-----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, V8q1D/7Tw6R4DHv7jg4P4S+BDw88AMen/ztSd6NQYgmIWnsRgLXYNMgod9ZUg726 V58AJN5CqUkE5KjljlZIXg== 0000354396-95-000028.txt : 19951119 0000354396-95-000028.hdr.sgml : 19951119 ACCESSION NUMBER: 0000354396-95-000028 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19950930 FILED AS OF DATE: 19951114 SROS: NYSE SROS: PSE FILER: COMPANY DATA: COMPANY CONFORMED NAME: USF&G CORP CENTRAL INDEX KEY: 0000354396 STANDARD INDUSTRIAL CLASSIFICATION: FIRE, MARINE & CASUALTY INSURANCE [6331] IRS NUMBER: 521220567 STATE OF INCORPORATION: MD FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-08233 FILM NUMBER: 95592980 BUSINESS ADDRESS: STREET 1: 100 LIGHT ST CITY: BALTIMORE STATE: MD ZIP: 21202 BUSINESS PHONE: 4105473000 MAIL ADDRESS: STREET 1: P O BOX 1138 CITY: BALTIMORE STATE: MD ZIP: 21203 10-Q 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q Quarterly Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934 For the Quarter Ended Commission File Number September 30, 1995 1-8233 USF&G CORPORATION (Exact name of registrant as specified in its charter) Maryland 52-1220567 (State of incorporation) (IRS employer identification no.) 100 Light Street, Baltimore, Maryland 21202 (Address of principal executive offices and zip code) (410) 547-3000 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve (12) months, and (2) has been subject to such filing requirements for the past 90 days. Yes x No Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: Common Stock, Par Value $2.50; 119,263,025 shares outstanding as of November 13, 1995. USF&G Corporation Table of Contents PART I. Financial Information Item 1. Financial Statements: Condensed Consolidated Statement of Financial Position 3 Condensed Consolidated Statement of Operations 4 Condensed Consolidated Statement of Cash Flows 6 Notes to Condensed Consolidated Financial Statements 8 Report of Independent Auditors 12 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 13 PART II. Other Information Item 6. Exhibits and Reports on Form 8-K 25 Exhibit 11- Computation of Earnings Per Share 26 Exhibit 12- Computation of Ratio of Consolidated Earnings to Fixed Charges and Preferred Stock Dividends 27 Exhibit 15- Letter Regarding Unaudited Interim Financial Information 28 Signature 29 USF&G Corporation Condensed Consolidated Statement of Financial Position At September 30 At December 31 (dollars in millions except per share data) 1995 1994* Assets Investments: Fixed maturities: Held to maturity, at amortized cost (market, 1995, $4,576; 1994, $4,284) $ 4,547 $ 4,659 Available for sale, at market (cost, 1995, $4,581; 1994, $4,265) 4,658 4,081 Common stocks, at market (cost, 1995, $41; 1994, $53) 37 46 Preferred stocks, at market (cost, 1995, $27; 1994, $26) 27 26 Short-term investments 399 450 Mortgage loans 160 349 Real estate 654 662 Other invested assets 439 288 Total investments 10,921 10,561 Cash 97 69 Accounts, notes, and other receivables 735 741 Reinsurance receivables 757 554 Servicing carrier receivables 699 706 Deferred policy acquisition costs 475 504 Other assets 876 845 Total assets $14,560 $13,980 Liabilities Unpaid losses, loss expenses, and policy benefits $ 9,842 $ 9,962 Unearned premiums 1,051 968 Corporate debt 603 586 Real estate and other debt 20 42 Other liabilities 1,288 981 Total liabilities 12,804 12,539 Shareholders' Equity Preferred stock, par value $50.00 (12,000,000 shares authorized; shares issued, 1995, 5,110,110; 1994, 6,627,896) 256 331 Common stock, par value $2.50 (240,000,000 shares authorized; shares issued, 1995, 112,357,823; 1994, 104,810,794) 281 262 Paid-in capital 1,161 1,104 Net unrealized gains (losses) on investments and foreign currency 63 (147) Minimum pension liability (63) (63) Retained earnings (deficit) 58 (46) Total shareholders' equity 1,756 1,441 Total liabilities and shareholders' equity $14,560 $13,980 See Notes to Condensed Consolidated Financial Statements. * 1994 amounts have been restated to reflect mergers with Discover Re Managers, Inc., and Victoria Financial Corporation. See Note 12. USF&G Corporation Condensed Consolidated Statement of Operations (Unaudited) Three Months Ended September 30 (dollars in millions except per share data) 1995 1994* Revenues Premiums earned $ 692 $ 634 Net investment income 179 187 Other 11 14 Revenues before realized gains 882 835 Net realized gains on investments 3 - Total revenues 885 835 Expenses Losses, loss expenses, and policy benefits 551 518 Underwriting, acquisition, and operating expenses 272 268 Interest expense 12 10 Facilities exit costs (income) - - Total expenses 835 796 Income from operations before income taxes 50 39 Provision for income taxes (benefit) 1 (36) Net income $ 49 $ 75 Preferred stock dividend requirements 8 12 Net income available to common stock $ 41 $ 63 Primary Earnings Per Common Share $.37 $.67 Fully Diluted Earnings Per Common Share $.35 $.58 Weighted average common shares outstanding (000s): Primary 111,541 94,792 Fully diluted 121,087 125,502 Dividends declared per common share $ .05 $ .05 See Notes to Condensed Consolidated Financial Statements. * 1994 amounts have been restated to reflect mergers with Discover Re Managers, Inc., and Victoria Financial Corporation. See Note 12. USF&G Corporation Condensed Consolidated Statement of Operations (Unaudited) Nine Months Ended September 30 (dollars in millions except per share data) 1995 1994* Revenues Premiums earned $1,968 $1,828 Net investment income 546 564 Other 38 35 Revenues before realized gains 2,552 2,427 Net realized gains on investments 7 6 Total revenues 2,559 2,433 Expenses Losses, loss expenses, and policy benefits 1,620 1,576 Underwriting, acquisition, and operating expenses 766 728 Interest expense 34 27 Facilities exit costs (income) (6) - Total expenses 2,414 2,331 Income from operations before income taxes 145 102 Provision for income taxes (benefit) 1 (71) Net income $ 144 $ 173 Preferred stock dividend requirements 23 36 Net income available to common stock $ 121 $ 137 Primary Earnings Per Common Share $ 1.10 $ 1.45 Fully Diluted Earnings Per Common Share $ 1.04 $ 1.33 Weighted average common shares outstanding (000s): Primary 109,770 94,077 Fully diluted 130,662 123,230 Dividends declared per common share $ .15 $ .15 See Notes to Condensed Consolidated Financial Statements. * 1994 amounts have been restated to reflect mergers with Discover Re Managers, Inc., and Victoria Financial Corporation. See Note 12. USF&G Corporation Condensed Consolidated Statement of Cash Flows (Unaudited) Three Months Ended September 30 (in millions) 1995 1994* Operating Activities Direct premiums collected $ 549 $ 528 Net investment income collected 174 177 Direct losses, loss expenses, and policy benefits paid (412) (501) Net reinsurance activity - 10 Underwriting and operating expenses paid (145) (201) Interest paid (1) 18 Income taxes paid - (3) Other items, net (6) 15 Net cash provided from operating activities 159 43 Investing Activities Net sales and maturities of short-term investments (113) 82 Purchases of fixed maturities held to maturity - (33) Sales of fixed maturities held to maturity 1 10 Maturities/repayments of fixed maturities held to maturity 31 44 Purchases of fixed maturities available for sale (180) (101) Sales of fixed maturities available for sale 107 20 Maturities/repayments of fixed maturities available for sale 78 84 Purchases of equities and other investments (20) (50) Sales, maturities, and repayments of equities and other investments 17 37 Purchases of property and equipment (9) (10) Disposals of property and equipment 1 - Net cash provided from (used in) investing activities (87) 83 Financing Activities Deposits for universal life and investment contracts 69 68 Withdrawals of universal life and investment contracts (127) (193) Net short-term borrowings (repayments) 1 2 Long-term borrowings - - Repayments of long-term borrowings (1) (1) Issuances of common stock 1 8 Redemptions of preferred stock - (10) Cash dividends paid to shareholders (15) (17) Net cash used in financing activities (72) (143) Decrease in cash - (17) Cash at beginning of period 97 85 Cash at end of period $ 97 $ 68 See Notes to Condensed Consolidated Financial Statements. * 1994 amounts have been restated to reflect mergers with Discover Re Managers, Inc., and Victoria Financial Corporation. See Note 12. USF&G Corporation Condensed Consolidated Statement of Cash Flows (Unaudited) Nine Months Ended September 30 (in millions) 1995 1994* Operating Activities Direct premiums collected $ 1,554 $ 1,509 Net investment income collected 550 552 Direct losses, loss expenses, and policy benefits paid (1,290) (1,428) Net reinsurance activity 73 (5) Underwriting and operating expenses paid (556) (602) Interest paid (22) - Income taxes paid (2) (8) Other items, net 8 22 Net cash provided from operating activities 315 40 Investing Activities Net (purchases)/sales and maturities of short-term investments 37 65 Purchases of fixed maturities held to maturity - (384) Sales of fixed maturities held to maturity 7 60 Maturities/repayments of fixed maturities held to maturity 84 295 Purchases of fixed maturities available for sale (628) (259) Sales of fixed maturities available for sale 239 220 Maturities/repayments of fixed maturities available for sale 244 375 Purchases of equities and other investments (73) (303) Sales, maturities, and repayments of equities and other investments 160 282 Purchases of property and equipment (22) (25) Disposals of property and equipment 1 4 Net cash provided from investing activities 49 330 Financing Activities Deposits for universal life and investment contracts 237 174 Withdrawals of universal life and investment contracts (524) (459) Net short-term borrowings (repayments) (226) (156) Long-term borrowings 228 270 Repayments of long-term borrowings (15) (124) Issuances of common stock 5 35 Redemptions of preferred stock - (10) Cash dividends paid to shareholders (41) (50) Net cash used in financing activities (336) (320) Increase in cash 28 50 Cash at beginning of period 69 18 Cash at end of period $ 97 $ 68 See Notes to Condensed Consolidated Financial Statements. * 1994 amounts have been restated to reflect mergers with Discover Re Managers, Inc., and Victoria Financial Corporation. See Note 12. USF&G Corporation Notes to Condensed Consolidated Financial Statements Note 1 Basis of Accounting The condensed consolidated financial statements are prepared in accordance with generally accepted accounting principles ("GAAP"). These statements include the accounts of USF&G Corporation and its subsidiaries ("USF&G"). Intercompany transactions are eliminated in consolidation. Certain 1994 amounts have been reclassified to conform to the 1995 presentation. (See also Note 12 regarding restatements for mergers consummated in the second quarter of 1995.) The interim financial statements in this report should be read in conjunction with the consolidated financial statements and notes thereto in USF&G's Annual Report to Shareholders (Restated) for the year ended December 31, 1994. In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain the necessary adjustments, all of which are of a normal recurring nature for interim period reporting purposes, for a fair presentation of results for the interim periods. Note 2 Review of Independent Auditors USF&G's independent auditors, Ernst & Young LLP, have performed a review of the condensed consolidated financial statements in this Form 10-Q as to the three and nine month periods ended September 30, 1995 and 1994. Their limited review in accordance with standards established by the American Institute of Certified Public Accountants did not constitute an audit. Accordingly, they do not express an opinion on this information. Note 3 Earnings Per Common Share Primary earnings per common share are based on income, after deduction of preferred stock dividends, and the weighted average number of common shares outstanding during the periods. Common stock equivalents were not included as they were insignificant. Fully diluted earnings per common share assume the conversion of all securities whose contingent issuance would have a dilutive effect on earnings. Refer to the computation in Exhibit 11. Note 4 Ratio of Consolidated Earnings to Fixed Charges For purposes of computing the ratio of consolidated earnings to fixed charges and preferred stock dividends, earnings consist of income before considering income taxes and fixed charges. Fixed charges consist of interest and that portion of rents that is deemed to be an appropriate interest factor. Refer to the computation in Exhibit 12. Note 5 Supplemental Cash Flow Information The Condensed Consolidated Statement of Cash Flows is presented using the "direct method," which reports major classes of cash receipts and cash payments. A reconciliation of net income to net cash provided from operating activities is as follows: Three Months Ended Nine Months Ended September 30 September 30 (in millions) 1995 1994 1995 1994 Operating Activities Net income $ 49 $ 75 $ 144 $ 173 Adjustments to reconcile net income to net cash provided from operating activities: Realized gains on investments (3) - (7) (6) Change in insurance liabilities 119 (6) 246 55 Change in deferred policy acquisition costs 1 (13) 29 (56) Change in receivables (130) 19 (193) (49) Change in other liabilities 153 (1) 150 (78) Change in other assets (15) (26) (27) (32) Other items, net (15) (5) (27) 33 Net cash provided from operating activities $ 159 $ 43 $ 315 $ 40 Note 6 Unrealized Gains (Losses) on Investments At September 30, 1995, gross unrealized gains and gross unrealized losses pertaining to equity securities totaled $2 million and $4 million, respectively. In addition, gross unrealized gains and gross unrealized losses on limited partnerships, foreign currency and other investments totaled $15 million and $6 million, respectively. At September 30, 1995, there were gross unrealized gains of $109 million and gross unrealized losses of $32 million pertaining to fixed maturities available for sale. There were also $21 million of gross unrealized losses relating to a deferred policy acquisition cost ("DPAC") adjustment. This DPAC adjustment was made to reflect assumptions about the effect of potential asset sales of fixed maturities available for sale on future DPAC amortization. The changes in net unrealized gains (losses) on investments and foreign currency amount to a gain of $210 million during the nine months ended September 30, 1995, compared with a loss of $299 million during the nine months ended September 30, 1994. Note 7 Proceeds From Sales of Fixed Maturity Investments During the nine month period ended September 30, 1995, proceeds from sales of fixed maturities held to maturity were $7 million. These sales involved the entire holdings of one issuer, and the partial holdings of two other issuers and were based on evidence of significant deterioration of the issuers' creditworthiness. Gross losses of $1 million were realized on these sales. During the nine month period ended September 30, 1995, transfers from held to maturity to available for sale totaled $26 million of amortized cost. These transfers involved the remaining positions of the two aforementioned issuers, and the entire holdings of another issuer and were also based on evidence of significant deterioration of the issuers' creditworthiness. Gross unrealized losses on these securities totaled $9 million at September 30, 1995. During the nine month period ended September 30, 1994, proceeds from sales of fixed maturities held to maturity were $60 million. Such sales involved the entire holdings of 18 different issuers and were based on evidence of significant deterioration of the issuers' creditworthiness. Gross gains of less than $1 million and gross losses of $1 million were realized on these sales. Proceeds from sales of fixed maturities available for sale were $239 million for the nine months ended September 30, 1995, compared with $223 million for the same period in 1994. Gross gains of $3 million and gross losses of $2 million were realized on 1995 sales. Gross gains and gross losses of $2 million were realized on 1994 sales. Note 8 Facilities Exit Costs During 1994, USF&G committed to a plan to consolidate its home office operations in Baltimore, Maryland at its Mount Washington facility. Facilities exit costs of $183 million were recorded in the fourth quarter of 1994, representing the present value of the rent and other operating expenses to be incurred under the lease on the Corporation's principal office building ("the Tower") from the time USF&G vacates the building through the expiration of the lease in 2009. Facilities exit costs recorded in 1994 did not consider any potential future sublease income, as such income was neither probable nor reasonably estimable at that time. To the extent that additional or extended subleases are subsequently negotiated, the present value of income to be received over the term of those subleases is recognizable in the period such income becomes probable and reasonably estimable. Net income for the nine months ended September 30, 1995 includes $6 million of sublease income recognized as a result of USF&G's renegotiation in the first quarter of 1995 of a sublease with a tenant. The sublease covers two floors of the Tower already occupied by the tenant and extends that occupancy through July 2009. No subleases were negotiated in the second or third quarters of 1995. Note 9 Legal Contingencies USF&G's insurance subsidiaries are routinely engaged in litigation in the normal course of their business, including defending claims for punitive damages. As a liability insurer, they defend third-party claims brought against their insureds. As an insurer, they defend themselves against coverage claims. Additional information regarding contingencies that may arise from insurance regulatory matters and regulatory litigation matters may be found in the Regulation section of Management's Discussion and Analysis of Financial Condition and Results of Operations, as well as in USF&G's Annual Report to Shareholders (Restated) for the year ended December 31, 1994. In the opinion of management, such litigation and the litigation described below is not expected to have a material adverse effect on USF&G's consolidated financial position, although it is possible that the results of operations in a particular quarter or annual period would be materially affected by an unfavorable outcome. 9.1. North Carolina workers' compensation litigation On November 24, 1993, N.C. Steel, Inc. and six other North Carolina employers filed a class action in the General Court of Justice, Superior Court Division, Wake County, North Carolina against the National Council on Compensation Insurance ("NCCI"), North Carolina Rate Bureau, USF&G and eleven other insurance companies which served as servicing carriers for the North Carolina involuntary workers' compensation market. On January 20, 1994, the plaintiffs filed an amended complaint seeking to certify a class of all employers who purchased workers' compensation insurance in the State of North Carolina after November 24, 1989. The amended complaint, which is captioned N.C. Steel, Inc., et al., v. National Council on Compensation Insurance, et al ., alleges that the defendants conspired to suppress competition with respect to the North Carolina voluntary and involuntary workers' compensation business, thereby artificially inflating the rates in such markets and the fees payable to the insurers. The complaint also alleges that the carriers agreed to improperly deny qualified companies from acting as servicing carriers, improperly encourage agents to place employers in the assigned risk pool, and improperly promote inefficient claims handling. USF&G has acted as a servicing carrier in North Carolina since 1990. The plaintiffs are pursuing their claims under various legal theories, including violations of the North Carolina antitrust laws, unlawful conspiracy, breach of fiduciary duty, breach of implied covenant of good faith and fair dealing, unfair competition, constructive fraud, and unfair and deceptive trade practices. The plaintiffs seek unspecified compensatory damages, punitive damages for the alleged constructive fraud and treble damages under the North Carolina antitrust laws. On February 14, 1995, the trial court granted the defendant's motion to dismiss the complaint. The plaintiffs have appealed the trial court's dismissal of the case. USF&G believes that it has meritorious defenses and has determined to defend the action vigorously. 9.2. South Carolina workers' compensation litigation On August 22, 1994, the Attorney General of the State of South Carolina filed suit in the County of Greenville, South Carolina on behalf of South Carolina employers that have allegedly been damaged as a result of alleged unfair and deceptive trade practices. Specifically, the Attorney General alleges that the NCCI, the National Workers' Compensation Reinsurance Pool, USF&G and seven other insurance companies which served as servicing carriers for the South Carolina involuntary workers' compensation market, conspired to fix servicing carrier fees at unreasonably high and noncompetitive levels in violation of the South Carolina Uniform Trade Practices Act, allegedly causing inflated deficits in the involuntary market and an excessive expansion of the residual market. The Attorney General alleges that the conspiracy occurred for an unspecified period of time prior to January 1994. The Attorney General has indicated that he intends to pursue recovery on behalf of all South Carolina employers who have suffered an ascertainable loss as a result of such alleged conduct, civil penalties of $5,000 for each willful violation, and temporary and permanent injunctive relief. USF&G believes that it has meritorious defenses and has determined to defend the action vigorously. 9.3. Alabama workers' compensation litigation On September 14, 1994, three Alabama employers filed a class action captioned Four Way Plant Farm, Inc., et al., v. National Council on Compensation Insurance, et al., in the Circuit Court of Bullock County, Alabama on behalf of all Alabama employers that have allegedly been damaged as a result of an alleged conspiracy by the NCCI, the National Workers' Compensation Reinsurance Pool, USF&G and numerous other insurance companies which served as servicing carriers for the Alabama involuntary workers' compensation market, to fix servicing carrier fees at unreasonably high and noncompetitive levels in violation of Alabama law. The plaintiffs allege that the conspiracy occurred during the period January 1, 1985 to January 1, 1994, and caused inflated deficits in the involuntary market and an alleged excessive expansion of the workers' compensation residual market. The plaintiffs seek unspecified damages on behalf of each member of the proposed class action. USF&G believes that it has meritorious defenses and has determined to defend the action vigorously. 9.4. Proposition 103 In November 1988, voters in the State of California passed Proposition 103, which required insurers doing business in California to rollback most property/casualty premium prices in effect between November 1988 and November 1989 to November 1987 levels, less an additional 20 percent discount, unless an insurer could establish that such rate levels threatened its solvency. The California Supreme Court subsequently ruled that an insurer does not have to face insolvency in order to qualify for an exemption from the rollback requirements and is entitled to a "fair and reasonable return." The California Insurance Department has adopted regulations establishing a broad industry-wide formula for implementing Proposition 103, but it is not clear how these regulations will apply to USF&G, and many issues remain unsettled. The range of liability to USF&G could be from less than $10 million up to approximately $31 million, including interest. The ultimate outcome of this issue is not expected to have a material adverse effect on USF&G's results of operations or financial position since any such liability is not expected to materially exceed amounts already reserved. Note 10 Series B Preferred Stock During August 1995, 189,800 shares of USF&G's Series B Cumulative Convertible Preferred Stock ("Series B Stock") were converted into 1.6 million shares of common stock, and on October 11, 1995, USF&G called for redemption 75 percent, or 832,650 shares of its remaining outstanding Series B Stock. As a result, on November 9, the shares of Series B Stock called were converted into 6.9 million shares of USF&G's common stock. The balance of the shares of Series B Stock are not subject to redemption prior to June 1996. Note 11 Subsequent Events During October 1995, USF&G purchased approximately $4.8 million of its outstanding 7% Senior Notes. In addition, during November 1995, USF&G purchased approximately $11 million of the 5 1/2% Swiss Franc Bonds. Both purchases were accomplished through the use of excess corporate cash. Note 12 Business Combinations On April 13, and May 22, 1995, USF&G consummated mergers with Discover Re Managers, Inc. ("Discover Re"), and Victoria Financial Corporation ("Victoria"), respectively. In the transactions, USF&G exchanged 5.4 million shares of common stock, worth approximately $78.5 million, for all of the outstanding equity of Discover Re, and 3.8 million shares of common stock, worth approximately $59.1 million, for all of the outstanding equity of Victoria. Discover Re provides insurance, reinsurance and related services to the alternative risk transfer market. Victoria is an insurance holding company which specializes in nonstandard auto coverage. Both of these business combinations are accounted for as poolings-of-interests. Accordingly, 1994 amounts have been restated to reflect the mergers with Discover Re and Victoria. A reconciliation of the previously separate enterprises to the restated results of operations for periods prior to the mergers are as follows: Three Months Ended September 30, 1994 Nine Months Ended September 30, 1994 USF&G USF&G USF&G USF&G Corporation Corporation Corporation Corporation As Previously Discover As As Previously Discover As (in millions) Reported Re Victoria Restated Reported Re Victoria Restated Revenues Premiums earned $ 615 $ 6 $13 $ 634 $1,774 $15 $39 $1,828 Net investment income 186 - 1 187 560 2 2 564 Other 10 2 2 14 28 4 3 35 Revenues before realized gains 811 8 16 835 2,362 21 44 2,427 Net realized gains on investments - - - - 6 - - 6 Total revenues 811 8 16 835 2,368 21 44 2,433 Expenses Losses, loss expenses, and policy benefits 505 5 8 518 1,537 12 27 1,576 Underwriting, acquisition, and operating expenses 259 3 6 268 706 7 15 728 Interest expense 10 (1) 1 10 26 - 1 27 Facilities exit costs (income) - - - - - - - - Total expenses 774 7 15 796 2,269 19 43 2,331 Income from operations before income taxes 37 1 1 39 99 2 1 102 Provision for income taxes (benefit) (37) 1 - (36) (71) - - (71) Net income $ 74 $ - $ 1 $ 75 $ 170 $ 2 $ 1 $ 173 Preferred stock dividend requirements 12 - - 12 36 - - 36 Net income available to common stock $ 62 $ - $ 1 $ 63 $ 134 $ 2 $ 1 $ 137 Note: A reconciliation of the previously separate enterprises to the restated consolidated financial position at December 31, 1994 is disclosed in USF&G's Form 10-Q for the quarter ended June 30, 1995.
USF&G Corporation Report of Independent Auditors Board of Directors USF&G Corporation We have reviewed the accompanying condensed consolidated statement of financial position of USF&G Corporation as of September 30, 1995 and the related condensed consolidated statements of operations and cash flows for the three- month and nine-month periods ended September 30, 1995 and 1994. These financial statements are the responsibility of the company's management. We conducted our reviews in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical review procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with generally accepted auditing standards, which will be performed for the full year with the objective of expressing an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our reviews, we are not aware of any material modifications that should be made to the accompanying condensed consolidated financial statements referred to above for them to be in conformity with generally accepted accounting principles. We have previously audited, in accordance with generally accepted auditing standards, the consolidated statement of financial position of USF&G Corporation as of December 31, 1994, and the related consolidated statements of operations, stockholders' equity, and cash flows for the year then ended (not presented herein) and, in our report dated February 24, 1995, except for Note 1.11, as to which the date is May 22, 1995, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated statement of financial position as of December 31, 1994, is fairly stated in all material respects, in relation to the consolidated statement of financial position from which it has been derived. ERNST & YOUNG LLP Baltimore, Maryland November 14, 1995 USF&G Corporation Management's Discussion and Analysis of Financial Condition and Results of Operations This section provides an analysis of financial results and material changes in financial position for USF&G Corporation and its subsidiaries ("USF&G") for the quarter ended September 30, 1995. The analysis focuses on the performance of USF&G's business segments and its investment portfolio. This discussion updates the "Management's Discussion and Analysis" in the 1994 Annual Report to Shareholders (Restated) and should be read in conjunction therewith. The results of operations for the quarter and nine months ended September 30, 1995, are compared with those for the same periods of 1994, unless otherwise noted. Financial position at September 30, 1995, is compared with December 31, 1994. Amounts for 1994 have been restated to reflect mergers with Discover Re Managers, Inc. ("Discover Re"), and Victoria Financial Corporation ("Victoria"), which were completed during the second quarter of 1995. Restatement of prior periods is required due to the application of the pooling-of-interests method of accounting. (Note: A glossary of certain terms used in the discussion can be found at the end of this section. The terms are italicized the first time they appear in text.) Index 1. Consolidated Results 13 2. Property/Casualty Insurance Operations 14 3. Life Insurance Operations 17 4. Parent and Noninsurance Operations 18 5. Investments 18 6. Financial Condition 21 7. Liquidity 22 8. Regulation 23 9. Glossary of Terms 24 1. Consolidated Results The table below shows the major components of net income. Three Months Ended Nine Months Ended September 30 September 30 (in millions) 1995 1994 1995 1994 Income from operations before realized gains, facilities exit costs, and income taxes $47 $ 39 $132 $ 96 Net realized gains on investments 3 - 7 6 Facilities exit (costs) income - - 6 - Income taxes (1) 36 (1) 71 Net income $49 $ 75 $144 $173 The table below shows the components by major business segment of income from continuing operations before realized gains, facilities exit costs, and income taxes. Three Months Ended Nine Months Ended September 30 September 30 (in millions) 1995 1994 1995 1994 Property/casualty insurance $ 61 $ 57 $176 $144 Life insurance 7 4 19 12 Parent and noninsurance (21) (22) (63) (60) Income from operations before realized gains, facilities exit costs, and income taxes $ 47 $ 39 $132 $ 96 Income from operations before realized gains, facilities exit costs, and income taxes for the property/casualty insurance segment increased for the quarter and nine months ended September 30, 1995, due to continued improvement in underwriting results. The continued improvement in the life insurance segment resulted principally from higher product sales and improved profit margins. During 1994, USF&G developed and committed to a plan to consolidate its Baltimore headquarters facilities. The plan encompasses relocating all USF&G personnel currently residing at the 40-story office building ("the Tower") in downtown Baltimore to the Mount Washington facilities in Baltimore which USF&G owns. Implementation of the plan began in January 1995. The relocation of Tower personnel is expected to be substantially completed by the end of 1996. Activities associated with the relocation are in process and are generally proceeding as originally planned. In the first quarter of 1995, USF&G renegotiated and extended the terms of a sublease with a tenant. The new lease, which covers the two floors of the Tower already occupied by the tenant, expires in July 2009. The present value of the additional income to be received over the term of the new lease, $6 million, was recognized in the first quarter of 1995, and is shown as a separate item captioned "facilities exit costs (income)" in the condensed consolidated statement of operations. No subleases were negotiated in the second or third quarters of 1995; however, management is actively marketing the Tower space to prospective subtenants. 2. Property/Casualty Insurance Operations Property/casualty insurance operations, the principal business segment, accounted for 85 percent of USF&G's revenues in the nine month periods ended September 30, 1995 and 1994. Financial results for this segment were as follows: Three Months Ended Nine Months Ended September 30 September 30 (in millions) 1995 1994 1995 1994 Premiums earned* $ 649 $ 598 $ 1,843 $ 1,724 Losses and loss expenses incurred (465) (425) (1,338) (1,290) Underwriting expenses (217) (213) (627) (589) Net underwriting loss (33) (40) (122) (155) Net investment income 105 106 324 320 Other revenues and expenses, net (11) (9) (26) (21) Income from operations before realized gains, facilities exit costs, and income taxes $ 61 $ 57 $ 176 $ 144 *See Glossary of Terms Improved underwriting results were the primary reason for the increase in income from property/casualty operations before realized gains, facilities exit costs, and income taxes in the third quarter and first nine months of 1995 when compared with the same periods of 1994. Over the last several years, management has spent considerable effort improving the overall quality of the book of business. This improvement in the mix of business along with targeted premium growth and continued expense management are the primary contributing factors to the improved underwriting results. Lower catastrophe losses in the first and third quarters were also a major factor in the improvement in the nine-month results. 2.1. Premiums earned Premiums earned totaled $649 million and $1,843 million for the third quarter and first nine months of 1995, respectively, compared with $598 million and $1,724 million for the same periods in 1994. The following table shows the major components of premiums earned and premiums written. Three Months Ended September 30 1995 1994 Premiums Premiums (in millions) Written Earned Written Earned Branch office voluntary production: Direct $548 $518 $506 $492 Ceded reinsurance (36) (42) (33) (36) Net branch office voluntary 512 476 473 456 Discover Re and Victoria 18 19 18 19 Pools and associations 23 20 18 29 Other premium adjustments (10) (1) (7) (2) Total primary 543 514 502 502 Assumed reinsurance: Finite risk 63 69 53 41 Traditional risk 75 66 67 55 Total assumed 138 135 120 96 Total $681 $649 $622 $598 Nine Months Ended September 30 1995 1994 Premiums Premiums (in millions) Written Earned Written Earned Branch office voluntary production: Direct $1,586 $1,500 $1,491 $1,435 Ceded reinsurance (120) (117) (121) (109) Net branch office voluntary 1,466 1,383 1,370 1,326 Discover Re and Victoria 58 57 56 54 Pools and associations 41 56 75 89 Other premium adjustments (18) (1) (19) (4) Total primary 1,547 1,495 1,482 1,465 Assumed reinsurance: Finite risk 161 149 137 115 Traditional risk 213 199 160 144 Total assumed 374 348 297 259 Total $1,921 $1,843 $1,779 $1,724 Premiums earned for the quarter ended September 30, 1995 increased $51 million, or 9 percent, compared with the same period in 1994, while premiums earned in the first nine months of 1995 were $119 million, or 7 percent, higher than in the first nine months of 1994. The increases are largely attributable to the increases in branch office voluntary direct premiums and assumed reinsurance premiums. The year-to-date increases were offset somewhat by first quarter decreases in premiums from voluntary and involuntary pools and associations as a result of reduced participation in these markets. Branch office direct voluntary premiums written in the third quarter of 1995 are over eight percent higher when compared with the corresponding period of 1994. Premiums from new business increased 13 percent in the third quarter of 1995, and retention ratios for both commercial and personal lines improved when compared to the same period in 1994. The decline in premiums seen in previous years was largely the result of management's efforts to eliminate unprofitable business. The growth in 1995 is occurring in higher margin business segments, particularly middle market commercial lines, fidelity/surety and assumed reinsurance, which have been targeted by management to be expanded in a systematic and controlled manner. The table below shows premiums earned and the statutory loss ratios by lines of property/casualty insurance. Three Months Ended September 30 1995 1994 Premiums Statutory Premiums Statutory (dollars in millions) Earned Loss Ratio Earned Loss Ratio Commercial Lines $311 76.3% $306 76.7% Fidelity/Surety 38 46.2 35 37.6 Personal Lines 146 73.1 142 68.9 Discover Re 6 78.8 6 77.2 Victoria 13 76.8 13 66.0 Total primary 514 73.2 502 71.6 Assumed reinsurance 135 65.2 96 69.4 Total $649 71.5% $598 71.2% Nine Months Ended September 30 1995 1994 Premiums Statutory Premiums Statutory (dollars in millions) Earned Loss Ratio Earned Loss Ratio Commercial Lines $ 897 75.8% $ 890 77.3% Fidelity/Surety 105 39.5 93 33.3 Personal Lines 436 76.4 427 80.7 Discover Re 18 78.3 16 77.2 Victoria 39 74.8 39 70.1 Total primary 1,495 73.4 1,465 75.3 Assumed reinsurance 348 68.9 259 64.2 Total $1,843 72.6% $1,724 73.6% 2.2. Underwriting results Underwriting results generally represent premiums earned less incurred losses, loss adjustment expenses, and underwriting expenses. It is not unusual for property/casualty insurance companies to have underwriting losses that are offset by investment income. Underwriting gains (losses) by major business category are as follows: Three Months Ended Nine Months Ended September 30 September 30 (in millions) 1995 1994 1995 1994 Commercial Lines $(40) $(40) $ (103) $ (122) Fidelity/Surety 5 - 14 10 Personal Lines (11) (13) (57) (73) Discover Re - - - - Victoria (2) 1 (4) - Total primary (48) (52) (150) (185) Assumed reinsurance 15 12 28 30 Net underwriting loss $(33) $(40) $ (122) $ (155) Consolidated property/casualty underwriting ratios, calculated based on generally accepted accounting principles ("GAAP") and statutory accounting practices, are as follows: Three Months Ended Nine Months Ended September 30 September 30 1995 1994 1995 1994 GAAP underwriting ratios: Loss ratio 71.5% 71.3% 72.6% 74.8% Expense ratio* 33.4 35.6 34.0 34.2 Combined ratio 104.9 106.9 106.6 109.0 Statutory underwriting ratios: Loss ratio 71.5 71.2 72.6 73.6 Expense ratio 32.7 35.2 33.6 35.0 Combined ratio 104.2 106.4 106.2 108.6 *See Glossary of Terms Underwriting results improved by $7 million in the third quarter and $33 million in the first nine months of 1995 when compared with the same periods of 1994. The results continue to benefit from the overall improvement in the quality and mix of business and continued emphasis on underwriting discipline. The improvement in commercial lines underwriting performance in the first nine months of 1995 resulted from management's targeted business mix strategies, better quality underwriting and adherence to pricing guidelines, particularly in the middle markets. Fidelity/surety's underwriting results improved in the third quarter of 1995, when compared to the same period of 1994, on the strength of increased premiums and reduced underwriting expenses, as a result of management's focus on lowering costs and expanding the surety business. In personal lines, the comparison between third quarter and year-to-date underwriting results for 1995 and 1994 are primarily effected by catastrophe losses. Exclusive of catastrophe losses, personal lines incurred underwriting losses of $9 million and $46 million in the third quarter and first nine months of 1995, compared with $11 million and $43 million in the same periods of 1994. Underwriting results in the third quarter and first nine months of 1995 included $4 million and $41 million of net catastrophe losses, respectively, compared with $15 million and $65 million in the same periods of 1994. The primary businesses incurred catastrophe losses of $11 million in the third quarter of 1995, primarily from Hurricane Erin and tornadoes in the south-central United States. Primary business catastrophe losses for the first nine months of 1995, which also include various second quarter hailstorms, tornadoes and floods, and the April bombing of the federal building in Oklahoma City, totaled $32 million, compared with $57 million in the same period of 1994. The 1994 catastrophe losses in the primary businesses resulted from severe first quarter snow and ice storms. The assumed reinsurance business incurred $6 million of catastrophe losses for Hurricane Luis in the third quarter of 1995, but reduced the reserve for catastrophe losses from the January Kobe, Japan earthquake by $11 million in the quarter. Losses from the Kobe earthquake are currently estimated to be only $1 million. Year-to-date assumed reinsurance net catastrophe losses of $9 million also include further development of $4 million from the February 1994 Los Angeles earthquake, which contributed most of the $8 million of catastrophe losses incurred by the assumed reinsurance business in the first nine months of 1994. Underwriting results showed improvement despite continuing competitive pressures, the inflationary claims environment, and the adverse impact of involuntary markets. Competitive pressures continue to effect underwriting results, especially in the pricing of commercial lines products. 2.3. Loss reserves Reserves for unpaid losses and loss expenses totaled $6.2 billion at September 30, 1995, and approximate the December 31, 1994 position. Exclusive of claims from catastrophe losses, both pending claims and the number of new claims reported have decreased 10 percent since the third quarter of 1994. USF&G categorizes environmental, asbestos and other long term exposures where multiple claims relate to a similar cause of loss (excluding catastrophes) as "common circumstance claims." Reserves for losses that have been reported and certain legal expenses are established on the "case basis." Common circumstance claims which have emerged, while substantial, are a relatively small portion of total claim payments and reserves. The most significant common circumstance claim exposures include negligent construction, environmental, and asbestos claims. Case reserves for these exposures are less than two percent of total reserves for unpaid losses and loss expenses at September 30, 1995. Other common circumstance claim categories stem from a variety of situations such as lead paint, toxic fumes, breast implants, sexual molestation and other disparate causes, provisions for which are included in the total common circumstance case reserves. The following table sets forth selected information for each of the three primary categories, net of ceded reinsurance. Negligent (in millions) Construction Environmental Asbestos Total case and bulk reserves at December 31, 1994 $ 55 $329 $125 Losses incurred - 10 7 Claims (paid) recovered (10) (22) (4) Total case and bulk reserves at September 30, 1995 $ 45 $317 $128 Management believes that USF&G's reserve position is adequate relative to its exposure to environmental and asbestos matters, and compares favorably to other large property/casualty insurers. USF&G's customer base generally does not include large manufacturing companies, which tend to incur most of the known environmental and asbestos exposures. Many of USF&G's environmental claims relate to small industrial or transportation accidents which individually are unlikely to involve material exposures. In addition, USF&G has traditionally been a primary coverage carrier, having written relatively little high-level excess coverage; therefore, liability exposures are generally restricted to primary coverage limits. The level of loss reserves for both current and prior years' claims is continually monitored and adjusted for changing economic, social, judicial and legislative conditions, as well as for changes in historical trends as information regarding such conditions and actual claims develops. Management believes that loss reserves are adequate, but establishing appropriate reserves, particularly with respect to environmental, asbestos and other long-term exposure claims, is highly judgmental and an inherently uncertain process. It is possible that, as conditions change and claims experience develops, additional reserves may be required in the future. There can be no assurance that such adjustments will not have a material adverse effect on USF&G's results of operations or financial condition. 3. Life Insurance Operations Life insurance operations ("F&G Life") represent 14 percent of USF&G's total revenues for the first nine months of 1995 and for the same period of 1994. F&G Life also represents 31 percent of the assets at September 30, 1995 compared with 33 percent at December 31, 1994. F&G Life's financial results were as follows: Three Months Ended Nine Months Ended September 30 September 30 (in millions) 1995 1994 1995 1994 Premiums $ 43 $ 36 $ 125 $ 104 Net investment income 75 77 230 241 Other income - 2 - 2 Policy benefits (86) (93) (282) (286) Underwriting and operating expenses (25) (18) (54) (49) Income from operations before realized gains, facilities exit costs, and income taxes $ 7 $ 4 $ 19 $ 12 Premium increases are resulting from expanded sales and marketing strategies. Policy benefits decreased in the third quarter 1995 by $7 million over the same period from the prior year due to decreases in death benefits and liabilities for future policy benefits, as well as a decrease in interest credited on accounts due to a lower single premium deferred annuity ("SPDA") base. Underwriting and operating expenses increased by $7 million from the prior year quarter due to accelerated amortization of deferred acquisition costs. As profits improve, primarily due to improved investment spreads, the amortization of these costs increases proportionately. The third quarter and nine month declines in net investment income are generally affected by the declining asset base resulting from annuity surrender activity. In addition, the nine month 1994 amount includes $8 million of net investment income from the sale of a timberland investment. In November 1995, F&G Life announced plans for the outsourcing of information services and policy administration. F&G Life expects to enter into an eight- year contract which will result in a financial commitment for F&G Life, primarily based on fixed per policy fees, of approximately $100 million (projected on current policies in force and future sales estimates). The expected benefits of the proposed arrangements include higher customer service levels, reduced time frames to bring products to market, and access to new technologies, in addition to substantial reductions in per policy and new issue costs. F&G Life expects to incur up to $3 million of transition related costs, including separation costs, in the fourth quarter of 1995. 3.1. Sales The following table shows life insurance and annuity sales (premiums and deposits) by distribution system and product type. Three Months Ended Nine Months Ended September 30 September 30 (in millions) 1995 1994 1995 1994 Distribution System: Direct-structured settlements $ 30 $ 24 $ 82 $ 59 Property/casualty brokerage 12 10 48 34 National brokerage 11 13 37 30 National wholesaler 22 22 70 50 Senior distribution 3 - 9 - Other 5 6 20 25 Total $ 83 $ 75 $266 $198 Product Type: Structured settlement annuities $ 30 $ 24 $ 82 $ 59 Single premium deferred annuities 20 21 81 54 Tax sheltered annuities 20 20 64 44 Other annuities 6 4 26 31 Life insurance 7 6 13 10 Total $ 83 $ 75 $266 $198 Sales increased in the third quarter of 1995 by $8 million over the same period in 1994. This increase was led by structured settlement annuities, the large majority of which are sold to structure claims of USF&G's property/casualty operations. F&G Life has continued to develop and introduce new products in its structured settlement and SPDA lines as well as modifying current product offerings to meet customer needs. F&G Life intends to continue to concentrate on the expansion of its existing distribution channels while also creating and developing other marketing networks. Despite F&G Life's attention to expanding its distribution channels and to product development, demand for its products is affected by fluctuating interest rates and the relative attractiveness of alternative investment, annuity or insurance products, as well as its credit ratings. As a result, there is no assurance that the improved sales trend will continue at the same level. Total life insurance in force was $11.5 billion at September 30, 1995 and $11.8 billion at December 31, 1994. 3.2. Policy surrenders Deferred annuities and universal life products are subject to surrender. Nearly all of F&G Life's surrenderable annuity policies allow a refund of the cash value balance less a surrender charge. The surrender charge varies by product. SPDAs, which represent 62 percent of surrenderable business, have surrender charges that decline from six percent in the first policy year to zero percent in the seventh and later policy years. Newer products that have been issued during 1994 and 1995 have surrender charges that decline from nine percent in the first policy year to zero percent in the tenth and later policy years. Such built-in surrender charges provide protection against premature policy surrender. Policy surrenders totaled $108 million and $461 million for the quarter and nine months ended September 30, 1995, respectively. This compares with $170 million and $388 million for the same periods in 1994. Management has implemented a policy conservation program that provides policyholders with a competitive renewal option within F&G Life once their surrender charge period has expired for this block. Due to the fluctuating interest rate environment, this option was suspended on January 1, 1995, and subsequently reinstituted as of July 1, 1995. As of September 30, 1995, based on surrender experience beginning in 1993, policyholders representing approximately 18 percent of the expiring block had elected this option. An additional 27 percent of the expiring block was retained under the terms of the original contract, free of surrender charges and at interest rates which are adjusted annually. The total account value of F&G Life's deferred annuities is $2.1 billion, 22 percent of which is surrenderable at current account value (i.e., without surrender charges). The surrender charge period on $1.0 billion of the large block of SPDAs expires through the end of 1996, of which $288 million expires during the remainder of 1995. The experience thus far for $1.1 billion of SPDAs where the surrender charge period expired in the fourth quarter of 1993 through the third quarter of 1995 indicates that, on average, 55 percent of the expiring block may surrender; however, in the future, a larger percentage may surrender should interest rates trend upward. While this will put pressure on F&G Life's ability to increase assets, given the relatively high interest rates credited when these annuities were issued, overall profit margins would continue to improve as policyholders surrender or rollover to new products with lower rates. Management believes that F&G Life, with a liquid assets to surrender value ratio of 136 percent at September 30, 1995, continues to maintain a high degree of liquidity and has the ability to meet surrender obligations for the foreseeable future. 4. Parent and Noninsurance Operations Parent company interest and other unallocated expenses and net results from noninsurance operations were as follows: Three Months Ended Nine Months Ended September 30 September 30 (in millions) 1995 1994 1995 1994 Parent Company Expenses: Interest expense $ (11) $ (9) $ (32) $ (24) Unallocated expense, net (11) (17) (35) (37) Noninsurance Operations 1 4 4 1 Loss from operations before realized gains, facilities exit costs, and income taxes $ (21) $ (22) $ (63) $ (60) The results for parent and noninsurance operations for the nine months ended September 30, 1995 show an increase in loss from operations of $3 million when compared to the nine months ended September 30, 1994. This increase is primarily due to an $8 million increase in interest expense as a result of the higher short-term interest rate environment and the refinancing of corporate debt in 1994 and 1995 from floating rates to fixed rates. This increase is offset by a $2 million decrease in unallocated expenses as well as an improvement in the results of noninsurance operations of $3 million. Unallocated expenses for the third quarter of 1995 decreased due to a $9 million loss incurred on long-term subleases recognized in the corresponding quarter of 1994. 5. Investments At September 30, 1995, USF&G's investment mix is comparable with year-end 1994. Long-term fixed maturities comprise 84 percent and 83 percent of total investments at September 30, 1995 and December 31, 1994, respectively. The table below shows the distribution of USF&G's investment portfolio. (dollars in millions) At September 30, 1995 At December 31, 1994 Total investments $10,921 $10,561 Fixed maturities: Held to maturity 42% 44% Available for sale 42 39 Total fixed maturities 84 83 Common and preferred stocks 1 1 Short-term investments 4 4 Mortgage loans and real estate 7 9 Other invested assets 4 3 Total 100% 100% 5.1. Net investment income The following table shows the components of net investment income. Three Months Ended Nine Months Ended September 30 September 30 (dollars in millions) 1995 1994 1995 1994 Net investment income from: Fixed maturities $165 $168 $497 $508 Equity securities 1 6 3 7 Short-term investments 5 3 16 10 Real estate and mortgage loans 11 10 35 44 Other, less expenses (3) - (5) (5) Total $179 $187 $546 $564 Average yields (annualized): 6.9% 6.9% 6.8% 6.9% Investment income from fixed maturities has decreased due to an asset base which declined throughout 1994 in order to meet SPDA surrenders and other cash flow needs. Average annualized yields on fixed maturities were 7.4 percent and 7.3 percent for the nine months ended September 30, 1995 and 1994, respectively. Interest on short-term investments has increased due to higher short-term yields. Investment income from equity securities has decreased due to deferred dividend income on preferred stock that was recorded in the third quarter of 1994. Other income less expenses declined for the third quarter due to a $4 million increase in interest credited to funds withheld on assumed reinsurance contracts. Other income less expenses for the nine months ended September 30, 1995 and 1994 includes $21 million and $11 million, respectively, of income relating to USF&G's share of earnings from an equity interest in Renaissance Re. Included in investment income on real estate and mortgage loans for the first nine months of 1994 is $8 million related to timberland investments in F&G Life which were sold in 1994. 5.2. Realized gains (losses) The components of net realized gains (losses) include the following: Three Months Ended Nine Months Ended September 30 September 30 (in millions) 1995 1994 1995 1994 Net gains (losses) from sales: Fixed maturities $ 3 $ - $ 3 $ 3 Equity securities - - 2 - Real estate and other 2 1 14 13 Total net gains 5 1 19 16 Impairments: Fixed maturities (2) - (2) (1) Real estate and other - (1) (10) (9) Total impairments (2) (1) (12) (10) Net realized gains $ 3 $ - $ 7 $ 6 Real estate and other realized gains of $14 million for the first nine months of 1995 primarily relate to USF&G's equity in the realized gains of certain limited partnership investments. Realized gains on real estate and other investments for the first nine months of 1994 resulted from F&G Life's sale of timberland investments and USF&G's portion of realized gains from investments in limited partnerships. Provisions for impairment relate to certain investments, declines in the fair value of which are judged to be other than temporary. 5.3. Unrealized gains (losses) The components of the changes in unrealized gains (losses) were as follows: Nine Months Ended September 30 (dollars in millions) 1995 Fixed maturities available for sale $ 261 Deferred policy acquisition costs adjustment (54) Equity securities 3 Total $ 210 Fixed maturity investments classified as "available for sale" are recorded at market value with the unrealized gains (losses) reported as a component of shareholders' equity. An average interest rate decrease of 171 basis points on two to 30 year maturities during the first nine months of 1995 reduced the prior year's unrealized loss on fixed maturities available for sale from $184 million to an unrealized gain of $77 million at September 30, 1995. This was partially offset by a related change in F&G Life's DPAC adjustment from the prior year's unrealized gain of $33 million to an unrealized loss of $21 million at September 30, 1995. This adjustment is made to reflect assumptions about the effect of potential asset sales of fixed maturities available for sale on future DPAC amortization. 5.4. Fixed maturity investments The tables below detail the composition of the fixed maturity portfolio. (dollars in millions) At September 30, 1995 At December 31, 1994 Corporate investment-grade bonds $5,181 57% $5,031 56% Mortgage-backed securities 1,964 22 1,921 22 Asset-backed securities 1,023 11 942 11 U.S. Government bonds 309 3 286 3 High-yield bonds* 605 7 616 7 Tax-exempt bonds 46 - 121 1 Other - - 7 - Total fixed maturities at amortized cost 9,128 100% 8,924 100% Total market value of fixed maturities 9,234 8,365 Net unrealized gains (losses) $ 106 $ (559) Percent market-to-amortized cost 101% 94% *See Glossary of Terms At September 30, 1995 At December 31, 1994 Net Net Amortized Market Unrealized Amortized Market Unrealized (in millions) Cost Value Gain Cost Value (Loss) Fixed maturities: Held to maturity $4,547 $4,576 $ 29 $4,659 $4,284 $(375) Available for sale 4,581 4,658 77 4,265 4,081 (184) Total $9,128 $9,234 $106 $8,924 $8,365 $(559) Decreasing interest rates, which resulted in rising bond prices, were responsible for the seven percentage point increase in the fixed maturity portfolio's overall market-to-amortized cost ratio from December 31, 1994. Debt obligations of the U.S. Government and its agencies and other investment- grade bonds comprised 93 and 92 percent of the portfolio at September 30, 1995 and December 31, 1994, respectively. The following table shows the credit quality of the long-term fixed maturity portfolio as of September 30, 1995. Percent Market-to- Amortized Market Amortized (dollars in millions) Cost Percent Value Cost U.S. Government and U.S. Government Agencies $2,163 24% $2,196 102% AAA 1,454 16 1,473 101 AA 1,377 15 1,384 100 A 2,511 28 2,546 101 BBB 1,018 10 1,046 103 Below BBB 605 7 589 97 Total $9,128 100% $9,234 101% USF&G's holdings in high-yield bonds comprised seven percent of the total fixed maturity portfolio at September 30, 1995 and December 31, 1994. Of the total high-yield bond portfolio, 70 percent is held by the life insurance segment, representing 10 percent of F&G Life's total investments. The table below illustrates the credit quality of USF&G's high-yield bond portfolio as of September 30, 1995. Percent Market-to- Amortized Market Amortized (dollars in millions) Cost Percent Value Cost BB $348 58% $337 97% B 252 42 247 98 CCC and lower 5 - 5 100 Total $605 100% $589 97% The information on credit quality in the preceding two tables is based upon the higher of the rating assigned to each issue of fixed-income maturities by either Standard & Poor's or Moody's. Where neither Standard & Poor's nor Moody's has assigned a rating to a particular fixed maturity issue, classification is based on 1) ratings available from other recognized rating services; 2) ratings assigned by the NAIC; or 3) an internal assessment of the characteristics of the individual security, if no other rating is available. At September 30, 1995, USF&G's five largest investments in high-yield bonds totaled $100 million in amortized cost and had a market value of $84 million. None of these investments individually exceeded $30 million. USF&G's largest single high-yield bond exposure represented five percent of the high-yield portfolio and 0.3 percent of the total fixed maturity portfolio. 5.5. Real estate The table below shows the components of USF&G's real estate portfolio. (in millions) At September 30, 1995 At December 31, 1994 Mortgage loans $ 160 $ 349 Equity real estate 749 760 Reserves (95) (98) Total $ 814 $1,011 The decrease in real estate from the prior year is primarily due to first quarter 1995 sales of two properties. Approximately $140 million of the decrease in mortgage loans from the prior year is due to the securitization of certain fixed-rate, multi-family mortgages into commercial mortgage-backed securities backed by the FNMA. These mortgage-backed securities were classified on the balance sheet as fixed maturities available for sale at September 30, 1995, and were sold in October, 1995. Also contributing to the decrease from the prior year is the prepayment of a loan, and the foreclosure of a loan, which is now included in equity real estate. USF&G's real estate investment strategy emphasizes diversification by geographic region and property type. The diversification of USF&G's mortgage loan and real estate portfolio at September 30, 1995, is as follows: Geographic Region Type of Property Development Stage Pacific/Mountain 37% Office 40% Operating property 69% Midwest 24 Land 31 Land packaging 19 Mid-Atlantic 16 Apartments 15 Land development 12 Southeast 11 Industrial 6 Southwest 6 Retail/other 5 Northeast 6 Hotel 3 Real estate investments are generally appraised at least once every three years. Appraisals are obtained more frequently under certain circumstances such as significant changes in property performance or market conditions. All of these appraisals are performed by professionally certified appraisers. At September 30, 1995, USF&G's five largest real estate investments had a book value of $325 million. The largest single investment was a land development project located in San Diego, California with a book value of $94 million, or ten percent of the total real estate portfolio. Mortgage loans and real estate investments not performing in accordance with contractual terms, or performing significantly below expectation, are categorized as nonperforming. The level of nonperforming real estate investments at September 30, 1995 is consistent with December 31, 1994. The book value of the components of nonperforming real estate are as follows: (dollars in millions) At September 30, 1995 At December 31, 1994 Real estate acquired through foreclosure or deed-in-lieu of foreclosure* $116 $117 Land investments* 56 56 Nonperforming equity investments* 33 35 Total nonperforming real estate $205 $208 Real estate valuation allowance $(95) $(98) Reserves/nonperforming real estate 46% 47% *See Glossary of Terms Valuation allowances are established for impairments of mortgage loans and real estate equity values based on periodic evaluations of the operating performance of the properties and their exposure to declines in value. The allowance totaled $95 million, or 12 percent of the net real estate portfolio at September 30, 1995, and $98 million, or ten percent of the net real estate portfolio at December 31, 1994. In light of USF&G's current plans with respect to the portfolio, management believes the allowance at September 30, 1995 continues to adequately reflect the current condition of the portfolio. Should deterioration occur in the general real estate market or with respect to individual properties in the future, or plans with respect to individual properties change, additional reserves may be required. Prospectively, efforts will continue to reduce risk and increase yields in the real estate portfolio by selling equity real estate when it is advantageous to do so and reinvesting the proceeds in medium-term mortgage loans. 6. Financial Condition 6.1. Assets USF&G's assets totaled $14.6 billion at September 30, 1995, compared with $14.0 billion at December 31, 1994. The increase is primarily due to a $261 million increase in the market value of fixed maturity investments available for sale. In addition, reinsurance receivables and other liabilities increased $203 million due to the reclassification of certain related receivables and payables. 6.2. Debt USF&G's corporate debt totaled $603 million at September 30, 1995, compared with $586 million at December 31, 1994. The increase in debt resulted primarily from $14 million of foreign currency translation adjustments from non-U.S. dollar denominated debt. As a result of entering into currency forward agreements, there was no effect on net income from translation of non-U.S. dollar denominated debt. USF&G's real estate and other debt totaled $20 million at September 30, 1995 and $42 million at December 31, 1994. The decrease of $22 million since year-end relates to Victoria's line of credit which was repaid in full during the second quarter of 1995 and the defeasance of $10 million of real estate bonds during the third quarter of 1995. During October 1995, USF&G purchased approximately $4.8 million of its outstanding 7% Senior Notes. In addition, during November 1995, USF&G purchased approximately $11 million of the 5 1/2% Swiss Franc Bonds. Both purchases were accomplished through the use of excess corporate cash. 6.3. Shareholders' equity USF&G's shareholders' equity totaled $1.8 billion at September 30, 1995, compared with $1.4 billion at December 31, 1994. The increase is primarily the result of an approximately $261 million increase in unrealized gains on fixed maturity investments available for sale less a $54 million change in the related life insurance segment deferred policy acquisition costs adjustment. In addition, shareholders' equity increased due to net income of $144 million less $41 million in common and preferred stock dividends for the nine months ended September 30, 1995. 6.4. Capital transactions At December 31, 1994, USF&G had outstanding 1.3 million shares of its Series C Preferred Stock. In February 1995, these shares were converted into approximately 5.5 million shares of common stock. During the second quarter of 1995, in exchange for all of the outstanding equity of Discover Re and Victoria, respectively, USF&G issued another 5.4 million and 3.8 million shares of common stock. During August 1995, 189,800 shares of USF&G's Series B Cumulative Convertible Preferred Stock ("Series B Stock") were converted into 1.6 million shares of common stock, and on October 11, 1995, USF&G called for redemption 75 percent, or 832,650 shares of its remaining outstanding Series B Stock. As a result, on November 9, the shares of Series B Stock called were converted into 6.9 million shares of USF&G's common stock. The balance of the shares of Series B Stock are not subject to redemption prior to June 1996. 7. Liquidity 7.1. Cash flow from operations USF&G had cash flow from operations of $159 million and $315 million for the quarter and nine month periods ended September 30, 1995, compared with cash flow from operations of $43 million and $40 million for the same periods in 1994. Cash flow improved over the nine months ended September 30, 1995 primarily due to a $78 million improvement in net reinsurance activity which relates to an increase in assumed reinsurance written premium of $77 million over the prior year. In addition, the increase is due to favorable experience in losses, loss expenses, and policy benefits paid over the quarter and nine months ended September 30, 1995. 7.2. Credit facilities At September 30, 1995, USF&G maintained a $250 million committed credit facility with a group of foreign and domestic banks. This represents a reduction of the credit facility from $400 million at December 31, 1994. Management elected to reduce the size of the facility due to the reduction in borrowings against it and USF&G's expanded access to capital markets. Borrowings outstanding under the credit facility, which totaled $215 million at December 31, 1994, were repaid in full during the second quarter of 1995. The credit agreement contains restrictive covenants pertaining to indebtedness, tangible net worth, liens and other matters. USF&G was in compliance with these covenants at September 30, 1995 and December 31, 1994. In addition, at September 30, 1995, USF&G maintained a $100 million foreign currency credit facility and a $50 million letter of credit facility. At September 30, 1995, there were no borrowings on the foreign currency credit facility; the balance outstanding on the letter of credit facility was $8 million. 7.3. Marketable securities USF&G's fixed-income, equity security, and short-term investment portfolios are liquid and represent substantial sources of cash. The market value of its fixed-income securities was $9.2 billion at September 30, 1995, which represents 101 percent of its amortized cost. At September 30, 1995, equity securities, which are reported at market value in the balance sheet, totaled $64 million. Short-term investments totaled $399 million. 7.4. Liquidity restrictions There are certain restrictions on payments of dividends by insurance subsidiaries that may limit USF&G Corporation's ability to receive funds from its subsidiaries. Under the Maryland Insurance Code, Maryland insurance subsidiaries, such as United States Fidelity and Guaranty Company ("USF&G Company") and F&G Life, must provide the Maryland Insurance Commissioner (the "Commissioner") with not less than thirty days' prior written notice before payment of an "extraordinary dividend" to its holding company. "Extraordinary dividends" are dividends which, together with any dividends paid during the immediately preceding twelve month period, would be in excess of 10% of the subsidiary's statutory policyholders' surplus as of the prior calendar year end. Extraordinary dividends may not be paid until such thirty day period has expired and the Commissioner has not disapproved the payment, or the Commissioner has approved the payment within such period. In addition, ten days' prior notice of any dividend must be given to the Commissioner prior to payment, and the Commissioner has the right to prevent payment of such dividend if it is determined that such payment could impair the insurer's surplus or financial condition. Effective June 1, 1995 and with the consent of the Maryland Insurance Commissioner, USF&G Company, the principal property/casualty subsidiary of USF&G, declared an extraordinary dividend payable to USF&G Corporation consisting of all of the issued and outstanding capital stock of F&G Life. Prior to the payment of such dividend, F&G Life was a wholly-owned subsidiary of USF&G Company. As a result of such dividend payment, F&G Life is now a direct, wholly-owned subsidiary of USF&G Corporation. In addition, because any dividends paid during the immediately preceding twelve month period are considered when determining whether future dividends constitute extraordinary dividends, any dividends which USF&G Company would propose to pay in the twelve month period beginning June 1, 1995 would be deemed extraordinary dividends and subject to the thirty-day notice period described above. During 1995, approximately $33 million in dividends are available for payment to USF&G Corporation from F&G Life without providing the notice required for extraordinary dividends. As of September 30, 1995 dividends of approximately $25 million have been paid to USF&G Corporation by F&G Life. The application of the thirty-day notice requirement to any dividends of USF&G Company is not expected to materially affect the liquidity of USF&G Corporation. In addition to the extraordinary dividend paid on June 1, dividends of approximately $83 million have been paid as of September 30, 1995 to USF&G Corporation by USF&G Company. 8. Regulation USF&G's insurance subsidiaries are subject to extensive regulatory oversight in the jurisdictions where they do business. This regulatory structure, which generally operates through state insurance departments, involves the licensing of insurance companies and agents, limitations on the nature and amount of certain investments, restrictions on the amount of single insured risks, approval of policy forms and rates, setting of capital requirements, limitations on dividends, limitations on the ability to withdraw from certain lines of business such as personal lines and workers' compensation, and other matters. From time to time, the insurance regulatory framework has been the subject of increased scrutiny. At any one time there may be numerous initiatives within state legislatures or state insurance departments to alter and, in many cases, increase state authority to regulate insurance companies and their businesses. Proposals to adopt a federal regulatory framework have also been discussed. It is not possible to predict the future impact of increasing state or potential federal regulation on USF&G's operations. Additional information regarding legal and regulatory contingencies may be found in Note 9, "Legal Contingencies," to the condensed consolidated financial statements, as well as in USF&G's Annual Report to Shareholders (Restated) for the year ended December 31, 1994. 9. Glossary of Terms Account value: Deferred annuity cash value available to policyholders before the assessment of surrender charges. Catastrophe losses: Property/casualty insurance claim losses resulting from a sudden calamitous event, such as a severe storm, are categorized as "catastrophes" when they meet certain severity and other criteria determined by a national organization . Expense ratio: The ratio of underwriting expenses to net premiums written, if determined in accordance with statutory accounting practices ("SAP"), or the ratio of underwriting expenses (adjusted by deferred policy acquisition costs) to earned premiums, if determined in accordance with GAAP. High-yield bonds: Fixed maturity investments with a credit rating below the equivalent of Standard & Poor's "BBB". In addition, nonrated fixed maturities that, in the judgment of USF&G, have credit characteristics similar to those of a fixed maturity rated below BBB are considered high-yield bonds. Involuntary pools and associations: Property/casualty insurance companies are required by state laws to participate in a number of assigned risk pools, automobile reinsurance facilities, and similar mandatory plans ("involuntary market plans"). These plans generally require coverage of less desirable risks, principally for workers' compensation and automobile liability, that do not meet the companies' normal underwriting standards. As mandated by legislative authorities, insurers generally participate in such plans based upon their shares of the total writings of certain classes of insurance. Liquid assets to surrender value: GAAP liquid assets (publicly traded bonds, stocks, cash, and short-term investments) divided by surrenderable policy liabilities, net of surrender charges. A measure of a life insurance company's ability to meet liquidity needs in case of policy surrenders. Loss ratio: The ratio of incurred losses and loss adjustment expenses to earned premiums, determined in accordance with SAP or GAAP, as applicable. The difference between SAP and GAAP relates to deposit accounting for GAAP related to financial reinsurance assumed. Nonperforming real estate: Mortgage loans and real estate investments that are not performing in accordance with their contractual terms or that are performing or projected to perform at an economic level significantly below expectations. Included in the table of nonperforming real estate are the following terms: Deed-in-lieu of foreclosure: Real estate to which title has been obtained in satisfaction of a mortgage loan receivable in order to prevent foreclosure proceedings. Land investments: Land investments that are held for future development where, based on current market conditions, returns are projected to be significantly below original expectations. Nonperforming equity investments: Equity investments with cash and GAAP return on book value less than five percent, but excluding land investments. Policyholders' surplus: The net assets of an insurer as reported to regulatory agencies based on accounting practices prescribed or permitted by the National Association of Insurance Commissioners and the state of domicile. Premiums earned: The portion of premiums written applicable to the expired period of policies. Premiums written: Premiums retained by an insurer. Underwriting results: Property/casualty pretax operating results excluding investment results, policyholders' dividends, and noninsurance activities; generally, premiums earned less losses and loss adjustment expenses incurred and "underwriting" expenses incurred. USF&G Corporation Part II. Other Information Item 6. Exhibits and Reports on Form 8-K (a) Exhibits. Exhibit 11. Computation of Earnings per Share. Exhibit 12. Computation of Ratio of Consolidated Earnings to Fixed Charges and Preferred Stock Dividends. Exhibit 15. Letter Regarding Unaudited Interim Financial Information. (b) Reports on Form 8-K. On October 12, 1995, the Registrant filed a Form 8-K, reporting under Item 5, Other Events, a press release announcing call of shares of Series B Cumulative Convertible Preferred Stock. USF&G Corporation Exhibit 11 - Computation of Earnings Per Share (Unaudited) Nine Months Ended September 30 (dollars in millions except per share data) 1995 1994* Net Income Available to Common Stock Primary: Net income $ 144 $ 173 Less preferred stock dividend requirements (23) (36) Net income available to common stock $ 121 $ 137 Fully Diluted: Net income $ 144 $ 173 Less preferred stock dividend requirements (12) (12) Add interest expense on convertible notes 5 3 Net income available to common stock $ 137 $ 164 Weighted Average Shares Outstanding Primary Common Shares 109,769,809 94,077,236 Fully Diluted: Common shares 109,769,809 94,077,236 Assumed conversion of preferred stock 11,557,477 22,492,438 Assumed exercise of stock options 2,107,729 1,038,797 Assumed conversion of zero coupon convertible subordinated notes 7,227,255 5,621,198 Total 130,662,270 123,229,669 Earnings Per Common Share Primary (A) $ 1.10 $ 1.45 Fully Diluted (B) $ 1.04 $ 1.33 *1994 amounts have been restated to reflect mergers with Discover Re Managers, Inc., and Victoria Financial Corporation, which were completed during the second quarter of 1995. Restatement of prior periods is required due to the application of the pooling-of-interests method of accounting. (A) Shares issuable under stock options (1,122,655 shares in 1995 and 1,038,797 in 1994) have not been used as common stock equivalents in the computation of primary earnings per common share presented on the face of the Condensed Consolidated Statement of Operations because the dilutive effect is not material. (B) Fully diluted earnings per common share amounts are calculated assuming the conversion of all securities whose contingent issuance would have a dilutive effect on earnings. The calculations assume the conversion of preferred stock series B and C and the zero coupon convertible subordinated notes, as well as shares issuable under stock options. USF&G Corporation Exhibit 12 - Computation of Ratio Consolidated Earnings to Fixed Charges and Preferred Stock Dividends Nine Months Ended September 30 (dollars in millions) 1995 1994* Fixed Charges Interest expense $ 34 $ 27 Portion of rents representative of interest 15 20 Total fixed charges 49 47 Preferred stock dividend requirements (A) 23 36 Combined Fixed Charges and Preferred Stock Dividends $ 72 $ 83 Consolidated Earnings Available for Fixed Charges and Preferred Stock Dividends Income from operations before income taxes $ 145 $102 Adjustment: Fixed charges 49 47 Consolidated earnings available for fixed charges and preferred stock dividends $ 194 $149 Ratio of Consolidated Earnings to Fixed Charges 3.9 3.2 Ratio of Consolidated Earnings to Combined Fixed Charges and Preferred Stock Dividends 2.7 1.8 * 1994 amounts have been restated to reflect mergers with Discover Re Managers, Inc., and Victoria Financial Corporation, which were completed during the second quarter of 1995. Restatement of prior periods is required due to the application of the pooling-of-interests method of accounting. (A) Preferred stock dividends of $23 million in 1995 and $36 million in 1994 divided by 100% less the effective income tax rate of 0.6% in 1995 and 0% in 1994. USF&G Corporation Exhibit 15 - Letter Regarding Unaudited Interim Financial Information USF&G Corporation We are aware of the incorporation by reference in the Registration Statement Numbers 33-20449, 33-9405, 33-33271, 33-21132, 33-51859 and 33-63333 on Form S-3 and Numbers 2-61626, 2-72026, 2-98232, 33-16111, 33-35095, 33-38113, 33-43132, 33-45664, 33-45665, 33-61965, 33-55667, 33-55669, 33-55671 and 33-59535 on Form S-8 of our report on the unaudited condensed consolidated interim financial statements of USF&G Corporation which is included in its Form 10-Q for the quarter ended September 30, 1995. Pursuant to Rule 436(c) of the Securities Act of 1933, our report is not a part of the registration statements prepared or certified by accountants within the meaning of Section 7 or 11 of the Securities Act of 1933. ERNST & YOUNG LLP Baltimore, Maryland November 14, 1995 USF&G Corporation Signature Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Quarterly Report to be signed on its behalf by the undersigned, thereunto duly authorized. USF&G Corporation By DAN L. HALE Dan L. Hale Executive Vice President and Chief Financial Officer Dated at Baltimore, Maryland November 14, 1995 EX-27 2
7 1000000 9-MOS DEC-31-1995 SEP-30-1995 4658 4547 4576 64 160 654 10921 97 757 475 14560 9832 1051 10 81 623 281 0 256 1219 14560 1968 546 7 38 1620 538 228 145 1 144 0 0 0 144 1.10 1.04 5142 1487 (149) 374 970 5136 (149)
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