is a cumulative number for that year and all previous years. The net deficiencies in 1990, 1991 and 1992 were attributable to the settlement of certain large losses for which the Company initially determined it would not have liability; the settlement of some outstanding claims for more than was originally anticipated; unusually late notice of loss provided by the insured for several large losses; and reserves established for losses on which the coverage was being contested. 17 The redundancies shown for 1987 and 1988 were attributed to the difficulty in estimating claims due to inflationary impacts and business interruption, which became a larger component of claims. The claim reserves established in those years have been favorably settled, adjusted or closed based on the results of claim audits, technical loss analysis, subrogation, settlement with property carriers and the latest available information. The net impact of those favorable settlements was to decrease claims expenses as reported by $10.2 million in 1990 and $28.0 million in 1989. RECONCILIATION OF BEGINNING AND ENDING CLAIMS RESERVES AND EXHIBIT OF REDUNDANCIES (DEFICIENCIES) (In Millions) Net Reserves YEAR ENDED 1987 1988 1989 1990 1991 1992 1993 1994 1995* 1996* 1997* - - ---------- ---- ---- ---- ---- ---- ---- ---- ---- ----- ----- ----- Net Liability for Unpaid Claims and Claim $147.5 $157.4 $139.6 $115.7 $111.4 $132.8 $171.3 $161.3 $145.5 $177.8 $190.8 Adjustment Expenses Cumulative Amount Paid as of: End of Year - - - - - - - - - - - One Year Later 57.4 78.8 85.6 86.7 91.2 99.7 108.8 111.7 80.6 122.6 - Two Years Later 75.9 92.1 104.2 109.7 115.5 134.0 152.1 126.9 99.8 - - Three Years Later 74.5 95.5 110.3 120.6 127.0 154.4 153.4 134.5 - - - Four Years Later 75.4 95.4 112.5 127.6 137.7 151.1 157.8 - - - - Five Years Later 74.5 93.6 118.9 132.7 135.7 151.6 - - - - - Six Years Later 74.2 100.5 123.0 131.4 135.7 - - - - - - Seven Years Later 80.4 101.5 121.4 130.9 - - - - - - - Eight Years Later 80.4 100.1 120.8 - - - - - - - - Nine Years Later 79.6 100.2 - - - - - - - - - Ten Years Later 79.7 - - - - - - - - - - Net Liability Reestimated as of: End of Year 147.5 157.4 139.6 115.7 111.4 132.8 171.3 161.3 145.5 177.8 190.8 One Year Later 131.9 129.4 129.4 135.4 137.5 159.7 172.7 163.9 135.7 186.2 - Two Years Later 100.4 108.7 127.4 138.0 139.7 166.6 173.9 157.3 128.8 - - Three Years Later 86.0 106.8 127.8 136.9 141.1 165.2 170.6 154.2 - - - Four Years Later 83.7 103.0 125.0 137.9 142.0 163.0 169.2 - - - - Five Years Later 80.8 102.3 125.8 135.7 141.4 161.5 - - - - - Six Years Later 82.0 104.0 125.5 136.0 141.3 - - - - - - Seven Years Later 82.9 103.8 125.8 135.8 - - - - - - - Eight Years Later 82.6 104.2 125.5 - - - - - - - - Nine Years Later 83.6 104.7 - - - - - - - - - Ten Years Later 84.1 - - - - - - - - - - Cumulative Redundancy (Deficiency) 63.4 52.7 14.1 (20.1) (29.9) (28.7) 2.1 7.1 16.7 (8.4) 0.00
The above table includes information related to the Company's participation in the IRI. *For 1997, incurred claims and claims adjustment expenses include $31.6 million related to the Company's 23.5 percent participation in IRI effective December 1, 1996 plus development of ($1.3 million) relating to prior accident years. For 1996, incurred clams and claims adjustment expenses include $23.2 million related to the Company's 14 percent participation in IRI effective December 1, 1995, plus development of ($.4 million) relating to prior accident years. The Company carried net reserves in the amounts of $22.2, $11.6 and $3.2 million related to its participation in IRI at December 31, 1997, 1996, and 1995 (at a .5 percent participation), respectively. 18 Gross Reserves YEAR ENDED 1993 1994 1995 1996 1997 - - ---------- ---- ---- ---- ---- ---- Gross Liability for Unpaid Claims and Claim Adjustment Expenses $214.4 $199.4 $190.9 $302.9 $276.7 Cumulative Amount Paid as of: End of Year - - - - - One Year Later 144.2 135.2 108.9 198.8 - Two Years Later 189.9 164.1 158.0 - - Three Years Later 200.2 201.1 - - - Four Years Later 229.8 - - - - Gross Liability Reestimated as of: End of year 214.4 199.4 190.9 302.9 276.7 One Year Later 224.3 212.0 205.5 302.7 - Two Years Later 227.0 228.3 194.6 - - Three Years Later 243.4 226.8 - - - Four Years Later 245.0 - - - - Cumulative Redundancy (Deficiency) (30.6) (27.4) (3.7) .2 -
G. INVESTMENTS Income from the Company's investment portfolio contributes significantly to earnings. Each year there is a significant net inflow of cash from insurance, engineering services and investment operations into the Company's investment portfolio. In addition, cash flow is affected by the normal maturity of fixed income investments, and the purchase and sale of equity securities. (in millions) 1997 1996 1995 1994 1993 ------- ------ ------ ------ ----- Net Investment Income $ 36.8 $ 32.3 $ 28.9 $ 26.2 $ 29.3 Realized Investment Gains 14.1 12.1 2.8 8.7 26.1 ------ ------ ------ ------ ------ Income from Investment Operations $ 50.9 $ 44.4 $ 31.7 $ 34.9 $ 55.4 Net Unrealized Gains $ 95.3 $ 81.4 $ 65.4 $ 16.5 $ 59.2 Statutory Surplus (HSBIIC) $550.8 $292.4 $280.6 $238.0 $259.2 The fluctuations in income from investment operations is largely driven by the amount of realized gains generated in any given year. The Company's strategy continues to be to maximize total return on the investment portfolio through investment income and capital appreciation. Investment strategies for any given year are developed based on many factors including operational results, tax implications, regulatory requirements, interest rates, dividends to stockholders and market conditions. In 1994 the stock market experienced a significant decline which impacted both the Company's realized and unrealized gains. In 1995 the Company curtailed its realized gains in order to take advantage of a strongly performing market and to build statutory surplus. In 1996 the Company continued to build statutory surplus, however, high valuations towards the end of the year caused the Company to realize gains. Realized investment gains increased in 1997 over 1996 as the Company 19 managed its portfolio to respond to changing market conditions and tax planning opportunities, and as a result of calls of fixed income and convertible securities. Net investment income reached its lowest level during 1994 as a result of a lower average investment portfolio as holdings were liquidated to pay dividends, repay debt, and purchase fixed assets and treasury stock. The increase in 1995 resulted from the full consolidation of EIG, Co. offset by a lower interest rate environment. Net investment income increased 11.8 percent in 1996 due to an increased level of investable assets and to a lesser extent by dividend increases on the Company's common stock investments. Net investment income for 1997 increased 13.9 percent compared to 1996. The increase is attributable to calls of high yielding preferred stocks early in the year the proceeds of which were invested in fully taxable securities, and more investable funds as the Company invested the proceeds from its capital securities offerings. The significant increase in statutory surplus of HSBIIC for 1997 resulted from a contribution to capital of $250 million of the $300 million in proceeds received by the Company from the sale of its convertible capital securities to Employers Reinsurance Corporation on December 31, 1997. The Company's investment portfolio consists of high grade domestic and foreign investments. Excluding short-term investments, HSB's investments are primarily comprised of publicly traded, highly liquid securities. Investment strategies for any given year are developed based on many factors including operational results, tax implications, regulatory requirements, interest rates, dividends to shareholders and market conditions. In December 1996 HSBIIC entered into three "zero cost collar" contracts to mitigate the effects of market risk on its U.S. common stock portfolio (which for management purposes included certain convertible preferreds). In the fourth quarter of 1997, HSBIIC settled all of its outstanding contracts which required HSBIIC to pay its counterparty $30.7 million in foregone appreciation on its portfolio. The Company's U.S. common stock portfolio has experienced a total return of $57 million (which includes price appreciation of approximately $54 million) since December 31, 1996, and has had a price movement correlation with the S&P 500 Index well in excess of 80 percent. At December 31, 1997 the Company had approximately 38.1 percent of its invested assets (exclusive of the short-term investments made with the proceeds from its sale of $300 million in convertible capital securities on December 31, 1997) in fixed maturities as compared to 40 percent at year-end 1996. In the period 1991-1996 the Company gradually reduced its investments in common stocks as part of its overall capital management strategy. At year-end 1997 the carrying value of the equity securities portfolio represented 49.7 percent of invested assets compared to 44 percent at year-end 1996. The 5.7 percent increase is primarily attributable to market appreciation relative to the overall portfolio. The Company does not engage in cash-flow underwriting; it seeks to have underwriting profit each year. None of the Company's claim reserves are discounted as most claims 20 settle, on average, within one year. Therefore, the Company does not use duration measurements in managing its interest rate exposure. Instead, the Company manages its portfolio by laddering its maturities such that the average maturity is generally maintained between 5-10 years. This technique provides the Company with a predictable cash flow each year and enables it to respond to the previously discussed parameters that impact its investment strategy. See "Investment Operations" in the Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations located in Item 7 and Note 6 to Consolidated Financial Statements in Item 8 of Part II herein for additional information. The following table summarizes the investment results of the Company's investment portfolio: Annualized Rate Investment Net Invest- of Return (2) Investment Cash and ment Income --------------- Gains (Losses) (3) Invested Less Before After -------------------- Assets, Less Interest Income Income Change in Borrowed Money Expense (1) Taxes Taxes Realized Unrealized ---------------------------- ----- ----- ---------------------- (In Millions) (In Millions) 1997 $ 629.2* $ 35.5 6.1% 5.1% $ 14.1 $ 13.9 1996 572.6 31.7 6.0 5.4 12.1 16.0 1995 514.8 28.5 6.2 5.2 2.8 48.9 * Does not include $300 million in proceeds from the sale of convertible capital securities on December 31, 1997. (1) Net investment income excludes realized investment gains and is reduced by investment expenses, but is before the deduction for income taxes. (2) The rates of return on investments shown above have been determined in accordance with rules prescribed by the National Association of Insurance Commissioners. These rates have been determined by the following formula: 2I -- A + B - I I is equal to net investment income, before taxes, earned on investment assets. A+B is equal to the sum of the beginning and end of the year amounts shown under "Cash and Invested Assets, Less Borrowed Money". The after tax rates of return are computed in the same manner, but net investment income is reduced by income taxes. (3) Realized and unrealized investment gains (losses) are before income taxes. 21 H. EMPLOYEES At year-end 1997, the Company, including its wholly-owned subsidiaries, had 1,932 full and part-time employees. Management believes that its relations with its employees are satisfactory. I. FORWARD-LOOKING STATEMENTS For a summary of factors that may materially affect the Company's future business, see "Forward- Looking Statements" in Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations in Item 7. Item 2. Properties. - - ------- ----------- The Hartford Steam Boiler Inspection and Insurance Company leases approximately 227,288 square feet for its home office at One State Street, Hartford, Connecticut under a long-term capital lease with One State Street Limited Partnership. In addition to its home office facility, the Company leases facilities for its branch offices and subsidiaries throughout the United States and Canada, and in a small number of other foreign locations. The Company considers the office facilities and other operating resources to be suitable and adequate for its current and anticipated level of operations. See Notes 7 and 8 to Consolidated Financial Statements located in Item 8 of Part II herein for additional information. Item 3. Legal Proceedings. - - ------- ------------------ HSBIIC is involved in three arbitration or litigation proceedings regarding the extent to which certain explosion events are insured under boiler and machinery policies of HSBIIC or under the all-risk property insurance policies issued by other companies. Management believes HSBIIC's policies do not provide coverage for losses resulting from the explosion events that are the subject of these proceedings. A lower court ruling in one of these cases held that an explosion did occur, and that HSBIIC was not liable for losses of the insured resulting from the explosion. In a further action, the court denied HSBIIC's motion for summary judgment on certain issues, thus leaving HSBIIC potentially liable for certain unquantified losses resulting from events prior to the explosion. In the first quarter of 1997, HSBIIC and the property insurer jointly settled the case with the insured. HSBIIC's ultimate share of the settlement will be determined in an arbitration proceeding with the property carrier. HSBIIC has incurred gross loss and loss adjustment expenses (LAE) of $40.7 million and a net loss, after taking into account reinsurance recoverables, of $6.5 million, of which $5 million represents claim costs and the remaining $1.5 million represents LAE. As a result of payments made to date, as of December 31, 1997, HSBIIC carried gross loss and LAE reserves of $2.8 million and recoverables from reinsurers of $2.8 million. 22 HSBIIC has accrued $6.5 million with respect to the other two cases for potential LAE, including legal costs to defend HSBIIC's position. One case is in the process of pre-trial summary judgment motions and appeals; the other case is involved in both arbitration and litigation proceedings. A trial date has not been set for either case. In the event that HSBIIC is held liable for one or both of the remaining claims, amounts in excess of HSBIIC's net maximum aggregate retention of $8.5 million is recoverable from reinsurers. Claim amounts potentially recoverable from reinsurers in the event of a possible adverse outcome in these cases could range, in the aggregate, from $40 million to $195 million. The obligations of HSBIIC's reinsurers with respect to these cases are not in dispute. Therefore, management believes that any adverse outcomes in these cases will not, in the aggregate, have a material effect on either the results of operations or financial condition of the Company. HSBIIC's reinsurance contracts do not require HSBIIC to reimburse its reinsurers for any losses such reinsurers might incur should these cases not be decided in HSBIIC's favor. Nevertheless, reinsurers often quote rates for future coverages based upon their or other reinsurers' experience on a particular account. Therefore, in the event HSBIIC's reinsurers pay significant sums pursuant to the arbitration or litigation proceedings described above, it is likely HSBIIC's reinsurance rates would increase in future periods. However, given the insured capacity that exists in reinsurance markets worldwide, coupled with HSBIIC's ability to negotiate a redesign or restructuring of its reinsurance program, it does not necessarily mean that such an increase would be material. The Company is also involved in various other legal proceedings as defendant or co-defendant that have arisen in the normal course of its business. In the judgment of management, after consultation with counsel, it is improbable that any liabilities which may arise from such litigation will have a material adverse impact on the results of operations or the financial position of the Company. Item 4. Submission of Matters to a Vote of Security Holders. - - ------- ---------------------------------------------------- None. Item 4(a). Executive Officers of the Registrant. - - ---------- ------------------------------------- All executive officers are elected by the Board of Directors to hold office until the next Annual Meeting of Shareholders. An officer may be removed at any time by the Board of Directors. On June 24, 1997 all of the outstanding shares of common stock of The Hartford Steam Boiler Inspection and Insurance Company were exchanged for shares of common stock of the Company. The service listed for each executive officer listed below includes their service with Hartford Steam Boiler. 23 Gordon W. Kreh, 50, Chief Executive Officer, President and Director since 4/94; President and Director 9/93 - 4/94; Senior Vice President - Marketing 4/92 - 9/93; President - Engineering Insurance Group 10/89 - 4/92; Vice President 11/84 - - - 10/89; Assistant Vice President 4/81 - 11/84. Saul L. Basch, 51, Senior Vice President, Treasurer and Chief Financial Officer since 10/95; Partner, Coopers & Lybrand L.L.P. 9/73 - 10/95, most recently as Partner-in-Charge of Coopers & Lybrand's New York Insurance Industry Practice. Michael L. Downs, 48, Senior Vice President - Special Risks since 2/94; Managing Director - Engineering Insurance Co., Ltd. 1/91 - 2/94; Second Vice President 7/87 - 1/91; Assistant Vice President 2/85 - 7/87; Assistant Secretary 4/80 - 2/85. John J. Kelley, 52, Senior Vice President - Commercial Risks since 2/94; Corporate Secretary and Special Assistant to the President 5/87 - 2/94; Assistant Vice President and Special Assistant to the President 9/83 - 5/87; Assistant Vice President 9/79 - 9/83; Assistant Secretary 4/77 - 9/79. William A. Kerr, 60, Senior Vice President - Engineering since 9/95; Vice President and General Manager, Pratt & Whitney Turbo Power and Marine Division, United Technologies Corporation 8/95 - 9/95; Vice President of Aftermarket Operations, Pratt & Whitney 4/92 - 8/95; Vice President of Development Operations and Materials Engineering, Pratt & Whitney 1989-4/92. R. Kevin Price, 51, Senior Vice President and Corporate Secretary since 2/94; Second Vice President 4/89 - 2/94; Assistant Vice President 1/84 - 4/89. William Stockdale, 52, Senior Vice President since 9/95; Managing Director and Chief Executive Officer of HSB Engineering Insurance Ltd., London, since 9/94; Director of Engineering, Engineering Insurance Co., Ltd. 9/92-9/94; Managing Director Scottish Power PLC, Glasgow, Scotland 1/89 - 8/92. Robert C. Walker, 54, Senior Vice President-Claims and General Counsel since 1/95; Senior Vice President - Claims 3/94 - 1/95; Associate General Counsel and head of Corporate Litigation Department of United Technologies Corporation 5/89-3/94. PART II Item 5. Market for Registrant's Common Equity and Related - - ------- ------------------------------------------------- Stockholder Matters. -------------------- The Company's common stock is traded on the New York Stock Exchange under the symbol HSB. As of February 17, 1998, the Company had 5,152 holders of record. 24 Dividends paid by The Hartford Steam Boiler Inspection and Insurance Company, HSB Group's principal subsidiary, are limited by state insurance regulations. Approval from the Connecticut Insurance Commissioner is required for dividend distributions within a twelve-month period which would exceed the greater of (i) 10 percent of an insurer's statutory surplus or (ii) net income calculated as of the December 31st last preceding. Regulatory approval was required for the payment of 1997 dividends but is not anticipated to be necessary for 1998 dividends since approximately $55.1 million of HSBIIC's statutory surplus is available for distribution to HSB Group, Inc. without prior regulatory approval. Quarterly dividends declared for the 1997 and 1996 fiscal years were as follows: First Second Third Fourth Year ----- ------ ----- ------ ---- 1997 $.57 $.57 $.60 $.60 $2.34 1996 $.57 $.57 $.57 $.57 $2.28 Quarterly market prices for the Company's common stock were as follows for the two most recent years: First Second Third Fourth Year ----- ------ ----- ------ ---- 1997 High $47 5/8 $53 7/8 $56 11/16 $55 3/4 $56 11/16 1997 Low $44 5/8 $44 $52 7/16 $49 13/16 $44 1996 High $52 1/2 $50 3/4 $49 $47 1/8 $52 1/2 1996 Low $48 $46 $43 1/4 $42 3/4 $42 3/4 25 Item 6. Selected Financial Data. - - ------- ------------------------ The following selected consolidated financial data should be read in conjunction with the consolidated financial statements and notes included elsewhere herein. (in millions, except per share amounts) (1)(2) 1997 1996 1995 1994 1993 - - -------------------------------------------------------------------------------------------------------------------------- Summary of Consolidated Statements of Operations Revenues: Insurance premiums $ 491.2 $ 448.6 $ 389.1 $ 336.6 $ 349.2 Engineering services 61.3 55.8 49.9 48.0 46.0 Income from investment operations 50.9 44.4 31.7 34.9 55.4 ------- ------- ------- ------- ------- Total revenues (3) $ 603.4 $ 548.8 $ 470.7 $ 419.5 $ 450.6 ------- ------- ------- ------- ------- Income from continuing operations $ 66.3 $ 54.6 $ 52.7 $ 44.5 $ 11.1 Income from continuing operations per common share - basic $ 3.32 $ 2.71 $ 2.58 $ 2.17 $ 0.54 Income from continuing operations per common share - diluted $ 3.29 $ 2.71 $ 2.58 $ 2.17 $ 0.54 Dividends paid per common share $ 2.31 $ 2.28 $ 2.22 $ 2.14 $ 2.12 - - --------------------------------------------------------------------------------------------------------------------------- Summary of Consolidated Statements of Financial Position Total assets $ 1,540.2 $ 1,116.3 $ 954.1 $ 877.8 $ 857.6 Long-term borrowings and capital lease obligations $ 53.0 $ 53.0 $ 53.4 $ 28.4 $ 28.4 Convertible redeemable preferred stock -- $ 20.0 -- -- -- Company obligated mandatorily redeemable capital securities $ 408.9 -- -- -- -- Shareholders' equity: Common $ 345.3 $ 345.6 $ 341.1 $ 299.5 $ 324.7 Per common share $ 17.63 $ 17.25 $ 16.81 $ 14.67 $ 15.80 Return on average equity before accounting 19.1% 15.6% 19.5% 16.9% 3.7% changes Stock price per share: High $ 56.69 $ 52.50 $ 50.38 $ 53.38 $ 59.50 Low $ 44.00 $ 42.75 $ 39.25 $ 36.13 $ 43.25 Close $ 55.19 $ 46.38 $ 50.00 $ 39.88 $ 44.50 Common shares outstanding at end of year (4) 19.6 20.0 20.3 20.4 20.5 - - --------------------------------------------------------------------------------------------------------------------------- Insurance Operating gain (loss) $ 39.8 $ 21.8 $ 34.2 $ 20.7 $ (26.4) Loss ratio 44.4% 45.6% 39.8% 42.5% 57.1% Expense ratio 47.3% 49.1% 50.9% 50.5% 50.5% ------- ------- ------- ------- ------- Combined ratio 91.7% 94.7% 90.7% 93.0%(5) 107.6% - - --------------------------------------------------------------------------------------------------------------------------- Engineering Services (3) Operating gain $ 4.3 $ 7.3 $ 6.7 $ 4.3 $ 4.0 Engineering services margin 7.1% 13.2% 13.3% 9.0% 8.7% Investments Net investment income $ 36.8 $ 32.3 $ 28.9 $ 26.2 $ 29.3 Realized investment gains 14.1 12.1 2.8 8.7 26.1 Income from investment operations $ 50.9 $ 44.4 $ 31.7 $ 34.9 $ 55.4 - - ----------------------------------------------------------------------------------------------------------------------------
(1) Prior year information has been restated to reflect Radian International LLC as a discontinued operation. (2) All per share data has been restated to reflect stock splits. (3) Excludes revenues from investments accounted for under the equity method. (4) Reflects the repurchase of approximately 1.0 in 1997, 0.3 in 1996, 0.1 in 1995, 0.1 in 1994, 0.2 in 1993. (5) Excludes charge for Proposition 103. 26 Item 7. Management's Discussion and Analysis of Financial - - ------- ------------------------------------------------- Condition and Results of Operations. ------------------------------------ (dollar amounts in millions, except per share amounts) SUMMARY OF RESULTS OF OPERATIONS Consolidated Overview For the years ended December 31, 1997 1996 1995 - - ------------------------------------------------------------------------------ Revenues: Insurance premiums $ 491.2 $ 448.6 $ 389.1 Engineering services 61.3 55.8 49.9 Net investment income 36.8 32.3 28.9 Realized investment gains 14.1 12.1 2.8 ------- --------- -------- Total Revenues $ 603.4 $ 548.8 $ 470.7 Income from continuing operations $ 66.3 $ 54.6 $ 52.7 Net income $ 66.3 $ 53.4 $ 62.6 Earnings Per Share: Income from continuing operations: Basic $ 3.32 $ 2.71 $ 2.58 Diluted 3.29 2.71 2.58 Net income: Basic $ 3.32 $ 2.65 $ 3.07 Diluted 3.29 2.65 3.07 ------- ---------- --------- The table above presents consolidated results of HSB Group, Inc. (HSB or the Company). Net income and income from continuing operations per common share on a diluted basis increased 24.2 percent and 21.4 percent, respectively, in 1997 from 1996 due to significantly higher underwriting gains in the Company's insurance operations. On July 28, 1997 the HSB Board ratified management's decision to exercise its option to put its share of Radian International LLC (Radian) to The Dow Chemical Company (Dow) on or about January 1, 1998 for approximately $144 million. Due to this decision, the results of Radian have been classified as discontinued operations and HSB's share of losses incurred subsequent to this decision of approximately $10 million pre-tax have been deferred until HSB's share of Radian has been transferred to Dow. On January 2, 1998 the Radian transaction closed resulting in an estimated after-tax gain of approximately $30 million, which includes absorption of the deferred loss. (See note 3). Income from continuing operations in 1996 increased 3.6 percent from 1995 as catastrophe losses from 27 unusually severe weather conditions in our domestic insurance operations, which caused our underwriting gain to drop by $12.4 million, were largely offset by increased income from investment operations of $12.7 million. Net income in 1996 declined 14.7 percent from 1995 as Radian's contribution to pre-tax earnings declined by approximately $15.7 million during 1996. Revenue shortfalls caused the venture to reduce its workforce during the year by about 10 percent, resulting in a charge of $3.5 million. Consolidated revenues grew 9.9 percent in 1997 and 16.6 percent in 1996. Insurance premiums grew 9.5 percent in 1997, with the increased participation in Industrial Risk Insurers (IRI) a contributing factor as well as growth in both the domestic and international books of business. Effective December 1, 1996, The Hartford Steam Boiler Inspection and Insurance Company (HSBIIC) increased its participation in IRI from 14 to 23.5 percent. The combined ratio for the Company improved to 91.7 percent in 1997 from 94.7 percent in 1996. In 1995 the combined ratio was 90.7 percent. Engineering services revenue increased 9.9 percent in 1997 and 11.8 percent in 1996. The effective tax rates on income from continuing operations before distributions on capital securities for 1997 was 26.8 percent compared to 25.1 percent and 27.0 percent for 1996 and 1995. Tax rate fluctuations occur as the levels of underwriting and engineering services results and realized gains change the mix of pre-tax income between fully taxable earnings and tax-preferred earnings that can be obtained by investing in certain instruments. Various tax credits (primarily foreign tax credits) also impact the effective rate. The Company continues to manage its use of tax advantageous investments to maximize after tax earnings. Recent Accounting Developments - - ------------------------------ In February 1997, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 128, "Earnings per Share". This statement establishes standards for computing and presenting earnings per share (EPS). It replaces the presentation of primary EPS with a presentation of basic EPS. It also requires dual presentation of basic and diluted EPS on the face of the Consolidated Statements of Operations and a reconciliation of the numerator and denominator of the basic EPS computation to the numerator and denominator of the diluted EPS computation. This statement was implemented at year end 1997. (See note 2). In June 1997 the FASB issued SFAS No. 130, "Reporting Comprehensive Income" which requires items that comprise comprehensive income be reported in a financial statement display with the same prominence as other financial statements. This will include a presentation of items such as market value adjustments of securities, foreign currency translation, and certain adjustments made for benefit plans. This accounting standard will be effective beginning in 1998 with presentation of prior periods required. 28 Also in June of 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information". This standard requires companies to report financial and descriptive information about reportable operating segments. It includes disclosure requirements relating to products and services, geographic areas and major customers. This statement will be effective with calendar year 1998, however application is not required for interim financial statements in the initial year. It is possible that this disclosure may redefine our segment information. However, the Company has not yet determined how SFAS No. 131 will be applied. Other Developments At a special meeting of HSBIIC on June 23, 1997, shareholders voted to approve a proposal which enabled the formation of a new holding company, HSB Group, Inc. Shareholders of HSBIIC's common and convertible redeemable preferred stock became holders of HSB common and convertible redeemable preferred stock, respectively, through a share exchange approved by the shareholders. Certificates representing HSBIIC's common and convertible redeemable preferred stock automatically represent the corresponding shares of HSB common and convertible redeemable preferred stock. The holding company was formed in order to achieve greater operating and financial flexibility in connection with certain investments, business operations and financing activities. On December 1, 1996, HSBIIC increased its participation in IRI from 14 percent to 23.5 percent. IRI is an unincorporated, voluntary joint underwriting association which provides property insurance for the class of business known as Highly Protected Risks (HPR) for larger manufacturing, processing and industrial businesses, which have invested in protection against loss through the use of sprinklers and other means. IRI primarily writes policies on a syndicate basis which specifies to the insured the percentage share of risk accepted by each member of the association. Each member company, therefore, operates as a direct insurer or reinsurer on such policies and participates in the premiums and losses generated thereunder in proportion to its membership interest. In 1995 and prior, HSBIIC's membership share was .5 percent. In essence, IRI facilitates the proportional sharing of risk under one policy where each member is essentially considered to be the direct writer for reporting, premium tax and other regulatory purposes. Liability on such policies is several and not joint, and therefore, members are not responsible for policy liabilities of the other members. An increased participation does not expose HSBIIC to the effect of adverse loss development on claims incurred prior to the effective date of the increase; conversely a decrease in participation doesn't release HSBIIC from the effects of adverse development. On January 6, 1998, HSBIIC sold its interest in IRI to Employers Reinsurance Corporation (ERC) in accordance with a previously announced purchase and sale agreement between ERC and IRI's twenty-three member insurers. HSBIIC received gross proceeds of approximately $50 million, prior to transaction costs, for its 23.5 percent 29 share in IRI. Because the sale was structured in part as a reinsurance transaction, a portion of HSBIIC's gross proceeds will be utilized to reinsure in-force policies with ERC. Contemporaneous with the close of the sale, IRI was reconstituted with ERC (with a 99.5 percent share) and HSBIIC (with a .5 percent share) as the sole members. Initially HSBIIC will write the business for the reconstituted IRI using its insurance licenses and will provide certain other services. HSBIIC will transfer its HPR manufacturing book of business to IRI and through various reinsurance arrangements with IRI/ERC will retain 85 percent of the equipment breakdown business and 15 percent of the property business of the combined insurance portfolio. To support HSB's expanded role, on December 31, 1997, a business trust formed by HSB sold $300 million of 20 year, 7 percent Convertible Capital Securities in a private placement to ERC. The Convertible Capital Securities are convertible into HSB common stock, at any time, subject to regulatory approval, at a conversion price of $85. $250 million of the proceeds were contributed to HSBIIC and $50 million was retained by HSB. (See note 12). Insurance Operations For the years ended December 31, 1997 1996 1995 - - ------------------------------------------------------------------- Gross earned premiums $ 609.3 $ 556.5 $ 455.0 Ceded premiums 118.1 107.9 65.9 -------------------------------- Insurance premiums $ 491.2 $ 448.6 $ 389.1 Claims and adjustment expenses 217.9 204.4 154.9 Underwriting, acquisition and other expenses 233.5 222.4 200.0 ---------------------------------- Underwriting gain $ 39.8 $ 21.8 $ 34.2 Loss ratio 44.4% 45.6% 39.8% Expense ratio 47.3% 49.1% 50.9% Combined ratio 91.7% 94.7% 90.7% - - -------------------------------------------------------------------- Insurance operations include the underwriting results of HSBIIC, HSB Engineering Insurance Limited (EIL), The Boiler Inspection and Insurance Company of Canada (BI&I), The Allen Insurance Company, Ltd., HSB of Connecticut, HSB of Texas and HSBIIC's participation in IRI and various other pools. Insurance premiums in 1997 increased 9.5 percent from 1996. This growth is primarily attributable to the increased participation in IRI ($22.4 million) and to growth in both the domestic and global markets. The increase in 1996 was a result of the increased participation in IRI ($22.6 million) as well as growth in the global markets. It is possible 30 that the reduction in HSBIIC's interest in IRI, as a result of the sale on January 6, 1998, may dampen growth in net insurance premiums. Insurance premiums representing coverage outside the U.S. increased 7.1 percent to $93.3 million from $87.1 million in 1996 and $73.3 million from 1995. In certain areas of the Company's direct domestic and international businesses, the market is experiencing price erosion. The Company will not write business at rates which would lessen its ability to maintain underwriting profit. Increases in ceded premium of 9.5 percent in 1997 were primarily due to the additional participation in IRI and the purchase of facultative reinsurance at EIL. The Company continues to see opportunities for growth, particularly in those countries where the infrastructure development is moving to the private sector. At the same time, softening of the pricing in this market has occurred globally as the number of insurers offering capacity has expanded. Domestically, exclusive of IRI, premiums increased approximately $16.3 million, or 5.0 percent in 1997 and 3.9 percent in 1996. These increases were a combination of growth in written premiums from our client companies in 1997 and 1996 respectively, and reflects the addition of new client companies, offset by a loss of business as a result of industry consolidation. The insurance industry, in general, continues to undergo significant restructuring and consolidation. Considerable merger and acquisition activity has occurred recently and more is possible in the future. Depending on the specific companies involved in these activities and other market factors, the level of reinsured business the Company assumes in the future could be impacted. HSB is positioned to benefit from these changes over the long term due to its strong market position and reinsurance relationships with more than 100 multi-line carriers; while over the shorter term, there is both opportunity and challenge. The Company participates in various facultative, quota share and excess of loss reinsurance agreements to limit its exposure, particularly to catastrophic losses and high risk lines, and to provide additional capacity to write business. The Company re-evaluates its exposures and reinsurance needs annually to implement a program which corresponds with the level of exposure the Company is willing to retain. Because the Company has primary responsibility to its insureds, a careful evaluation of the financial strength of those reinsurers it cedes business to is performed. The Company's reinsurance costs continue to be impacted by its prior loss experience and business growth. 31 For the years ended December 31, 1997 1996 1995 - - -------------------------------------------------------------------------------- Provision for claims and adjustment expenses occurring in the current year $ 209.5 $ 214.2 $ 152.2 Increase (decrease) in estimated claims and adjustment expenses arising in prior years* 8.4 (9.8) 2.7 ----------------------------- Total incurred claims and adjustment expenses $ 217.9 $ 204.4 $ 154.9 Loss ratio 44.4% 45.6% 39.8% - - ------------------------------------------------------------------------------- * Includes approximately $3.3, $4.9 and $1.1 million subrogation recoveries, respectively. The loss ratio decreased 1.2 percentage points in 1997 as compared to 1996 primarily as a result of fewer weather-related losses. The 1996 increase of 5.8 percentage points as compared to 1995, was primarily the result of the high frequency of claims and unusually severe winter weather. Adverse development in 1997 added 1.7 percentage points to the loss ratio, while positive development in 1996 benefited the loss ratio by 2.2 percentage points. The components of claims and adjustment expenses, net of reinsurance, are displayed above. Claims and adjustment expense reserves comprise one of the largest liabilities on the Company's Consolidated Statements of Financial Position. Reserves are established to reflect the Company's estimates of total losses and loss adjustment expenses that will ultimately be paid under direct and assumed insurance contracts. Loss reserves include claims and adjustment expenses on claims that have been reported but not settled and those that have been incurred but not yet reported to the Company. The length of time that reserves are carried on the Consolidated Statements of Financial Position is a function of the pay-out patterns associated with the types of coverages involved. The majority of claims the Company incurs are short-tailed in nature, relative to the property/casualty industry as a whole, meaning they generally settle shortly after claims are reported. The Company's loss reserve estimates reflect such variables as past loss experience and inflation. In addition, due to the nature of much of the Company's coverages, complex engineering judgments are involved. Previously established loss reserves are regularly adjusted as loss experience develops and new information becomes available. Adjustments to previously established reserves are reflected in the financial statements in the period in which the estimates are changed. The Company doesn't discount its loss reserves. HSBIIC is involved in three arbitration or litigation proceedings regarding the extent to which certain explosion events are insured under boiler and machinery policies of HSBIIC or under the all-risk property insurance policies issued by other companies. Management believes HSBIIC's policies do not provide coverage for losses resulting from explosion events that are the subject of these proceedings. 32 A lower court ruling in one of these cases held that an explosion did occur, and that HSBIIC was not liable for losses of the insured resulting from the explosion. In a further action, the court denied HSBIIC's motion for summary judgment on certain issues, thus leaving HSBIIC potentially liable for certain unquantified losses resulting from events prior to the explosion. In the first quarter of 1997 HSBIIC and the property insurer jointly settled the case with the insured. HSBIIC's ultimate share of the settlement will be determined in an arbitration proceeding with the property insurer. HSBIIC has incurred gross losses and loss adjustment expenses (LAE) of $40.7 million and a net loss, after taking into account reinsurance recoverables, of $6.5 million, of which $5 million represents claim costs and the remaining $1.5 million represents LAE. As a result of payments made to date, at December 31, 1997, HSBIIC carried gross loss and LAE reserves of $2.8 million and recoverables from reinsurers of $2.8 million. HSBIIC has accrued $6.5 million with respect to the other two cases for potential LAE, including legal costs to defend HSBIIC's position. One case is in the process of pre-trial summary judgment motions and appeals; the other case is involved in both arbitration and litigation proceedings. A trial date has not been set for either case. In the event that HSBIIC is held liable for one or both of the remaining claims, amounts in excess of HSBIIC's net maximum aggregate retention of $8.5 million is recoverable from reinsurers. Claim amounts potentially recoverable from reinsurers in the event of a possible adverse outcome in these cases could range, in the aggregate, from $40 million to $195 million. The obligations of HSBIIC's reinsurers with respect to these cases are not in dispute. Therefore, management believes that any adverse outcomes in these cases will not, in the aggregate, have a material effect on either the results of operations or financial condition of the Company. HSBIIC's reinsurance contracts do not require HSBIIC to reimburse its reinsurers for any losses such reinsurers might incur should these cases not be decided in HSBIIC's favor. Nevertheless, reinsurers often quote rates for future coverages based upon their or other reinsurers' experience on a particular account. Therefore, in the event HSBIIC's reinsurers pay significant sums pursuant to the arbitration or litigation proceedings described above, it is likely HSBIIC's reinsurance rates would increase in future periods. However, given the insured capacity that exists in reinsurance markets worldwide, coupled with HSBIIC's ability to negotiate a redesign or restructuring of its reinsurance program, it does not necessarily mean that such an increase would be material. The Company is also involved in various other legal proceedings as defendant or co-defendant that have arisen in the normal course of its business. In the judgment of management, after consultation with counsel, it is improbable that any liabilities which may arise from such litigation will have a material adverse impact on the results of operations or the financial position of the Company. 33 Engineering Services Operations* For the years ended December 31, 1997 1996 1995 - - ------------------------------------------------------------------------------ Engineering services revenues $ 61.3 $ 55.8 $ 49.9 Engineering services expenses 57.0 48.5 43.2 Operating gain $ 4.3 $ 7.3 $ 6.7 -------------------------------- Engineering services margin 7.1% 13.2% 13.3% - - ------------------------------------------------------------------------------ * Excludes Radian. Engineering services operations include the results of HSBIIC's and BI&I's engineering services, HSB Reliability Technologies (HSBRT), HSB Professional Loss Control, HSB International, and the Company's interest in Integrated Process Technologies, LLC. Engineering services revenue increased 9.8 percent in comparison to 1996. This was primarily attributable to increased sales of $3.2 million at HSBRT and a modest increase in revenues from our engineering operations based in Asia. Engineering services revenues in 1996 increased 11.8 percent in comparison to 1995. The growth in revenues was primarily due to increases generated by HSBRT as their revenues were $4.8 million (35 percent) higher in 1996 compared to 1995, almost entirely attributable to increases in volume. Margins declined in 1997 as the Company decreased the staff utilization domestically in order to develop new growth opportunities. The Company is also maintaining staff levels in Asia during the current economic downturn at somewhat lower productivity levels as the Company continues to have confidence in its long-term growth prospects in the region. Investment Operations For the years ended December 31, 1997 1996 1995 - - ------------------------------------------------------------------------------- Net investment income $ 36.8 $ 32.3 $ 28.9 Realized investment gains 14.1 12.1 2.8 ------------------------------------------- Income from investment operations $ 50.9 $ 44.4 $ 31.7 Total cash and invested assets, at fair value $ 996.7 $ 600.9 $ 550.5 Unrealized gains, pre-tax $ 95.3 $ 81.4 $ 65.4 - - -------------------------------------------------------------------------------- The Company's investment strategy continues to be to maximize total return on the investment portfolio through investment income and capital appreciation. Investment strategies for any given year are developed based on many factors including operational results, tax implications, regulatory requirements, interest rates, dividends to stockholders and market conditions. The investment portfolio includes a wide variety of high quality equity securities and both domestic and foreign fixed maturities. The Company continues to manage its use of tax advantageous investments to maximize after tax investment 34 earnings. The Company does not engage in cash flow underwriting; it seeks to have underwriting profit each year. None of the Company's claim reserves are discounted as most claims settle, on average, within one year. Therefore, the Company does not use duration measurements in managing its interest rate exposure. Instead, the Company manages its portfolio by laddering its maturities such that the average maturity is generally maintained between 5-10 years. This technique provides the Company with a predictable cash flow each year that enables it to respond to the previously discussed parameters that impact its investment strategy. On December 19, 1996, HSBIIC entered into three "zero cost collar contracts" to mitigate the effects of market risk on its U.S. common stock portfolio (which, for management purposes, included certain convertible preferreds). Each contract had a notional value of $50 million and maturity dates ranging from November 1997 to January 1998. The contracts were European style, which meant they only settled upon maturity. The contracts, which were entered into when the S&P 500 Index was 744.3, allowed HSBIIC to recover from the counterparty if the index was below 695.2 at the time of maturity, and required HSBIIC to reimburse the counterparty if the index was above a range of 811.3 to 818.7 at the time of maturity. In the fourth quarter of 1997, HSBIIC settled all of its outstanding contracts which required HSBIIC to pay its counterparty $30.7 million in foregone appreciation on its portfolio. The Company's U.S. common stock portfolio has experienced a total return of $57 million (which includes price appreciation of approximately $54 million) since December 31, 1996, and has had a price movement correlation with the S&P 500 Index well in excess of 80 percent. Net investment income for 1997 increased $4.5 million compared to 1996. Investable assets increased in 1997 in comparison to 1996 as the Company invested the proceeds from its capital securities offerings. Net investment income was impacted earlier in 1997 by calls of high yielding preferred stocks. Net investment income increases also reflected more investable funds, which were invested during a period of declining rates in comparison to our portfolio averages, and a modest change in the mix of the portfolio from tax preferred investments to more taxable investments with higher pre-tax yields. Higher interest costs relate to a larger amount of commercial paper outstanding. Through its U.K. subsidiary, EIL, the Company writes business in Malaysia and is required to maintain approximately 50 million ringgit denominated investments on deposit in that country. The Company intends to maintain its current level of deposits in that currency, which equated to $12.8 million at December 31, 1997. Due to the recent fluctuations of currencies in southeast Asia, realized investment gains were reduced by approximately $7.4 million during 1997. Net investment income increased 11.8 percent in 1996 due to an increased level of investable assets and to a lesser extent by dividend increases on the Company's common stock investments. Invested assets growth was due to significant cash flow from 35 operations during 1995 as well as the portfolio transfer arising from the increased participation in IRI during 1996. Investment income in the global market also increased as these operations have shown significant growth over the past year. HSB's investment portfolio continues to consist of high grade domestic and foreign investments. Excluding short-term investments, HSB's investments are primarily comprised of publicly traded, highly liquid securities. At the end of 1997, HSB's fixed maturities portfolio comprised 26.1 percent of the value of the invested assets. The credit quality of HSB's bond investments at December 31, 1997, averaged a AA rating. HSB's portfolio does not include any bonds in default as to either principal or interest. Bonds held at December 31, 1997, had a fair value of $113 million. Redeemable preferred stocks averaged a BBB rating. Declining yields available on new fixed maturities relative to higher yields on maturing investments over the past few years have also moderated investment income growth. The carrying value of the equity securities portfolio represented 34 percent of the investments at December 31, 1997. This included $92.5 million of unrealized investment gains, which had a net increase of $12.7 million from 1996 on a sharp upturn in the stock market in 1997. HSB also recorded $13 million of dividends and $43 million of net pre-tax realized gains from this portfolio in 1997. The Company's largest single holding accounted for less than 1 percent of total consolidated assets. Realized investment gains increased in 1997 over 1996 (and in 1996 in comparison to 1995) as HSB managed its portfolio to respond to changing market conditions and tax planning opportunities. Liquidity and Capital Resources At December 31, 1997 1996 - - ------------------------------------------------------------------------------- Total assets $ 1,540.2 $ 1,116.3 Short-term investments 379.2 97.9 Cash 45.3 4.5 Short-term borrowings 42.4 3.2 Capital securities of subsidiary Trust I 108.8 -- Capital securities of subsidiary Trust II 300.0 -- Convertible redeemable preferred stock -- 20.0 Common shareholders' equity 345.3 345.6 - - -------------------------------------------------------------------------------- Liquidity refers to the Company's ability to generate sufficient funds to meet the cash requirements of its business operations. HSB is a holding company whose principal 36 subsidiary is HSBIIC. HSB relies on investment income, primarily in the form of dividends from HSBIIC in order to meet its short and long-term liquidity requirements including the service requirements for its capital securities. The Company receives a regular inflow of cash from maturing investments and engineering services and insurance operations. The mix of the investment portfolio is managed to respond to expected claim pay-out patterns and the service requirements equivalent of the Company's capital securities. HSB also maintains a highly liquid short-term portfolio to provide for immediate cash needs and since the issuance of the $110 million of Global Floating Rate Capital Securities in July 1997, which are discussed below, to offset a portion of interest rate risk relating to such securities. The Company's short-term portfolio at December 31, 1997 reflects the temporary investment of the proceeds from the $300 million Convertible Capital Securities discussed below. It is unlikely that HSB will maintain such high levels of short-term investments; however, given the current interest rate environment, HSB is proceeding carefully to structure an appropriate investment portfolio. On July 15, 1997, HSB sold $110 million of 30 year Global Floating Rate Capital Securities (Capital Securities), in a private placement. The securities are generally non-callable for ten years, but may be called earlier by HSB upon the occurrence of certain tax events including loss of deductibility of interest on the securities. The securities were issued through HSB Capital I (Trust I), a Delaware business trust created by HSB, at a floating rate equal to 90 day LIBOR plus .91 percent. The current coupon at December 31, 1997 is 6.7 percent. Holders of the Capital Securities will be entitled to receive preferential cumulative cash distributions accumulating from the date of original issuance and payable quarterly in arrears. HSB has the right to defer payment of distributions on the securities at any time or from time to time for a period not exceeding 20 consecutive quarterly periods with respect to each deferral period. During an extension period, interest will continue to accrue and the amount of distributions to which holders of the Capital Securities are entitled will accumulate, and the Company will be prohibited from paying any cash dividends on its common stock. The Company has irrevocably and unconditionally guaranteed all of Trust I's obligations under the Capital Securities. The Company has used or may use the proceeds for general corporate purposes, including the repurchase of HSB common stock; funding investments in, or extensions of credit to, subsidiaries; repayment of maturing debt; and financing possible future acquisitions. HSB subsequently filed a registration statement covering securities with terms identical in all material respects and offered to exchange registered securities for the original Capital Securities. The exchange was completed on December 11, 1997. The floating rate Capital Securities are currently rated BBB by Standard & Poor's and BBB+ by Duff & Phelps credit rating agency. On December 31, 1997, HSB sold $300 million of 20 year Convertible Capital Securities in a private placement to ERC. The Convertible Capital Securities are callable by HSB at its option (i) at any time after seven years; (ii) upon the occurrence of certain tax events including loss of deductibility of the interest on the securities; (iii) in the event that HSB vetoes a prospective purchaser of the Convertible Capital Securities; or (iv) in the event 37 of a change in control of ERC. The Convertible Capital Securities are mandatorily redeemable on December 31, 2017, and are redeemable at par plus a redemption premium, at the option of ERC, in the event of a change in control of HSB within five years following issuance of the securities. The Convertible Capital Securities are convertible, in whole or in part, at ERC's option at any time, subject to regulatory approval, into shares of HSB common stock at a conversion price of $85, subject to adjustment. HSB has provided certain registration rights to ERC in connection with the common stock into which the Convertible Capital Securities are convertible pursuant to a Registration Rights Agreement dated December 31, 1997. Were ERC to exercise its conversion rights in total, it would hold, on a fully diluted basis, approximately 15.3 percent of HSB's common stock. Pursuant to certain provisions contained in the Purchase Agreement dated December 31, 1997, ERC has agreed to certain "standstill" arrangements which for a period of five years will preclude ERC from purchasing any common stock of HSB, other than by exercise of its conversion rights, and will limit its ability to take certain other actions with respect to HSB during that period. The securities were issued through HSB Capital II, (Trust II), a Delaware business trust created by HSB, at a 7 percent coupon, payable semi-annually. The Convertible Capital Securities rank pari passu with the Capital Securities issued July 1997. Holders of the Convertible Capital Securities will be entitled to receive preferential cumulative cash distributions accumulating from the date of original issuance and payable semi-annually in arrears. HSB has the right to defer payment of interest at any time or from time to time for a period not exceeding 10 consecutive semi-annual periods with respect to each deferral period. During an extension period, interest will continue to accrue and the amount of distributions to which holders of the Convertible Capital Securities are entitled will accumulate, and HSB will be prohibited from paying any cash dividends on its common stock. HSB has irrevocably and unconditionally guaranteed all of Trust II's obligations under the Convertible Capital Securities. Cash provided from operations was $26.1 million in 1997 compared to $92.9 million for 1996. Insurance operations cash flow (excluding IRI) decreased as net claims paid increased 21.8 percent compared to the same period in 1996, and premiums collected were 1.9 percent higher than last year. Payments to reinsurers for ceded premium increased approximately 17 percent in the current year. HSBIIC's participation in IRI impacted components of the Consolidated Statements of Cash Flows for 1997, including a positive impact of $1.5 million and $2.2 million for 1997 and 1996, respectively, to cash provided from operations. Capital resources consist of shareholders' equity, convertible redeemable preferred stock, capital securities and debt outstanding, and represent those funds deployed or available to be deployed to support business operations. Common shareholders' equity of $345.3 million at December 31, 1997 decreased $0.3 million since December 31, 1996. The decrease reflects net income of $66.3 million year to date and an increase in unrealized 38 investment gains, net of tax, of $7.0 million, offset by dividends of $47 million and $54 million of share repurchases. Also, on October 30, 1997, the sole holder of convertible redeemable preferred stock converted into 398,406 shares of common stock, adding $20 million to common shareholders' equity. On January 27, 1997 the Board of Directors renewed HSBIIC's authorization to repurchase up to one million of its common shares. At its July meeting, the HSB Board of Directors increased the authorization to repurchase shares to two million. Through December 31, 1997, HSB has purchased approximately one million shares at a cost of $54 million. On January 26, 1998 the Board of Directors renewed HSB's authorization to repurchase up to two million shares of its common stock. At December 31, 1997 treasury stock of $85.9 million was reclassified to retained earnings and additional paid-in capital to reflect the elimination of the concept of treasury shares in accordance with the Connecticut Business Corporation Act which became effective January 1, 1997. For comparative purposes, treasury stock of $59.5 million was likewise reclassified at December 1996. At December 31, 1997, HSBIIC had significant short-term borrowing capacity. HSBIIC is currently authorized to issue up to $75 million of commercial paper. Commercial paper outstanding at December 31, 1997 and December 31, 1996 was $42.4 million and $3.2 million, respectively. In early January, Standard & Poor's and Duff & Phelps credit rating services reaffirmed their highest ratings for the commercial paper. HSBIIC had authorized a guaranty of up to 40 percent of Radian's $40 million credit facility with Dow. At December 31, 1997 the amount guaranteed was $14.3 million. Such guaranty terminated upon the sale of HSBIIC's interest in Radian to Dow on January 2, 1998. In 1996 the Company began a comprehensive effort to assess and address issues relating to the ability of its policy processing and other operational systems to properly recognize calendar dates beginning in the year 2000. The analysis indicated roughly 30 percent of existing code is compliant, roughly 60 percent is represented by legacy systems, which were scheduled to be replaced before the end of 1998 due to current business needs, and the remainder will be addressed through modification to compliant code or discontinuation. The impact of year 2000 expenditures on a stand alone basis is not clearly evident as the Company is replacing legacy applications due to changing business needs and such replacement applications will be year 2000 compliant. However, the overall cost of modification efforts and application replacement, which include substantial enhancements to business functionality, has been estimated at $13-$20 million over a three year period. Certain of the costs related to the replacement of legacy applications due to changing business needs will be capitalized consistent with the Company's existing capitalization policy. Forward-Looking Statements Certain statements contained in this report are forward-looking and are based on management's current expectations. Actual results may differ materially from such 39 expectations depending on the outcome of certain factors described with such forward-looking statements and other factors including: significant natural disasters and severe weather conditions; changes in interest rates and the performance of the financial markets; changes in the availability, cost and collectibility of reinsurance; changes in domestic and foreign laws, regulations and taxes; the entry of new or stronger competitors and the intensification of pricing competition; the loss of current customers or the inability to obtain new customers; changes in the coverage terms selected by insurance customers, including higher deductibles and lower limits; the adequacy of loss reserves; changes in asset valuations; consolidation and restructuring in the insurance industry; changes in the Company's participation in joint underwriting associations, and in particular IRI; changes in the demand and customer base for engineering and inspection services offered by the Company, whether resulting from changes in the law or otherwise, and other general market conditions. Item 8. Financial Statements and Supplementary Data. - - ------- -------------------------------------------- INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Page No. Report of Independent Accountants 42 Financial Statements Consolidated Statements of Operations for the years ended December 31, 1997, 1996 and 1995. 43 Consolidated Statements of Financial Position - December 31, 1997 and 1996. 44 Consolidated Statements of Cash Flows for the years ended December 31, 1997, 1996 and 1995. 45 Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 1997, 1996 and 1995. 46 Notes to Consolidated Financial Statements 47 Schedule I - Summary of Investments- Other than Investments in Related Parties 79 40 Schedule II - Condensed Financial Information of HSB Group, Inc. 80 Schedule IV - Reinsurance 83 Schedule V - Valuation and Qualifying Accounts 84 Schedule VI - Supplemental Information Concerning Property-Casualty Insurance Operations 85 Schedules other than the ones listed above are omitted for the reason that they are not required or are not applicable or the required information is shown in the financial statements or notes thereto. 41 REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders and Board of Directors of HSB Group, Inc., the newly formed parent of The Hartford Steam Boiler Inspection and Insurance Company: We have audited the consolidated financial statements and the financial statement schedules of HSB Group, Inc. and its subsidiaries listed in Item 8 of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules 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 consolidated 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 HSB Group, Inc. and its subsidiaries as of December 31, 1997 and 1996, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. Coopers & Lybrand L.L.P. Hartford, Connecticut January 26, 1998 42 Financial Statements Consolidated Statements of Operations - - ------------------------------------- For the years then ended December 31, (in millions, except per share amounts) 1997 1996 1995 - - -------------------------------------------------------------------------------------------- Revenues: Insurance premiums $ 491.2 $ 448.6 $ 389.1 Engineering services 61.3 55.8 49.9 Net investment income 36.8 32.3 28.9 Realized investment gains 14.1 12.1 2.8 ---------------------------------- Total revenues 603.4 548.8 470.7 ---------------------------------- Expenses: Claims and adjustment 217.9 204.4 154.9 Policy acquisition 90.7 86.0 78.1 Underwriting and inspection 142.8 136.4 121.9 Engineering services 57.0 48.5 43.2 Interest 1.3 0.6 0.4 ---------------------------------- Total expenses 509.7 475.9 398.5 ---------------------------------- Income from continuing operations before income taxes and distributions on capital securities 93.7 72.9 72.2 Income taxes (benefit): Current 23.8 24.7 20.5 Deferred 1.3 (6.4) (1.0) ---------------------------------- Total income taxes 25.1 18.3 19.5 ---------------------------------- Distributions on capital securities of subsidiary trusts, net of income taxes of $1.2; $--; and $-- 2.3 -- -- ---------------------------------- Income from continuing operations 66.3 54.6 52.7 ---------------------------------- Discontinued operations: Income (loss) from operations of Radian International LLC, net of income taxes (benefit) of ($.1); ($.4); and $4.2 -- (1.2) 9.9 ----------------------------------- Net income $ 66.3 $ 53.4 $ 62.6 ----------------------------------- Earnings (loss) per common share - basic: Income from continuing operations $ 3.32 $ 2.71 $ 2.58 Discontinued operations -- (0.06) 0.49 ----------------------------------- Net income $ 3.32 $ 2.65 $ 3.07 ----------------------------------- Average common shares outstanding 19.7 20.2 20.4 Earnings (loss) per common share - diluted: Income from continuing operations $ 3.29 $ 2.71 $ 2.58 Discontinued operations -- (0.06) 0.49 ----------------------------------- Net income $ 3.29 $ 2.65 $ 3.07 ----------------------------------- Average common shares outstanding and common stock equivalents 20.1 20.2 20.4 -----------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial statements. 43 Consolidated Statements of Financial Position - - --------------------------------------------- At December 31, (in millions, except per share amounts) 1997 1996 - - ---------------------------------------------------------------------------------------------------------------- Assets: Cash $ 45.3 $ 4.5 Short-term investments, at cost 379.2 97.9 Fixed maturities, at fair value (cost - $241.1; $231.3) 248.4 235.8 Equity securities, at fair value (cost - $231.3; $182.9) 323.8 262.7 -------------------------- Total cash and invested assets 996.7 600.9 Insurance premiums receivable 138.0 106.4 Engineering services receivable 12.2 11.7 Fixed assets 36.4 32.3 Prepaid acquisition costs 45.5 40.6 Capital lease 15.3 16.1 Investment in Radian 83.4 79.7 Reinsurance assets 124.5 162.9 Other assets 88.2 65.7 ------------------------- Total assets $ 1,540.2 $ 1,116.3 ------------------------- Liabilities: Unearned insurance premiums $ 290.3 $ 270.6 Claims and adjustment expenses 276.7 302.9 Short-term borrowings 42.4 3.2 Long-term borrowings 25.1 25.1 Capital lease 27.9 27.9 Deferred income taxes 31.5 23.7 Dividends payable 13.3 11.4 Other liabilities 78.8 85.9 ------------------------- Total liabilities 786.0 750.7 ------------------------- Convertible redeemable preferred stock - Series B (stated and redemption value; shares authorized, issued and outstanding .002) -- 20.0 Company obligated mandatorily redeemable capital securities of subsidiary Trust I holding solely junior subordinated deferrable interest debentures of the Company, net of unamortized discount of $1.1 108.9 -- Company obligated mandatorily redeemable convertible capital securities of subsidiary Trust II holding solely junior subordinated deferrable interest debentures of the Company 300.0 -- Shareholders' equity: Common stock (stated value; shares authorized 50.0; shares issued 21.3; shares outstanding 19.6; 20.0) 10.0 10.0 Additional paid-in capital 31.6 32.0 Unrealized investment gains, net of tax 59.8 52.8 Retained earnings 248.8 255.1 Benefit plans (4.9) (4.3) --------------------------- Total shareholders' equity 345.3 345.6 --------------------------- Total $ 1,540.2 $ 1,116.3 --------------------------- Common shareholders' equity per share $ 17.63 $ 17.25 - - ---------------------------------------------------------------------------------------------------------------- - - ----------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial statements. 44 Consolidated Statements of Cash Flows - - ------------------------------------- for the years ended December 31, (in millions) 1997 1996 1995 - - ----------------------------------------------------------------------------------------- Operating activities: Net income $ 66.3 $ 53.4 $ 62.6 Adjustments to reconcile net income to cash provided by operating activities: Depreciation and amortization 8.3 9.8 19.4 Deferred income taxes (benefit) 1.3 (10.0) (0.6) Realized investment gains (14.1) (12.1) (2.8) Change in: Insurance premiums receivable (31.6) (19.2) (4.1) Engineering services receivable (.5) (2.7) 3.3 Prepaid acquisition costs (4.9) (6.5) 1.4 Investment in Radian (3.7) 12.9 -- Reinsurance assets 38.4 (103.4) (.8) Unearned insurance premiums 19.7 54.4 14.9 Claims and adjustment expenses (26.2) 112.0 (8.5) Other (26.9) 4.3 10.7 ------------------------------ Cash provided by operating activities 26.1 92.9 95.5 ------------------------------ Investing activities: Fixed asset additions, net (10.4) (1.7) (16.8) Investments: Purchase of short-term investments, net (281.4) (24.1) -- Purchase of fixed maturities (60.6) (89.0) (152.1) Proceeds from sale of fixed maturities 27.9 93.1 91.5 Redemption of fixed maturities 14.4 11.5 17.0 Purchase of equity securities (252.9) (149.3) (95.0) Proceeds from sale of equity securities 254.1 131.2 122.9 Settlement of collar contracts (30.7) -- -- Cash transferred to investment in Radian -- (0.7) -- ----------------------------- Cash used in investment activities (339.6) (29.0) (32.5) ----------------------------- Financing activities: Proceeds from Company obligated mandatorily redeemable capital securities of subsidiary Trust I 108.9 -- -- Proceeds from Company obligated mandatorily redeemable convertible capital securities of subsidiary Trust II 300.0 -- -- Increase (decrease) in short-term borrowings 39.1 (10.2) (37.5) Repayment of long-term debt -- (0.5) (0.1) Increase in long-term debt -- -- 25.1 Dividends paid to shareholders (46.7) (46.1) (45.3) Reacquisition of stock (54.0) (13.0) (6.3) Repayment of employee stock ownership plan debt -- -- (1.7) Exercise of stock options 7.0 1.1 -- ----------------------------- Cash provided by (used in) financing activities 354.3 (68.7) (65.8) ----------------------------- Net increase (decrease) in cash 40.8 (4.8) (2.8) Cash at beginning of period 4.5 9.3 12.1 ----------------------------- Cash at end of period $ 45.3 $ 4.5 $ 9.3 ----------------------------- Interest paid $ 3.2 $ 2.3 $ 4.1 ----------------------------- Federal income tax paid $ 33.8 $ 25.7 $ 23.4 - - ----------------------------------------------------------------------------------------
Non-cash investing and financing activities: Issuance of HSB convertible preferred stock in exchange for EIG, Co. preferred stock in 1996, and conversion into HSB common stock in 1997. (See note 3). The accompanying notes are an integral part of the consolidated financial statements. 45 Consolidated Statements of Changes in Shareholders' Equity - - ---------------------------------------------------------- For the years ended December 31, (in millions) Net Total Unrealized Share- Additional Investment holders' Common Paid-in Gains Retained Treasury Benefit Equity Stock Capital (Losses) Earnings Stock Plans - - -------------------------------------------------------------------------------------------------------- Balances at December 31, 1994 $ 299.5 $ 10.0 $ 34.0 $ 13.9 $ 288.1 ($ 41.9) (4.6) - - -------------------------------------------------------------------------------------------------------- Net income 62.6 -- -- -- 62.6 -- -- Dividends declared (45.6) -- -- -- (45.6) -- -- Change in unrealized investment gains, net of tax 30.0 -- -- 30.0 -- -- -- Benefit plans 0.4 -- (0.1) -- -- -- 0.5 Purchase of treasury stock (6.3) -- -- -- -- (6.3) -- Issuance of reacquired stock, net of forfeitures 0.5 -- -- -- -- 0.5 -- ----------------------------------------------------------------------------------------------------- Balances at December 31, 1995 $ 341.1 $ 10.0 $ 33.9 $ 43.9 $ 305.1 ($ 47.7) ($ 4.1) - - ------------------------------------------------------------------------------------------------------ Net income 53.4 -- -- -- 53.4 -- -- Dividends declared (45.9) -- -- -- (45.9) -- -- Change in unrealized investment gains, net of tax 8.9 -- -- 8.9 -- -- -- Benefit plans -- -- -- -- -- 0.2 (0.2) Purchase of treasury stock (13.0) -- -- -- -- (13.0) -- Exercise of stock options 1.1 -- 0.1 -- -- 1.0 -- Reclassification of treasury stock -- -- (2.0) -- (57.5) 59.5 -- -------------------------------------------------------------------------------------------------- Balances at December 31, 1996 $ 345.6 $ 10.0 $ 32.0 $ 52.8 $ 255.1 -- ($ 4.3) - - ------------------------------------------------------------------------------------------------------ Net income 66.3 -- -- -- 66.3 -- -- Dividends declared (47.0) -- -- -- (47.0) -- -- Change in unrealized investment gains, net of tax 7.0 -- -- 7.0 -- -- -- Benefit plans (0.6) -- -- -- -- -- (0.6) Reacquisition of stock (54.0) -- (1.8) -- (52.2) -- -- Conversion of redeemable preferred stock 20.0 -- 0.7 -- 19.3 -- -- Exercise of stock options 7.0 -- 0.5 -- 6.5 -- -- Issuance of reacquired stock, net of forfeitures 1.0 -- 0.2 -- 0.8 -- -- - - ----------------------------------------------------------------------------------------------------- Balances at December 31, 1997 $ 345.3 $ 10.0 $ 31.6 $ 59.8 $ 248.8 -- ($ 4.9) - - ------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial statements. 46 Notes to Consolidated Financial Statements (in millions, except per share amounts) 1. Accounting Policies Consolidation The accompanying financial statements present the consolidated accounts of HSB Group, Inc. and its subsidiaries (collectively, HSB or the Company) (See note 3) and are prepared in accordance with generally accepted accounting principles (GAAP). Significant intercompany transactions and balances have been eliminated in consolidation. The preparation of financial statements in accordance with GAAP requires the use of estimates in reporting certain assets and liabilities. Actual results may differ from estimates. Certain amounts for 1996 and 1995 have been reclassified to conform with the 1997 presentation. Insurance Insurance premium revenues are net of reinsurance ceded and are generally earned on a pro rata basis over the contract period. The portion of gross insurance premiums not earned at the end of the period is recorded as unearned insurance premiums on the Consolidated Statements of Financial Position. Prepaid acquisition costs, consisting principally of commissions and premium taxes, are amortized as the related insurance premiums are earned. All other acquisition costs are charged to operations as incurred. Liabilities for claims and adjustment expenses for boiler and machinery, property and other coverages represent estimated reserves on claims and adjustment expenses reported but not yet settled and the cost of claims and adjustment expenses incurred but not yet reported. Reserves for claims and adjustment expenses are undiscounted and are gross of amounts recoverable from reinsurers. Reserves are reduced for estimated amounts of salvage and subrogation and deductibles from customers. HSB records subrogation when recoverability is probable, such as when a judgment is returned, liability is admitted to or settlement is reached. The length of time that reserves for claims and adjustment expenses are carried on the Consolidated Statements of Financial Position is a function of the pay-out patterns associated with the types of coverages involved. Estimates for these reserves reflect such variables as past loss experience, changes in judicial interpretation of legal liability, policy coverage and inflation. The establishment of such reserves frequently require complex engineering judgments. Due to the nature of the variables involved in the reserving process, subjective judgments are an integral component. Previously estimated reserves are regularly adjusted as loss experience develops and new information becomes available. Since reserves are based on estimates, the ultimate liability may be more or less than such reserves. The effects of changes in estimated reserves are included in the results of operations in the period in which the estimates are changed. (See note 10). Reinsurance assets represents amounts due from reinsurers for paid and unpaid claims, paid and unpaid loss adjustment expenses and the unearned portion of premiums ceded through reinsurance agreements. 47 Engineering Services HSB recognizes the majority of its engineering services revenues as the service is provided. Costs on such contracts are included in operations as incurred. Provisions are made for losses on contracts at the time such losses become known. Investments Short-term investments have a maturity of one year or less and are carried at cost which, together with accrued interest thereon, approximates fair value. Fixed maturities include bonds, notes and redeemable preferred stocks. Equity securities include common and non-redeemable preferred stocks. All fixed maturities and equity securities are classified as available for sale. Accordingly, these investments are carried at estimated fair value. Estimated fair values of securities classified as available for sale are based principally upon quoted market prices. Unrealized gains and losses on investments classified as available for sale and foreign exchange gains and losses on certain investments in foreign operations where the U.S. dollar is not the functional currency are included net of income tax in shareholders' equity. Investment income is net of investment expenses. Realized investment gains and losses are determined on the basis of costs related to those investments sold and are recorded on the trade date. Also, included in realized investment gains and losses are losses arising from declines in the realizable value of investments considered to be other than temporary. The carrying values of short-term investments, investment income accrued and securities transactions in the course of settlement approximate their fair value because of the relatively short period of time between origination of the instruments and their expected realization. Financial investments which qualify for hedge accounting are recorded at market with gains and losses reflected in shareholders' equity. To the extent such instruments do not qualify for hedge accounting, related gains and losses are reflected in results of operations. Income Taxes Deferred tax assets and liabilities are generally determined based on the difference between financial statement and tax bases for certain assets and liabilities using tax rates in effect for the year in which the differences are expected to reverse. Deferred tax assets are allowed if future realization is more likely than not. Deferred income taxes are provided for unrealized appreciation/depreciation on fixed maturities and equity securities available for sale, prepaid acquisition costs, loss reserve discounting, unearned premiums, certain employee benefit costs and other items which are the result of temporary differences in the treatment of such items for tax and financial statement purposes. Fixed Assets Fixed assets are carried at cost less accumulated depreciation. Depreciation is calculated on the basis of estimated useful lives using straight-line and accelerated methods. Upon retirement or replacement, any gain or loss is included in results of operations. 48 Goodwill and Other Intangible Assets Goodwill represents the cost of acquiring a business which is in excess of the fair value of its net assets. Goodwill is generally amortized over 15 years and other intangible assets over their estimated useful lives. These assets are included in other assets on the Consolidated Statements of Financial Position and amounted to $20.7 and $12.1 million at December 31, 1997 and 1996, respectively. HSB evaluates the reliability of goodwill based upon projections of undiscounted cash flows. 2. Changes in Accounting Principles In February 1997, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 128, "Earnings per Share". This statement establishes standards for computing and presenting earnings per share (EPS). It replaces the presentation of primary EPS with a presentation of basic EPS. It also requires dual presentation of basic and diluted EPS on the face of the Consolidated Statements of Operations and a reconciliation of the numerator and denominator of the basic EPS computation to the numerator and denominator of the diluted EPS computation. The requirements of this statement are effective for year end 1997 financial statements with prior period restatement required. The effect of this standard on EPS net income is as follows: 1997 1996 1995 - - -------------------------------------------------------------- APB No. 15 methodology (as previously reported) N/A $ 2.65 $ 3.07 SFAS No. 128 methodology Basic EPS $ 3.32 $ 2.65 $ 3.07 Diluted EPS $ 3.29 $ 2.65 $ 3.07 - - -------------------------------------------------------------- 49 The following is a reconciliation of the numerator and denominator of the calculation of basic and diluted EPS for income from continuing operations for the years ended 1997, 1996 and 1995: For the years ended December 31, 1997 1996 1995 - - ---------------------------------------------------------------- --------------------------- --------------------------- Income Shares Per-Share Income Shares Per-Share Income Shares Per-Share ------ ------ --------- ------ ------ --------- ------ ------ --------- Income from continuing operations $66.3 $53.4 $62.6 Less: preferred stock dividends (1.1) -- -- ---------------------------- ---------------------------- --------------------------- Basic EPS: Income available to common shareholders 65.2 53.4 62.6 Weighted average shares outstanding 19.7 20.2 20.4 Basic EPS $3.32* $2.65* $3.07* Effect of dilutive securities: Convertible preferred stock 1.1 0.3 -- -- -- -- Stock options 0.1 -- -- --------------------------- ---------------------------- -------------------------- Diluted EPS: Income available to common shareholders and assumed conversions $66.3 20.1 $53.4 20.2 $62.6 20.4 Diluted EPS $3.29* $2.65* $3.07* - - ---------------------------------------------------------------- --------------------------- -------------------------- - - -------------------------------------------------------------------------------------------------------------------------------
* Computation is carried out to thousands On December 31, 1997, HSB sold $300 million of convertible capital securities. The securities carry a 7 percent coupon and are convertible into 3,529,411 shares. (See note 12). Due to the timing of the issuance, the securities had minimal impact on the EPS calculation in 1997, but will affect the diluted calculation in 1998. In June 1997, FASB issued SFAS No. 130, "Reporting Comprehensive Income", which requires items that comprise comprehensive income be reported in a financial statement display with the same prominence as other financial statements. This presentation will include such items as market value adjustments of securities, foreign currency translation, and certain adjustments made for benefit plans, which are currently reported as components of the Consolidated Statements of Changes in Shareholders' Equity. This statement will be effective beginning in 1998 with retroactive restatement of prior periods required. Also in June of 1997, FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information". This standard requires companies to report financial 50 and descriptive information about reportable operating segments. It includes disclosure requirements relating to products and services, geographic areas and major customers. This statement will be effective for 1998, however, application is not required for interim financial statements in the initial year. It is possible that this disclosure may redefine our segment information. However, HSB has not yet determined how SFAS No. 131 will be applied. 3. Corporate Activity At a special meeting of The Hartford Steam Boiler Inspection and Insurance Company (HSBIIC) on June 23, 1997, shareholders voted to approve a proposal which enabled the formation of a new holding company, HSB Group, Inc. (HSB). Shareholders of HSBIIC's common and convertible redeemable preferred stock became holders of HSB's common and convertible redeemable preferred stock, respectively, through a share exchange approved by the shareholders. Certificates representing HSBIIC's common and convertible redeemable preferred stock automatically represent the corresponding shares of HSB common and convertible redeemable preferred stock. HSBIIC remains the principal subsidiary of HSB. In December 1994, HSBIIC acquired the remaining 50 percent interest in Engineering Insurance Group (EIG), a partnership which was jointly formed by HSBIIC and General Reinsurance Corporation (Gen Re) in 1988. The partnership was the parent of Engineering Insurance Company Limited, a London based insurer formed in 1989 principally to offer machinery breakdown coverage to business and industry outside the United States and Canada. Coincident with the December 1994 acquisition, the partnership was incorporated with HSBIIC acquiring all outstanding common shares and Gen Re acquiring preferred shares of the new company, EIG, Co. HSBIIC had the option to request Gen Re to exchange the EIG, Co. preferred stock for HSBIIC convertible redeemable preferred stock at the end of 1996. This option was exercised on December 30, 1996 resulting in the issuance of 2,000 shares of HSBIIC convertible redeemable preferred stock. On October 30, 1997, these shares were converted into 398,406 shares of common stock of HSB. (See note 12). On July 15, 1997, HSB sold $110 million of 30 year Global Floating Rate Capital Securities in a private placement. On December 31, 1997, HSB sold $300 million of 20 year fixed rate Convertible Capital Securities to Employers Reinsurance Corporation (ERC), a subsidiary of GE Capital Services. (See note 12). Subsequent Events Radian In January 1996, HSBIIC and The Dow Chemical Company (Dow) formed a new entity, Radian International LLC (Radian). According to the terms of the agreement, the ownership of Radian was initially 60 percent Dow and 40 percent HSBIIC, via the wholly 51 owned subsidiaries of each company. At the date of the transaction, HSBIIC transferred virtually all of the assets and liabilities of Radian Corporation at historical cost to Radian. No gain was recognized on the transfer. The agreement provided HSBIIC the option to put its share of the venture to Dow any time during the period from December 31, 1997 to December 31, 1998 upon giving appropriate notice. On July 28, 1997 the HSB Board of Directors ratified management's decision to put its share of Radian to Dow on or about January 1, 1998. Due to this decision, the results of Radian have been classified as discontinued operations. HSB's share of Radian's losses generated subsequent to this decision of approximately $10 million pre-tax have been deferred until HSB's share of Radian was sold and a gain recognized. On January 2, 1998 HSB exercised its option to put its share of Radian to Dow for approximately $144 million. This transaction will result in an after tax gain of approximately $30 million which will be recorded in the first quarter of 1998. Summarized financial data for Radian follows: 1997* 1996* 1995 - - --------------------------------------------------------- Assets $ 159.7 $ 156.3 $ 108.6 Liabilities 88.4 62.1 37.1 Revenues 288.0 229.6 202.2 Expenses 314.0 233.6 188.1 - - --------------------------------------------------------- *Presented at 100 percent--HSBIIC's interest in Radian during these periods was 40 percent. Industrial Risk Insurers On January 6, 1998 HSBIIC sold its interest in Industrial Risk Insurers (IRI) to ERC in accordance with a previously announced purchase and sale agreement between ERC and IRI's twenty-three member insurers. IRI is an unincorporated, voluntary joint underwriting association which underwrites property insurance on highly protected risks. HSBIIC received gross proceeds of approximately $50 million, prior to transaction costs, for its 23.5 percent share in IRI. Because the sale was structured in part as a reinsurance transaction, a portion of HSBIIC's gross proceeds will be utilized to reinsure in-force policies with ERC. Contemporaneous with the close of the sale, IRI was reconstituted with ERC (with a 99.5 percent share) and HSBIIC (with a .5 percent share) as its sole members. Initially HSBIIC will write the business for the reconstituted IRI using its insurance licenses and will provide certain other services. It is anticipated that HSBIIC will transfer its domestic highly protected risk manufacturing book of business to IRI and will retain 85 percent of 52 the equipment breakdown business and 15 percent of the property business of the combined insurance portfolio. To support HSB's expanded role, on December 31, 1997, a business trust formed by HSB sold $300 million of 20 year Convertible Capital Securities in a private placement to ERC. These capital securities are convertible into HSB common stock, at any time, subject to regulatory approval, at a conversion price of $85. $250 million of the proceeds were contributed by HSB to HSBIIC and $50 million was retained at HSB. (See note 12). 4. Segment Information HSB is a multi-national company operating primarily in North American, European, and Asian markets. The Company operates three principal businesses -- insurance, engineering services and investments. The Company primarily offers coverage for machinery intensive risks and provides insurance against losses from accidents to boilers, pressure vessels, and a wide variety of mechanical and electrical machinery and equipment, along with a high level of inspection services aimed at loss prevention. The Company also offers professional scientific and technical consulting for industry and government on a worldwide basis. While the principal market for insurance and engineering services is the United States, the Company continues to see growth opportunities in overseas markets. The following presents financial data of the Company based on geographic location: Revenues from continuing operations For the years ended December 31, 1997 1996 1995 - - ------------------------------------------------------------------------------- U.S. $ 491.6 $ 444.9 $ 383.4 Non-U.S 111.8 103.9 87.3 ------------------------------------- Total $ 603.4 $ 548.8 $ 470.7 ------------------------------------- - - ------------------------------------------------------------------------------- Income from continuing operations before taxes and distributions on capital - - ---------------------------------------------------------------------------- securities - - ---------- For the years ended December 31, 1997 1996 1995 - - ------------------------------------------------------------------------------- U.S. $ 74.1 $ 52.7 $ 53.4 Non-U.S. 19.6 20.2 18.8 ---------------------------------------- Total $ 93.7 $ 72.9 $ 72.2 ---------------------------------------- - - ------------------------------------------------------------------------------- Identifiable assets At December 31, 1997 1996 1995 - - ------------------------------------------------------------------------------- U.S. $1,247.7 $ 858.3 $ 743.1 Non-U.S. 292.5 258.0 211.0 -------------------------------------- Total $1,540.2 $1,116.3 $ 954.1 -------------------------------------- - - ------------------------------------------------------------------------------- 53 HSB's foreign operations (primarily insurance) are widely dispersed such that no country or logical aggregation of countries in a geographic area compromise a significant concentration with respect to either revenues or identifiable assets. Export sales from HSB's domestic operations are minimal due to the existence of the Company's foreign subsidiaries which are responsible for virtually all of the Company's foreign sales. The following presents financial data of continuing operations of the Company based on industry segments: Revenues from continuing operations - - ----------------------------------- For the years ended December 31, 1997 1996 1995 - - ------------------------------------------------------------------------ Insurance premiums $ 491.2 $ 448.6 $ 389.1 Engineering services 61.3 55.8 49.9 Net investment income and realized investment gains 50.9 44.4 31.7 ------------------------------- Total $ 603.4 $ 548.8 $ 470.7 ------------------------------- Income from continuing operations before income taxes and distributions on - - -------------------------------------------------------------------------- capital securities - - ------------------ For the years ended December 31, 1997 1996 1995 - - -------------------------------------------------------------------------- Insurance $ 39.8 $ 21.8 $ 34.2 Engineering 4.3 7.3 6.7 Investment 49.6 43.8 31.3 --------------------------------------- Total $ 93.7 $ 72.9 $ 72.2 - - -------------------------------------------------------------------------- Identifiable assets At December 31, 1997 1996 1995 - - -------------------------------------------------------------------------- Insurance $ 308.0 $ 309.9 $ 180.8 Engineering 95.6 91.4 97.0 Investment 996.7 600.9 553.8 Other 139.9 114.1 122.5 -------------------------------------- Total $1,540.2 $1,116.3 $ 954.1 - - -------------------------------------------------------------------------- 5. Statutory Financial Information HSBIIC is a Connecticut domiciled insurance company which is licensed to conduct business in all 50 states, the District of Columbia, Puerto Rico and the U.S. Virgin Islands. The annual statements for state insurance regulatory authorities are currently prepared using accounting methods prescribed or permitted by such authorities (statutory basis) and are not consolidated. Statutory accounting practices (SAP) also differ in certain other respects from GAAP. With respect to HSBIIC, these differences are primarily comprised of the accounting for prepaid acquisition costs, deferred income taxes, fixed maturity investments, valuation of certain non-insurance affiliates and employee benefit plans. At year-end 1997 and 1996, policyholders' surplus on a statutory basis was $550.8 54 and $292.4 million, respectively. Statutory net income, adjusted to include the earnings of all HSBIIC domestic insurance subsidiaries for 1997, 1996, and 1995 was $42.9, $32.1, and $66.7 million, respectively. HSBIIC is currently subject to various regulations that limit the maximum amount of dividends available to its shareholders without prior approval of insurance regulatory authorities. Under SAP, approximately $55.1 million of statutory surplus is available for distribution to HSB Group, Inc. in 1998 without prior regulatory approval. 55 6. Investments 1997 1996 1995 - - -------------------------------------------------------------------------------- Income from Investment Operations Net investment income: Short-term interest $ 6.7 $ 4.8 $ 6.2 Fixed maturities: Taxable interest 9.6 9.8 9.0 Tax exempt interest 2.1 1.8 1.9 Redeemable preferred dividends 7.2 7.9 6.3 Equity securities: Common dividends 4.7 4.6 4.0 Non-redeemable preferred dividends 8.3 5.9 4.6 Other 2.1 1.0 1.2 ------------------------ Total investment income 40.7 35.8 33.2 Investment expenses (3.9) (3.5) (4.3) ------------------------ Net investment income $ 36.8 $ 32.3 $ 28.9 ------------------------ Realized investment gains (losses): Fixed maturities: Bonds: Gains $ 0.5 $ 2.0 $ 0.7 Losses (0.3) (0.2) (1.5) ------------------------ Net gains (losses) 0.2 1.8 (0.8) Redeemable preferred stocks: Gains 0.4 0.3 0.7 Losses (0.3) (1.5) (0.6) ------------------------ Net gains (losses) 0.1 (1.2) 0.1 Equity securities: Common stocks: Gains 48.1 14.6 11.4 Losses (5.1) (3.3) (7.4) ------------------------ Net gains 43.0 11.3 4.0 Non-redeemable preferred stocks: Gains 7.7 4.2 0.2 Losses (0.2) (4.0) (0.7) ------------------------ Net gains (losses) 7.5 0.2 (0.5) Foreign Exchange Losses (7.4) -- -- Collar Contracts Losses (30.7) -- -- Other Gains 1.4 -- -- ------------------------ Realized investment gains $ 14.1 $ 12.1 $ 2.8 ------------------------ ------------------------------------------------------------------------------ There were no material declines in the realizable value of investments considered to be other than temporary for 1997 or 1995. Realized investment gains and losses for 1996 56 included $0.8 million of losses on non-redeemable preferred stock arising from declines in the realizable value of investments considered to be other than temporary. 1997 1996 1995 - - ------------------------------------------------------------------------------- Unrealized Investment Gains, Net of Tax Fixed maturities: Gains $ 7.9 $ 6.1 $ 9.3 Losses (0.6) (1.6) (1.6) --------------------------- Net gains 7.3 4.5 7.7 Equity securities: Gains 94.3 82.0 64.2 Losses (1.8) (2.2) (3.8) --------------------------- Net gains 92.5 79.8 60.4 Foreign exchange losses (4.5) (2.9) (2.7) --------------------------- Total unrealized investment gains 95.3 81.4 65.4 Income taxes (35.5) (28.6) (21.5) --------------------------- Unrealized investment gains, net of tax $ 59.8 $ 52.8 $ 43.9 -------------------------- - - ------------------------------------------------------------------------------ 57 Fixed Maturities The amortized cost, estimated fair values (based principally upon quoted market prices) and gross unrealized gains and losses of fixed maturities at December 31, were as follows: 1997 - - -------------------------------------------------------------------------------- Estimated Gross Gross Amortized Fair Unrealized Unrealized Category Cost Value Gains Losses - - -------------------------------------------------------------------------------- Redeemable preferred stocks $ 131.2 $ 135.4 $ 4.7 $ 0.5 States and municipalities 37.6 39.7 2.2 0.1 Foreign governments 33.1 33.5 0.4 -- Corporate and other 39.2 39.8 0.6 -- ------------------------------------------- Total fixed maturities $ 241.1 $ 248.4 $ 7.9 $ 0.6 - - -------------------------------------------------------------------------------- 1996 - - -------------------------------------------------------------------------------- Estimated Gross Gross Amortized Fair Unrealized Unrealized Category Cost Value Gains Losses - - -------------------------------------------------------------------------------- Redeemable preferred stocks $ 99.6 $ 101.6 $ 3.1 $ 1.1 States and municipalities 39.4 40.7 1.6 0.3 Foreign governments 30.1 30.5 0.5 0.1 Corporate and other 62.2 63.0 0.9 0.1 ------------------------------------------- Total fixed maturities $ 231.3 $ 235.8 $ 6.1 $ 1.6 - - -------------------------------------------------------------------------------- The amortized cost and estimated fair value of fixed maturities at December 31, by contractual years-to-maturity follows. Actual maturities may differ from contractual maturities because borrowers may have the right to prepay obligations. 1997 - - ---------------------------------------------------------------- Estimated Amortized Fair Maturity Cost Value - - ---------------------------------------------------------------- One year or less $ 13.3 $ 13.7 Over one year through five years 98.6 101.1 Over five years through ten years 32.8 34.1 Over ten years 96.4 99.5 -------------------- Total fixed maturities $ 241.1 $ 248.4 -------------------- - - ---------------------------------------------------------------- 58 Equity Securities The cost, estimated fair values (based principally upon quoted market prices) and gross unrealized gains and losses of equity securities at December 31, were as follows: 1997 - - -------------------------------------------------------------------------------- Estimated Gross Gross Fair Unrealized Unrealized Cost Value Gains Losses - - -------------------------------------------------------------------------------- Common stocks $ 97.5 $ 179.0 $ 82.2 $ 0.7 Non-redeemable preferred stocks 133.8 144.8 12.1 1.1 ------------------------------------------ Total equity securities $ 231.3 $ 323.8 $ 94.3 $ 1.8 ------------------------------------------ - - -------------------------------------------------------------------------------- 1996 - - ------------------------------------------------------------------------------- Estimated Gross Gross Fair Unrealized Unrealized Cost Value Gains Losses - - ------------------------------------------------------------------------------- Common stocks $ 95.7 $ 168.3 $ 73.6 $ 1.0 Non-redeemable preferred stocks 87.2 94.4 8.4 1.2 ------------------------------------------ Total equity securities $ 182.9 $ 262.7 $ 82.0 $ 2.2 ------------------------------------------ - - ------------------------------------------------------------------------------- On December 19, 1996, HSBIIC entered into three "zero cost collar contracts" to mitigate the effects of market risk on its U.S. common stock portfolio (which, for management purposes, included certain convertible preferreds). Each contract had a notional value of $50 million and maturity dates ranging from November 1997 to January 1998. The contracts, which were entered into when the S&P 500 Index was 744.3, allowed HSBIIC to recover from the counterparty if the index was below 695.2 at the time of maturity, and required HSBIIC to reimburse the counterparty if the index was above a range of 811.3 to 818.7 at the time of maturity. In the fourth quarter of 1997 HSBIIC settled all of its outstanding contracts resulting in realized losses of $30.7 million for the year, all of which were offset by and represented portfolio appreciation and returns that were realized. The Company's U.S. common stock portfolio has experienced a total return of $57 million (which includes price appreciation of approximately $54 million) since December 31, 1996, and has had a price movement correlation with the S&P 500 Index well in excess of 80 percent. The collar subjected the Company to market and counterparty credit risk. The Company managed this exposure by frequently modeling the effects of potential future price movements on the value of the collar and HSB's portfolio and by entering into contracts 59 with internationally recognized financial institutions, which were expected to perform under the terms of the contract, and by evaluating the credit worthiness of such institutions by taking into account credit ratings and other factors. The Company held no derivative financial instruments in its investment portfolio at December 31, 1997 and December 31, 1995. The Company sells covered call options, at times, to protect against adverse changes in market values. Premiums received on options written are deferred and recognized as a component of gross realized gains when the option contracts are exercised or expire. During 1995, aggregate premiums received by the Company on covered call options amounted to less than $.1 million. Net gains recognized on sales of underlying instruments amounted to less than $.1 million for 1995. Generally, the duration of covered call options written by the Company does not exceed thirty days. 7. Fixed Assets Fixed assets are summarized as follows: 1997 1996 - - -------------------------------------------------------------------------------- Land and buildings $ 5.0 $ 7.3 Furniture, equipment, leasehold improvements, and other 57.1 65.7 Systems development costs 6.6 0.6 ------------------------ $ 68.7 $ 73.6 Less accumulated depreciation and amortization (32.3) (41.3) ------------------------ Fixed assets $ 36.4 $ 32.3 ------------------------ - - -------------------------------------------------------------------------------- Property and equipment are stated at cost. Depreciation expense is computed using straight-line and accelerated methods over the estimated useful lives of 31.5 years for buildings and 3 to 10 years for equipment and furniture. Leasehold improvements are amortized over the shorter of the assets' life or the remaining contractual lease term. The Company has a policy capitalizing certain systems development costs. Systems development costs are amortized over estimated useful lives of 3 to 5 years. In 1996 the Company began a comprehensive effort to assess and address issues relating to the ability of its policy processing and other operational systems to properly recognize calendar dates beginning in the year 2000. The analysis indicated roughly 30 percent of existing code is compliant, roughly 60 percent is represented by legacy systems, which were scheduled to be replaced before the end of 1998 due to current business needs, and the remainder will be addressed through modification to compliant code or discontinuation. The impact of year 2000 expenditures on a stand alone basis is not clearly evident as the Company is replacing legacy applications due to changing business needs and such replacement applications will be year 2000 compliant. However, the overall cost of modification efforts and application replacement, which include substantial enhancements to business functionality, has been estimated at $13-$20 million over a three year period. Certain of the costs related to the replacement of legacy 60 applications due to changing business needs are being capitalized consistent with the Company's existing capitalization policy. 8. Leases The Company leases its home office facility at One State Street under a long-term capital lease with the One State Street Limited Partnership (Partnership). The lease obligation of $26.1 million was recorded at July 1, 1983 at an interest rate of 15 percent. An asset of $26.1 million was also recorded in 1983. Accumulated amortization on the asset was $10.8 and $10.1 million at December 31, 1997 and 1996, respectively. Terms of the lease require annual payments of approximately $4 million a year through June 30, 2018. In addition, the Company is required to pay over the lease term a proportional share of the facility's variable operating expenses. This amounted to approximately $2.6, $2.8 and $2.8 million for the years ended 1997, 1996 and 1995, respectively. The Company owns the One State Street land and leases it to the Partnership. The Company receives a base rent for the land and a participation in the net cash flow of the Partnership. If the facility is sold, the Company will receive 50 percent or more of the sales proceeds in excess of the mortgages, all operating expenses and costs of sale and the rental obligations pursuant to the land lease. Under certain circumstances, the Company has the right to purchase the facility. In addition to its home office facility, the Company leases facilities and certain equipment which are accounted for as operating leases. Lease expenses amounted to $8.4, $5.7 and $4.7 million in 1997, 1996 and 1995, respectively. At December 31, 1997, future minimum rental commitments under noncancelable leases accounted for as operating leases with initial or remaining terms of more than one year were as follows: 1998 $ 5.0 1999 4.4 2000 2.9 2001 1.6 2002 0.8 2003 and thereafter 0.3 ------- Total $15.0 ------- 61 9. Reinsurance The components of net written and net earned insurance premiums were as follows: 1997 1996 1995 - - -------------------------------------------------------------------------------- Written premiums: Direct $ 361.4 $ 338.6 $ 285.3 Assumed 257.1 232.6 182.9 Ceded (120.0) (116.8) (59.9) ---------------------------------- Net written premiums $ 498.5 $ 454.4 $ 408.3 ------------------------------------ Earned premiums: Direct $ 370.1 $ 343.4 $ 279.7 Assumed 239.2 213.1 175.3 Ceded (118.1) (107.9) (65.9) ------------------------------------ Insurance premiums $ 491.2 $ 448.6 $ 389.1 ------------------------------------ - - -------------------------------------------------------------------------------- The Company writes direct business through agencies and brokerage firms. In addition, the Company assumes boiler and machinery exposures from over 100 insurance companies and several insurance pools. Under the reinsurance agreements, the Company's reinsured companies may include equipment breakdown exposures in their multi-peril policies, and such risks will be assumed by the Company under the terms of the agreement. These plans generally provide that the Company will assume 100 percent of each boiler and machinery risk, subject to the capacity specified in the agreement, and will receive the entire equipment breakdown premium except for a ceding commission, which will be retained by the reinsured company for commissions to agents and brokers, premium taxes and handling expenses. Although the Company assumes the role of reinsurer, it continues to have selling and underwriting responsibilities as well as involvement in inspecting and claims adjusting. In effect, the Company becomes the equipment breakdown insurance department of the reinsured company and provides all equipment breakdown underwriting (that is, the examination and evaluation of the risk based on its engineering judgments), claims and engineering services as if it were part of that organization. Traditionally, as part of the underwriting process, the Company retains the right to decline or restrict coverage in the same manner as it does for its own business. In 1996 the Company began to write a simplified program (referred to as ReSource) under which a reinsured company agrees to include equipment breakdown insurance on an entire portfolio of accounts meeting specific underwriting guidelines and occupancy parameters, which the Company agrees to reinsure for equipment breakdown losses. The insurance industry, in general, is undergoing a shakeout and consolidation. A significant amount of merger and acquisition activity has occurred recently and may continue in the future. Depending on the specific companies involved in these activities and other market factors, the level of reinsured business the Company assumes in the future could be impacted. As a property insurer, the Company is subject to losses that may arise from catastrophic events. The Company participates in various facultative, quota share and excess of loss 62 reinsurance agreements to limit its exposure, particularly to catastrophic losses, and to provide additional capacity to write business. In the unlikely event that ceded reinsurers are unable to meet their obligations, the Company would continue to have primary liability to policyholders for losses incurred. Reinsurance recoverable on unpaid claims and the unearned portion of ceded reinsurance premiums are reported as assets, rather than netted against the related liability accounts. The Company is not party to any contracts which do not comply with the risk transfer provisions of SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts". The Company recorded $45.2, $113.9 and $28.5 million of reinsurance recoveries as a reduction of its claims and adjustment expenses for the years ended December 31, 1997, 1996 and 1995, respectively. Reinsurance recoverable on paid claims and adjustment expenses was $8.0 million at both December 31, 1997 and 1996. IRI is a voluntary joint underwriting association providing property insurance for the class of business known as Highly Protected Risks - larger manufacturing, processing, and industrial businesses which have invested in protection against loss through the use of sprinklers and other means. Effective December 1, 1996, HSBIIC increased its participation in IRI to 23.5 percent. Prior to the December 1, 1996 increase in participation, HSBIIC's interest in IRI was 14 percent. The 1996 increase resulted in HSBIIC assuming approximately $15.5 million net unearned premium reserves which have not been reflected in written premiums. Likewise in 1995, HSBIIC increased its participation from .5 percent to 14 percent resulting in the assumption of $27.9 million in the net unearned premium reserves which were also not reflected in written premiums. IRI has a fiscal year ending November 30 and provides quarterly reports to member companies of the association. As a result, HSBIIC's increases in participation were initially reflected in the first quarter financial reports for the subsequent year. Effective January 1, 1998 members of IRI sold their membership to ERC. (See note 3). 63 10. Reconciliation of Liability for Claims and Adjustment Expenses The following tables provide reconciliations of the beginning and ending reserves for claims and adjustment expenses on both a gross liability and net (of reinsurance) liability basis: Reconciliation of Gross Liability for Claims and Adjustment Expenses - - -------------------------------------------------------------------- 1997 1996 1995 - - ------------------------------------------------------------------------------------------ Gross liability for claims and adjustment expenses at January 1, $ 302.9 $ 190.9 $ 199.4 Plus: Provision for claims and adjustment expenses occurring in the current year 263.3 313.3 183.3 Increase (decrease) in estimated claims and adjustment expenses arising in prior years (0.2) 16.1 12.6 --------------------------------- Total incurred claims and adjustment expenses $ 263.1 $ 329.4 $ 195.9 --------------------------------- Less: Payment for claims arising in: Current year 90.6 103.3 65.1 Prior years 198.7 114.1 139.3 --------------------------------- Total payments $ 289.3 $ 217.4 $ 204.4 --------------------------------- Gross liability for claims and adjustment expenses at December 31, $ 276.7 $ 302.9 $ 190.9 ---------------------------------
64 Reconciliation of Net Liability for Claims and Adjustment Expenses - - ------------------------------------------------------------------ 1997 1996 1995 - - ---------------------------------------------------------------------------------------------- Net liability for claims and adjustment expenses at January 1, $ 177.8 $ 145.5 $ 161.3 Plus: Provision for claims and adjustment expenses occurring in the current year 209.5 214.2 152.2 Increase (decrease) in estimated claims and adjustment expenses arising in prior years 8.4 (9.8) 2.7 ---------------------------------- Total incurred claims and adjustment expenses $ 217.9 $ 204.4 $ 154.9 ---------------------------------- Less: Payment for claims arising in: Current year 82.3 91.4 58.9 Prior years 122.6 80.7 111.8 --------------------------------- Total payments $ 204.9 $ 172.1 $ 170.7 --------------------------------- Net liability for claims and adjustment expenses at December 31, $ 190.8 $ 177.8 $ 145.5 --------------------------------- - - ---------------------------------------------------------------------------------------------
1997 and 1996 claims and adjustment expenses incurred have been reduced by subrogation recoveries of approximately $3.3 million and $4.9 million, respectively. Subrogation recoveries applied against 1995 claims and adjustment expenses are immaterial. A reconciliation of the net liability to the gross liability for claims and adjustment expenses is as follows: 1997 1996 1995 - - --------------------------------------------------------------------------------------- Net liability for claims and adjustment expenses at December 31, $ 190.8 $ 177.8 $ 145.5 Reinsurance recoverable on unpaid claims and adjustment expenses 85.9 125.1 45.4 --------------------------------- Gross liability for claims and adjustment expenses at December 31, $ 276.7 $ 302.9 $ 190.9 --------------------------------- - - --------------------------------------------------------------------------------------
The Company utilizes well-capitalized domestic and international reinsurance companies and syndicates for its reinsurance program and monitors their financial condition on an ongoing basis. For reinsurers that are not accredited in their state of domicile, the Company generally requires collateral for reinsurance recoverable from such carriers. Uncollectible reinsurance recoverables have not had, and are not expected by management to have in the future, a material adverse effect on the consolidated results of operations or financial position of the Company. 65 The following table displays information concerning the primary participant in the Company's current reinsurance program as of December 31, 1997: Reinsurer Ceded Written Reinsurance Asset 1997 A.M. Best's Premium Rating - - -------------------------------------------------------------------------------- General Reinsurance Corporation $38.6 $50.5 A++(Superior) As of December 31, 1997 no other reinsurance asset of the Company due from any single reinsurer exceeded 3 percent of shareholders' equity. Certain Lloyds' syndicates participate in the excess of loss reinsurance program, primarily in the excess layers. The highest aggregate percentage participation of such syndicates, at 44.6 percent, is in the $50 million excess of $100 million layer. No individual syndicate has more than a 7.7 percent participation in any of the excess layers. The Company's reinsurance asset in the aggregate from all Lloyds' syndicates is less than 2 percent of shareholders' equity at December 31, 1997. Lloyd's has historically participated more heavily in the higher treaty layers, including those years relating to the arbitration and litigation cases discussed below. HSBIIC is involved in three arbitration or litigation proceedings regarding the extent to which certain explosion events are insured under boiler and machinery policies of HSBIIC or under the all-risk property insurance policies issued by other companies. Management believes HSBIIC's policies do not provide coverage for losses resulting from the explosion events that are the subject of these proceedings. A lower court ruling in one of these cases held that an explosion did occur, and that HSBIIC was not liable for losses of the insured resulting from the explosion. In a further action, the court denied HSBIIC's motion for summary judgment on certain issues, thus leaving HSBIIC potentially liable for certain unqualified losses resulting from events prior to the explosion. In the first quarter of 1997, HSBIIC and the property insurer jointly settled the case with the insured. HSBIIC's ultimate share of the settlement will be determined in an arbitration proceeding with the property insurer. HSBIIC has incurred gross losses and loss adjustment expenses (LAE) of $40.7 million and a net loss after taking into account reinsurance recoverables of $6.5 million, of which $5 million represents claim costs and the remaining $1.5 million represents LAE. As a result of payments made to date, at December 31, 1997, HSBIIC carried gross loss and LAE reserves of $2.8 million and recoverables from reinsurers of $2.8 million. HSBIIC has accrued $6.5 million with respect to the other two cases for potential LAE, including legal costs to defend HSBIIC's position. One case is in the process of pre-trial summary judgment motions and appeals; the other case is involved in both arbitration and litigation proceedings. A trial date has not been set for either case. In the event that HSBIIC is held liable for one or both of the remaining claims, amounts in excess of HSBIIC's net maximum aggregate retention of $8.5 million is recoverable from reinsurers. Claim amounts potentially recoverable from reinsurers in the event of a possible adverse outcome in these cases could range, in the aggregate, from $40 million to $195 million. 66 The obligations of HSBIIC's reinsurers with respect to these cases are not in dispute. Therefore, management believes that any adverse outcomes in these cases will not, in the aggregate, have a material effect on either the results of operations or financial condition of the Company. HSBIIC's reinsurance contracts do not require HSBIIC to reimburse its reinsurers for any losses such reinsurers might incur should these cases not be decided in HSBIIC's favor. Nevertheless, reinsurers often quote rates for future coverages based upon their or other reinsurers' experience on a particular account. Therefore, in the event HSBIIC's reinsurers pay significant sums pursuant to the arbitration or litigation proceedings described above, it is likely HSBIIC's reinsurance rates would increase in future periods. However, given the insured capacity that exists in reinsurance markets worldwide, coupled with HSBIIC's ability to negotiate a redesign or restructuring of its reinsurance program, it does not necessarily mean that such an increase would be material. The Company is also involved in various other legal proceedings as defendant or co-defendant that have arisen in the normal course of its business. In the judgment of management, after consultation with counsel, it is improbable that any liabilities which may arise from such litigation will have a material adverse impact on the results of operations or the financial position of the Company. 11. Income Taxes Tax Provision A reconciliation of income taxes (benefit) at U.S. statutory rates to the income taxes (benefit) as reported is as follows: 1997 1996 1995 - - ----------------------------------------------------------------------------------------------------------- % of % of % of Pre-Tax Pre-Tax Pre-Tax Amount Income Amount Income Amount Income - - ----------------------------------------------------------------------------------------------------------- Income from continuing operations before income taxes and distributions on capital securities $ 93.7 100% $ 72.9 100% $ 72.2 100% - - ----------------------------------------------------------------------------------------------------------- Tax at statutory rates $ 32.8 35% $ 25.5 35% $ 25.3 35% Income taxed at foreign rates 1.0 1 0.5 1 0.2 -- Dividends received deduction (4.9) (5) (4.5) (6) (3.9) (5) Tax exempt interest (0.8) (1) (0.6) (1) (0.7) (1) Tax credits and others (3.0) (3) (2.6) (4) (1.4) (2) Total income taxes and effective tax rate $ 25.1 27% $ 18.3 25% $ 19.5 27% --------------------------------------------------------------------- - - ------------------------------------------------------------------------------------------------------------
67 Income taxes (benefit) consisted of the following: 1997 1996 1995 - - -------------------------------------------------------------------------------- Current provision: U.S $ 16.8 $ 17.3 $ 12.3 Foreign 7.0 7.4 8.2 -------------------------------- Total current provision 23.8 24.7 20.5 -------------------------------- Deferred provision: U.S 1.1 (6.0) 0.4 Foreign 0.2 (0.4) (1.4) -------------------------------- Total deferred provision 1.3 (6.4) (1.0) -------------------------------- Total income taxes $ 25.1 $ 18.3 $ 19.5 -------------------------------- - - -------------------------------------------------------------------------------- Deferred Income Taxes Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Components of the Company's deferred tax liabilities and assets as of December 31, 1997 and 1996 are as follows: 1997 1996 - - -------------------------------------------------------------------------------- Deferred tax liabilities: Prepaid acquisition costs $ (13.2) $ (11.8) Accelerated depreciation (0.3) (2.0) Pension asset (13.3) (11.9) Unrealized investment gains (35.4) (28.6) Other (12.6) (12.7) --------------------- Total deferred tax liabilities (74.8) (67.0) --------------------- Deferred tax assets: Benefit plans 9.0 9.6 Capital lease 4.4 4.1 Unearned insurance premiums 15.0 14.0 Loss reserve discounting 5.9 6.5 Other 9.0 9.1 --------------------- Total deferred tax assets 43.3 43.3 --------------------- Net deferred tax liabilities $ (31.5) $ (23.7) --------------------- - - -------------------------------------------------------------------------------- Other Information Federal income tax returns for the years 1995 and 1994 are currently under examination by the Internal Revenue Service. 68 12. Capital Structure HSB's capital structure is as follows: 1997 1996 - - --------------------------------------------------------------------------- Short-term borrowings $ 42.4 $ 3.2 Long-term borrowings * $ 25.1 $ 25.1 Convertible redeemable preferred stock -- $ 20.0 Company obligated mandatorily redeemable capital securities of subsidiary Trust I holding solely junior subordinated deferrable interest debenture of the Company $ 108.9 -- Company obligated mandatorily redeemable convertible capital securities of subsidiary Trust II holding solely junior subordinated deferrable interest debenture of the Company $ 300.0 -- Common shareholders' equity $ 345.3 $ 345.6 - - ---------------------------------------------------------------------------- *Excludes capital lease. (See note 8). Short-term and Long-term Borrowings HSBIIC has a commercial paper program with a limit of $75 million. Commercial paper outstanding at December 31, 1997 and 1996 was $42.4 million and $3.2 million, respectively. Commercial paper outstanding at year end 1997 matured on or before January 6, 1998. Long-term debt consists of $25.1 million of senior notes due May 15, 2000 at an interest rate of 6.83 percent. Current market value is estimated to be $25.3 million. Convertible Redeemable Preferred Stock On December 30, 1996, HSBIIC exercised its right to exchange 2,000 shares of EIG, Co. preferred stock, which was issued at the time HSBIIC acquired the remaining 50 percent interest in EIG, Co. from Gen Re, for 2,000 shares of HSBIIC's convertible redeemable preferred stock. The stock had no par value, but had voting rights and carried a quarterly dividend of $162.50. The stock was converted on October 30, 1997 into 398,406 shares of HSB common stock at a price of $50.20 per share. Capital Securities On July 15, 1997, HSB sold $110 million of 30 year Global Floating Rate Capital Securities (Capital Securities) in a private placement. The securities are generally non-callable for ten years but may be called earlier by HSB upon the occurrence of certain tax events including loss of deductibility of interest on the securities. The securities were 69 issued through HSB Capital I (Trust I), a Delaware business trust created by HSB, at a floating rate tied to 90 day LIBOR. The current coupon is 6.7 percent. Holders of the Capital Securities will be entitled to receive preferential cumulative cash distributions accumulating from the date of original issuance and payable quarterly in arrears. HSB has the right to defer payment of distributions on the securities at any time or from time to time for a period not exceeding 20 consecutive quarterly periods with respect to each deferral period. During an extension period, interest will continue to accrue and the amount of distributions to which holders of the Capital Securities are entitled will accumulate, and HSB will be prohibited from paying any cash dividends on its common stock. HSB has irrevocably and unconditionally guaranteed all of Trust I's obligations under the Capital Securities. The Company has used or may use the proceeds for general corporate purposes, including the repurchase of HSB common stock; funding investments in, or extensions of credit to, subsidiaries; repayment of maturing debt; and financing possible future acquisitions. HSB subsequently filed a registration statement covering securities with terms identical in all material respects and offered to exchange registered securities for the original Capital Securities. The exchange was completed on December 11, 1997. On December 31, 1997, HSB sold $300 million of 20 year Convertible Capital Securities in a private placement to ERC. The Convertible Capital Securities are callable by the Company at its option (i) at any time after seven years; (ii) upon the occurrence of certain tax events including loss of deductibility of the interest on the securities; (iii) in the event that the Company vetoes a prospective purchaser of the Convertible Capital Securities; or (iv) in the event of a change in control of ERC. The Convertible Capital Securities are mandatorily redeemable on December 31, 2017, and are redeemable at par plus a redemption premium, at the option of ERC, in the event of a change in control of the Company within five years following issuance of the securities. The Convertible Capital Securities are convertible, in whole or in part, at ERC's option at any time, subject to regulatory approval, into shares of Company common stock at a conversion price of $85, subject to adjustment. The Company has provided certain registration rights to ERC in connection with the common stock into which the Convertible Capital Securities are convertible pursuant to a Registration Rights Agreement dated December 31, 1997. Were ERC to exercise its conversion rights in total, it would hold, on a fully diluted basis, approximately 15.3 percent of the Company's common stock. Pursuant to certain provisions contained in the Purchase Agreement dated December 31, 1997, ERC has agreed to certain "standstill" arrangements, which for a period of five years will preclude ERC from purchasing any common stock of the Company, other than by exercise of its conversion rights, and will limit its ability to take certain other actions with respect to the Company during that period. The securities were issued through HSB Capital II (Trust II), a Delaware business trust created by HSB at a 7 percent coupon, payable semi-annually. The Convertible Capital Securities rank pari passu with the capital securities issued July 1997. Holders of the Convertible Capital Securities will be entitled to receive preferential cumulative cash 70 distributions accumulating from the date of original issuance and payable semi-annually in arrears. HSB has the right to defer payment of interest at any time or from time to time for a period not exceeding 10 consecutive semi-annual periods with respect to each deferral period. During an extension period, interest will continue to accrue and the amount of distributions to which holders of the Convertible Capital Securities are entitled will accumulate, and HSB will be prohibited from paying any cash dividends on its common stock. HSB has irrevocably and unconditionally guaranteed all of Trust II's obligations under the Convertible Capital Securities. The estimated fair value of the Capital Securities issued by Trust I and Trust II is equal to their carrying value. Common Shareholders' Equity The Connecticut Business Corporation Act, which became effective on January 1, 1997, eliminated the concept of treasury shares. Therefore, shares reacquired by the Company constitute authorized but unissued shares. As a result of this change in law, the Company eliminated the caption Treasury Stock from its balance sheet and reclassified the amounts as reductions to additional paid-in capital and retained earnings. These amounts were $85.9 and $59.5 million as of December 31, 1997 and 1996, respectively. The reclassifications were distributed as follows: At December 31, 1997 1996 - - -------------------------------------------------------------------- Additional paid in capital $ 2.8 $ 2.0 Retained earnings 83.1 57.5 --------------------------------- Total $85.9 $ 59.5 --------------------------------- - - -------------------------------------------------------------------- Financial Guarantees HSBIIC had guaranteed 40 percent of Radian's loan outstanding with Dow. The guaranty was terminated on January 2, 1998 in conjunction with the sale of HSBIIC's interest in Radian to Dow. 13. Pension Plans HSB maintains various types of pension plans covering employees of certain subsidiaries. The plans are non-contributory and benefits are based upon an employee's years of service and final average pay based upon the highest three out of five years. Vesting occurs after five years of service in compliance with the provisions of the Tax Reform Act of 1986. As a result of the plan's investment returns, the Company made no contribution to the plan in 1997, 1996 or 1995. Assets available for plan benefits include approximately $20.9 million of Company stock at December 31, 1997. 71 The pension expense for the U.S. pension plans was a net credit to earnings for 1997, 1996 and 1995 due to the over funded status of the primary plan. The components of the credit were as follows: 1997 1996 1995 - - ------------------------------------------------------------------- Service costs $ 4.1 $ 3.6 $ 2.9 Interest costs 10.7 10.2 10.2 Return on assets (42.4) (20.1) (30.9) Net amortization and deferral 24.8 4.0 15.3 -------------------------------- Net pension credit $ (2.8) $ (2.3) $ (2.5) -------------------------------- - - ------------------------------------------------------------------- The following table represents a reconciliation of the U.S. plans funded status and the amounts recognized in the Company's Statements of Financial Position at December 31: Funded Unfunded - - ----------------------------------------------------------------------------------------------------- 1997 1996 1997 1996 ------------------------------------------------- Actuarial present value of benefit obligations Vested benefit obligation $ 109.8 $ 99.4 $ 22.5 $ 20.3 ---------------------------------------------- Accumulated benefit obligation $ 110.7 $ 100.0 $ 23.8 $ 20.9 ---------------------------------------------- Projected benefit obligation $ 128.1 $ 115.7 $ 27.9 $ 24.3 Assets available for plan benefits (equity securities and fixed income investments at fair value) 213.0 178.0 -- -- ---------------------------------------------- Assets in excess of (less than) projected benefit obligation 84.9 62.3 (27.9) (24.3) ---------------------------------------------- Unamortized net transition asset (obligation) 8.4 10.5 (1.9) (2.2) Unrecognized prior service costs (1.6) (1.9) (1.0) (1.1) Unrecognized net gain (loss) 21.8 3.9 (8.6) (7.1) ---------------------------------------------- Unrecognized net asset (liability) 28.6 12.5 (11.5) (10.4) Additional liability -- -- (6.0) (4.6) ---------------------------------------------- Net pension asset (liability) $ 56.3 $ 49.8 $ (22.4) $ (18.5) ---------------------------------------------- - - --------------------------------------------------------------------------------------------------
Assumptions used for the primary U.S. plan at years ended were as follows: 1997 1996 1995 - - ------------------------------------------------------------------------- Discount rate 7.25% 7.5% 7.5% Long-term rate of return on assets 10.00% 9.5% 9.5% Rate of increase in future compensation levels 4.50% 4.5% 5.0% - - ------------------------------------------------------------------------- 72 14. Postretirement Plans The Company makes available health care and life insurance benefits for retired employees of the Company and certain subsidiaries. The Company makes contributions to the plans as claims are incurred. Contributions totaled $1.9, $2.4 and $2.6 million for 1997, 1996 and 1995, respectively. At December 31, 1997, 1996 and 1995 these plans were unfunded. Retirees' contributions to these plans vary, based upon retiree's age, years of service and coverage elected. The Company periodically amends the plan changing the contribution rate of retirees and amounts of coverage. Components of net periodic postretirement benefit cost were: For the years ended December 31, 1997 1996 1995 - - -------------------------------------------------------------------------------- Service cost $ 0.3 $ 0.3 $ 0.3 Interest cost 2.1 2.0 2.3 Amortization of unrecognized obligations 0.1 -- -- Net periodic postretirement benefit cost $ 2.5 $ 2.3 $ 2.6 - - -------------------------------------------------------------------------------- The following table sets forth the amounts recognized in the Consolidated Statements of Financial Position at December 31, in accordance with SFAS No. 106, "Employers Accounting for Postretirement Benefits Other Than Pensions". 1997 1996 - - -------------------------------------------------------------------------------- Accumulated postretirement benefit obligations for: Retirees $ 23.5 $ 22.0 Other fully eligible plan participants 1.5 1.0 Other active plan participants 4.9 3.8 ------------------- Total accumulated postretirement benefit obligation 29.9 26.8 Unrecognized net loss (5.5) (3.0) ------------------- Accrued postretirement benefit liability $ 24.4 $ 23.8 ------------------- - - -------------------------------------------------------------------------------- The assumptions used to calculate the obligations at December 31, were as follows: 1997 1996 - - ---------------------------------------------------------------- Weighted average discount rate 7.25% 7.5% Current year health care cost trend rate 7.00% 8.0% Ultimate health care cost trend rate 4.50% 4.5% - - ---------------------------------------------------------------- 73 For measurement purposes, the annual rate of increase in the per capita cost of covered health care benefits ranges from 7 percent in 1997 decreasing gradually to 4.5 percent by the year 2001 and remaining level thereafter. The health care cost trend rate assumption has a significant effect on the amount reported. To illustrate, increasing the assumed health care cost trend rates by 1 percent each year would increase the accumulated postretirement benefit obligation as of December 31, 1997 of $29.9 million by approximately $1.5 million and the aggregate of the service and interest cost for the year ended December 31, 1997 by $0.1 million. 15. Stock Compensation Plans HSB has a Stock Option Plan under which key employees may be granted restricted stock and stock options. HSB's Long-Term Incentive Plan grants senior management awards contingent upon achievement of specified performance objectives over a three year period which may be paid out in cash or shares of common stock (which may be restricted shares). The number of shares subject to issuance under this plan cannot exceed 150,000. HSB's restricted stock is an award of common shares that may not be sold or transferred during the restriction period, usually three years under the stock option plan and five years under the long-term incentive plan, from the date on which the award is granted. During the restriction period, the employee is the registered owner, receives dividends and may vote the restricted shares. Compensation expense is based on the market value of the Company's common stock at the date of grant and is recognized over the period of the restriction. Compensation expense for this benefit was $0.6 million in 1997 and 1996 and $1.1 million in 1995. The unamortized compensation expense related to this plan is included in benefit plans as a component of shareholders' equity. These amounts were $1.2 and $0.7 million in 1997 and 1996, respectively. A summary of grants follow: 1997 1996 1995 - - -------------------------------------------------------------------------------- Restricted shares awarded 20,396 13,250 9,350 Weighted-average fair value of shares on grant date $ 47.89 $ 48.85 $ 42.78 - - -------------------------------------------------------------------------------- A stock option award under HSB's stock option plan allows for the purchase of HSB common stock at no less than the market price on the date of grant. Options granted to date are exercisable no earlier than one year after the grant date and expire no more than ten years from the date of grant. 74 A summary of the status of HSB's stock options as of December 31, 1997, 1996 and 1995 and changes during the years ended on those dates is presented below: 1997 1996 1995 - - --------------------------------------------------------------------------------------------------------------------------- Weighted- Weighted- Weighted- Shares Average Shares Average Shares Average Exercise Price Exercise Price Exercise Price - - --------------------------------------------------------------------------------------------------------------------------- Outstanding at beginning of year 1,319,650 $ 48.67 1,300,000 $ 50.86 1,263,550 $ 54.42 Granted 372,500 48.83 394,000 49.81 303,500 42.54 Exercised (157,000) 46.68 (24,250) 46.26 -- -- Forfeited (50,400) 50.23 (350,100) 58.29 (267,050) 58.39 ---------- ---------- ---------- ---------- Outstanding at end of year 1,484,750 48.86 1,319,650 48.67 1,300,000 50.83 ---------- ---------- ---------- Options exercisable at year-end 1,121,250 $ 48.76 949,650 $ 48.23 1,003,500 $ 53.32 Weighted-average fair value of options granted during the year $ 6.36 $ 7.05 $ 7.42 - - ------------------------------------------------------------------------------------------------------------------------
The following table summarizes information about stock options outstanding as of December 31, 1997: Options Outstanding Options Exercisable - - -------------------------------------------------------------------------------------- Weighted- Range of Average Weighted- Weighted- Exercise Number Remaining Average Number Average Prices Outstanding Contractual Life Exercise Price Exercisable Exercise Price - - ----------------------------------------------------------------------------------------------- $41 - $45.99 587,000 8.43 $ 44.44 226,500 $ 42.27 $46 - $50.99 646,500 6.13 48.63 646,500 48.63 $51 - $55.99 98,800 1.55 51.84 95,800 51.79 $56 - $60.99 152,450 3.33 57.06 152,450 57.06 --------- --------- 1,484,750 1,121,250 --------- --------- - - -----------------------------------------------------------------------------------------------
SFAS No. 123, "Accounting for Stock Based-Compensation" was issued in October 1995 for implementation by year end 1996. SFAS No. 123 allows the use of a fair value based method of accounting for an employee stock option or similar equity instruments or the intrinsic value based method prescribed by APB Opinion No. 25, "Accounting for Stock Issued to Employees" with pro forma disclosures of net income and earnings per share as if the fair value based method of accounting had been applied. The Company has elected to continue using the intrinsic value based method. Had the Company elected to recognize compensation cost using the fair value based method, compensation would 75 have been measured at date of grant and recognized over the service period. Pro forma net income and earnings per share would have been reduced as follows for 1997 and 1996: 1997 1996 - - ------------------------------------------------------------------------------ Net Income As Reported $66.3 $53.4 Pro Forma 64.5 51.4 Earnings per common share - basic As Reported $ 3.32 $ 2.65 Pro Forma 3.22 2.55 Earnings per common share - diluted As Reported $ 3.29 $ 2.65 Pro Forma 3.20 2.55 - - ------------------------------------------------------------------------------ These pro forma disclosure amounts derived by the use of SFAS No. 123 are not indicative of future amounts. SFAS No. 123 is not applicable to options granted prior to 1995, and additional options may be granted in future years. The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions for 1997 and 1996, respectively: risk-free interest rates of 6.3 percent in 1997 and 6.1 percent in 1996; dividend yield of 5 percent for both years; expected lives of 6 years; and volatility of 15.8 percent in 1997 and 16.8 percent in 1996. 16. Stock Purchase Rights On November 28, 1988, the Board of Directors created and authorized 250,000 shares of Series A Junior Participating Preferred Stock at no par value and declared a dividend distribution of one right for each outstanding share of common stock to shareholders of record on December 8, 1988. The rights will separate from the common stock and become exercisable if a person or group acquires ownership of 20 percent or more of the outstanding common stock of the Company, commences a tender or exchange offer to acquire 20 percent or more of the outstanding shares, or if any person or group has become the beneficial owner of an amount of common stock which the Board determines to be substantial and not in the best interest of the shareholders. The rights entitle holders to purchase preferred shares at an exercise price of $110 per share. If an acquirer obtains 20 percent or more of the Company's common stock and the Board of Directors determines that such acquisition is not in the best interest of the shareholders, the rights will entitle holders to purchase common shares of the Company at a discount. If the Company is involved in a merger or other transactions in which shares are exchanged, the rights will entitle holders to purchase common shares of the acquirer at a discount. The rights expire on November 28, 1998 and may be redeemed by the Company for $.01 per right any time until the tenth business day following public announcement that a 20 percent position has been acquired. 76 17. Consolidated Quarterly Data (unaudited) First Second Third Fourth 1997 Quarter Quarter Quarter Quarter Year - - -------------------------------------------------------------------------------------------------------------- Insurance premiums $ 122.3 $ 117.2 $ 121.3 $ 130.4 $ 491.2 Engineering services 14.8 15.0 15.5 16.0 61.3 Net investment income 7.9 8.8 9.1 11.0 36.8 Realized investment gains 0.5 3.4 2.3 7.9 14.1 -------------------------------------------------------------------- Total revenues* $ 145.5 $ 144.4 $ 148.2 $ 165.3 $ 603.4 -------------------------------------------------------------------- Income from continuing operations before income taxes and distributions on capital securities $ 21.3 $ 22.1 $ 21.5 $ 28.8 $ 93.7 Income taxes 5.5 5.7 5.3 8.6 25.1 Distributions on capital securities of subsidiary trust, net of income tax -- -- 1.0 1.3 2.3 -------------------------------------------------------------------- Income from continuing operations $ 15.8 $ 16.4 $ 15.2 $ 18.9 $ 66.3 Discontinued operations: Income from operations of Radian International LLC, net of income tax -- -- -- -- -- -------------------------------------------------------------------- Net income $ 15.8 $ 16.4 $ 15.2 $ 18.9 $ 66.3 -------------------------------------------------------------------- Earnings per common share - basic: Income from continuing operations $ 0.78 $ 0.81 $ 0.77 $ 0.96 $ 3.32 Discontinued operations -- -- -- -- -- -------------------------------------------------------------------- Net income $ 0.78 $ 0.81 $ 0.77 $ 0.96 $ 3.32 -------------------------------------------------------------------- Earnings per common share - diluted: Income from continuing operations $ 0.78 $ 0.80 $ 0.76 $ 0.95 $ 3.29 Discontinued operations -- -- -- -- -- -------------------------------------------------------------------- Net income $ 0.78 $ 0.80 $ 0.76 $ 0.95 $ 3.29 -------------------------------------------------------------------- Dividends declared per common share $ 0.57 $ 0.57 $ 0.60 $ 0.60 $ 2.34 -------------------------------------------------------------------- Common stock price ranges: High 47 5/8 53 7/8 56 11/16 55 3/4 56 11/16 Low 44 5/8 44 52 7/16 49 13/16 44 Close 44 3/4 53 3/8 55 11/16 55 3/16 55 3/16 Shareholders at December 31, 5,221 - - --------------------------------------------------------------------------------------------------------------
77 First Second Third Fourth 1996 Quarter Quarter Quarter Quarter Year - - ---------------------------------------------------------------------------------------------------------- Insurance premiums $ 108.4 $ 112.9 $ 113.8 $ 113.5 $ 448.6 Engineering services 12.7 14.1 14.0 15.0 55.8 Net investment income 8.0 7.9 7.6 8.8 32.3 Realized investment gains 0.9 5.1 2.5 3.6 12.1 ---------------------------------------------------------------- Total revenues* $ 130.0 $ 140.0 $ 137.9 $ 140.9 $ 548.8 ---------------------------------------------------------------- Income from continuing operations before income taxes and distributions on capital securities $ 19.2 $ 15.3 $ 15.4 $ 23.0 $ 72.9 Income taxes 4.9 3.3 3.5 6.6 18.3 Distributions on capital securities of subsidiary trust, net of income tax -- -- -- -- -- Income from continuing ---------------------------------------------------------------- operations $ 14.3 $ 12.0 $ 11.9 $ 16.4 $ 54.6 Discontinued operations: Income from operations of Radian International LLC, net of income tax 2.7 1.4 (0.3) (5.0) (1.2) ---------------------------------------------------------------- Net income $ 17.0 $ 13.4 $ 11.6 $ 11.4 $ 53.4 ---------------------------------------------------------------- Income from continuing operations $ 0.71 $ 0.59 $ 0.59 $ 0.82 $ 2.71 Discontinued operations 0.13 0.07 (0.01) (0.25) (0.06) ---------------------------------------------------------------- Net income $ 0.84 $ 0.66 $ 0.58 $ 0.57 $ 2.65 ---------------------------------------------------------------- Earnings per common share - diluted: Income from continuing operations $ 0.71 $ 0.59 $ 0.59 $ 0.82 $ 2.71 Discontinued operations 0.13 0.07 (0.01) (0.25) (0.06) ---------------------------------------------------------------- Net income $ 0.84 $ 0.66 $ 0.58 $ 0.57 $ 2.65 ---------------------------------------------------------------- Dividends declared per common share $ 0.57 $ 0.57 $ 0.57 $ 0.57 $ 2.28 ---------------------------------------------------------------- Common stock price ranges: High 52 1/2 50 3/4 49 47 1/8 52 1/2 Low 48 46 43 1/4 42 3/4 42 3/4 Close 50 5/8 49 1/8 44 3/4 46 3/8 46 3/8 Shareholders at December 31, 5,644 - - ----------------------------------------------------------------------------------------------------------
*Total revenues exclude revenues for investments accounted for on the equity method. 78 Schedule I HSB Group, Inc. Summary of Investments - Other Than Investments in Related Parties (in millions) Column A Column B Column C Column D Column E Column F Column G - - -------------------------------------------------------- ----------------------- ----------- ------------ ----------- --------- 1997 1996 ------------------------------------- ------------------------------------ Amount Amount Shown Shown In The In The Market Balance Market Balance Type of Investment Cost Value Sheet Cost Value Sheet - - -------------------------------------------------------- --------------------------------------------------- ------------ ------- Fixed Maturities: Bonds: U.S. Government and Government Agencies and Authorities $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 States, Municipalities and Political Subdivisions 37.6 39.7 39.7 39.4 40.7 40.7 Foreign Governments 33.1 33.5 33.5 30.1 30.5 30.5 Public Utilities $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 Convertibles and Bonds with Warrants Attached 0.0 0.0 0.0 0.0 0.0 0.0 All Other Bonds 28.1 28.7 28.7 51.1 51.9 51.9 Certificates of Deposit $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 Mortgage Receivable 11.1 11.1 11.1 11.1 11.1 11.1 Redeemable Preferred Stocks 131.2 135.4 135.4 99.6 101.6 101.6 --------------------------------- --------------------------------- Total Fixed Maturities $241.1 $248.4 $248.4 $231.3 $235.8 $235.8 Equity Securities: Common Stocks: Public Utilities 16.3 19.8 19.8 15.3 16.6 16.6 Banks and Insurance 13.4 23.5 23.5 12.0 20.0 20.0 Industrial and Other 67.8 135.7 135.7 68.4 131.7 131.7 Non-Redeemable Preferred Stocks 133.8 144.8 144.8 87.2 94.4 94.4 --------------------------------- --------------------------------- Total Equity Securities $231.3 $323.8 $323.8 $182.9 $262.7 $262.7 Short-term Investments and Cash: $424.5 $424.5 $424.5 $102.4 $102.4 $102.4 --------------------------------- --------------------------------- Total Investments $896.9 $996.7 $996.7 $516.6 $600.9 $600.9 ================================= =================================
79 HSB GROUP, INC. (Registrant) SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF HSB GROUP, INC. CONDENSED STATEMENT OF INCOME INFORMATION For the period from June 23, 1997 through December 31, 1997 (In millions) 1997 ------------ Revenues: Net investment income $ 1.5 Expenses: Interest expense 0.1 ------------ Income before income taxes and 1.4 distributions on capital securities Income taxes 0.5 Distributions on capital securities of subsidiary trusts, net of income taxes of $1.2 2.3 ------------ Net Loss - Parent only (1.4) Equity in net income of subsidiaries 35.4 ------------ Consolidated net income $ 34.0 ============ 80 HSB GROUP, INC. (Registrant) SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF HSB GROUP, INC. BALANCE SHEET INFORMATION December 31, 1997 (In millions) 1997 --------------- Assets Cash $ 0.7 Short-term investments, at cost 60.5 Investment in subsidiaries 657.0 Fixed maturities 11.8 Equity securities, at fair value 27.2 Other assets 23.9 --------------- Total assets $ 781.1 =============== Liabilities Dividends payable $ 11.8 Other liabilities 15.1 --------------- Total liabilities 26.9 --------------- Company obligated mandatorily redeemable capital 108.9 securities of subsidiary Trust I holding solely junior subordinated deferrable interest debentures of the Company, net of unamortized discount of $1.1 Company obligated mandatorily redeemable convertible 300.0 capital securities of subsidiary Trust II holding solely junior subordinated deferrable interest debentures of the Company. Shareholders' Equity Common stock 10.0 Paid in capital 31.6 Unrealized investment gains, net of tax 59.8 Retained earnings 248.8 Benefit plans (4.9) --------------- Total shareholders' equity 345.3 --------------- Total liabilities and shareholders' equity $ 781.1 =============== 81 HSB GROUP, INC. (Registrant) SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF HSB GROUP, INC. CONDENSED STATEMENT OF CASH FLOWS INFORMATION For the period from June 23, 1997 through December 31, 1997 (In millions) 1997 ------------- Operating Activities: Net income $ 34.0 Undistributed earnings of subsidiary (21.2) Increase in other assets (26.2) Increase in other liabilities 14.3 ------------- Cash provided by operating activities 0.9 ------------- Investing Activities: Purchase of short-term investments, net (60.5) Purchase of fixed maturities (11.8) Purchase of equity securities (27.0) Contribution to subsidiaries (279.5) ------------- Cash used in investing activities (378.8) ------------- Financing Activities: Dividends paid to shareholders (11.9) Net proceeds from issuance of company obligated 408.9 manditorily redeemable capital securities Options Exercised 5.5 Reacquisition of Stock (36.5) Other 12.6 ------------- Cash provided by financing activities 378.6 ------------- Change in cash 0.7 Cash at beginning of period - Cash at end of period $ 0.7 ============= 82 Schedule IV HSB Group, Inc. Reinsurance (in millions) Column A Column B Column C Column D Column E Column F Insurance Gross Ceded to Assumed Net Percentage of Premiums Amount Other From Other Amount Amount Companies Companies Assumed to Net - - ------------------------------------------------------------------------------- - - ------------------------------------------------------------------------------- 1997 Property and Liability Insurance $370.1 $118.1 $239.2 $491.2 48.7% 1996 Property and Liability Insurance $343.4 $107.9 $213.1 $448.6 47.5% 1995 Property and Liability Insurance $279.7 $65.9 $175.3 $389.1 45.1% 83 SCHEDULE V HSB Group, Inc. Valuation and Qualifying Accounts (in millions) Column A Column B Column C Column D Column E Column F - - ---------------------------------- -------- -------- -------- --------- --------- Description Balance at Charged to Charged to Balance Beginning of Costs and Other Deductions At End of Period Expenses Accounts Describe (a) Period - - ----------------------------------------------------------------------------------------------------- 1997 Reserve for Accounts Receivable $3.0 $0.9 $0.0 $0.3 $3.6 1996 Reserve for Accounts Receivable $3.3 $1.4 $0.0 $1.7 $3.0 1995 Reserve for Accounts Receivable $3.0 $2.3 $0.0 $2.0 $3.3
(a) Engineering Services and Insurance Premium Receivables written off as uncollectible. 84 Schedule VI HSB Group, Inc. Supplemental Information Concerning Property-Casualty Insurance Operations For Years Ended December 31, 1997, 1996, 1995 Column A Column B Column C Column D Column E Column F Column G Column H Column I Column J Column K - - ------------ ----------- --------- ---------- -------- -------- --------- --------- -------- -------- --------- Affiliation Prepaid Reserves Discount, if Unearned Earned Net investment Claims and Amortiza- Paid claims Premiums with Acquisition for unpaid any deducted Premium Premium income Claim tion of and claim written Registrant Costs claims and in Column C Adjustment prepaid adjustment (Consolidated claim Expenses policy expenses property- adjustment incurred acquisi- casualty expenses related to tion costs entities) Current Prior Year Years 1997 45.5 276.7 -- 290.3 491.2 36.8 209.5 8.4 90.7 204.9 498.5 1996 40.6 302.9 -- 270.6 448.6 32.3 214.2 -9.8 86.0 172.1 454.4 1995 34.1 190.9 -- 216.2 389.1 28.9 152.2 2.7 78.1 170.7 408.3
Item 9. Changes in and Disagreements with Accountants on ------------------------------------------------ Accounting and Financial Disclosure. ------------------------------------ None. PART III Item 10. Directors and Executive Officers of the Registrant. --------------------------------------------------- "Nominees for Election to the Board of Directors for Three-Year Term Expiring in 2001" and "Members of the Board of Directors Continuing in Office" on pages 2-4 of the Company's Proxy Statement dated March 6, 1998 are incorporated herein by reference. Also see pages 23 - 24 herein. Item 11. Executive Compensation. ---------------------- "Meetings and Remuneration of the Directors" on pages 5-6, "Human Resources Committee Report on Executive Compensation" on pages 8-11, "Summary Compensation Table" on page 12, "Stock Option and Long-Term Incentive Plan Tables" on pages 13-14, "Retirement Plans" on pages 14-15, "Employment Arrangements" on pages 15-16, "Compensation Committee Interlocks and Insider Participation" on page 16, and "Performance Graphs" on page 17 of the Company's Proxy Statement dated March 6, 1998 are incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management. --------------------------------------------------------------- "Security Ownership of Certain Beneficial Owners and Management" on page 6-8 of the Company's Proxy Statement dated March 6, 1998 is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions. ----------------------------------------------- "Compensation Committee Interlocks and Insider Participation" on page 16 of the Company's Proxy Statement dated March 6, 1998 is incorporated herein by reference. 85 PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. ----------------------------------------------------------------- (a) The financial statements and schedules listed in the Index to Financial Statements and Financial Statement Schedules on page 40 herein are filed as part of this report. (b) Reports on Form 8-K - (i) Form 8-K dated January 12, 1998 to report sale of interest in Industrial risk Insurers and $300 million of convertible capital securities to Employers Reinsurance Corporation; and (ii) Form 8-K dated January 28, 1998 to report Fourth Quarter 1997 Results of Registrant. (c) The exhibits listed in the accompanying Index to Exhibits are filed as part of this report. 86 SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. HSB GROUP, INC. (Registrant) By: /s/ Gordon W. Kreh Gordon W. Kreh President and Chief Executive Officer March 30, 1998 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. (Signature) (Title) By:/s/ Gordon W. Kreh Gordon W. Kreh President, Chief Executive Officer March 30, 1998 Director /s/ Saul L. Basch Senior Vice President, Treasurer Saul L. Basch and Chief Financial Officer March 30, 1998 (Principal Financial Officer and Principal Accounting Officer) /s/ Robert C. Walker Robert C. Walker Senior Vice President and General March 30, 1998 Counsel (Joel B Alvord)* Director (Colin G. Campbell)* Director (Richard G. Dooley)* Director (William B. Ellis)* Director (E. James Ferland)* Director 87 (Simon W. Leathes)* Director (Lois Dickson Rice)* Director (John M. Washburn, Jr.)* Director (Wilson Wilde)* Director *By: /s/ Robert C. Walker Robert C. Walker (Attorney-in-Fact) March 30, 1998 88 INDEX TO EXHIBITS Exhibit Number Description (3)(i) Certificate of Incorporation of HSB Group, Inc. (3)(ii) By-laws of HSB Group, Inc. **(4)(i) Rights Agreement dated November 28, 1988 between The Hartford Steam Boiler Inspection and Insurance Company ("HSBIIC") and The First National Bank of Boston, as Rights Agent; assumed by Registrant; incorporated by reference to Exhibit 4(i) to HSBIIC's Form 10-K for the year ended December 31, 1995, File No. 001-10527. **(4)(ii) Documents related to HSB Capital I: (a) Indenture of Registrant relating to the Junior Subordinated Debentures, incorporated by reference to Exhibit 4 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1997, File No. 001-13135. (b) First Supplemental Indenture of Registrant, incorporated by reference to Exhibit 4 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1997, File No. 001-13135. (c) Form of Certificate of Exchange Junior Subordinated Debentures, incorporated by reference to Exhibit 4.3 to Registrant's and HSB Capital I's Registration Statement on Form S-4 filed with the Commission on October 10, 1997, Registration No. 333-37581. (d) Certificate of Trust of HSB Capital I, incorporated by reference to Exhibit 4.4 to Registrant's and HSB Capital I's Registration Statement on Form S-4 filed with the Commission on October 10, 1997, Registration No. 333-37581. (e) Amended and Restated Trust Agreement of HSB Capital I, incorporated by reference to Exhibit 4 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1997, File No. 001-13135. (f) Form of Exchange Capital Security Certificate for HSB Capital I, incorporated by reference to Exhibit 4.6 to Registrant's and HSB Capital I's Registration Statement on Form S-4 filed with the Commission on October 10, 1997, Registration No. 333-37581. (g) Form of Exchange Guarantee of Registrant relating to the Exchange Capital Securities, incorporated by reference to Exhibit 4.7 to Registrant's and HSB Capital I's Registration Statement on Form S-4 filed with the Commission on October 10, 1997, Registration No. 333-37581. Documents related to HSB Capital II: (a) Purchase Agreement as of December 31, 1997 among Employers Reinsurance Corporation, ERC Life Reinsurance Corporation and Registrant, incorporated by reference to Registrant's 89 Current Report on Form 8-K. File No. 001-13135, filed January 12, 1998 (the "January 12, 1998 8-K). (b) Indenture of Registrant relating to the 7.0% Convertible Subordinated Deferrable Interest Debentures Due December 31, 2017, incorporated by reference to the January 12, 1998 8-K. (c) Form of Certificate of 7.0% Convertible Subordinated Deferrable Interest Debentures due December 31, 2017, incorporated by reference to the January 12, 1998 8-K. (d) Certificate of Trust of HSB Capital II, incorporated by reference to the January 12, 1998 8-K. (e) Trust Agreement dated as of December 31, 1997 among Registrant, The First National Bank of Chicago, First Chicago Delaware Inc. and The Administrative Trustees named therein, incorporated by reference to the January 12, 1998 8-K. (f) Form of Capital Securities Certificate of HSB Capital II, incorporated by reference to the January 12, 1998 8-K. (g) Guarantee Agreement between Registrant and The First National Bank of Chicago dated as of December 31, 1997 relating to HSB Capital II, incorporated by reference to the January 12, 1998 8-K. (h) Registration Rights Agreement dated as of December 31, 1997 among Employers Reinsurance Corporation, ERC Life Reinsurance Corporation and Registrant, incorporated by reference to the January 12, 1998 8-K. **(10)(i) Lease Agreement between HSBIIC and One State Street Limited Partnership; incorporated by reference to Exhibit (10)(i) to HSBIIC's Form 10. File No. 0-13300, filed March 18, 1985. (10)(iii) **(a) Employment Agreement dated February 3, 1997 between HSBIIC and various executive officers, assumed by Registrant; incorporated by reference to HSBIIC's Form 10-K for the year ended December 31, 1996, filed with the Commission on March 31, 1997, File No. 001-10527 (the "1996 10-K").* **(b) The Hartford Steam Boiler Inspection and Insurance Company Long-Term Incentive Plan, as amended and restated December 23, 1996, assumed by Registrant; incorporated by reference to the 1996 10-K.* **(c) The Hartford Steam Boiler Inspection and Insurance Company Short-Term Incentive Plan, as amended and restated December 23, 1996, assumed by Registrant; incorporated by reference to the 1996 10-K.* **(d) The Hartford Steam Boiler Inspection and Insurance Company 1985 Stock Option Plan, as amended and restated December 23, 1996, assumed by Registrant, incorporated by reference to the 1996 10-K. * **(e) The Hartford Steam Boiler Inspection and Insurance Company 1995 Stock Option Plan, 90 as amended and restated effective December 23, 1996, assumed by Registrant, incorporated by reference to the 1996 10-K. * **(f) Pre-Retirement Death Benefit and Supplemental Pension Agreement between HSBIIC and various executive officers, as amended and restated effective March 14, 1997, assumed by Registrant, incorporated by reference to the 1996 10-K. * **(g) Pre-Retirement Death Benefit and Supplemental Pension Agreement between HSBIIC and William A. Kerr, dated March 14, 1997, assumed by Registrant, incorporated by reference to the 1996 10-K. * **(h) Pre-Retirement Death Benefit and Supplemental Pension Agreement between HSBIIC and Robert C. Walker, dated March 14, 1997, assumed by Registrant, incorporated by reference to the 1996 10-K.* **(i) The Hartford Steam Boiler Inspection and Insurance Company Directors Stock and Deferred Compensation Plan, assumed by Registrant, incorporated by reference to the 1996 10-K.* **(j) Description of certain arrangements not set forth in any formal documents, as described on pages 5 - 6 , with respect to directors' compensation, and on pages 8 -16, with respect to executive officer's compensation, which pages are incorporated by reference to Registrant's Proxy Statement dated and filed March 6, 1998. * (21) Subsidiaries of the Registrant. (23) Consent of experts and counsel - consent of Coopers & Lybrand. (24) Power of attorney. (27) Financial Data Schedule. * Management contract, compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 14(c) of this report. ** Previously filed. 91 EX-3 2 Exhibit 3(i) Amended and Restated CERTIFICATE OF INCORPORATION of HSB GROUP, INC. Hartford, Connecticut CERTIFICATE OF INCORPORATION of HSB GROUP, INC. Article I The name of the Corporation is HSB Group, Inc. Article II The address of the registered office of the Corporation is One State Street, Hartford, Connecticut, 06102-5024. The name of the registered agent at that address is R. Kevin Price. Article III The nature of the business to be transacted, and the purposes to be promoted or carried out by the Corporation, are to engage in any lawful act or activity for which corporations may be formed under the Connecticut Business Corporation Act or any successor statute thereto. Article IV A. The authorized number of shares, which may be increased from time to time when and if authorized by the shareholders shall consist of 50,000,000 shares of common stock and 500,000 shares of preferred stock, of which 250,000 shares have been designated as "Series A Junior Participating Preferred Stock" and 2,000 shares have been designated as "Series B Convertible Preferred Stock". B. The Board of Directors is authorized to fix and determine the terms, limitations and relative rights and preferences of the preferred stock including, without limitation, any voting rights thereof, to divide and issue the preferred stock in series, to fix and determine the variations among series to the extent permitted by law and to provide that shares of the preferred stock, or any series thereof, may be convertible into the same or a different number of shares of common stock. No shareholder shall have any preemptive right to purchase or subscribe to any shares of any class of stock of the Corporation, whether now or hereafter authorized, or to any securities convertible into shares of any class of stock of the Corporation. C. The designations, voting powers, preferences and relative, participating, optional and other special rights of the Series A Junior Participating Preferred Stock, and the qualifications, limitations or restrictions thereof are as follows: 1. Designation and Amount. The shares of such series shall be designated as "Series A Junior Participating Preferred Stock" and the number of shares constituting such series shall be 250,000. 2. Dividends and Distributions. (a) Subject to the prior and superior rights of the holders of any shares of any series of Preferred Stock ranking prior and superior to the shares of Series A Junior Participating Preferred Stock with respect to dividends, the holders of shares of Series A Junior Participating Preferred Stock shall be entitled to receive, when, as and if declared by the Board of Directors out of funds legally available for the purpose, quarterly dividends payable in cash on the last business day of January, April, July and October in each year (each such date being referred to herein as a "Quarterly Dividend Payment Date ), commencing on the first Quarterly Dividend Payment Date after the first issuance of a share or fraction of a share of Series A Junior Participating Preferred Stock, in an amount per share (rounded to the nearest cent) equal to the greater of (a) $12.00 or (b) subject to the provision for adjustment hereinafter set forth, 200 times the aggregate per share amount of all cash dividends, and 200 times the aggregate per share amount (payable in kind) of all non-cash dividends or other distributions other than a dividend payable in shares of Common Stock or a subdivision of the outstanding shares of Common Stock (by reclassification or otherwise), declared on the Common Stock, without par value, of the Corporation (the "Common Stock") since the immediately preceding Quarterly Dividend Payment Date, or, with respect to the first Quarterly Dividend Payment Date, since the first issuance of any share or fraction of a share of Series A Junior Participating Preferred Stock. In the event the Corporation shall at any time after November 28, 1988 (the "Rights Declaration Date") (i) declare any dividend on Common Stock payable in shares of Common Stock, (ii) subdivide the outstanding Common Stock or (iii) combine the outstanding Common Stock into a smaller number of shares, then in each such case the amount to which holders of shares of Series A Junior Participating Preferred Stock were entitled immediately prior to such event under clause (b) of the preceding sentence shall be adjusted by multiplying such amount by a fraction the numerator of which is the number of shares of Common Stock outstanding immediately after such event and the denominator of which is the number of shares of Common Stock that were outstanding immediately prior to such event. (b) The Corporation shall declare a dividend or distribution on the Series A Junior Participating Preferred Stock as provided in Paragraph 2.(a) above immediately after it declares a dividend or distribution on the Common Stock (other than a dividend payable in shares of Common Stock); provided that, in the event no dividend or distribution shall have been declared on the Common Stock during the period between any Quarterly Dividend Payment Date and the next subsequent Quarterly Dividend Payment Date, a dividend of $12.00 per share on the Series A Junior Participating Preferred Stock shall nevertheless be payable on such subsequent Quarterly Dividend Payment Date. (c) Dividends shall begin to accrue and be cumulative on outstanding shares of Series A Junior Participating Preferred Stock from the Quarterly Dividend Payment Date next preceding the date of issue of such shares of Series A Junior Participating Preferred stock unless the date of issue of such shares is prior to the record date for the first Quarterly Dividend Payment Date, in which case dividends on such shares shall begin to accrue from the date of issue of such shares or unless the date of issue is a Quarterly Dividend Payment Date or is a date after the record date for the determination of holders of shares of Series A Junior Participating Preferred Stock entitled to receive a quarterly dividend and before such Quarterly Dividend Payment Date in either of which events such dividends shall begin to accrue and be cumulative from such Quarterly Dividend Payment Date. Accrued but unpaid dividends shall not bear interest. Dividends paid on the shares of Series A Junior Participating Preferred Stock in an amount less than the total amount of such dividends at the time accrued and payable on such shares shall be allocated pro rata on a share-by-share basis among all such shares at the time outstanding. The Board of Directors may fix a record date for the determination of holders of shares of Series A Junior Participating Preferred Stock entitled to receive payment of a dividend or distribution declared thereon, which record date shall be no more than 30 days prior to the date fixed for the payment thereof. 3. Voting Rights. The holders of shares of Series A Junior Participating Preferred Stock shall have the following voting rights: (a) Subject to the provision for adjustment hereinafter set forth, each share of Series A Junior Participating Preferred Stock shall entitle the holder thereof to 200 votes on all matters submitted to a vote of the shareholders of the Corporation. In the event the Corporation shall at any time after the Rights Declaration Date (i) declare any dividend on Common stock payable in shares of Common Stock (ii) subdivide the outstanding Common Stock, or (iii) combine the outstanding Common Stock into a smaller number of shares, then in each such case the number of votes per share to which holders of shares of Series A Junior Participating Preferred Stock were entitled immediately prior to such event shall be adjusted by multiplying such number by a fraction the numerator of which is the number of shares of Common Stock outstanding immediately after such event and the denominator of which is the number of shares of Common Stock that were outstanding immediately prior to such event. (b) Except as otherwise provided herein or by law, the holders of shares of Series A Junior Participating Preferred Stock and the holders of shares of Common Stock shall vote together as one class on all matters submitted to a vote of shareholders of the Corporation. (c (i) If at any time dividends on any Series A Junior Participating Preferred Stock shall be in arrears in an amount equal to six (6) quarterly dividends thereon, the occurrence of such contingency shall mark the beginning of a period (herein called a "default period") which shall extend until such time when all accrued and unpaid dividends for all previous quarterly dividend periods and for the current quarterly dividend period on all shares of Series A Junior Participating Preferred Stock then outstanding shall have been declared and paid or set apart for payment. During each default period, all holders of Preferred Stock (including holders of the Series A Junior Participating Preferred Stock) with dividends in arrears in an amount equal to six (6) quarterly dividends thereon, voting as a class, irrespective of series, shall have the right to elect two (2) Directors. (ii) During any default period, such voting right of the holders of Series A Junior Participating Preferred Stock may be exercised initially at a special meeting called pursuant to subparagraph (iii) of this Section 3.(c). or at any annual meeting of shareholders, and thereafter at annual meetings of shareholders, provided that neither such voting right nor the right of the holders of any other series of Preferred Stock, if any, to increase, in certain cases, the authorized number of Directors shall be exercised unless the holders of ten percent (10%) in number of shares of Preferred Stock outstanding shall be present in person or by proxy. The absence of a quorum of the holders of Common Stock shall not affect the exercise by the holders of Preferred Stock of such voting right. At any meeting at which the holders of Preferred Stock shall exercise such voting right initially during an existing default period, they shall have the right, voting as a class, to elect Directors to fill such vacancies, if any in the Board of Directors as may then exist up to two (2) Directors or, if such right is exercised at an annual meeting, to elect two (2) Directors. If the number which may be so elected at any special meeting does not amount to the required number, the holders of the Preferred Stock shall have the right to make such increase in the number of Directors as shall be necessary to permit the election by them of the required number. After the holders of the Preferred Stock shall have exercised their right to elect Directors in any default period and during the continuance of such period, the number of Directors shall not be increased or decreased except by vote of the holders of Preferred Stock as herein provided or pursuant to the rights of any equity securities ranking senior to or pari passu with the Series A Junior Participating Preferred Stock. (iii)Unless the holders of Preferred Stock shall, during an existing default period, have previously exercised their right to elect Directors, the Board of Directors may order, or any shareholder or shareholders owning in the aggregate not less than ten percent (10%) of the total number of shares of Preferred Stock outstanding, irrespective of series, may request, the calling of special meeting of the holders of Preferred Stock, which meeting shall thereupon be called by the President, a Vice-President or the Secretary of the Corporation. Notice of such meeting and of any annual meeting at which holders of Preferred Stock are entitled to vote pursuant to this paragraph 3(c)(iii) shall be given to each holder of record of Preferred Stock by mailing a copy of such notice to him at his last address as the same appears on the books of the Corporation. Such meeting shall be called for a time not earlier than 20 days and not later than 60 days after such order or request or in default of the calling of such meeting within 60 days after such order or request, such meeting may be called on similar notice by any shareholder or shareholders owning in the aggregate not less than ten percent (10%) of the total number of shares of Preferred Stock outstanding. Notwithstanding the provisions of this paragraph 3(c)(iii), no such special meeting shall be called during the period within 60 days immediately preceding the date fixed for the next annual meeting of the shareholders. (iv) In any default period, the holders of Common Stock, and other classes of stock of the Corporation if applicable, shall continue to be entitled to elect the whole number of Directors until the holders of Preferred Stock shall have exercised their right to elect two (2) Directors voting as a class, after the exercise of which right (x) the Directors so elected by the holders of Preferred Stock shall continue in office until their successors shall have been elected by such holders or until the expiration of the default period and (y) any vacancy in the Board of Directors may (except as provided in paragraph 3(c)(ii) of this Section) be filled by vote of a majority of the remaining Directors theretofore elected by the holders of the class of stock which elected the Director whose office shall have become vacant. References in this paragraph 3.(c) to Directors elected by the holders of a particular class of stock shall include Directors elected by such Directors to fill vacancies as provided in clause (y) of the foregoing sentence. (v) Immediately upon the expiration of a default period,(x) the right of the holders of Preferred Stock as a class to elect Directors shall cease, (y) the term of any Directors elected by the holders of Preferred Stock as a class shall terminate and (z) the number of Directors shall be such number as may be provided for in the certificate of incorporation or bylaws irrespective of any increase made pursuant to the provisions of paragraph 3(c)(ii) (such number being subject, however, to change thereafter in any manner provided by law or in the certificate of incorporation or bylaws). Any vacancies in the Board of Directors effected by the provisions of clauses (y) and (z) in the preceding sentence may be filled by a majority of the remaining Directors. (d) Except as set forth herein, holders of Series A Junior Participating Preferred Stock shall have no special voting rights and their consent shall not be required (except to the extent they are entitled to vote with holders of Common Stock as set forth herein) for taking any corporate action. 4. Certain Restrictions. (a) Whenever quarterly dividends or other dividends or distributions payable on the Series A Junior Participating Preferred Stock as provided in Section 2 are in arrears, thereafter and until all accrued and unpaid dividends and distributions, whether or not declared, on shares of Series A Junior Participating Preferred Stock outstanding shall have been paid in full, the Corporation shall not: (i) declare or pay dividends on, make any other distributions on, or redeem or purchase or otherwise acquire for consideration any shares of stock ranking junior (either as to dividends or upon liquidation, dissolution or winding up) to the Series A Junior Participating Preferred Stock; (ii)declare or pay dividends on or make any other distributions on any shares of stock ranking on a parity (either as to dividends or upon liquidation, dissolution or winding up) with the Series A Junior Participating Preferred Stock, except dividends paid ratably on the Series A Junior Participating Preferred Stock and all such parity stock on which dividends are payable or in arrears in proportion to the total amounts to which the holders of all such shares are then entitled; (iii)redeem or purchase or otherwise acquire for consideration shares of any stock ranking on a parity (either as to dividends or upon liquidation, dissolution or winding up) with the Series A Junior Participating Preferred Stock, provided that the Corporation may at any time redeem, purchase or otherwise acquire shares of any such parity stock in exchange for shares of any stock of the Corporation ranking junior (either as to dividends or upon dissolution, liquidation or winding up) to the Series A Junior Participating Preferred Stock; (iv) purchase or otherwise acquire for consideration any shares of Series A Junior Participating Preferred Stock, or any shares of stock ranking on a parity with the Series A Junior Participating Preferred Stock, except in accordance with a purchase offer made in writing or by publication (as determined by the Board of Directors) to all holders of such shares upon such terms as the Board of Directors, after consideration of the respective annual dividend rates and other relative rights and preferences of the respective series and classes, shall determine in good faith will result in fair and equitable treatment among the respective series or classes. (b) The Corporation shall not permit any subsidiary of the Corporation to purchase or otherwise acquire for consideration any shares of stock of the Corporation unless the Corporation could, under paragraph (a) of this Section 4, purchase or otherwise acquire such shares at such time and in such manner. 5. Reacquired Shares. Any shares of Series A Junior Participating Preferred Stock purchased or otherwise acquired by the Corporation in any manner whatsoever shall be retired and cancelled promptly after the acquisition thereof. All such shares shall upon their cancellation become authorized but unissued shares of Preferred Stock and may be reissued as part of a new series of Preferred Stock to be created by resolution or resolutions of the Board of Directors, subject to the conditions and restrictions on issuance set forth herein. 6. Liquidation, Dissolution or Winding Up. (a) Upon any liquidation (voluntary or otherwise), dissolution or winding up of the Corporation, no distribution shall be made to the holders of shares of stock ranking junior (either as to dividends or upon liquidation, dissolution or winding up) to the Series A Junior Participating Preferred Stock unless, prior thereto, the holders of shares of Series A Junior Participating Preferred Stock shall have received $200 per share, plus an amount equal to accrued and unpaid dividends and distributions thereon, whether or not declared, to the date of such payment (the "Series A Liquidation Preference"). Following the payment of the full amount of the Series A Liquidation Preference, no additional distributions shall be made to the holders of shares of Series A Junior Participating Preferred Stock unless, prior thereto, the holders of shares of Common Stock shall have received an amount per share (the "Common Adjustment") equal to the quotient obtained by dividing (i) the Series A Liquidation Preference by (ii) 200 (as appropriately adjusted as set forth in paragraph 6(c) below to reflect such events as stock splits, stock dividends and recapitalizations with respect to the Common Stock) (such number in clause (ii), the "Adjustment Number"). Following the payment of the full amount of the Series A Liquidation Preference and the Common Adjustment in respect of all outstanding shares of Series A Junior Participating Preferred Stock and Common Stock, respectively, holders of Series A Junior Participating Preferred Stock and holders of shares of Common Stock shall receive their ratable and proportionate share of the remaining assets to be distributed in the ratio of the Adjustment Number to 1 with respect to such Preferred Stock and Common Stock, on a per share basis, respectively. (b) In the event, however that there are not sufficient assets available to permit payment in full of the Series A Liquidation Preference and the liquidation preferences of all other series of preferred stock if any, which rank on a parity with the Series A Junior Participating Preferred Stock, then such remaining assets shall be distributed ratably to the holders of such parity shares in proportion to their respective liquidation preferences. In the event, however, that there are not sufficient assets available to permit payment in full of the Common Adjustment then such remaining assets shall be distributed ratably to the holders of Common Stock. (c) In the event the Corporation shall at any time after the Rights Declaration Date (i) declare any dividend on Common Stock payable in shares of Common Stock, (ii) subdivide the outstanding Common Stock or (iii) combine the outstanding Common Stock into a smaller number of shares, then in each such case the Adjustment Number in effect immediately prior to such event shall be adjusted by multiplying such Adjustment Number by a fraction the numerator of which is the number of shares of Common Stock outstanding immediately after such event and the denominator of which is the number of shares of Common Stock that were outstanding immediately prior to such event. 7. Consolidation, Merger, etc. In case the Corporation shall enter into any consolidation, merger, combination or other transaction in which the shares of Common Stock are exchanged for or changed into other stock or securities, cash and/or any other property, then in any such case the shares of Series A Junior Participating Preferred Stock shall at the same time be similarly exchanged or changed in an amount per share (subject to the provision for adjustment hereinafter set forth) equal to 200 times the aggregate amount of stock, securities, cash and/or any other property (payable in kind), as the case may be, into which or for which each share of Common Stock is changed or exchanged. In the event the Corporation shall at any time after the Rights Declaration Date (i) declare any dividend on Common Stock payable in shares of Common Stock, (ii) subdivide the outstanding Common Stock or (iii) combine the outstanding Common Stock into a smaller number of shares, then in each such case the amount set forth in the preceding sentence with respect to the exchange or change of shares of Series A Junior Participating Preferred Stock shall be adjusted by multiplying such amount by a fraction the numerator of which is the number of shares of Common Stock outstanding immediately after such event and the denominator of which is the number of shares of Common Stock that were outstanding immediately prior to such event. 8. Optional Redemption. (a) The Corporation shall have the option to redeem the whole or any part of the Series A Junior Participating Preferred Stock at any time at a redemption price equal to, subject to the provision for adjustment hereinafter set forth, 200 times the "current per share market price" of the Common Stock on the date of the mailing of the notice of redemption, together with unpaid accumulated dividends to the date of such redemption. In the event the Corporation shall at any time after the Rights Declaration Date (i) declare any dividend on Common Stock payable in shares of Common Stock, (ii) subdivide the outstanding Common Stock, (iii) combine the outstanding Common Stock into a smaller number of shares or (iv) issue any shares by reclassification of its shares of Common Stock, then in each such case the amount to which holders of shares of Series A Junior Participating Preferred Stock shall be otherwise entitled immediately prior to such event under the immediately preceding sentence shall be adjusted by multiplying such amount by a fraction the numerator of which shall be the number of shares of Common Stock outstanding immediately after such event and the denominator of which shall be the number of shares of Common Stock that shall have been outstanding immediately prior to such event. The "current per share market price" on any date shall be deemed to be the average of the closing prices per share of such Common Stock for the 10 consecutive Trading Days (as such term is hereinafter defined) immediately prior to such date. The closing price for each day shall be the last sale price, regular way, or, in case no such sale shall take place on such day, the average of the closing bid and asked prices, regular way, in either case as reported in the principal consolidated transaction reporting system with respect to securities listed or admitted to trading on the New York Stock Exchange or, if the Common Stock shall not be listed or admitted to trading on the New York Stock Exchange, as reported in the principal consolidated transaction reporting system with respect to securities listed or admitted to trading on the principal national securities exchange on which the Common Stock shall not be listed or admitted to trading or, if the Common Stock shall not be listed or admitted to trading on any national securities exchange, the last quoted price or, if not so quoted the average of the high bid and low asked prices in the over-the-counter market, as reported by the National Association of Securities Dealers, Inc. Automated Quotation System ("NASDAQ") or such other system then in use or, if on any such date the Common Stock shall not be quoted by any such organization, the average of the closing bid and asked prices as furnished by a professional market maker making a market in the Common Stock selected by the Board of Directors of the Corporation. If on such date no such market maker shall be making a market in the Common Stock, the fair value of the Common Stock on such date as determined in good faith by the Board of Directors of the Corporation shall be used. The term "Trading Day" shall mean a day on which the principal national securities exchange on which the Common Stock shall be listed or admitted to trading shall be open for the transaction of business or, if the Common Stock shall not be listed or admitted to trading on any national securities exchange, a Monday, Tuesday, Wednesday, Thursday or Friday on which banking institutions in the State of New York shall not be authorized or obligated by law or executive order to close. (b) Notice of any such redemption shall be given by mailing to the holders of the Series A Junior Participating Preferred Stock a notice of such redemption, first class postage prepaid, not later than the thirtieth day and not earlier than the sixtieth-day before the date fixed for redemption, at their last address as the same shall appear upon the books of the Corporation. Any notice which shall be mailed in the manner herein provided shall be conclusively presumed to have been duly given, whether or not the stockholder shall have received such notice, and failure duly to give such notice by mail, or any defect in such notice, to any holder of Series A Junior Participating Preferred Stock shall not affect the validity of the proceedings for the redemption of such Series A Junior Participating Preferred Stock. (c) If less than all the outstanding shares of the Series A Junior Participating Preferred Stock are to be redeemed by the Corporation, the number of shares to be redeemed shall be determined by the Board of Directors and the shares to be redeemed shall be determined by lot or pro rata or in such fair and equitable other manner as may be prescribed by resolution of the Board of Directors. (d) The notice of redemption to each holder of Series A Junior Participating Preferred Stock shall specify (a) the number of shares of Series A Junior Participating Preferred Stock of such holder to be redeemed, (b) the date fixed for redemption, (c) the redemption price and (d) the place of payment of the redemption price. (e) If any such notice of redemption shall have been duly given or if the corporation shall have given to the bank or trust company hereinafter referred to irrevocable written authorization promptly to give or complete such notice, and if on or before the redemption date specified therein the funds necessary for such redemption shall have been deposited by the Corporation with the bank or trust company designated in such notice, doing business in the United States of America and having a capital, surplus and undivided profits aggregating at least $25,000,000 according to its last published statement of condition, in trust for the benefit of the holders of Series A Junior Participating Preferred Stock called for redemption, then, notwithstanding that any certificate for such shares so called for redemption shall not have been surrendered for cancellation, from and after the time of such deposit all such shares called for redemption shall no longer be deemed outstanding, all rights with respect to such shares shall no longer be deemed outstanding and all rights with respect to such shares shall forthwith cease and terminate, except the right of the holders thereof to receive from such bank or trust company at any time after the time of such deposit the funds so deposited, without interest, the right to exercise, up to the close of business on the fifth day before the date fixed for redemption, all privileges of conversion or exchange if any. In case less than all the shares represented by any surrendered certificate shall be redeemed, a new certificate shall be issued representing the unredeemed shares. Any interest accrued on such funds so deposited shall be paid to the Corporation from time to time. Any funds so deposited and unclaimed at the end of six years from such redemption date shall be repaid to the Corporation, after which the holders of shares of Series A Junior Participating Preferred Stock called for redemption shall look only to the Corporation for payment thereof; provided, however, that any funds so deposited which shall not be required for redemption because of the exercise of any privilege of conversion or exchange subsequent to the date of deposit shall be repaid to the Corporation forthwith. 9. Ranking. The Series A Junior Participating Preferred Stock shall rank junior to all other series of the Corporation's Preferred Stock as to the payment of dividends and the distribution of assets, unless the terms of any such series shall provide otherwise. 10. Amendment. The Articles of Incorporation of the Corporation shall not be further amended in any manner which would materially alter or change the powers, preferences or special rights of the Series A Junior Participating Preferred Stock so as to affect them adversely without the affirmative vote of the holders of at least a majority of the outstanding shares of Series A Junior Participating Preferred Stock, voting separately as a class. D. The designations, voting powers, preferences and relative, participating, optional and other special rights of the Series B Convertible Preferred Stock, and the qualifications, limitations or restrictions thereof are as follows: 1. Number of Shares and Designations. Two thousand (2,000) shares of the Preferred Stock, without par value, of the Corporation are constituted as a series thereof designated as Series B Convertible Preferred Stock (the "Series B Preferred Stock"). 2. Definitions. For purposes of the Series B Preferred Stock, the following terms shall have the meanings indicated: (a) "Accrued Dividends" shall have the meaning set forth in Section 4(a) below. (b) "Articles of Incorporation" shall mean the Articles of Incorporation of the Corporation, as amended from time to time. (c) "Board of Directors" shall mean the board of directors of the Corporation or any committee authorized by such board of directors to perform any of its responsibilities with respect to the Series B Preferred Stock. (d) "Business Day" shall mean any day other than a Saturday, Sunday or a day on which state or federally chartered banking institutions in New York, New York are not required to be open. (e) "Call Event" shall mean the consummation of a transaction pursuant to Section 2.2 of the Transaction Agreement. (f) "Common Stock" shall mean the common stock of the Corporation, without par value. (g) "Constituent Person" shall have the meaning set forth in Section 8(e) below. (h) "Conversion Price" shall mean the conversion price per share of Common Stock for which the Series B Preferred Stock is convertible, as such Conversion Price may be adjusted pursuant to Section 8 below. The initial conversion price will be $ 50.20. (i) "Current Market Price" of publicly traded shares of Common Stock or any other class of capital stock or other security of the Corporation or any other issuer for any day shall mean the last reported sales price, regular way on such day, or, if no sale takes place on such day, the average of the reported closing bid and asked prices on such day, regular way, in either case as reported on the New York Stock Exchange Composite Tape or, if such security is not listed or admitted for trading on the New York Stock Exchange ("NYSE"), on the principal national securities exchange on which such security is listed or admitted for trading or, if not listed or admitted for trading on any national securities exchange, on the National Market System of the National Association of Securities Dealers, Inc. Automated Quotations System ("NASDAQ") or, if such security is not quoted on such National Market System, the average of the closing bid and asked prices on such day in the over-the-counter market as reported by NASDAQ or, if bid and asked prices for such security on such day shall not have been reported through NASDAQ, the average of the bid and asked prices on such day as furnished by any NYSE member firm regularly making a market in such security selected for such purpose by the Board of Directors. (j) "Dividend Payment Date" shall mean the last business day of January, April, July and October in each year, commencing on the last business day of January, 1997, provided, however, that if any Dividend Payment Date falls on any day other than a Business Day, the dividend payment due on such Dividend Payment Date shall be paid on the Business Day immediately following such Dividend Payment Date. (k) "Dividend Periods" shall mean quarterly dividend periods commencing on the last business day of January, April, July and October of each year and ending on and including the day preceding the first day of the next succeeding Dividend Period (other than the initial Dividend Period, which shall commence on the Issue Date and end on and include January 30, 1997). (l) "Fair Market Value" shall mean the average of the daily Current Market Prices of a share of Common Stock during the five (5) consecutive Trading Days selected by the Corporation commencing not more than 20 Trading Days before, and ending not later than, the earlier of the day in question and the day before the "ex" date with respect to the issuance or distribution requiring such computation. The term "'ex' date," when used with respect to any issuance or distribution, means the first day on which the Common Stock trades regular way, without the right to receive such issuance or distribution, on the exchange or in the market, as the case may be, used to determine that day's Current Market Price. (m) "Issue Date" shall mean the first date on which shares of Series B Preferred Stock are issued and sold. (n) "Junior Stock" shall mean the Common Stock, the Series A Preferred Stock and any other class or series of shares of the Corporation over which the Series B Preferred Stock has preference or priority in the payment of dividends or in the distribution of assets on any liquidation, dissolution or winding up of the Corporation. (o) "Liquidation Preference" shall have the meaning set forth in Section 4(a) below. (p) "non-electing share" shall have the meaning set forth in Section 8(e) below. (q) "Person" shall mean any individual, firm, partnership, corporation or other entity, and shall include any successor (by merger or otherwise) of such entity. (r) "Put Event" shall mean the consummation of a transaction pursuant to Section 2.3 of the Transaction Agreement. (s) "Redemption Date" shall have the meaning set forth in Section 5(b) below. (t) "Rights" shall mean the rights of the Corporation which are issuable under the Corporation's Rights Agreement dated as of November 28, 1988, and as amended from time to time, or rights to purchase any capital stock of the Corporation under any successor shareholder rights plan or plans adopted in replacement of the Corporation's Rights Agreement. (u) "Securities" shall have the meaning set forth in Section 8(d)(3) below. (v) "Series A Preferred Stock" shall mean the series of Preferred Stock of the Corporation, without par value, designated Series A Junior Participating Preferred Stock. (w) "Series B Preferred Stock" shall have the meaning set forth in Section 1 above. (x) "set apart for payment" shall be deemed to include, without any action other than the following, the recording by the Corporation in its accounting ledgers of any accounting or bookkeeping entry which indicates, pursuant to a declaration of dividends or other distribution by the Board of Directors, the allocation of funds to be so paid on any series or class of capital stock of the Corporation; provided, however, that if any funds for any class or series of Junior Stock or any class or series of stock ranking on a parity with the Series B Preferred Stock as to the payment of dividends are placed in a separate account of the Corporation or delivered to a disbursing, paying or other similar agent, then "set apart for payment" with respect to the Series B Preferred Stock shall mean placing such funds in a separate account or delivering such funds to a disbursing, paying or other similar agent. (y) "Stated Value" shall have the meaning set forth in Section 4(a) below. (z) "Trading Day" shall mean any day on which the securities in question are traded on the NYSE, or if such securities are not listed or admitted for trading on the NYSE, on the principal national securities exchange on which such securities are listed or admitted, or if not listed or admitted for trading on any national securities exchange, on the National Market System of the NASDAQ, or if such securities are not quoted on such National Market System, in the applicable securities market in which the securities are traded. (aa) "Transaction" shall have the meaning set forth in Section D.8(e) hereof. (bb) "Transaction Agreement" shall mean that certain Transaction Agreement, dated as of December 30, 1994, by and among the Corporation and General Reinsurance Corporation. (cc) "Transfer Agent" means The First National Bank of Boston or such other agent or agents of the Corporation as may be designated by the Board of Directors as the transfer agent for the Series B Preferred Stock. 3. Dividends. (a) The holders of shares of the Series B Preferred Stock shall be entitled to receive, when, as and if declared by the Board of Directors out of assets legally available for that purpose, dividends payable in cash at the rate per annum of $650 per share of Series B Preferred Stock. Such dividends shall be cumulative from the Issue Date, whether or not in any Dividend Period or Periods there shall be assets of the Corporation legally available for the payment of such dividends, and shall be payable quarterly, when, as and if declared by the Board of Directors, in arrears on Dividend Payment Dates, commencing on January 31, 1997. Each such dividend shall be payable in arrears to the holders of record of shares of the Series B Preferred Stock, as they appear on the stock records of the Corporation at the close of business on such record dates, which shall not be more than 60 days nor less than 10 days preceding the payment dates thereof, as shall be fixed by the Board of Directors or a duly authorized committee thereof. Accrued and unpaid dividends for any past Dividend Periods may be declared and paid at any time, without reference to any Dividend Payment Date, to holders of record on such date, not exceeding 45 days preceding the payment date thereof, as may be fixed by the Board of Directors. (b) The amount of dividends payable for each full Dividend Period for the Series B Preferred Stock shall be computed by dividing the annual dividend rate by four. The amount of dividends payable for the initial Dividend Period, or any other period shorter or longer than a full Dividend Period, on the Series B Preferred Stock shall be computed on the basis of twelve 30-day months and a 360-day year. Holders of shares of Series B Preferred Stock shall not be entitled to any dividends, whether payable in cash, property or stock, in excess of cumulative dividends, as herein provided, on the Series B Preferred Stock. No interest, or sum of money in lieu of interest, shall be payable in respect of any dividend payment or payments on the Series B Preferred Stock that may be in arrears. (c) So long as any shares of the Series B Preferred Stock are outstanding, no dividends, except as described in the next succeeding sentence, shall be declared or paid or set apart for payment on any class or series of stock of the Corporation ranking, as to dividends and amounts distributable upon liquidation, dissolution or winding up, on a parity with the Series B Preferred Stock, for any period unless full cumulative dividends have been or contemporaneously are declared and paid or declared and a sum sufficient for the payment thereof set apart for such payment on the Series B Preferred Stock for all Dividend Periods terminating on or prior to the date of payment of the dividend on such class or series of parity stock. When dividends are not paid in full or a sum sufficient for such payment is not set apart, as aforesaid, all dividends declared upon shares of the Series B Preferred Stock and all dividends declared upon any other class or series of stock ranking on a parity as to dividends and amount distributable upon liquidation, dissolution or winding up shall be declared ratably in proportion to the respective amounts of dividends accumulated and unpaid on the Series B Preferred Stock and accumulated and unpaid on such parity stock. (d) So long as any shares of the Series B Preferred Stock are outstanding, no dividends (other than (i) the Rights and (ii) dividends or distributions paid in shares of, or options, warrants or rights to subscribe for or purchase shares of, Junior Stock) shall be declared or paid or set apart for payment or other distribution declared or made upon Junior Stock, nor shall any Junior Stock or any series of stock of the Corporation ranking, as to dividends and amounts distributable upon liquidation, dissolution or winding up, on a parity with Series B Preferred Stock be redeemed, purchased or otherwise acquired (other than a redemption, purchase or other acquisition of shares of Common Stock made for purposes of an employee incentive or benefit plan of the Corporation or any subsidiary) for any consideration (or any moneys be paid to or made available for a sinking fund for the redemption of any shares of any such stock) by the Corporation, directly or indirectly (except by conversion into or exchange for Junior Stock), unless in each case the full cumulative dividends on all outstanding shares of the Series B Preferred Stock and any other stock of the Corporation ranking on a parity with the Series B Preferred Stock, as to dividends and amounts distributable upon liquidation, dissolution or winding up shall have been paid or set apart for payment for all past Dividend Periods with respect to the Series B Preferred Stock and all past dividend periods with respect to such parity stock. 4. Payments upon Liquidation. (a) In the event of any liquidation, dissolution or winding up of the Corporation before any payment or distribution of the assets of the Corporation (whether capital or surplus) shall be made to or set apart for the holders of Junior Stock, the holders of the shares of Series B Preferred Stock shall be entitled to receive Ten Thousand Dollars ($10,000) per share of Series B Preferred Stock (the "Stated Value") plus an amount equal to all dividends (whether or not earned or declared) accrued and unpaid thereon ("Accrued Dividends") to the date of final distribution to such holders (the "Liquidation Preference"); but such holders shall not be entitled to any further payment. If, upon any liquidation, dissolution or winding up of the Corporation, the assets of the Corporation, or proceeds thereof, distributable among the holders of the shares of Series B Preferred Stock shall be insufficient to pay in full the Liquidation Preference, and the liquidation preference on all other shares of any class or series of stock ranking, as to dividends and amounts distributable upon liquidation, dissolution or winding up, on a parity with the Series B Preferred Stock, then such assets, or the proceeds thereof, shall be distributed among the holders of shares of Series B Preferred Stock and any such other parity stock ratably in accordance with the respective amounts that would be payable on such shares of Series B Preferred Stock and any such other stock if all amounts payable thereon were paid in full. For the purposes of this Section 4, (i) a consolidation or merger of the Corporation with one or more corporations, or (ii) a sale or transfer of all or substantially all of the Corporation's assets, shall not be deemed to be a liquidation, dissolution or winding up, voluntary or involuntary, of the Corporation. (b) Subject to the rights of the holders of shares of any series or class or classes of stock ranking on a parity with or prior to the Series B Preferred Stock as to dividends and amounts distributable upon liquidation, dissolution or winding up of the Corporation, after payment shall have been made to the holders of the Series B Preferred Stock, as and to the fullest extent provided in this Section 4, any other series or class or classes of Junior Stock shall, subject to the respective terms and provisions (if any) applying thereto, be entitled to receive any and all assets remaining to be paid or distributed, and the holders of the Series B Preferred Stock shall not be entitled to share therein. 5. Redemption at the Option of the Corporation. (a) The shares of Series B Preferred Stock shall be redeemable at the option of the Corporation by resolution of its Board of Directors, in whole (i) at any time on or after the fifth anniversary of the Issue Date or (ii) if on the date of a notice pursuant to Section 5(b) below, the Current Market Price of all Common Stock which would be issuable upon conversion of all of the 2,000 shares of Preferred Stock originally issued, as of any date within ten Business Days prior to such notice date, exceeded $22 million. In either case, such redemption shall be at the Stated Value, plus all dividends accrued and unpaid on the shares of Series B Preferred Stock up to the date fixed for the redemption, upon giving notice as provided hereinbelow. (b) At least 90 days prior to the date fixed for the redemption of shares of Series B Preferred Stock, a written notice shall be mailed in a postage prepaid envelope to each holder of record of the shares of Series B Preferred Stock to be redeemed, addressed to such holder at his post office address as shown on the records of the Corporation, notifying such holder of the election of the corporation to redeem such shares, stating the date fixed for redemption thereof (the "Redemption Date"), and calling upon such holder to surrender to the Corporation, on the Redemption Date at the place designated in such notice, his certificate or certificates representing the number of shares specified in such notice of redemption. On or after the Redemption Date, each holder of shares of Series B Preferred Stock to be redeemed shall present and surrender his certificate or certificates for such shares to the Corporation at the place designated in such notice and thereupon the redemption price of such shares shall be paid to or on the order of the person whose name appears on such certificate or certificates as the owner thereof and each surrendered certificate shall be canceled. In case less than all the shares represented by any such certificate are redeemed, a new certificate shall be issued representing the unredeemed shares. From and after the Redemption Date (unless default shall be made by the Corporation in payment of the redemption price), all dividends on the shares of Series B Preferred Stock designated for redemption in such notice shall cease to accrue, and all rights of the holders thereof as stockholders of the Corporation, except the right to receive the redemption price of such shares (including all accrued and unpaid dividends up to the Redemption Date) upon the surrender of certificates representing the same, shall cease and terminate and such shares shall not thereafter be transferred (except with the consent of the Corporation) on the books of the Corporation, and such shares shall not be deemed to be outstanding for any purpose whatsoever. At its election, the Corporation, prior to the Redemption Date, may deposit the redemption price (including all accrued and unpaid dividends up to the Redemption Date) of shares of Series B Preferred Stock so called for redemption in trust for the holders thereof with a bank or trust company (having a capital surplus and undivided profits aggregating not less than $50,000,000) in the Borough of Manhattan, City and State of New York, or in any other city in which the Corporation at the time shall maintain a transfer agency with respect to such shares, in which case the aforesaid notice to holders of shares of Series B Preferred Stock to be redeemed shall state the date of such deposit, shall specify the office of such bank or trust company as the place of payment of the redemption price, and shall call upon such holders to surrender the certificates representing such shares at such place on or after the date fixed in such redemption notice (which shall not be later than the Redemption Date) against payment of the redemption price (including all accrued and unpaid dividends up to the Redemption Date). Any interest accrued on such funds shall be paid to the Corporation from time to time. Any moneys so deposited which shall remain unclaimed by the holders of such shares of Series B Preferred Stock at the end of two years after the Redemption Date shall be returned by such bank or trust company to the Corporation. If a notice of redemption has been given pursuant to this Section 5 and any holder of shares of Series B Preferred Stock shall, prior to the close of business on the day preceding the Redemption Date, give written notice to the Corporation pursuant to Section 8 below of the conversion of any or all of the shares to be redeemed held by such holder (accompanied by a certificate or certificates for such shares, duly endorsed or assigned to the Corporation, and any necessary transfer tax payment, as required by Section 8 below), then such redemption shall not become effective as to such shares to be converted, such conversion shall become effective as provided in Section 8 below, and any moneys set aside by the Corporation for the redemption of such shares of converted Series B Preferred Stock shall revert to the general funds of the Corporation. 6. Redemption at the Option of the Holder. The Corporation, when requested to do so in writing by a holder of Series B Preferred Stock at any time after the earlier of (i) the eighth anniversary of an Issue Date pursuant to a Call Event or (ii) the fifth anniversary of an Issue Date pursuant to a Put Event, shall purchase or redeem the share or shares of Series B Preferred Stock identified by such holder, such purchase or redemption to occur on a date not more than thirty days after receipt by the Corporation of such request, at the Stated Value of the share or shares to be purchased or redeemed, plus all dividends accrued and unpaid on such share or shares up to the date of such purchase or redemption. 7. Shares to Be Retired. All shares of Series B Preferred Stock which shall have been issued and reacquired in any manner by the Corporation shall be restored to the status of authorized but unissued shares of Preferred Stock, without designation as to series. 8. Conversion. Holders of shares of Series B Preferred Stock shall have the right to convert all or a portion of such shares into shares of Common Stock, as follows: (a) Subject to and upon compliance with the provisions of this Section 8, a holder of shares of Series B Preferred Stock shall have the right, at its option, at any time after 5 Business Days after the Issue Date, to convert such shares into the number of fully paid and nonassessable shares of Common Stock obtained by dividing the aggregate Stated Value of such shares by the Conversion Price (as in effect on the date provided for in the last paragraph of Section 8(b)) by surrendering such shares to be converted, such surrender to be made in the manner provided in Section 8(b); provided, however, that the right to convert shares called for redemption pursuant to Section D.5 of this article shall terminate at the close of business on the day preceding the Redemption Date, unless the Corporation shall default in making payment of the cash payable upon such redemption under Section D.5 of this article. Certificates will be issued for the remaining shares of Series B Preferred Stock in any case in which fewer than all of the shares of Series B Preferred Stock represented by a certificate are converted. (b) In order to exercise the conversion right, the holder of shares of Series B Preferred Stock to be converted shall surrender the certificate or certificates representing such shares, duly endorsed or assigned to the Corporation or in blank, at the office of the Transfer Agent in the Borough of Manhattan, City of New York, accompanied by written notice to the Corporation that the holder thereof elects to convert Series B Preferred Stock. Unless the shares issuable on conversion are to be issued in the same name as the name in which such share of Series B Preferred Stock is registered, each share surrendered for conversion shall be accompanied by instruments of transfer, in form satisfactory to the Corporation, duly executed by the holder or such holder's duly authorized attorney and an amount sufficient to pay any transfer or similar tax (or evidence reasonably satisfactory to the Corporation demonstrating that such taxes have been paid). Holders of shares of Series B Preferred Stock at the close of business on a dividend payment record date shall be entitled to receive the dividend payable on such shares on the corresponding Dividend Payment Date notwithstanding the conversion thereof following such dividend payment record date and prior to such Dividend Payment Date. Except as provided above, the Corporation shall make no payment or allowance for unpaid dividends, whether or not in arrears, on converted shares or for dividends on the shares of Common Stock issued upon such conversion. As promptly as practicable after the surrender of certificates for shares of Series B Preferred Stock as aforesaid, the Corporation shall issue and shall deliver at such office to such holder, or on his or her written order, a certificate or certificates for the number of full shares of Common Stock issuable upon the conversion of such shares in accordance with provisions of this Section 8, and any fractional interest in respect of a share of Common Stock arising upon such conversion shall be settled as provided in Section 8(c). Each conversion shall be deemed to have been effected immediately prior to the close of business on the date on which the certificates for shares of Series B Preferred Stock shall have been surrendered and such notice (and if applicable, payment of an amount equal to the dividend payable on such shares) received by the Corporation as aforesaid, and the person or persons in whose name or names any certificate or certificates for shares of Common Stock shall be issuable upon such conversion shall be deemed to have become the holder or holders of record of the shares represented thereby at such time on such date and such conversion shall be at the Conversion Price in effect at such time on such date, unless the stock transfer books of the Corporation shall be closed on that date, in which event such person or persons shall be deemed to have become such holder or holders of record at the close of business on the next succeeding day on which such stock transfer books are open, but such conversion shall be at the Conversion Price in effect on the date upon which such shares shall have been surrendered and such notice received by the Corporation. (c) No fractional shares or scrip representing fractions of shares of Common Stock shall be issued upon conversion of the Series B Preferred Stock. Instead of any fractional interest in a share of Common Stock that would otherwise be deliverable upon the conversion of a share of Series B Preferred Stock, the Corporation shall pay to the holder of such share an amount in cash based upon the Current Market Price of Common Stock on the Trading Day immediately preceding the date of conversion. If more than one share shall be surrendered for conversion at one time by the same holder, the number of full shares of Common Stock issuable upon conversion thereof shall be computed on the basis of the aggregate number of shares of Series B Preferred Stock so surrendered. (d) The Conversion Price shall be adjusted from time to time as follows: (1) If the Corporation shall after the Issue Date (A) pay a dividend or make a distribution on its capital stock in shares of its Common Stock, (B) subdivide its outstanding Common Stock into a greater number of shares, (C) combine its outstanding Common Stock into a smaller number of shares or (D) issue any shares of capital stock by reclassification of its Common Stock, the Conversion Price in effect at the opening of business on the day next following the date fixed for the determination of stockholders entitled to receive such dividend or distribution or at the opening of business on the day next following the day on which such subdivision, combination or reclassification becomes effective, as the case may be, shall be adjusted so that the holder of any share of Series B Preferred Stock thereafter surrendered for conversion shall be entitled to receive the number of shares of Common Stock that such holder would have owned or have been entitled to receive after the happening of any of the events described above had such share been converted immediately prior to the record date in the case of a dividend or distribution or the effective date in the case of a subdivision, combination or reclassification. An adjustment made pursuant to this subparagraph (a) shall become effective immediately after the opening of business on the day next following the record date (except as provided in Section 8(h) below) in the case of a dividend or distribution and shall become effective immediately after the opening of business on the day next following the effective date in the case of a subdivision, combination or reclassification. (2) If the Corporation shall issue after the Issue Date rights or warrants (in each case, other than the Rights) to all holders of Common Stock entitling them (for a period expiring within 45 days after the record date mentioned below) to subscribe for or purchase Common Stock at a price per share less than the Fair Market Value per share of Common Stock on the record date for the determination of stockholders entitled to receive such rights or warrants, then the Conversion Price in effect at the opening of business on the day next following such record date shall be adjusted to equal the price determined by multiplying (I) the Conversion Price in effect immediately prior to the opening of business on the day next following the date fixed for such determination by (II) a fraction, the numerator of which shall be the sum of (A) the number of shares of Common Stock outstanding on the close of business on the date fixed for such determination and (B) the number of shares that the aggregate proceeds to the Corporation from the exercise of such rights or warrants for Common Stock would purchase at such Fair Market Value, and the denominator of which shall be the sum of (A) the number of shares of Common Stock outstanding on the close of business on the date fixed for such determination and (B) the number of additional shares of Common Stock offered for subscription or purchase pursuant to such rights or warrants. Such adjustment shall become effective immediately after the opening of business on the day next following such record date (except as provided in Section 8(h) below). In determining whether any rights or warrants entitle the holders of Common Stock to subscribe for or purchase shares of Common Stock at less than such Fair Market Value, there shall be taken into account any consideration received by the Corporation upon issuance and upon exercise of such rights or warrants, the value of such consideration, if other than cash, to be determined by the Board of Directors. (3) If the Corporation shall distribute to all holders of its Common Stock any shares of capital stock of the Corporation (other than Common Stock) or evidence of its indebtedness or assets (excluding cash dividends or distributions paid from profits or surplus of the Corporation) or rights or warrants (in each case, other than the Rights) to subscribe for or purchase any of its securities (excluding those rights and warrants issued to all holders of Common Stock entitling them for a period expiring within 45 days after the record date referred to in subparagraph (b) above to subscribe for or purchase Common Stock, which rights and warrants are referred to in and treated under subparagraph (b) above (any of the foregoing being hereinafter in this subparagraph (3) called the "Securities"), then in each such case the Conversion Price shall be adjusted so that it shall equal the price determined by multiplying (I) the Conversion Price in effect immediately prior to the close of business on the date fixed for the determination of stockholders entitled to receive such distribution by (II) a fraction, the numerator of which shall be the Fair Market Value per share of the Common Stock on the record date mentioned below less the then fair market value (as determined by the Board of Directors, whose determination shall be conclusive) of the portion of the capital stock or assets or evidences of indebtedness so distributed or of such rights or warrants applicable to one share of Common Stock, and the denominator of which shall be the Fair Market Value per share of the Common Stock on the record date mentioned below. Such adjustment shall become effective immediately at the opening of business on the Business Day next following (except as provided in Section 8(h) below) the record date for the determination of shareholders entitled to receive such distribution. For the purposes of this clause (c), the distribution of a Security, which is distributed not only to the holders of the Common Stock on the date fixed for the determination of stockholders entitled to such distribution of such security, but also is distributed with each share of Common Stock delivered to a person converting a share of Series B Preferred Stock after such determination date, shall not require an adjustment of the Conversion Price pursuant to this clause (c); provided that on the date, if any, on which a Person converting a share of Series B Preferred Stock would no longer be entitled to receive such Security with a share of Common Stock (other than as a result of the termination of all such Securities), a distribution of such Securities shall be deemed to have occurred and the Conversion Price shall be adjusted as provided in this clause (c) (and such day shall be deemed to be "the date fixed for the determination of the stockholders entitled to receive such distribution" and "the record date" within the meaning of the two preceding sentences). (4) No adjustment in the Conversion Price shall be required unless such adjustment would require a cumulative increase or decrease of at least 1% in such price; provided, however, that any adjustments that by reason of this subparagraph (4) are not required to be made shall be carried forward and taken into account in any subsequent adjustment until made; and provided, further, that any adjustment shall be required and made in accordance with the provisions of this Section 8 (other than this subparagraph (4)) not later than such time as may be required in order to preserve the tax-free nature of a distribution to the holders of shares of Common Stock. Notwithstanding any other provisions of this Section 8, the Corporation shall not be required to make any adjustment of the Conversion Price for the issuance of any shares of Common Stock pursuant to any plan providing for the reinvestment of dividends on securities of the Corporation. All calculations under this Section 8 shall be made to the nearest cent (with $.005 being rounded upward) or to the nearest 1/10 of a share (with .05 of a share being rounded upward), as the case may be. Anything in this Section 8(d) to the contrary notwithstanding, the Corporation shall be entitled, to the extent permitted by law, to make such reductions in the Conversion Price, in addition to those required by this Section 8(d), as it in its discretion shall determine to be advisable in order that any stock dividends, subdivision of shares, reclassification or combination of shares, distribution of rights or warrants to purchase stock or securities, or a distribution of other assets (other than cash dividends) hereafter made by the Corporation to its stockholders shall not be taxable. (e) If the Corporation shall be a party to any transaction (including without limitation a merger, consolidation, sale of all or substantially all of the Corporation's assets or recapitalization of the Common Stock and excluding any transaction as to which Section 8(d)(1) applies) (each of the foregoing being referred to herein as a "Transaction"), in each case as a result of which shares of Common Stock shall be converted into the right to receive stock, securities or other property (including cash or any combination thereof), each share of Series B Preferred Stock which is not converted into the right to receive stock, securities or other property in connection with such Transaction shall thereafter be convertible into the kind and amount of shares of stock, securities and other property (including cash or any combination thereof) receivable upon the consummation of such Transaction by a holder of that number of shares or fraction thereof of Common Stock into which one share of Series B Preferred Stock was convertible immediately prior to such Transaction, assuming such holder of Common Stock (i) is not a Person with which the Corporation consolidated or into which the Corporation merged or which merged into the Corporation or to which such sale or transfer was made, as the case may be ("Constituent Person"), or an affiliate of a Constituent Person and (ii) failed to exercise his rights of election, if any, as to the kind or amount of stock, securities and other property (including cash) receivable upon such Transaction (provided that if the kind or amount of stock, securities and other property (including cash) receivable upon such Transaction is not the same for each share of Common Stock of the Corporation held immediately prior to such Transaction by other than a Constituent Person or an affiliate thereof and in respect of which such rights of election shall not have been exercised ("non-electing share"), then for the purpose of this Section 8(e) the kind and amount of stock, securities and other property (including cash) receivable upon such Transaction by each non-electing share shall be deemed to be the kind and amount so receivable per share by the plurality of the non-electing shares). The Corporation shall not be a party to any Transaction unless the terms of such Transaction are consistent with the provisions of this Section 8(e) and it shall not consent or agree to the occurrence of any Transaction until the Corporation has entered into an agreement with the successor or purchasing entity, as the case may be, for the benefit of the holders of the Series B Preferred Stock that will contain provisions enabling the holders of the Series B Preferred Stock that remains outstanding after such Transaction to convert into the consideration received by holders of Common Stock at the Conversion Price in effect immediately prior to such Transaction. The provisions of this Section 8(e) shall similarly apply to successive Transactions. (f) If: (1) the Corporation shall declare a dividend (or any other distribution) on the Common Stock (other than in cash out of profits or surplus and other than the Rights); or (2) the Corporation shall authorize the granting to the holders of the Common Stock of rights or warrants (other than the Rights) to subscribe for or purchase any shares of any class or any other rights or warrants (other than the Rights); or (3) there shall be any reclassification of the Common Stock (other than an event to which Section 8(d)(1) applies) or any consolidation or merger to which the Corporation is a party and for which approval of any stockholders of the Corporation is required, or the sale or transfer of all or substantially all of the assets of the Corporation as an entirety; or (4) there shall occur the voluntary or involuntary liquidation, dissolution or winding up of the Corporation, then the Corporation shall cause to be filed with the Transfer Agent and shall cause to be mailed to the holders of shares of the Series B Preferred Stock at their addresses as shown on the stock records of the Corporation, as promptly as possible, but at least 15 days prior to the applicable date hereinafter specified, a notice stating (A) the date on which a record is to be taken for the purpose of such dividend, distribution or rights or warrants, or, if a record is not to be taken, the date as of which the holders of Common Stock of record to be entitled to such dividend, distribution or rights or warrants are to be determined or (B) the date on which such reclassification, consolidation, merger, sale, transfer, liquidation, dissolution or winding up is expected to become effective, and the date as of which it is expected that holders of Common Stock of record shall be entitled to exchange their shares of Common Stock for securities or other property, if any, deliverable upon such reclassification, consolidation, merger, sale, transfer, liquidation, dissolution or winding up. Failure to give or receive such notice or any defect therein shall not affect the legality or validity of the proceedings described in this Section 8. (g) Whenever the Conversion Price is adjusted as herein provided, the Corporation shall promptly file with the Transfer Agent an officer's certificate setting forth the Conversion Price after such adjustment and setting forth a brief statement of the facts requiring such adjustment which certificate shall be prima facie evidence of the correctness of such adjustment. Promptly after delivery of such certificate, the Corporation shall prepare a notice of such adjustment of the Conversion Price setting forth the adjusted Conversion Price and the effective date of such adjustment and shall mail such notice of such adjustment of the Conversion Price to the holder of each share of Series B Preferred Stock at such holder's last address as shown on the stock records of the Corporation. (h) In any case in which Section 8(d) provides that an adjustment shall become effective on the day next following a record date for an event, the Corporation may defer until the occurrence of such event (A) issuing to the holder of any share of Series B Preferred Stock converted after such record date and before the occurrence of such event the additional shares of Common Stock issuable upon such conversion by reason of the adjustment required by such event over and above the Common Stock issuable upon such conversion before giving effect to such adjustment and (B) paying to such holder any amount in cash in lieu of any fraction pursuant to Section 8(c). (i) For purposes of this Section 8, the number of shares of Common Stock at any time outstanding shall not include any shares of Common Stock then owned or held by or for the account of the Corporation. (j) There shall be no adjustment of the Conversion Price in case of the issuance of any stock of the Corporation in a reorganization, acquisition or other similar transaction except as specifically set forth in this Section 8. If any action or transaction would require adjustment of the Conversion Price pursuant to more than one paragraph of this Section 8, only one adjustment shall be made and such adjustment shall be the amount of adjustment that has the highest absolute value. (k) If the Corporation shall take any action affecting the Common Stock, other than action described in this Section 8, that in the opinion of the Board of Directors would materially adversely affect the conversion rights of the holders of the shares of Series B Preferred Stock, the Conversion Price for the Series B Preferred Stock may be adjusted, to the extent permitted by law, in such manner, if any, and at such time, as the Board of Directors may determine to be equitable in the circumstances. (l) The Corporation covenants that it will at all times reserve and keep available, free from preemptive rights, out of the aggregate of its authorized but unissued shares of Common Stock for the purpose of effecting conversion of the Series B Preferred Stock, the full number of shares of Common Stock deliverable upon the conversion of all outstanding shares of Series B Preferred Stock not theretofore converted. For purposes of this Section 8.(l)., the number of shares of Common Stock that shall be deliverable upon the conversion of all outstanding shares of Series B Preferred Stock shall be computed as if at the time of computation all such outstanding shares were held by a single holder. The Corporation covenants that any shares of Common Stock issued upon conversion of the Series B Preferred Stock shall be validly issued, fully paid and non-assessable. Before taking any action that would cause an adjustment reducing the Conversion Price below the then-par value of the shares of Common Stock deliverable upon conversion of the Series B Preferred Stock, the Corporation will take any corporate action that, in the opinion of its counsel, may be necessary in order that the Corporation may validly and legally issue fully-paid and nonassessable shares of Common Stock at such adjusted Conversion Price. (m) The Corporation will pay any and all documentary stamp or similar issue or transfer taxes payable in respect of the issue or delivery of shares of Common Stock or other securities or property on conversion of the Series B Preferred Stock pursuant hereto; provided, however, that the Corporation shall not be required to pay any tax that may be payable in respect of any transfer involved in the issue or delivery of shares of Common Stock or other securities or property in a name other than that of the holder of the Series B Preferred Stock to be converted and no such issue or delivery shall be made unless and until the person requesting any issue or delivery has paid to the Corporation the amount of any such tax or established, to the reasonable satisfaction of the Corporation, that such tax has been paid. 9. Ranking. Any class or series of stock of the Corporation shall be deemed to rank: (a) prior to the Series B Preferred Stock, as to the payment of dividends and as to distributions of assets upon liquidation, dissolution or winding up, if the holders of such class or series shall be entitled to the receipt of dividends and of amounts distributable upon liquidation, dissolution or winding up in preference or priority to the holders of Series B Preferred Stock; (b) on a parity with the Series B Preferred Stock, as to the payment of dividends and as to distribution of assets upon liquidation, dissolution or winding up, whether or not the dividend rates, dividend payment dates or redemption or liquidation prices per share thereof be different from those of the Series B Preferred Stock if the holders of such class of stock or series and the Series B Preferred Stock shall be entitled to the receipt of dividends and of amounts distributable upon liquidation, dissolution or winding up in proportion to their respective amounts of accrued and unpaid dividends per share or liquidation preferences, without preference or priority one over the other; and (c) junior to the Series B Preferred Stock, as to the payment of dividends or as to the distribution of assets upon liquidation, dissolution or winding up, if such stock or series shall be Common Stock or Series A Preferred Stock or if the holders of Series B Preferred Stock shall be entitled to receipt of dividends or of amounts distributable upon liquidation, dissolution or winding up in preference or priority to the holders of shares of such stock or series. 10. Voting. (a) The holders of shares of Series B Preferred Stock shall have the following voting rights: 1. Subject to the provision for adjustment hereinafter set forth, each share of Series B Preferred Stock shall entitle the holder thereof to 199 votes on all matters submitted to a vote of the shareholders of the Corporation. In the event the Corporation shall at any time after the Issue Date (i) declare any dividend on Common Stock payable in shares of Common Stock, (ii) subdivide the outstanding Common Stock, or (iii) combine the outstanding Common Stock into a smaller number of shares, then in each such case the number of votes per share to which holders of shares of Series B Preferred Stock were entitled immediately prior to such event shall be adjusted by multiplying such number by a fraction the numerator of which is the number of shares of Common Stock outstanding immediately after such event and the denominator of which is the number of shares of Common Stock that were outstanding immediately prior to such event. 2. Except as otherwise provided herein or by law, the holders of shares of Series B Preferred Stock and the holders of shares of Common Stock shall vote together as one class on all matters submitted to a vote of shareholders of the Corporation. (b) Unless the affirmative vote or consent of the holders of a greater number of shares shall then be required by law, the consent of the holders of at least 66 2/3% of all of the outstanding shares of Series B Preferred Stock (in addition to any vote required by the terms of any other affected series of Preferred Stock ranking on a parity with the Series B Preferred Stock as to dividends and amounts distributable upon liquidation, dissolution and winding up), given in person or by proxy, either in writing or by a vote at a meeting called for the purpose, at which the holders of shares of Series B Preferred Stock and such other series of Preferred Stock shall vote together as a single class without regard to series, shall be necessary for authorizing, effecting or validating the amendment, alteration or repeal of any of the provisions of the Articles of Incorporation or of any certificate amendatory thereof or supplemental thereto (including any Certificate of Designations, Preferences and Rights or any similar document relating to any series of Preferred Stock) which would materially adversely affect the preferences, rights, powers or privileges of the Series B Preferred Stock; provided, however, that the amendment of the provisions of the Articles of Incorporation so as to authorize or create, or to increase the authorized amount of, any Junior Stock or any shares of any class ranking on a parity with the Series B Preferred Stock shall not be deemed to materially adversely affect the preferences, rights, powers or privileges of Series B Preferred Stock. (c) Unless the affirmative vote or consent of the holders of a greater number of shares shall then be required by law, the consent of the holders of at least 66 2/3% of all of the outstanding shares of Series B Preferred Stock (in addition to any vote required by the terms of any other series of Preferred Stock ranking on a parity with the Series B Preferred Stock as to dividends and amounts distributable upon liquidation, dissolution or winding up), given in person or by proxy, either in writing or by a vote at a meeting called for the purpose at which the holders of shares of Series B Preferred Stock and such other series of Preferred Stock shall vote together as a single class without regard to series, shall be necessary for authorizing, effecting or validating the creation, authorization or issue of any shares of any class of stock of the Corporation ranking prior to the Series B Preferred Stock as to dividends or upon liquidation, dissolution or winding up, or the reclassification of any authorized stock of the Corporation into any such prior shares, or the creation, authorization or issuance of any obligation or security convertible into or evidencing the right to purchase any such prior shares. (d) For purposes of the provisions of Sections 10(b) and 10(c), each share of Series B Preferred Stock shall have one (1) vote per share. (e) Except as set forth herein, holders of Series B Preferred Stock shall have no special voting rights and their consent shall not be required (except to the extent they are entitled to vote with holders of Common Stock as set forth herein) for taking any corporate action. 11. Record Holders. The Corporation and the Transfer Agent may deem and treat the record holder of any shares of Series B Preferred Stock as the true and lawful owner thereof for all purposes, and neither the Corporation nor the Transfer Agent shall be affected by any notice to the contrary. Article V The corporate office shall be in Hartford or in such other town in Connecticut as the Board of Directors may determine. The annual meeting of the shareholders shall be held at such time and place within the state and upon such notice as may be determined from time to time either by or in accordance with the bylaws. At all meetings of the shareholders and subject, in the case of preferred shareholders, to such provisions concerning voting rights as the Board of Directors may determine pursuant to the authority granted in Article III hereof, each shareholder shall be entitled to vote in person or by an attorney duly authorized by a written proxy and each share of common stock represented at such meetings shall be entitled to one vote. Article VI The business property and affairs of the Corporation shall be managed by or under the direction of a Board of Directors consisting of the number of directors fixed from time to time by resolution adopted by the affirmative vote of a majority of the entire Board of Directors. The directors shall be divided into three classes, designated Class I, Class II and Class III. Each class shall consist, as nearly as may be possible, of one-third of the total number of directors constituting the entire Board of Directors. The directors initially elected to Class I shall serve for a term expiring at the annual meeting of shareholders next following the end of the calendar year 1997, the directors initially elected to Class II shall serve for a term expiring at the annual meeting of shareholders next following the end of the calendar year 1998 and the directors initially elected to the third class shall serve for a term expiring at the annual meeting of shareholders next following the end of the calendar year 1998. At each annual meeting of shareholders, successors to the class of directors whose term expires at the annual meeting shall be elected for a three-year term. If the number of directors is changed, any increase or decrease shall be apportioned among the classes so as to maintain the number of directors in each class as nearly equal as possible, and any additional director of any class elected to fill a vacancy resulting from an increase in such class shall hold office for a term that shall coincide with the remaining term of that class, but in no case will a reduction of the number of directors remove any director in office or shorten the term of any incumbent director. A director shall hold office until the annual meeting for the year in which his term expires and until his successor shall be elected and shall qualify, subject, however, to prior death, resignation, removal from office or order of court that, by reason of incompetency or any other lawful cause, he is no longer a director in office. Any vacancy on the Board of Directors that results from an increase in the number of directors may be filled by the concurring vote of directors holding a majority of the directorships, which number of directorships shall be the number prior to the vote on the increase, and any other vacancy occurring in the Board of Directors may be filled by concurring vote of a majority of the remaining directors then in office, although less than a quorum, or by a sole remaining director. Any director elected to fill a vacancy not resulting from an increase in the number of directors shall have the same remaining term as that of his predecessor. Any director or the entire Board of Directors may be removed only for cause by the affirmative vote of eighty percent (80%) of the votes entitled to be cast by the holders of all then outstanding shares of voting stock of the Corporation, voting together as a single class. For the purposes of this Article VI, "cause" shall be defined as (a) a final non-appealable order of conviction of a felony involving moral turpitude by a court of competent jurisdiction in the United States or (b) a final non-appealable order of a court of competent jurisdiction in the United States finding gross negligence in the performance of duties as a director or officer of the Corporation. Notwithstanding the foregoing, whenever the holders of any one or more classes or series of preferred stock issued by the Corporation shall have the right, voting separately by class or series, to elect directors at an annual or special meeting of shareholders, the election, term of office, filling of vacancies and other features of such directorships shall be governed by the terms of these Articles applicable thereto, and such directors so elected shall not be divided into classes pursuant to this Article VI unless expressly provided by such term. Notwithstanding any other provisions of these Articles or the bylaws of the Corporation (and notwithstanding the fact that a lesser percentage or separate class vote may be specified by law, these Articles or the bylaws of the Corporation) the affirmative vote of the holders of not less than eighty percent (80%) of the votes entitled to be cast by the holders of all then outstanding shares of voting stock of the Corporation, voting together as a single class, shall be required to amend or repeal, or adopt any provisions inconsistent with this Article VI; provided, however, that this paragraph shall not apply to, and such eighty percent (80%) vote shall not be required for any amendment, repeal or adoption recommended by three-quarters of the entire Board if all of such directors are persons who were members of the Board at the annual meeting of shareholders of the Corporation held prior to the proposal of any such amendment, repeal or adoption or persons nominated by such members. Article VII A. In addition to any affirmative vote required by law or these Articles or the bylaws of the Corporation, and except as otherwise expressly provided in Section B of this Article VII, a Business Combination (as hereinafter defined) shall require the affirmative vote of not less than eighty percent (80%) of the votes entitled to be cast by the holders of all then outstanding shares of Voting Stock (as hereinafter defined), voting together as a single class. Such affirmative vote shall be required notwithstanding the fact that no vote may be required, or that a lesser percentage or separate class vote may be specified, by law or in any agreement with any national securities exchange or otherwise. B. The provisions of Section A of this Article VII shall not be applicable to any particular Business Combination, and such Business Combination shall require only such affirmative vote, if any, as is required by law or by any other provision of these Articles or the bylaws of the Corporation, or any agreement with any national securities exchange, if all of the conditions specified in either of the following Paragraphs 1 or 2 are met: 1. The Business Combination shall have been approved by two-thirds (whether such approval is made prior to or subsequent to the acquisition of beneficial ownership of the Voting Stock that caused the Interested Shareholder, as hereinafter defined to become an Interested Shareholder) of the Continuing Directors, as hereinafter defined. 2. All of the following conditions shall have been met: (a) The aggregate amount of cash and the Fair Market Value (as hereinafter defined) as of the date of the consummation of the Business Combination of consideration other than cash to be received per share by holders of Common Stock in such Business Combination shall be at least equal to the highest amount determined under clauses (i), (ii), (iii) and (iv) below: (i) (if applicable) the highest per share price (including any brokerage commissions, transfer taxes and soliciting dealers' fees) paid by or on behalf of the Interested Shareholder for any share of Common Stock in connection with the acquisition by the Interested Shareholder of beneficial ownership of shares of Common Stock within the two-year period immediately prior to the first public announcement of the proposed Business Combination (the "Announcement Date"); (ii)the Fair Market Value per share of Common Stock on the Announcement Date or on the date on which the Interested Shareholder became an Interested Shareholder (the "Determination Date"), whichever is higher; (iii)(if applicable) the price per share equal to the Fair Market Value per share of Common Stock determined pursuant to the immediately preceding clause (ii), multiplied by the ratio of (x) the highest per share price (including any brokerage commissions, transfer taxes and soliciting dealers' fees) paid by or on behalf of the Interested Shareholder for any share of Common Stock in connection with the acquisition by the Interested Shareholder of beneficial ownership of shares of Common Stock within the two-year period immediately prior to the Announcement Date to (y) the Fair Market Value per share of Common Stock on the first day in such two-year period on which the Interested Shareholder acquired beneficial ownership of any share of Common Stock; and (iv) The Corporation's net income per share of Common Stock for the four full consecutive fiscal quarters immediately preceding the Announcement Date, multiplied by the higher of the then price/earnings multiple (if any) with respect to common stock of such Interested Shareholder or the highest price/earnings multiple with respect to Common Stock within the two-year period immediately preceding the Announcement Date (such price/earnings multiples being determined as customarily computed and reported in the financial community); (b) The aggregate amount of cash and the Fair Market Value as of the date of the consummation of the Business Combination of consideration other than cash to be received per share by holders of shares of any class or series of outstanding Capital Stock (as hereinafter defined), other than Common Stock, shall be at least equal to the highest amount determined under clauses (i), (ii), (iii) and (iv) below: (i) (if applicable) the highest per share price (including any brokerage commissions, transfer taxes and soliciting dealers' fees) paid by or on behalf of the Interested Shareholder for any share of such class or series of Capital Stock in connection with the acquisition by the Interested Shareholder of beneficial ownership of shares of such class or series of Capital Stock within the two-year period immediately prior to the Announcement Date; (ii) the Fair Market Value per share of such class or series of Capital Stock on the Announcement Date or on the Determination Date, whichever is higher; (iii) (if applicable) the price per share equal to the Fair Market Value per share of such class or series of Capital Stock determined pursuant to the immediately preceding clause (ii), multiplied by the ratio of (x) the highest per share price (including any brokerage commissions, transfer taxes and soliciting dealers' fees) paid by or on behalf of the Interested Shareholder for any share of such class or series of the Capital Stock in connection with the acquisition by the Interested Shareholder of beneficial ownership of shares of such class or series of Capital Stock within the two-year period immediately prior to the Announcement Date to (y) the Fair Market Value per share of such class or series of Capital Stock on the first day in such two-year period on which the Interested Shareholder acquired beneficial ownership of any share of such class or series of Capital Stock; and (iv) (if applicable) the highest preferential amount per share to which the holders of shares of such class or series of Capital Stock would be entitled in the event of any voluntary or involuntary liquidation, dissolution or winding up of the affairs of the Corporation, regardless of whether the Business Combination to be consummated constitutes such an event. The provision of this paragraph 2(b) shall be required to be met with respect to every class or series of outstanding Capital Stock, whether or not the Interested Shareholder has previously acquired beneficial ownership of any shares of a particular class or series of Capital Stock. (c) The consideration to be received by holders of a particular class or series of outstanding Capital Stock shall be in cash or in the same form as previously has been paid by or on behalf of the Interested Shareholder in connection with its direct or indirect acquisition of beneficial ownership of shares of such class or series of Capital Stock. If the consideration so paid for shares of any class or series of Capital Stock varied as to form, the form of consideration for such class or series of Capital Stock shall be either cash or the form used to acquire beneficial ownership of the largest number of shares of such class or series of Capital Stock previously acquired by the Interested Shareholder. (d) After such Interested Shareholder has become an Interested Shareholder and prior to the consummation of such Business Combination: (i) except as approved by two-thirds of the Continuing Directors, there shall have been no failure to declare and pay at the regular date therefor any full quarterly dividends (whether or not cumulative) payable in accordance with the terms of any outstanding Capital Stock; (ii) there shall have been no reduction in the annual rate of dividends paid on the Common Stock (except as necessary to reflect any stock split, stock dividend or subdivision of the Common Stock), except as approved by two-thirds of the Continuing Directors; (iii) there shall have been an increase in the annual rate of dividends paid on the Common Stock as necessary to reflect fully any reclassification (including any reverse stock split), recapitalization, reorganization or any similar transaction that has the effect of reducing the number of outstanding shares of Common Stock, unless the failure so to increase such annual rate is approved by two-thirds of the Continuing Directors; and (iv) such Interested Shareholder shall not have become the beneficial owner of any additional shares of Capital Stock except as part of the transaction that results in such Interested Shareholder becoming an Interested Shareholder and except in a transaction that, after giving effect thereto, would not result in any increase in the Interested Shareholder's percentage beneficial ownership of any class or series of Capital Stock. (e) After such Interested Shareholder has become an Interested Shareholder, such Interested Shareholder shall not have received the benefit, directly or indirectly (except proportionately as a shareholder of this Corporation), of any loans, advances, guarantees, pledges or other financial assistance or any tax credits or other tax advantages provided by this Corporation, whether in anticipation of or in connection with such Business Combination or otherwise. (f) A proxy or information statement describing the proposed Business Combination and complying with the requirements of the Securities Exchange Act of 1934 and the rules and regulations thereunder (the "Act") (or any subsequent provisions replacing such Act, rules and regulations) or the insurance laws and regulations of the State of Connecticut, if applicable, shall be mailed to all shareholders of the Corporation at least 30 days prior to the consummation of such Business Combination (whether or not such proxy or information statement is required by law to be mailed). The proxy or information statement shall contain on the first page thereof, in a prominent place, any statement as to the advisability (or inadvisability) of the Business Combination that the Continuing Directors, or any of them, may choose to make and, if deemed advisable by a majority of the Continuing Directors, the opinion of an investment banking firm selected by a majority of the Continuing Directors as to the fairness (or not) of the terms of the Business Combination from a financial point of view to the holders of the outstanding shares of Capital Stock other than the Interested Shareholder and its Affiliates or Associates (as hereinafter defined), such investment banking firm to be paid a reasonable fee for its services by the Corporation. (g) Such Interested Stockholder shall not have made or caused the making of any major change in the Corporation's business or equity capital structure without the approval of a majority of the continuing Directors. C. For the purposes of this Article VII: 1. The term "Business Combination" shall mean: (a) any merger or consolidation of the Corporation or any Subsidiary (as hereinafter defined) with (i) any Interested Shareholder or (ii) any other corporation (whether or not itself an Interested Shareholder) which is or after such merger or consolidation would be an Affiliate or Associate of an Interested Shareholder; or (b) any sale, lease, exchange, mortgage, pledge, transfer or other disposition (in one transaction or a series of transactions) with any Interested Shareholder or any Affiliate or Associate of any Interested Shareholder involving any assets or securities of this Corporation, any subsidiary or any Interested Shareholder or any Affiliate or Associate of any Interested Shareholder having an aggregate Fair Market Value of $10,000,000 or more; or (c) the adoption of any plan or proposal for the liquidation or dissolution of the Corporation proposed by or on behalf of an Interested Shareholder or any Affiliate or Associate of any Interested Shareholder; or (d) any reclassification of securities (including any reverse stock split), or recapitalization of the Corporation, or any merger or consolidation of the Corporation with any of its Subsidiaries or any other transaction (whether or not with or otherwise involving an Interested Shareholder) that has the effect, directly or indirectly, of increasing the proportionate share of any class or series of Capital Stock, or any securities convertible into Capital Stock or into equity securities of any Subsidiary, that is beneficially owned by any Interested Shareholder or any Affiliate or Associate of any Interested Shareholder: or (e) any agreement, contract or other arrangement providing for any one or more of the actions specified in the foregoing clauses (a) to (d). 2. The term "Capital Stock" shall mean all capital stock of the Corporation authorized to be issued from time to time under Article III of these Articles, and the term "Voting Stock" shall mean all Capital Stock which by its terms may be voted on all matters submitted to shareholders of the Corporation generally. 3. The term "person" shall mean any individual, firm, corporation or other entity and shall include any group comprised of any person and any other person with whom such person or any Affiliate or Associate of such person has any agreement, arrangement or understanding, directly or indirectly, for the purpose of acquiring, holding, voting or disposing of Capital Stock. 4. The term "Interested Shareholder" shall mean any person (other than the Corporation or any Subsidiary and other than any profit-sharing, employee stock ownership or other employee benefit plan of the Corporation or any Subsidiary or any trustee of or fiduciary with respect to any such plan when acting in such capacity) who (a) is the beneficial owner of Voting Stock representing ten percent (10%) or more of the votes entitled to be cast by the holders of all then outstanding shares of Voting Stock or (b) is an Affiliate or Associate of the Corporation and at any time within the two-year period immediately prior to the date in question was the beneficial owner of Voting Stock representing ten percent (10%) or more of the votes entitled to be cast by the holders of all then outstanding shares of Voting Stock. 5. A person shall be a "beneficial owner" of any Capital Stock (a) which such person or any of its Affiliates or Associates beneficially owns, directly or indirectly; (b) which such person or any of its Affiliates or Associates has, directly or indirectly, (i) the right to acquire (whether such right is exercisable immediately or subject only to the passage of time), pursuant to any agreement, arrangement or understanding or upon the exercise of conversion rights, convertible securities, exchange rights, warrants or options, or otherwise, or (ii) the right to vote pursuant to any agreement, arrangement or understanding or upon the exercise of conversion rights, convertible securities, exchange rights, warrants or options, or otherwise, or (ii) the right to vote pursuant to any agreement, arrangement or understanding; or (c) which are beneficially owned, directly or indirectly, by any other person with which such person or any of its Affiliates or Associates has any agreement, arrangement or understanding for the purpose of acquiring, holding, voting or disposing of any shares of Capital Stock. For the purposes of determining whether a person is an Interested Shareholder pursuant to paragraph 4 of this Section C, the number of shares of Capital Stock deemed to be outstanding shall include shares deemed beneficially owned by such person through application of paragraph 5 of this Section C, but shall not include any other shares of Capital Stock that may be issuable pursuant to any agreement, arrangement or understanding, or upon exercise of conversion rights, warrants or options, or otherwise. 6. The terms "Affiliate" and "Associate" shall have the respective meanings ascribed to such terms in Rule 12b-2 under the Act as in effect on March 1, 1984 (the term "registrant" in said Rule 12b-2 meaning in this case the Corporation). 7. The term "Subsidiary" means any corporation of which a majority of any class of equity security is beneficially owned by the Corporation; provided, however, that for the purposes of the definition of Interested Shareholder set forth in paragraph 4 of this Section C, the term "Subsidiary" shall mean only a corporation of which a majority of each class of equity security is beneficially owned by the Corporation. 8. The term "Continuing Director" means any member of the board of directors of the Corporation (the "Board") while such person is a member of the Board, who is not an Affiliate or Associate or representative of the Interested Shareholder and was a Member of the Board prior to the time that the Interested Shareholder became an Interested Shareholder, and any successor of a Continuing Director, while such successor is a member of the Board, who is not an Affiliate or Associate or representative of the Interested Shareholder and is recommended or elected to succeed the Continuing Director by a majority of Continuing Directors. 9. The term "Fair Market Value" means (a) in the case of cash, the amount of such cash; (b) in the case of stock, the highest closing sales price during the 30-day period immediately preceding the date in question of a share of such stock on the Composite Tape for New York Stock Exchange-Listed Stocks, or, if such stock is not quoted on the Composite Tape, on the New York Stock Exchange, or if such stock is not listed on such Exchange, on the principal United States securities exchange registered under the Act on which such stock is listed, or, if such stock is not listed on any such exchange, the highest closing bid quotation with respect to a share of such stock as determined by a majority of the Continuing Directors in good faith; and (c) in the case of property other than cash or stock, the fair market value of such property on the date in question as determined in good faith by a majority of the Continuing Directors. 10. In the event of any Business Combination in which this Corporation survives, the phrase "consideration other than cash to be received" as used in paragraphs 2.(a) and 2.(b) of Section B of this Article VII shall include the shares of Common Stock and/or the shares of any other class or series of Capital Stock retained by the holders of such shares. D. The Board of Directors shall have the power and duty to determine for the purposes of this Article VII on the basis of information known to them after reasonable inquiry, (a) whether a person is an Interested Shareholder, (b) the number of shares of Capital Stock or other securities beneficially owned by any person, (c) whether a person is an Affiliate or Associate of another, and (d) whether the assets that are the subject of any Business Combination have, or the consideration to be received for the issuance or transfer of securities by this Corporation have, or any Subsidiary in any Business Combination has, an aggregate Fair Market Value of $10,000,000 or more. Any such determination made in good faith shall be binding and conclusive on all parties. E. Nothing contained in this Article VII shall be construed to relieve any Interested Shareholder from any fiduciary obligation imposed by law. F. The fact that any Business Combination complies with the provisions of Section B of this Article VII shall not be construed to impose any fiduciary duty, obligation or responsibility on the Board, or any member thereof, to approve such Business Combination or recommend its adoption or approval to the shareholders of this Corporation, nor shall such compliance limit, prohibit or otherwise restrict in any manner the Board, or any member thereof, with respect to evaluations of or actions and responses taken with respect to such Business Combination. G. Notwithstanding any other provisions of these Articles or the bylaws of the Corporation (and notwithstanding the fact that a lesser percentage or separate class vote may be specified by law, these Articles or the bylaws of the Corporation), the affirmative vote of the holders of not less than eighty percent (80%) of the votes entitled to be cast by the holders of all then outstanding shares of Voting Stock, voting together as a single class, shall be required to amend or repeal, or adopt any provisions inconsistent with, this Article VII; provided, however, that this Section G shall not apply to, and such eighty percent (80%) vote shall not be required for, any amendment, repeal or adoption unanimously recommended by the Board if all of such directors are persons who would be eligible to serve as Continuing Directors within the meaning of Section C, paragraph 8 of this Article VII. Article VIII To the full extent permitted by the Connecticut General Statutes as the same exists or may hereafter be amended, no person who is or was a director of the Corporation shall be personally liable to the Corporation or its shareholders for monetary damages for breach of duty as a director in an amount that exceeds the compensation received by the director for serving the Corporation during the year of the violation. The limitation of liability of any person who is or was a director provided for in this Article shall not be exclusive of any other limitation or elimination of liability contained in, or pursuant to, the Connecticut General Statutes, as the same exists or may hereafter be amended. Any repeal or modification of this Article VIII by the shareholders of the Corporation shall not adversely affect any right or protection of a director of the Corporation existing at the time of such repeal or modification. Article IX The officers and directors of the Corporation shall be indemnified by the Corporation to the fullest extent permitted by, or pursuant to, the Connecticut General Statutes, as the same exists or may hereafter be amended. The Corporation may pay for or reimburse the reasonable expenses incurred by a director who is a party to a proceeding in advance of final disposition of the proceeding if such director is in full compliance with Section 33-773 of the Connecticut Business Corporation Act, as the same exists or may hereafter be amended. Any repeal or modification of this Article IX shall not adversely affect any right or protection of a director or officer of the Corporation existing at the time of such repeal or modification. EX-3 3 Exhibit 3(ii) BYLAWS of HSB GROUP, INC. ARTICLE I SHAREHOLDERS' MEETINGS All meetings of the Shareholders shall be held in the City of Hartford or such other place within Connecticut as the Board of Directors may appoint. The Annual Meeting shall be held on the 3rd Tuesday of April in each year or on some other day within two (2) months thereafter as fixed by the Board of Directors. Special meetings of the Shareholders may be held at such time as fixed by the Board of Directors. Notice of every meeting of the Shareholders and of the time and place thereof shall be given as required by law. At each meeting of the Shareholders the President or Chairman of the Board shall preside and act as Chairman. The Chairman may appoint a Committee on Proxies to receive, count and report the votes cast in person at such meeting and the votes represented by proxies. The holders of a majority of the shares of the issued and outstanding stock entitled to vote at a meeting, present either in person or by proxy, shall constitute a quorum for the transaction of business at such meeting of the Shareholders. If a quorum is not present at such meeting, the Shareholders present in person or by proxy may adjourn to such future time as shall be agreed upon by them, and notice of such adjournment shall be given to Shareholders not present or represented at the meeting. Regulations for the conduct of a meeting of Shareholders may be prescribed by the Chairman or at the Chairman's option be adopted by the Shareholders present by voice vote or by ballot. At any meeting of the Shareholders, only such business may be conducted as shall have been properly brought before the meeting and as shall have been determined to be lawful and appropriate for consideration by Shareholders at the meeting. To be properly brought before a meeting business must be (a) specified in the notice of meeting, (b) otherwise properly brought before the meeting by or at the direction of the Board of Directors or the Chairman of the meeting, or (c) otherwise properly brought before the meeting by a Shareholder. For business to be properly brought before a meeting by a Shareholder pursuant to clause (c) above, the Shareholder must have given timely notice thereof in proper written form to the Corporate Secretary. To be timely, a Shareholder's notice to the Corporate Secretary must be delivered to or mailed and received by the Corporate Secretary of the Company not less than sixty nor more than ninety days prior to the anniversary of the date on which the immediately preceding Annual Meeting of the Shareholders was convened; provided, however, that in the event that the Annual Meeting is called for a date that is not within thirty days before or after such anniversary date, notice by the Shareholder in order to be timely must be received not later than the close of business on the tenth day following the day on which such notice of the date of the Annual Meeting was mailed or such public disclosure of the date of the Annual Meeting was made, whichever first occurs. Such Shareholder's notice shall set forth as to each matter the Shareholder proposes to bring before the meeting (a) a brief description of the business desired to be brought before the meeting and the reasons for conducting such business at the meeting, (b) the name and record address of such Shareholder, (c) the class and number of shares of capital stock of the Company which are beneficially held by such Shareholder and (d) any material interest of such Shareholder in such business. Notwithstanding anything in these Bylaws to the contrary, no business shall be conducted at a meeting except in accordance with the procedures set forth herein. The Chairman of the meeting shall, if the facts warrant, determine and declare to the meeting that business was not properly brought before the meeting in accordance with the procedures set forth herein, or that business was not lawful or appropriate for consideration by Shareholders at the meeting, and if the Chairman of the meeting should so determine, the Chairman of the meeting shall so declare to the meeting and any such business not properly brought before the meeting shall not be transacted at that meeting. Nominations of persons for election to the Board of Directors of the Company may be made by the Board of Directors or by any Shareholder entitled to vote for the election of Directors in compliance with the notice procedures set forth herein. Any Shareholder entitled to vote for the election of Directors at a meeting may nominate persons for the election of Directors only if timely written notice of such Shareholder's intent is given to the Corporate Secretary. To be timely, a Shareholder's notice to the Corporate Secretary must be delivered to or mailed and received by the Corporate Secretary of the Company not less than sixty days nor more than ninety days prior to the anniversary of the date on which the immediately preceding Annual Meeting of the Shareholders was convened; provided, however, that in the event that the Annual Meeting is called for a date that is not within thirty days before or after such anniversary date, notice by the Shareholder in order to be timely must be received not later than the close of business on the tenth day following the day on which such notice of the date of the Annual Meeting was mailed or such public disclosure of the date of the Annual Meeting was made, whichever first occurs. Such Shareholder's notice shall set forth (a) as to each person whom the Shareholder proposes to nominate for election or re-election as a Director, (i) the name, age, business address and residence address of such person, (ii) the principal occupation or employment of such person, (iii) the class and number of shares of capital stock of the Company which are beneficially owned by such person and (iv) any other information relating to such person that is required to be disclosed in solicitations of proxies for election of Directors, or is otherwise required, in each case pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended (including, without limitation such person's written consent to being named in the proxy statement as a nominee and to serving as a Director if elected) and (b) as to the Shareholder giving the notice, (i) the name and address, as they appear on the Company's books, of such Shareholder and, (ii) the class and number of shares of capital stock of the Company which are beneficially owned by such Shareholder. If the Chairman of the meeting determines that a nomination was not in accordance with the foregoing procedures, such nomination shall be void. ARTICLE II DIRECTORS The Board of Directors shall consist of the number of directors fixed from time to time by resolution adopted by the affirmative vote of a majority of the entire Board of Directors. No person shall serve as Director beyond the date of the first Annual Meeting of Shareholders held subsequent to the Director's seventieth birthday. Regular and special meetings of the Board of Directors shall be held as determined by the Directors. At any meetings of the Board of Directors, a majority of the Directors then in office, but not less than one-third of the directorships fixed in accordance with this Article, shall constitute a quorum for the transaction of business. Unless otherwise prescribed herein or in the Articles of Incorporation of the Company, action of the Board of Directors shall be by majority vote of the Directors present. The compensation of Directors shall be determined by the Board of Directors. ARTICLE III COMMITTEES The Board of Directors may by resolution designate two or more Directors to constitute an executive committee or other committees, which committees shall have and may exercise all such authority of the Board of Directors as shall be provided in such resolution, subject to such limitations as are provided under Section 33-753 of the Connecticut General Statutes, as it may be amended from time to time. The Board of Directors may by resolution designate one or more Directors as alternate members of such committees who may replace any absent member at any meeting of such committees upon such notice and in such manner as may be provided in the resolution designating such alternate members. ARTICLE IV OFFICERS There shall be a President and there may be a Chairman of the Board, each elected by the Board of Directors from their own number. The President shall be the chief executive officer and responsible under the direction of the Board of Directors for the supervision, management and active control of the affairs and properties of the Company. The Board of Directors may also elect a Corporate Secretary, a Treasurer, one or more Executive Vice Presidents and Senior Vice Presidents. The President shall appoint such other Officers as may be required for the prompt and orderly transaction of the business of the Company. Any elected Officer may be removed at the pleasure of the Directors and any appointed Officer may also be removed by the President. The Officers shall be subject to the direction of and shall have such authority and perform such duties as may be assigned from time to time by the Board of Directors or the President. ARTICLE V AMENDMENTS These bylaws may be altered, amended, added to or repealed by a majority of the entire Board of Directors at any meeting of said Board, provided that notice thereof shall have been given in the notice of such meeting. STATE OF CONNECTICUT, ss. Hartford, CT..............19 COUNTY OF HARTFORD. The foregoing is a true copy of the bylaws of HSB Group, Inc. Attest:___________________ Corporate Secretary EX-21 4 Exhibit (21) LIST OF SUBSIDIARIES OF HSB GROUP, INC. NAME OF COMPANY STATE/JURISDICTION OF INCORPORATION/ FORMATION The Allen Insurance Company Bermuda The Boiler Inspection and Insurance Company of Canada (wholly-owned by HSB Engineering Insurance Ltd.) Canada EIG, Co. Delaware The Hartford Steam Boiler Inspection and Insurance Company Connecticut The Hartford Steam Boiler Inspection and Insurance Company of Connecticut Connecticut The Hartford Steam Boiler Inspection and Insurance Company of Texas Texas Hartford Steam Boiler International GmbH Germany Hartford Steam Boiler (Singapore) PTE Ltd. Singapore HSB Associates, Inc. New York HSB Capital I Delaware HSB Capital II Delaware HSB Engineering Finance Corporation Delaware HSB Engineering Insurance Limited (wholly-owned by EIG Co.) England HSB Haughton Engineering Insurance Services, Ltd. (wholly-owned by HSB Engineering Insurance Limited) England HSB Investment Corporation Connecticut HSB Professional Loss Control, Inc. Tennessee HSB Reliability Technologies Corp. Florida Integrated Process Technologies, LLC (51% owned) Delaware One State Street Intermediaries Connecticut Ra-Hart Investment Company Texas EX-23 5 Exhibit 23 Consent of Independent Accountants We consent to the incorporation by reference in the registration statements of HSB Group, Inc. on Forms S-8 (File Nos. 33-4397, 33-36519, and 333-29605) of our report dated January 26, 1998, on our audits of the consolidated financial statements and financial statement schedules of HSB Group, Inc. and its subsidiaries as of December 31, 1997 and 1996, and for the three years in the period ended December 31, 1997, which report is included in this Annual Report on Form 10-K. /s/ Coopers & Lybrand Hartford, Connecticut March 27, 1998 EX-24 6 Exhibit (24) POWER OF ATTORNEY We, the undersigned directors of HSB Group, Inc., hereby individually appoint Robert C. Walker and Roberta A. O'Brien, and each of them singly, with full power of substitution to each, our true and lawful attorneys with full power to them and each of them singly, to sign for us in our names in the capacities stated below the Form 10-K Annual Report, pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934, for the fiscal year ended December 31, 1997 for HSB Group, Inc., and any and all amendments to said Form 10-K, and generally to do all such things in our name and on our behalf in our capacities as directors that will enable the Company to comply with the provisions of the Securities Exchange Act of 1934, as amended, and all requirements of the Securities and Exchange Commission, which relate to said Form 10-K and the filing thereof, hereby ratifying and confirming our signatures as they may be signed by our said attorneys or any one of them to said Form 10-K and any and all amendments thereto. Pursuant to the requirements of the Securities Exchange Act of 1934, this Power of Attorney has been signed by the following persons in the capacities and on the date indicated. (Signature) (Title) (Date) - - ----------- ------- ------ /s/ Joel B. Alvord Joel B. Alvord Director February 23, 1998 /s/ Colin G. Campbell Colin G. Campbell Director February 23, 1998 /s/ Richard G. Dooley Richard G. Dooley Director February 23, 1998 (Signature) (Title) (Date) ----------- ------- ------ /s/ William B. Ellis William B. Ellis Director February 23, 1998 /s/ E. James Ferland E. James Ferland Director February 23, 1998 /s/ Simon W. Leathes Simon W. Leathes Director February 23, 1998 /s/ Lois Dickson Rice Lois Dickson Rice Director February 23, 1998 /s/ John M. Washburn, Jr. John M. Washburn, Jr. Director February 23, 1998 /s/ Wilson Wilde Wilson Wilde Director February 23, 1998 10KPOW.DOC EX-27 7
7 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE FINANCIAL STATEMENTS FILED HEREWITH AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000,000 YEAR DEC-31-1997 DEC-31-1997 237 0 0 324 11 0 572 425 125 46 1540 277 290 0 0 68 409 0 10 335 1540 491 37 14 61 218 91 200 97 26 66 0 0 0 66 3.32 3.29 0 0 0 0 0 0 0 Cash includes short-term investments
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